Real Estate Financing Investment Analysis

Case #4 (Fall 2020)

Investment Analysis for Hospitality Real Estate Project

The SHA Hospitality Corp. (SHAHC) plans to purchase a plot of land priced at $300,000 (NOW)

to develop a profitable hospitality real estate project. The SHAHC’s managers are considering a

select service hotel development -Kenmore Hotel. The SHAHC’s business plan is described

below.

With regard to the Kenmore Hotel development option, the managers

have projected the following:

• The hotel would have 200 rooms and be open 365 days a year. It would cost $9,000,000 to build and $2,000,000 for FF & E. Land preparation would cost an

additional $220,000 and $40,000 for FF&E transportation and installation

respectively.

• The building and FF & E will be depreciated over the 25 years and 6 years respectively, using the straight-line depreciation.

• Operating the hotel will require an investment in working capital of $120,000 (I0), $200,000 for initial inventory purchase.

• All existing FF/E (OLD) can be sold for $100,000 which is recorded at $50,000 (book

value) if a new hotel project is ready to operate.

• At the end of the ten years, when the management plans to sell the hotel, the estimated sales price will be approximated by assuming that the after-tax operating cash flow from

year ten onward will stay the same forever (that is, it will be a perpetuity). The present

value of these future after-tax operating cash flows at year ten will be equal to the fair

market value of the hotel. 6% of Brokerage fees (selling expense) will be applied for

this sales transaction.

• Demand forecasts for ROOM REVENUE indicate that room occupancy rates will be 75% for the first three years, 78% for the next five years (years four through eight),

and 80% in years nine and ten. The average daily room rate is expected to be $90.00

the first year and is expected to increase at a rate of 5% annually. Room operating

expenses are estimated to be 30% of room revenues for the first two years and 35% of

room revenues every year thereafter.

• Telephone sales are estimated to be 5% of room revenues. Telephone expenses are estimated to be 70% of telephone revenues.

• Other operating revenue is expected to be earned at the rate of 1% of room revenues. Other operating expenses are estimated to be 60% of other operating revenues.

• Administrative & general expenses are estimated to be 8% of total sales for the first year and this amount is expected to increase by 5% per year through year ten.

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• Marketing and sales expenses are estimated to be 5% of total sales for the first year and this amount is expected to increase by 6% per year through year ten.

• Energy expenses are estimated to be 8% of total sales for the first year and this amount is expected to increase by 9% per year through year ten.

• Property Maintenance expenses are estimated to be 4% of total sales for the first year and this amount is expected to increase by 8% per year through year ten.

The SHAHC has currently set an optimal capital structure (CSR) that is 50% common

equity, 20% debt (Bond), 30% Bank Loan, and no preferred stock issuance. The marginal

tax rate is 40%. Currently, $ 1,200,000 of retained earnings balance is available for

SHAHC to finance this hotel project in addition to the following financing sources for the

WACC.

• SHAHC just received the loan commitment letter from the Cheapy bank in town, having specified LTC, 30% at the prime +350 basis points for 20-year term loan,

given current economic environment, plus origination fee of 2% and closing fee

of 3%. (current prime rate is 4.5%)

• SHAHC can issue $1,000 par value bond with a 8% coupon rate to $950 before issuance (flotation) cost of 9% for the SHAPR project. The bonds mature in 10

years and coupon payments are paid semi-annually.

• SHAHC failed to persuade Preferred stock shareholders and no preferred stock equity financing available for this project.

• SHAHC generated net income of $600,000 and its dividend payout ratio is 40%. There are currently 100,000 shares outstanding and common stock can be sold at

a $20 price. Dividends have been growing at an annual compound rate of 6%

annually. Floatation costs will be an 5% of newly issued common shares if

necessary.

• SHAHC’s expected return for this project is based on the current market analysis: a beta of this type of project is 1.4, risk-free rate is 3% and the

expected market risk premium (MRP) on the market portfolio is 9%.

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SHAHC Kenmore Hotel Project Investment Parameters

Brokerage Fees (Selling Expenses) 6%

Origination Fees 2%

Closing Fees 3%

Holding Period (Years) 10

Ordinary income tax rate 40%

Depreciation recapture tax rate 25%

Capital gains tax rate 15%

Mezzanine Loan Financing for Equity Position 50%

Mezzanine Financing Coupon Rate 22%

Mezzanine Loan Profit Sharing Ratio 60%

Equity Capital Partner Investment after Mezzanine 45%

Capital Partners (Rate of Return) on Balance 15%

Deal (Project) Sponsor (Rate of Return) on Balance 20%

Residual Equity Distribution (Waterfall)

Capital Partners 60%

Sponsors 40%

Depreciation method: Straight Line Method

Depreciable Life years Building 25

FF & E 6

Required:

1. Based on all the information given above, please analyze the Kenmore Hotel project’s PBP, DPBP, NPV, IRR, MIRR, PI and EAA for unleveraged and leveraged yield.

What would be your decision as a consultant after performing total property

(UNLEVEARGED) and equity yield (LEVERAGED) analysis?

2. What would be the yield (IRR) for the mezzanine financing as contracted in the table above? What amount of profit from the net sales proceed should you distribute as a deal

sponsor if the mezzanine financier wants to have IRR of 30%?

3. What would be the yield (IRR) for capital partners and deal (project) sponsors as contracted in the table above?

4. What would be the lender’s yield (IRR)?