Angus Cartwright IV Real Estate Accounting Case Study Problem it is a real estate case study it is more like accounting problem. I need every calculation d
Angus Cartwright IV Real Estate Accounting Case Study Problem it is a real estate case study it is more like accounting problem. I need every calculation detail, because my professor want me to orally tell him how I do this. Question is in the end of the pdf. please have much detail as you can. there is no other requirement, I just need to know how you do it. and I am going to rewrite it after I understand how it work. 9-813-185
REV: JULY 31, 2017
KENNETH J. HATTEN
WILLIAM J. POORVU
HOWARD H. STEVENSON
ARTHUR I. SEGEL
JOHN H. VOGEL, JR.
Angus Cartwright IV
People
Angus Cartwright IV was an investment advisor based in Arlington, Virginia, the home of many
members of the DeRight family. In September 2013 his attention focused on the needs of two cousins
at different stages of their lives. John DeRight had recently sold his business to a medium-sized
public company in exchange for $35 million of the companys stock. He then retired and expected to
live comfortably on the $750,000 in dividends paid on the stock, plus retirement and other income he
had of $250,000. He felt the need to diversify his investments, however, and planned to sell up to half
of his stock and reinvest it in real estate and other investments. Even though the basis in the stock
was negligible, he felt that now would be a good time to take advantage of the 20% capital gains tax
rate before it went up further.
Judy DeRight was president and sole stockholder of a small-sized chemical company that had
earned in excess of $2.6 million before taxes and $2.1 million after taxes in each of the previous five
years. She had received many offers to sell her company in exchange for the stock of a public
company, but she enjoyed the independence of running her own business. She had determined that
her chemical business could best grow through internal expansion rather than by acquisition. On the
other hand, she did feel it was wise for her to diversify her own investments. Over time, she
personally had accumulated over $45 million, now invested in stocks, bonds, and short-term
securities, which she considered unnecessary for her present operations and thus available for
outside investment.
Both DeRights felt that real estate would give them the benefits of diversification, protection from
inflation, and some tax advantages. Each wanted to purchase a property large enough to attract the
interest of a professional real estate management company to relieve them of the burden of daily
management, and they wanted a minimum leveraged return on their investments of 10% after tax.
Properties
Angus Cartwright IV, like his father, had dealt with the DeRight family for many years and had
located four properties that he felt might be suitable investments for his two clients. He had brokers
________________________________________________________________________________________________________________
Professors Kenneth J. Hatten, William J. Poorvu, and Howard H. Stevenson prepared the original version of this case, Angus Cartwright III,
HBS No. 375-376. This version was prepared by Professor Arthur I. Segel and Professor John H. Vogel, Jr. of Tuck School of Business at
Dartmouth. This case is not based on a single individual or company but is a composite based on the authors general knowledge and experience.
Funding for the development of this case was provided by Harvard Business School. HBS cases are developed solely as the basis for class
discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.
Copyright © 2013, 2017 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-5457685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be
digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
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Angus Cartwright IV
show the properties to Judy and John DeRight, and both of the DeRights were enthusiastic about
them.
Alison Green
One property was Alison Green, a 100-unit garden apartment project located in
Montgomery County, Maryland. This property had been completed in 2009 and had been operating
at a 95% occupancy level since the initial rent-up. The asking price for Alison Green was $21 million,
but the broker had received indications that a price of $20 million would probably be acceptable. The
gross rental income before vacancy from the property was projected at $2,250,000, with cash flow
before financing of $1,450,000. Real estate taxes in Montgomery County were generally about 12% of
the gross rent roll. A new $14,000,000 mortgage at a 4% interest rate had recently been arranged. The
term of the mortgage was 10 years, but the amortization period was 30 years. The value of the land,
for purposes of depreciation, was estimated at $5,000,000, and the depreciation period (cost recovery
period) for the building would be 27.5 years.
900 Stony Walk Nearby was the second property, 900 Stony Walk, a five-story, 80,000-squarefoot office building, with 67,000 square feet of rentable space. The building was rented to lawyers,
accountants, and small service firms that each rented between 5,000 and 13,400 square feet. 900 Stony
Walk was completed in 2010 and had been operating at a 95% occupancy level since its initial rentup. The asking price was $15.5 million, but the broker believed a price of $15 million would be
accepted. The projected gross rental income for 900 Stony Walk was $1,750,000, with cash flow before
financing of $1,050,000. The seller had arranged a $12,250,000 mortgage that was fully assumable,
meaning that the buyer could step into this mortgage. To maximize proceeds the seller arranged this
mortgage as part of a commercial mortgage-backed security, or CMBS. CMBS loans had the
advantage of generally providing more proceeds and also being nonrecourse, meaning that the
lender could look to the property only in the case of a default and not go after the personal assets of
the borrower. The rate was 4.75%, which was fixed for a term of 10 years but had a 25-year
amortization schedule.
The land value for purposes of depreciation was estimated at $3.5 million. Since it was a
nonresidential building, 900 Stony Walk would have to be depreciated on a straight-line basis over 39
years. Like Alison Green, real estate taxes would be at a rate of 12% of gross rental income.
Ivy Terrace The third property was Ivy Terrace, a 75-unit garden apartment project under
construction near Arlington, Virginia. There was a building moratorium in parts of the county
because of inadequate public facilities, preventing much short-term competition. The property was
for sale for $11.2 million, but the broker was certain it could be purchased for $11 million. A 10-year,
$7 million mortgage at a 4.25% interest rate had been arranged. The loan had a 30-year amortization
period. The land was leased for 99 years with annual payments of $100,000. Although land leases
normally had cost of living or other increases every year or every third year, the land owner agreed
to keep the lease at a constant $100,000 for the first 10 years.
The buyer would take title upon completion of the construction and issuance of a certificate of
occupancy. For depreciation purposes, the owner would be able to depreciate the full $11 million
purchase price using a straight-line method over 27.5 years. The gross rentals for the property were
estimated at $1,450,000. The projected cash flow from operations1 after a vacancy allowance of 7%,
real estate taxes, operating expenses, and reserves, but before financing and leasehold payments,
1 Also known as Net Operating Income, or NOI. It is different from the finance and accounting NOI. Cash flow from
operations is also sometimes referred to as Free and Clear Cash Flow because it is free and clear of financial payments, land
lease payments, and capital expenditures. Capital expenditures may include tenant improvements, leasing commissions,
and/or structural improvements such as a new roof, parking lot, or elevator.
2
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Angus Cartwright IV
813-185
would be $900,000. Cartwright knew that property taxes in Arlington were about 10% of the gross
rents. Since they lived nearby, Cartwright and the DeRights had checked the area closely and
concluded that the rental and expense projections were reasonable.
The Fowler Building Also under construction in Arlington was The Fowler Building, a twostory, 135,000-square-foot office building with 110,000 square feet of rentable space. Leasing for the
building had already begun with 60% of the space rented, mostly to small technology and consulting
companies.
The Fowler Building was for sale for $28,000,000, but the broker was sure it could be purchased
for $27,500,000. A 10-year, $21.0 million mortgage had been arranged with a tier-one insurance
company at a 4.5% interest rate, amortized over 25 years. As with 900 Stony Walk, the buyer of The
Fowler Building would depreciate it using straight-line depreciation over 39 years. For depreciation
purposes, an appraiser estimated the land value at $6.5 million.
A knowledgeable broker estimated that the gross rentals for The Fowler Building would be
$2,950,000, and the cash flow before financing would be $1,865,000 once the building reached 93%
occupancy. These figures also seemed reasonable to Cartwright, but as a risk mitigator, he was able to
negotiate a guaranteed return based on his pro formas on both Ivy Terrace and The Fowler Building
during the first three years until rentals reached the projected 93% occupancy levels.
Assumptions
Although Cartwright expected income from these properties to keep up with inflation, he made
what he thought was a conservative assumption that the cash flow from operations would increase at
a rate of only 3% per year. After talking with the DeRights, Cartwright also felt that it was logical to
assume, for calculation purposes, that they would hold their investments for a 10-year period. He
therefore assumed a sale at the end of year 10 and projected a sales price for all four properties based
on projected cash flows and trends in the suburban Washington, DC, apartment and office markets.
Cartwright assumed that these four properties would all sell for cap rates similar to the current
cap rates. To be conservative, he added approximately 25100 basis points to the cap rate at which he
expected to purchase each property. Cartwright knew that it was easy to inflate the returns on any
acquisition by assuming a property could be bought at an 8% cap rate and sold at a 6% cap rate, but
he felt it was inappropriate to assume that cap rates would be more favorable for the seller at some
future date. Cartwright also based the sales price on the net operating income in year 10. Sellers
normally used the net operating income for the upcoming year, or in this case, year 11. Again, he
thought this made the projections conservative.
For Alison Green, Cartwright projected a sales price, net to the seller (after paying brokerage fees,
closing costs, and other transaction costs) at the end of year 10, of $24,000,000. For 900 Stony Walk, he
projected a sales price of $17,000,000. He estimated that Ivy Terrace would sell for $14,000,000, and
The Fowler Building would sell for $34,500,000.
In addition to the basic operating expenses, Cartwright felt it was important to include a capital
reserve, a line item that was rarely included by sellers. For the apartments, he assumed that he would
set aside in cash $250 per apartment per year. This reserve would build up so that sufficient funds
were available when it came time to replace the roof, repave the parking lot, replace carpeting and
appliances every five to seven years, and periodically refurbish the clubhouse. If the DeRights
actually decided to purchase one of the apartment properties, he would hire a construction
3
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Angus Cartwright IV
consultant to do a more detailed capital needs study, but for now, the $250 reserve would be
adequate, especially because the properties were either new or in very good condition.
For the office buildings, Cartwright found that he also needed to set aside a reserve for capital
expenditures. If the DeRights decided to purchase these properties, Cartwright would use a program
called ARGUS and do a lease-by-lease analysis, making assumptions about the likelihood that each
tenant would leave or renew at the end of their lease and then plug in an appropriate amount to pay
for leasing commissions and tenant improvements. He would also do an analysis of other
expenditures he would need for capital improvements. For purposes of this analysis, however, he
decided to plug in a reserve of $0.30 per rentable square foot for Stony Walk and Fowler for such
items as a roof replacement. Again, this was an assumption that would need to be carefully tested.2
Finally, Cartwright needed to consider the tax implications of these reserves. As noncash
expenses, they were not deductible for income tax purposes. In later years, when the reserves were
spent, they generally were added to the basis of the property and depreciated over the life of the
property (27.5 years for residential and 39 years for commercial). In this case, for simplicity, he
assumed that the entire reserves would be spent at the end of year 10 to prepare the property for sale.
Keeping careful records of these expenses and consulting an accountant were important since certain
of these expenses, such as lease commissions, could be deducted over the length of the lease. Still
others could be deducted faster if the tenant moved out and the improvements had to be ripped out.
For the purpose of this analysis, however, Cartwright felt the simplest solution was the conservative
one of not taking into account depreciation and amortization of these reserves during the DeRights
holding period. At the time of sale of the property, he would assume that these reserves had been
spent, which would increase the book value by the total amount of the reserve.
Preliminary Analysis
Time was valuable to Cartwright, but he had always found a preliminary analysis worthwhile. It
enabled him to identify quickly those properties where detailed financial analysis and a more careful
physical inspection and examination of day-to-day operations were warranted. He knew from
experience that he would then have to spend considerable time studying comparable projects if he
were to validate the reasonableness of the purchase prices, operating expenses, rent levels, and the
amenities provided in the properties he felt were worth purchasing.
Cartwright noted the key assumptions underlying his analysis. He assumed that:
1. There would be 3% annual increases in cash flow from operations or net operating income for
all four properties.
2. The vacancy rate for Alison Green and Stony Walk would be 5% throughout the holding period.
For Ivy Terrace and The Fowler Building, he would negotiate a rental guarantee3 with the developers
so that the property generated cash flow from operations as if they were 93% occupied. Once the
property reached this occupancy level, the developers would be released from their guarantees, and
2 Normally, the reserve would be inflated on an annual basis to reflect increases in building costs. To simplify the calculation in
Exhibit 5, you should assume that the apartment and office reserves remain flat throughout the 10-year period. Similarly,
assume that the leasehold payment remains flat for 10 years. In reality, the owner of the land would probably include an
inflationary increase annually or at least every few years.
3 There may be some complex tax implications depending on how the guarantee is written and how the property performs.
However, for case purposes, we will use the simplifying assumption that the developers guarantee is not used and the
property is 93% occupied throughout the holding period.
4
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Angus Cartwright IV
813-185
Cartwright assumed that these two properties would continue to operate with a vacancy rate of 7%
throughout the holding period.
3. His clients would supply the necessary equity investment.
4. In spite of uncertainties as to future changes in income tax laws, for purposes of this initial
calculation, he would assume an ordinary tax rate of 39.6% and a capital gains tax rate of 20%.4 He
would also assume, based on current tax law, a tax rate of 25% on that part of the gain on sale that
related to depreciation. (State income taxes would not be taken into account at this time, although in
some states the effective combined rate might be 45%. He would also not include the 3.8% Medicare
tax on the investment income of individuals with adjusted gross income over $200,000, or $250,000
for married couples.)
5. His clients could fully use any tax losses as they occurred against other income,5 and tax laws
would not change again during the holding period.
Then, being methodical, Cartwright developed a list of the salient facts he would use in his
analysis (see Exhibit 1).
Exhibit 1
List of Salient Facts ($000s)
No. of Units/Square Feet of Rental Space
a) Gross Purchase Price
b) Depreciable Base
c) Depreciable Life
d) Estimated Sales Price
e) Expected Year of Sale
f) Cash Flow from Operations (CFO) or
Net Operating Income (NOI)
g ) Annual Increase in CFO or NOI
h)
i)
j)
k)
Leasehold Payments
Equity Investment
Amount of 1st Mortgage
Interest Rate
1. Term
2. Amortization Period
3. Constant Loan Payments
Alison
Green
100
$20,000
$15,000
27.5
$24,000
10
Stony
Walk
67,000
Ivy
Terrace
Fowler
Building
6.84%
5.90%
6.67%
$1,450
3%
$0.0
$6,000
$14,000
4.00%
10
30
5.73%
4 For the real estate course, we will generally use the 2013 tax rate of 39.6%. It is noteworthy that this rate was only for
individuals with taxable income over $400,000, or married couples filing jointly who had taxable income of more than $450,000.
5 For investors not primarily in the real estate business, the federal regulations permit the deduction of losses from real estate
that is considered a passive investment, only from other investments generating passive income. Although the DeRights in this
case did not have other passive income, for the purpose of learning the mechanics, it is assumed that they can utilize any
losses. In practice, investors now attempted to balance their real estate portfolios to take advantage of any losses.
5
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813-185
Angus Cartwright IV
Cartwrights next step was to develop the property setups for each property. Once again he
returned to the original brochures the brokers gave him for each property. In general, the data was
not in the form he found most useful. The setup Angus Cartwright developed for Alison Green is
shown in Exhibit 2.
Exhibit 2
First Year Project Setups (000s)
Gross Rents
-Vacancies
Net Rents
-Real Estate Taxes
-Other Operating Expenses
-Capital Reserves
Net Operating Income
-Finance Payments
-Lease Payments
BEFORE TAX CASH FLOW
Alison
Green
2,250.0
(112.5)
2,137.5
(270.0)
(392.5)
(25.0)
1,450.0
(802.06)
0.0
647.94
Stony
Walk
Ivy
Terrace
Fowler
Building
Cartwright then calculated the major comparable stat…
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