The case study describes the inexperienced Edwards Alexander entering the real estate business in June 2013. The case study solution addresses his process of finding, evaluating, and lastly acquiring a four-unit building in need of renovation in Pinckney Street in the Beacon Hill area of Boston.
William J. Poorvu; Arthur I Segel; John H. Vogel Jr.; Lisa Strope
Harvard Business Review (813182-PDF-ENG)
May 31, 2013
Case questions answered:
Case study questions answered in the first and second solutions:
- How did Lee go about searching for a property? What difficulties and disappointments did he encounter? What conclusions can you draw about the ease or difficulty of the search in general, as well as for someone at Lee’s stage of an investing career?
- Enumerate and explain the risks and rewards associated with the Pinckney Street property.
- Take a look at the numbers, now…
a.)In ONE column of an Excel sheet, do your own verification that Lee has insufficient cash to get into the deal. Assume he receives Bicego’s loan for $1,050,000 and seller financing for $200,000. List all of the expenses that Lee will face during the acquisition and first six months of ownership (renovation period) of the property and compare those expenses to his sources of capital (bank loan, seller loan, and personal savings). [In calculating the mortgage payment obligations, note that both the bank and the seller agree to allow Lee to make only interest payments during the first six months of their respective loans, and then require full amortization (principal plus interest) over the remaining 354 months].
b.) In another Excel column, calculate the cash flows after financing during a single year of operations, once renovations are complete – that is, the cash flows from operations (given in Exhibit 1) minus the annual obligations to Bicego’s bank and to the seller financing.
c.) What are some of the biggest red flags you see from the cash flow assumptions from acquisition/renovations and operations? Are you satisfied with the cushion you calculated in part (b)?
- What do you believe are the biggest flaws in Lee’s thinking? (more broadly, not just in regards to the numbers)
Case study questions answered in the third solution:
- How would you evaluate the Pinckney Street property? Pros and cons? What are the risks and rewards associated with it?
- Prepare a “Setup” (means cash flow, = sources, and uses of funds) and evaluate the result of your calculations. There are 2 steps:
a.) How much cash down is needed at acquisition time, (table 1) and
b.) the expected annual cash flow generated after expenses and debt service (table 2).
- Compare the effects of the different mortgages and their implications: $1 million versus $1,050,000 loan:
a.) what is the annual financing cost for each?
b.) If you deduct them from the annual cash flow calculated in table 2 above, what is the actual return on equity for each alternative? (it is called Cash flow after finance, = CFAF) or sometimes cash on cash return, or sometimes equity dividend; 3 terms for the same thing.
c.) Implications from the FINA point of view?
- Does this investment make sense for Banay?
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Pinckney Street Case Answers
This case solution includes an Excel file with calculations.
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How did Lee go about searching for a property? What difficulties and disappointments did he encounter? What conclusions can you draw about the ease or difficulty of the search in general, as well as for someone at Lee’s stage of an investing career?
Lee spent evenings and weekends becoming familiar with the area. He referenced the 2010 Census to learn more about the general demographics, education, employment, marital status, income, length of stay, and ethnic background of residents of the area. He referenced maps to check the distance of nearby areas, such as shopping centers, entertainment centers, and other urban amenities.
He also searched online, using resources such as Trulia.com and Realtor.com for values and sales of properties; Bankrate.com for mortgage rates; Boston.com’s Multiple Listing Service for nearby listings; and popular site Zillow.com for recent sales and to compare properties. Finally, Lee discovered viable brokers by sifting through newspapers and visiting offices for suggestions.
Lee encountered several difficulties and disappointments while searching for a property. While many properties appeared promising on paper, Lee often found them in a more miserable condition when seeing them in person. As far as finances, income statements were misleading – one even failed to include costs of maintenance. Lenders were unwilling to lend more than 70-80% of the capitalized value. Lee himself didn’t have enough capital on hand for many properties. In addition, he found that real estate brokers often gave their best advice to their biggest customers, and real estate brokers also invested in real estate themselves, disincentivizing them to offer him the best deals present in the market.
From reading about Lee’s experience searching for a property, we can conclude that it is rather tricky to discover a property that is compatible with one’s financing ability as well as their property wish list. As a first-time investor in real estate, there is a lot of information to take in. Lee utilized many resources available to him, including the internet, newspapers, local realtors, and banks, yet he got differing opinions from his sources.
The real estate market is not black and white. Thus a lot of research is necessary in order to make a smart decision. In addition to the abundance of information, a first-time real estate investor faces experienced competition with higher amounts of expendable capital. The competition is notified of the majority of deals earlier than first-time investors, making it challenging to access high-potential deals.
Enumerate and explain the risks and rewards associated with the Pinckney Street property.
Our team has identified various risks and rewards after assessing the potential of the Pinckney Street property.
In terms of rewards, the property is located in an improving neighborhood, is in a prime location, and is aesthetically pleasing. The value of the property is likely to increase over time because it is in an improving neighborhood. The site is prime because the building gets natural lighting on two sides, and the top has a view of the Boston Harbor, both of which increase the value of his property. Finally, the property is aesthetically pleasing in its current state. The building has a history having been built in 1804, and with the ongoing renovations, it will have a modern interior look that many buyers will find appealing.
In terms of risks, the property is exposed to risk in the form of renovations, which are necessary due to its age and damage resulting from a fire in 2010, in the way of being located in a risky neighborhood; and being at the very end of Lee’s price range. The renovations required for this property are capital intensive at $450,000, which is approximately one-third of the property value. Due to the renovations, Lee will generate zero income for the first six months, and the renovations may not provide the return on investment he is hoping for. Secondly, although the neighborhood is improving, there is a risk that property values will not increase. Finally, this property is at the highest point of Lee’s price range. He is only able to put 16% down and is required to take two loans, one from a bank and another from the seller, to finance his investment. By taking on various loans, he runs the risk of defaulting on his payments if he does not generate the cash flow he expects.
Take a look at the numbers now.
In ONE column of an Excel sheet, do your own verification that Lee has insufficient cash to get into the deal. Assume he receives Bicego’s loan for $1,050,000 and seller financing for $200,000. List all of the expenses that Lee will face during the acquisition and first six months of ownership (renovation period) of the property and compare those expenses to his sources of capital (bank loan, seller loan, and personal savings).
[In calculating the mortgage payment obligations, note that both the bank and the seller agree to allow Lee to make only interest payments during the first six months of their respective loans, and then require full amortization (principal plus interest) over the remaining 354 months].
The total cash received is $1,490,000, whereas the total expense for the first six months is $1,506,451, which leaves Lee $16451 short in cash. Lee has insufficient cash to get into this deal.
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