Sexton wanted to erect a new building to make extra profits and increase the value of the building he inherited at 503 Cricket Road. He planned to convert the rooming house into a 14-unit, 5-story apartment house. What challenges did Sexton had to face in materializing his plan?
William J. Poorvu and Donald A. Brown
Harvard Business Review (396001-PDF-ENG)
August 29, 1995
Case questions answered:
- How and why does Sexton change his initial plan over time with regard to the property at 503 Cricket Road?
- How does Sexton’s expected return on investment evolve as his setup is revised over time?
- Looking at his latest setup, do you have any comments as to its financial implications?$1,050,000 loan?
- How did he figure the land value he is using?
- Is there a point in time where he should consider quitting pursuing his idea?
- Are the design /construction materials changes made by Sexton affecting the marketability of his units? In your view, if there are any, what are they?
- On what sources is he relying to validate the existence of a market for his project?
- Who is his most likely target among university students
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Case answers for 503 Cricket Road
Question 1: How and why does Sexton change his initial plan over time with regard to the property at 503 Cricket Road?
At first, Sexton was able to remodel the building at 503 Cricket Road, which led to an increase of 25% – 40% in rent. This move increased his profit. However, the building continued to age and deteriorate. It leads to a decrease in profit because of a high maintenance cost. Sexton wanted to erect a new building to make extra profits and increase the value of the building he inherited. He visited architectures and read all the zoning laws that must be applied to be able to build the housing. He also saw a contractor (most experienced) and concluded a cost of $630k.
Sexton then had to change his original plan because:
- All plans must be accepted by the City Planning Commission (Landscape architect $5k)
- March 2003, real estate was in a downturn; however, by spring 2003, the pace picked up again, which led to an increase to Sextons cost by $120k over his estimates.
- Sexton had to reinforce his spread footings that had to go down 40 feet (Increase cost by $50k)
This dilemma led Sexton to act on the problem and change his original plan by making the kitchens smaller, Taking out all the dishwashers and garbage disposal units, eliminating all the ceramic tile work, and replacing the electric switches with less costly one.
Also, development costs for the property at 503 Cricket Road were $850k, and then it increased to $940k, which meant Sexton could get a $700k loan. Also, the ROE is 6%, which is not that good, so he will have to also increase his rent to increase the ROE or decrease expenses (Another change in plan).
Question 2: How does Sexton’s expected return on investment evolve as his setup is revised over time?
Before the market changed, investment was $220k with a construction cost of $850k and a loan of $630k.
The NOI is 90,034 with an ADS of $60,921 (PV = $630k, Mortgage Constant = 9.67%, n = 25 years)
NOI – ADS = $29,112 cash after debt
Cash after debt / Capital ($220k) = 13%
After the market, construction costs $940k with a loan of $700K and an equity of $240k.
Cash after debt = $14,630
Equity = $240,000
Cash after debt / Equity = 6.1%
We can notice a decrease in ROE because OPEX has increased by 7,714$, which led to a decline in NOI. Moreover, we can see an increase in ADS and Equity investment, which led to a decrease in ROE.
Question 3: Looking at his latest setup, do you have any comments as to its financial implications?$1,050,000 loan?
The latest financial setup has differed a lot from the original setup. We can notice there is an obvious increase in ADS, equity investment, and OPEX. This all led to a decrease in NOI and cash after debt. To be able to achieve the original setup, he will have to increase his rents above $700. The approximate new rent must between $740 – $760. According to the market, this price is reasonable. For the students, they are willing to pay for anything as long as it is near to the university.
On the other hand, comparing the rent at 503 Cricket Road to other properties surrounding the location is pretty much a high rent. Overall, according to Appendix A, there is a high possibility the value of the property might…