To invest or not to invest: that is the question!

Sherman, Herbert ; Rowley, Daniel J.

CASE DESCRIPTION

This case describes a real estate rental startup venture with a twist; renters select their house to rent and then enter into a three-year contract and earn a $100/month credit to buy the house at the end of the contract period. The problem for the characters in the case is whether or not they should enter into this venture and how they should then proceed given their decision. Several factors complicate this business startup decision, including: their lack of business experience, one of the character's prior negative experiences with being a landlord, the need for further information in order to calculate costs (and therein profits), and the need to examine the potential risks associated with the venture. The case has a difficulty level appropriate for junior level or above. The case is designed to be taught in one class period (may vary from fifty to eighty minutes depending upon instructional approach employed, see instructor's note) and is expected to require between two to fours hours of outside preparation by students (again, depending upon instructor's choice of class preparation method).

CASE SYNOPSIS

Derived from observation and field interviews, the case describes how two English professors, Stephen Hodgetts and Richard Davis, are lamenting their losses in the stock market and how these losses have negatively affected their retirement funds. Davis's solution to working past retirement age (or praying for a miracle turnaround market) is to take control of his investment funds by becoming a landlord and developing a rental scheme which caters to lower income households and/or families with bad credit. Hodgetts has a visceral negative reaction to the plan, given his politics and prior experiences as a landlord, but intently listens as Davis describes in detail how a $10,000 investment per home will yield over $20,000 of profit within three years. Hodgetts is incredulous and wonders why more knowledgeable business people have not constructed a similar business. The case ends with both professors quoting from Shakespeare to support their positions. Hodgetts is willing to get involved in the venture if Davis can provide him with some assurances as to predictability of the success of the business venture.

INSTRUCTORS' NOTES

Overview

To quote Vesper (1990, p. 128) "sometimes the idea for a particular venture comes 'out of the blue' in the form of a proposal by someone else who has seen an opportunity and wants to collaborate in exploiting it." This statement aptly describes the situation that our two protagonists find themselves in; both individuals are English professors who have collaborated on books and articles and find that they both have suffered economically from a downturn in the stock market. Both want to take control of their investments and Davis proposes a plan in which they become specialty landlords who cater to families who can are looking to buy starter homes but do not have the down payment and/or credit rating that will allow them to obtain an affordable mortgage.

Several factors complicate this business startup decision, including: the lack of knowledge and business experience of the individuals involved in the business, one of the individual's prior negative experiences with being a landlord, the need for further information in order to calculate costs (and therein profits), and the need to examine potential risks associated with the venture. In this case, students are asked to analyze the proposed venture and to decide whether the offer "is a good deal." Students must also determine what additional information is needed in order to make a viable decision about this business venture, the risks associated with this business, and the legal form of organization the business should take.

Intended Instructional Audience & Placement in Course Instruction

This case was primarily developed for undergraduates taking an Entrepreneurship and/or Small Business Management course, focusing on the areas of business startups and ownership. Secondarily, this case could also be utilized in a personal finance course (the locus of the case). The case should be introduced after the students have read the chapters on business start-ups, and legal forms of organization (Chapters 4, 5 and in Hodgetts and Kuratoko, 1998; Chapters 1, 6 and in Hisrich and Peters, 1998; Chapter 2 [Section 2], and 5 in Coulter, 2001). For personal finance courses, the case may be employed in conjunction with investment planning strategies and risk tolerance (Mittra, Kirkman, and Seifert, 2002, Chapter 14; Strong, 2004, Chapter 2).

Secondly, it is also strongly recommended that students prior to reading the case be exposed to material dealing with rental properties and the duties and obligations of landlords. Managing rental properties is far more than collecting rents and includes tenant and property selection, avoiding vacancies, property repair, landlord--tenant laws, and how to create a psychological bond between the tenant and the property (Perry, 2000). Material is provided later on in the teaching note on real estate investment, valuation and return on investment, tax considerations, and residential property management that may be supplied to students to support their analyses of this investment decision.

This case may be employed as a chapter or sectional summary case, especially in the areas of business startups and business formation--it may not be sufficiently complex for graduate students or broad enough to be used as a comprehensive end-of-semester case.

LEARNING OBJECTIVES

The overall purpose of this case is to introduce students to the nuances associated with a small business startup related to the real estate market. Students obtain a "real-world" feel of the situation given the low capital investment (less than $5,000 per person), the manner in which the opportunity arises (drop in the stock market), and the lack of information that the decision-makers have about their investment decision. This case is of particular value to students since many of them may be presented with similar deals from co-workers, family members, and friends. Specific learning objectives are as follows:

* For students to determine what information is needed (and whether Davis and Hodgetts have that information) in order to make a cogent decision on whether or not to start this business.

* For students to develop preliminary recommendations on whether Davis and Hodgetts should move forward with the new business.

* For students to recommend what legal form of organization this new venture should employ.

TEACHING STRATEGIES

Preparing the Student Prior to Case Analysis

There are several approaches, none of which are mutually exclusive, that an instructor may employ in terms of utilizing this case. It is strongly recommended that regardless of the specific methodology employed, that students prior to reading this case be exposed to some material on business startups, legal forms of organization, and the real estate market. (Greene, 2001) See Overview and Discussion Concerning Related Literature for details--may be used as class handouts. This conceptual framework may be delivered prior to assigning the case by using at least one (1) of the follow methods:

* a short lecture and/or discussion session on aforementioned topics.

* a reading assignment prior to reading the case on the pros and cons of starting your own business (Vinturella, 1999).

* a short student presentation on each topic.

* a guest lecturer from a local real estate agent or property management corporation on how and why a person would invest in real estate.

Case Method

In the traditional case method, the student assumes the role of a manager or consultant and therein takes a generalist approach to analyzing and solving the problems of an organization. This approach requires students to utilize all of their prior learning in other subject areas as well as the field of management. This case in particular will also require students to draw upon their knowledge of business startups and small business management. It is strongly suggested that students prepare for the case prior to class discussion, using the following recommendations:

* allow adequate time in preparing the case

* read the case at least twice

* focus on the key issues

* adopt the appropriate time frame

* draw on all your knowledge of business. (Pearce and Robinson, 2000)

The instructor's role in case analysis is one of a facilitator. The instructor helps to keep the class focused on the key issues; creates a classroom environment that encourages classroom discussion and creativity; bridges "theory to practice" by referring back to key concepts learned in this or prior courses; and challenges students' analyses in order to stimulate further learning and discussion. There are several variations of the aforementioned approach including: written assignments, oral presentations, team assignments, structured case competitions, and supplemental field work. (Nicastro and Jones, 1994)

Regardless of the variation employed, it is recommended that the students' work be evaluated and graded as partial fulfillment of the course's requirements. However, if this case is not employed as a comprehensive case, it is not recommended that this case (and its related assignments) have a large weight or impact on students' overall course standing.

OVERVIEW AND DISCUSSION CONCERNING RELATED LITERATURE

The following sections are short summaries of some of the literature pertaining to legal forms of organization, real estate investment, and residential rental property management. More detailed material can be found in the cited references and the discussion section of the teaching note. It is strongly suggested that students be given access to this information prior to reading the case since knowledge of this material is pertinent to analyzing the case.

Legal Forms of Organization

One of the most critical decisions in a business startup is determining the legal form of the business organization. Each form has differing set-up costs, tax treatments, liabilities to the owner(s), advantages and disadvantages and therefore the pros and cons of each form should be considered by the entrepreneur. The forms are as follows:

* Sole Proprietorship--one owner, profits and losses of the business are taxed at the personal rate of the owner and are filed on his or her personal income tax. Advantages include low startup costs, freedom from most government regulations, direct control by owner, and easy exit from business. Disadvantages include unlimited personal liability, assume all risk, excluded from business tax deductions, may be difficult to raise capital.

* General Partnership--Two or more owners, profits/losses taxed at personal rate with flexibility in profit-loss allocation to partners, and personal assets of all partners are at risk. Advantages include ease of formation, pooled resources and talent, somewhat easier financing than sole proprietorship, and some tax benefits. Disadvantages include unlimited personal liability, divided authority and decisions, potential for conflict, and lack of continuity of transfer of ownership.

* Limited Liability Partnership (LLP)--Similar to a partnership except only one partner retains unlimited liability (others are limited). An advantage to the LLP is that it is a good way to acquire funds from limited partners. Disadvantages include the cost and complexity is high and the limited partners are excluded from the management of the business.

* C Corporation--Unlimited number of owners (no limits to type of stock or voting arrangements). Dividends are taxed twice (corporate and personal) while the corporation handles the taxes from profits and losses. Advantages include limited liability, transferable ownership, continuous existence, and easier access to resources. Disadvantages include expensive to establish, closely regulated, double taxation, extensive record keeping, and charter restrictions.

* S Corporation--Up to 75 shareholders (no limits to type of stock or voting arrangements). Profits/losses taxed at personal rate with flexibility in profit-loss allocation to partners. Advantages include easy to set up, enjoy limited liability and tax benefits of partnerships, can have a tax-exempt entity as a shareholder. Disadvantages include must meet certain requirements and may limit future financing options.

* Limited Liability Company (LLC)--Unlimited number of members (no limits to type of stock or voting arrangements). Profits/losses taxed at personal rate with flexibility in profit-loss allocation to partners. Advantages include greater flexibility, not constrained by regulations on C and S corporations, and taxed as a partnership. Disadvantages include the switching cost from one legal form to a LLC can be high and you need legal and financial advice in forming the operating agreement. (Coulter, 2001, 136-7)

Ridley (1999) noted that certain business forms may be appropriate during the start-up, precapital phase but become less attractive from a venture capital funds perspective (i.e. S Corporations, partnerships, LLP's, and LLC's). These firms would not be able to obtain preferred stock or convertible debt, their preferred choices of security, from certain legal forms of business.

Real Estate Investment

According to Tyson (1997), real estate investing is attractive for the following reasons:

Land is a limited and fixed resource. Demand for housing and land continues to grow while supplies are dwindling. Basic economics would then suggest that prices should rise over time increasing the value of the property.

Land can be leveraged. Real estate, unlike other investments, require a small percentage (10 to 20 percent) of the value of the investment as collateral for a loan. Investment dollars hence can purchase more property, increasing the value of property holdings.

Get both growth and income. Like a stock that pays a dividend, rental properties earn an income and appreciate in value. The value appreciation is tax-deferred so that taxes are only due on the sale of the property. Unlike stocks, however, "rolling over" property (using the proceeds from the sale of one property to buy another of similar value) avoids capital gains taxes.

Diversification. Real estate does not necessarily move in conjunction with the stock market and is far more tied to lending rates, and the local economy. For example, even though the economy has slowed since 1999, Las Vegas led all cities in building growth with a Private Construction Intensity index rating of 40.94, putting it well ahead of second-ranked Atlanta (30.35). http://www.reviewjournal.com/lvrj_home/ 2002/Jun-26-Wed-2002/business/19054359.html

Ability to add value. Properties can be purchased below fair market value (i.e. handy-man specials) or can have additional work done in order to increase the value of the property and/or rental fee (i.e. finishing a basement).

Ego gratification. Real estate is a tangible asset, easy to display and show off--it is visible wealth.

Real estate is less emotionally loaded than other investments. Financial investments such as stocks and bonds vary on a constant basis and therefore it is easier for investors to get caught up in the rollercoaster ride of the stock market. The inability of investors in real estate to get an immediate read on the value of their properties actually allows them time to think through their long-term investment strategies.

Tyson (1997) also noted that certain individuals would be poor candidates for real estate investing if:

Lacked free time. Property purchasing and management are "time sinks" (p. 239)--evaluating properties and potential tenants is time consuming (or costly, if you hire a property manager) and requires proper due diligence.

Low tolerance for stress. Since tenants in general do not care for properties as well as property owners do, they tend to abuse or overlook property damage (i.e. stained rugs) that might send homeowners up a wall. Property owners who are going to agonize over damage to their property might want to avoid this investment.

Not funding retirement accounts. Retirement accounts have immediate tax advantages and profits accrued in these accounts are either tax-deferred or tax free. Real estate operating profits are taxable while being earned (although capital gains can be sheltered).

Real estate or being a landlord isn't appealing. Some people just do not want to be a landlord, with stocks providing comparable returns in the long run.

Deciding where and what to buy is critical to the investment decision. Tyson (1997) indicated that single-family residences are easiest to deal with since you need to find and deal with only one renter. Factors influencing the buying decision include local economic issues, the real estate market (building permits, vacancy rates, property listing and number of sales, and rents), and financial return considerations.

Valuation and Return on Investment (ROI)

Muto (2002) indicated that one quick way to value a potential residential rental property is through its price/earnings (P/E) ratio. The higher the P/E, the more earnings growth is implied. To determine the P/E ratio for a house, divide the price of the house by the estimated annual rent the house could generate. For instance, if a $500,000 home could rent for $25,000 a year after maintenance and management expenses, the P/E ratio is 20. This methodology. also known as the rent multiplier, provides a clean-cut approach that allows potential investors to compare real estate investments with stock and bond performance. A second method for calculating property valuation is the capitalization rate. (Pond,1998) Here the net operating income (revenues--operating expenses excluding cost of debt) is divided by the total property cost where the property cost includes both the down payment and the amount financed. This method accounts for operating expenses but does not factor in debt service and tax savings.

Pond (1998) offers an alternative method for calculating residential property values and return on investment. This method computes the net cash flow of the property in order to determine ROI where cash flow ROI =

(Rental Income + Tax Savings) - (Operating Expenses + Reserves + Mortgage Debt Service) / Equity Investment

This method, however, does not account for the impact of inflation on the investment, risk, or opportunity costs.

Sherman and Rowley (in press) indicated that another method for determining whether a property should be purchased is through the net present value (NPV) rule. This rule states that a project should be undertaken if its net present value is positive and should be rejected if its net present value is negative. In order to calculate the net present value of any project, we must first subtract the cost of financing the proposal (called the discount rate) over the time it will take to implement the project. This discount rate could refer to either opportunity costs (the return the investor could receive from putting the funds into a guaranteed investment i.e. a bank certificate of deposit) or borrowing costs (the interest rate, dividend, or bond rate the investor would pay in order to purchase the property). The net present value can be calculated as follows:

NPV = Net Cash Flow Per Year for each year of investment - Initial Investment / (1 + Annual Discount Rate)

The internal rate of return (IRR) rule is a second method for determining whether or not a residence should be purchased. This rule states that a property should be purchased if its internal rate of return is higher than its cost of capital. The minimum internal rate of return, also known as the hurdle rate, is the discount rate that makes the net present value of a project equal to zero. The internal rate of return is then adjusted for the time value of money (the length of time the project will take). The equation is as follows:

Initial Investment = Net Cash Flow Per Year for each year of investment / (1 + Internal Rate of Return)

Yet a third method of making an appropriate decision is to analyze the pay back period (based on the breakeven point)--the time it takes for any project to recoup its initial investment. Most firms employ a two to three year pay back period as their cutoff period; projects above the cutoff period are rejected, those in a shorter time span are funded. Many businesses adjust the measure of years using net present value, that is, they discount their cash flow by their cost of capital. The breakeven point is calculated as follows:

Breakeven Point (In Years) = Down Payment / Net Cash Flow Per Year

Using net present value allows comparisons between projects and internal rate of return does not. The payback method ignores time value of money and all cash flows the moment payback occurs.

Tax Considerations

According to Pond (1998), tax reforms in the 1980's has had a significant negative impact on real estate investing hence real estate investments must be based predominately on economic considerations. Several tax laws effect real estate investments.

* Passive Tax Shelter and Losses and Credits--a taxpayer's deduction for net losses from rental properties are only allowed to offset net income from other passive activities such as stock dividends and bond interest. They may not be used to offset active income such as wages or other active business income. Real estate income is considered passive if the taxpayer works less than 50% in the real estate business.

* At-Risk Rules--a taxpayer's deductible loss on a real estate property is the limited to the amount that the taxpayer invested in that property, specifically the amount of money paid into the property, the adjusted basis of any property contributed, and any amounts borrowed where the taxpayer is held personally liable.

* Rehabilitation Tax Credit--a 10% tax credit is available for rehabilitating residential buildings built prior to 1936 while a 20% credit is available for certified historic structures.

* Low-Income Housing Credit--eligibility for this program requires that at least 20% of the units of a housing development or project be set aside for families with incomes no higher than 50% of the area median income or at least 40% of the units earmarked for families at or below 60% of the are median income. Rents for these units cannot exceed 30% of the qualifying income limit.

* Modified Accelerated Cost Recovery System--residential property is depreciated over a 27.5 year period.

Residential Rental Property Management

Residential housing, compared to commercial properties, is easier to understand since personal home ownership has already introduced most novice investors to issues dealing with house location, purchasing, and upkeep. Managing property entails developing rental collection processes and procedures, property maintenance and repair, delinquency procedures (dealing with late payments, and returned checks), increasing the lease renewal ratio, reducing turnover rates, increasing rent rates, decreasing the load factor (none income-producing space), preparing the rental space, tenant move-in and evictions, marketing ands showing the property, rent and other income, and addressing tenant problems. (http://www.atlastitle.net/literature/ CreativeInvestment08c1-PMBRI-RentalIncome.htm)

The cornerstone of any rental arrangement is the lease. Characteristics of a lease include:

* Requirements of all contracts--offer and acceptance, consideration, competent parties, legal purpose

* As a type of real estate contract, a lease should contain a precise description of the leased property

* The term should be specified, with all significant dates (e.g., start and end) noted

* Must be in writing if for longer than 1 year; but putting things in writing is a good idea even for a shorter term

* Signature of the lessor (just like a grantor must sign a deed while a grantee need not); but it is good for the lessee to sign also, to show that the lease features are understood and acceptable. (http://www2.cob.ilstu.edu/jwtrefz/ FIL260/F260Ch9.doc)

In a residential lease, rent is generally a fixed monthly amount. Rents are determined by:

* Age, location, and other features of the property, relative to those of competing properties

* The benchmark usually is per room or per bedroom.

Operating expenses.

Negotiating strength--Manager may remodel premises, give prizes (free trips), or give "free" rent to attract tenants in a competitive market, or Tenants may have to agree to longer-term leases, and to escalation clauses, when renting in low supply markets. http://www2.cob.ilstu.edu/jwtrefz/FIL260/F260Ch9.doc)

A recent issue that property managers have had to deal with is the growth of home-based businesses, according to Sleeper and Walker (2002). The success of residential property managers in limiting nuisance-creating home businesses depends on whether those uses are usually associated with family residences and whether they are favored in particular city and state laws and policies. Property managers do have direct legal authority over parties who have signed contracts and the courts will back their rights to that extent. Calling the police remains the best response, but eviction requires proof that residents themselves have committed contract violations. Recommendations for protecting residential real estate from home business nuisances are: background checks and testing, contract drafting, public authority enforcement, and political efforts.

Bell (2002) has noted that there has been a structural shift in the residential property management industry. "It's definitely a tougher market today, one that has made dear the need to differentiate from competitors with better service. The overall goal is tenant retention." (p. 25) Bell suggested that the property manager become more proactive with tenants--"the property manager's altered role is one of insuring the existing tenant base is satisfied. It means spending more personal time with tenants and connecting with them on a face-to-face basis. Managers need the skills that will create positive experiences for tenants. The building is not just a place where you house somebody." (p.26)

Smith (2002) indicated that the decision as to whether to pay a third-party manager to run the property, (leaving all the fixing of leaky roofs, faulty faucets and clogged sinks, plus rent collection and leasing the property to someone else) boiled down to two main considerations: cost and tolerance of middle-of-the-night calls from tenants. In terms of costs, owners should expect to pay 5% to 10% of the gross income from the property. The more services a property manager has to perform, the higher the cost. While considering cost, a lot depends on an owner's proximity to the properties and the number of properties owned. Property managers themselves say hiring a third party to manage 20 units or less that are within reasonable distance may not be necessary. Unless, of course, one hates to deal with daily landlord/tenant matters.

SUGGESTED CASE QUESTIONS

1. Do Davis and Hodgetts have enough information in order to decide whether or not to go into this business? If not, what more information would you want before starting this business?

In answering this question, we must first inventory the information that Davis has already collected about the real estate business. We have the following information:

* rent on a three bedroom two bath house is between $1,100 to $1,400 a month.

* three bedroom homes sell new for around $175,000, with real estate taxes of around $1,000/year

* on a $175,0000 home, a 5%, 30 year mortgage would cost be about $900/month.

* renters earn a $100/month credit towards the purchase of their home by paying their rent on time.

* goal is to make at least $200/month per rental, not counting administrative costs associated with managing our operation.

* homes in our area are appreciating in value about 5% every year--a $ 174,000 home today will be worth slight over $200,000 at the end of a three year lease.

* would make over $20,000 dollars in three years with an investment of less than $10,000 by: selling the home back to the homeowner yielding a $26,000 profit rental fees over the first three years are $7200 dollars, lose $3600 for rental credit towards home purchase.

* Furthermore, we also know that Hodgetts has a very negative attitude towards becoming a landlord, given his prior rental experience.

The below average student would make a determination that Hodgetts and Davis have enough information as to whether they should go into this business venture. They would argue that Davis has perhaps not worked out all of the details (as per Hodgett's comments) but that there certainly is enough information in which to make a decision, one way or another, given the revenue streams and costs projected by Davis.

Most of the other students may note that more specific information is needed and/or needs to be verified. For example, Pond (1998) recommended that the following information is needed just to forecast rental real estate income and expenses: occupancy rate, level of rent increases, inflation rate, nonrecurring repairs and maintenance, advertising, travel, bank charges, cleaning and regular maintenance, commissions, depreciation, insurance, interest, legal and professional fees, salary and wages, supplies, taxes, telephone, and utilities.

Further, most students will also note Hodgetts and Davis's general lack of knowledge of residential rental property management. They may also point out that once Hodgetts and Davis have researched the industry from an operational standpoint, that Davis and Hodgetts may determine that they are unwilling and/or unable to perform the functions of a rental manager.

The average student would may argue that a business plan is needed in order to demonstrate the profitability and manageability of the new venture. The plan would provide an explanation of the business concept and delineate the market channel for the rental/home purchase service, set specific goals for Hodgetts and Davis and the business, describe the strategies employed to achieve those goals, and describe the background and experience of the people involved in the business startup. The plan would highlight capital requirements and capital formation, the organization's legal structure, and include a SWOT analysis demonstrating the viability of the project.

The above average student would note that before putting allot of time and effort into developing a full-blown business plan that a feasibility study is needed in order to determine whether the business is worth pursuing. This study would include a brief description of the venture, industry and economic background; competitive analysis; accounting, management, marketing, finance, legal and tax considerations. The feasibility study should also highlight the areas of distinctive competence and the competitive advantage of the proposed business model as well as include estimated start-up costs, an operating budget, and a simple break-even analysis.

The exceptional student would note that the most critical information lacking is the personal, financial, and managerial background of both Hodgetts and Davis. All that we know from the case is that both Hodgetts and Davis lost money in their retirement accounts and their personal stock portfolios and that both were college professors on a fixed income, with at most 3% annual raises, and that Davis was married and liked to travel to Europe. We do not have even the most basic information concerning their personal financial means including their net worth, liquidity, and credit rating. Leimberg et. al. (2002) indicated that before any investment is contemplated that a basic financial portfolio be developed that includes:

* Current financial information--balance sheet, cash flow analysis, asset liquidity analysis. Includes age, marital status, dependents, and life style.

* Retirement plans--including income at death/disability and financial security of heirs.

* Investment tactics--tax implications, risk management, and wealth transfer.

Although the initial investment in this business would seem quite small, (assuming only one house, $5000 per person), we cannot ascertain at this time whether Davis and/or Hodgetts would qualify for a 30 year mortgage or have the assets to leverage or liquidate for the initial down payment. Furthermore, although Hodgetts has some experience in being a landlord (although not positive), it is not clear from the case what skills or expertise either Hodgetts or Davis bring to the venture or how the business venture will be managed (will they self-manage or look for a property manager?). This would seem to be a critical issue since some student may be skeptical as to Hodgetts and Davis's ability to deal with troublesome tenants (will they have the heart to evict bad tenants?) and in general manage a business. Davis has started to create a network of experts (mortgage lender, real estate agent) but has yet to bring in someone with either real estate or rental insurance experience.

Given the financial information in the case and the general economic trends in August, 2002, conduct a preliminary financial feasibility study of renting a $ 175,000 home for $1200/month.

There are several methods that could be employed to analyze this investment. The simplest method would be to conduct a price/earning (P/E) analysis. With a price of $175,000 and an annual income of $ 14,400 the P/E ratio is approximately 12.15. Comparing this ratio with the S&P 500 of nearly 30 at about the same time period, this would seem to be a very conservative investment. Lower than average students will conduct this simple assessment and may have a positive recommendation.

The average student would conduct a second analysis. The second method might be to calculate the return on invest as indicated by the equation:

(Rental Income + Tax Savings) - (Operating Expenses + Reserves + Mortgage Debt Service) / Equity Investment

Students would need to generate several pieces of information to complete this equation. Assuming that they purchase new construction and that there are no tax savings per se (given the form of ownership, there may be tax deductions as a second mortgage), the first calculation would have to be mortgage debt service. Assuming 5% down on a $175,000 mortgage, Hodgetts and Davis would have to obtain a loan for $166,250. The 30 year mortgage rate in early September of 2002 was below 6% (http://www.usatoday .com/money/perfi/housing/2002-10-10-mortgage-rates_x.htm) so students might assume a mortgage rate in August 2002 of 6%. The monthly mortgage would be $996.75, annualized at $11,961.

Better students will note that this information does not correlate to the information in the case (Davis is told that the cost of this mortgage is $900/month) and may either work with the new mortgage figures or recalculate the borrowing amount (for a 30 year loan at 6% interest, $900/month will finance a $150,000 loan--14.2% down on a $175,000 home). Assuming students work with the calculated mortgage figures, we would then have to calculate maintenance costs and taxes. Taxes are stated in the case as $1000/year. Maintenance expenses for a new home would seem to be minimal (repairs at least in the first year would be covered by the builder's warranty, appliances warranties, or by the renter), however, students may set aside 10% of the rent as a reserve or as a management fee ($1,440). These assumptions would yield the following:

$14, 400 - ($ 11,961 + $ 1,000 + $ 1,440) / $8,750

= -1 = 0 0

Since this yields a negative cash flow of $1/year and a '0' ROI, some students may recalibrate the ROI by adding back the reserve/management fee (or a percentage thereof). This would yield an ROI of 16.4% ($1439/$8750) and a positive recommendation.

Better students might also calculate Net Present value, producing the following assuming a three year time horizon and a 6% discount rate:

NPV =$1439 X 3 (a 3 yr. investment) = $ 4072.64 - $ 8,750 (Initial investment) = ($4677.36) (1 +.06)

It would take a little over 6 years for this investment to produce a positive NPV or breakeven. Under these circumstances, one would not invest in this project.

Better students will perform several analyses and conclude that the investment may have relatively low risk (given the low P.E. ratio), but has discouraging returns (if one deducts the reserves from the cash flow), a negative NPV, and a high breakeven point. They may also note that this lack of cash flow does not provide any salary for either of the owners (unless they manage the property on their own and use the reserves to pay themselves) and may reject the business proposal.

On the other hand, exceptional students will note that none of the calculations include the appreciated value of the property, that is, that the property may rise in value although the cash flow from that property may be neutral. They may note that given the near break-even cash flow of the situation, that any accrual to the property beyond the opportunity costs associated with the initial down payment ($8,750) would be considered a profit. This will be minimal given the very low interest rates of CD's and/or government bonds in August of 2002. They may also observe, however, that property is not as liquid as stock or bonds and therefore Hodgetts and Davis may not be able to sell the home in a timely manner. This may lead to a vacant property and negative cash flow given the need to still pay the monthly mortgage and taxes.

Given the misinformation provided by their mortgage lender, these advanced students may also question the price growth rate information provided by the real estate agent. The Federal Reserve reported that in August 2002 prices for new homes rose 5.25 percent, and the repeat-sales price index for existing homes was up 6.25 percent. (www.federal reserve.gov/pubs/bulletin/2002/0802lead.pdf) This would verify the real estate agent's assessment of the property.

Assuming that the property breaks-even in terms of cash flow, the capital appreciation of the property would then be calculated by compounding the value of the home, $175,000 by 5.25% over a three year period; equaling $204,034.85. Students may try to adjust the revenue by accounting for sales commission, at the standard 6% rate, producing a net revenue of $ 191,792.75, or they may assume that the renter has purchased the property and discount the sale price by $3,600, making the total revenue $200,434.85. Assuming the worst case scenario, commissioned sales, the net profit of $ 16,792.75 would then be divided by the original financial invest ($ 8,750) and then divided by 3 (the years of investing), yielding nearly a 64% return on investment. Property appreciation clearly makes the project a viable one.

2. Assuming that Davis and Hodgetts do opt to go into business, what legal form of organization would you recommend?

The issues related to the legal form of organization in this case include personal liability (Davis and Hodgett's personal assets), tax implications, and entity ownership. In terms of personal liability, it is probable that, Davis and Hodgetts would require a legal form of organization that would limit their liability to solely their investment in the business. None of the participants would want their personal assets at risk.

Secondly, the student's choice of ownership may partially be determined by his or her projected cash flow for the business; if the business will show a loss that loss should be passed on to the owners to deduct from their personal income taxes. Gains, on the other hand, should be paid by the business if the business tax rate would be lower than the corresponding personal tax rate.

Third, ownership arrangements should reflect each participant's invest equity, whether the equity is in-kind services (sweat equity/labor) or assets. It is not clear who will be managing the property (Davis, Hodgetts, both, or a property manager) but one would expect an equal ownership arrangement would be the most acceptable.

Given the neutral cash flow, and the desire to protect personal assets, and the need to have ownership reflected as the percentage of equity investment, it would seem that a limited liability corporation would meet be appropriate for the situation.

3. Discuss the risks of this venture and the associated liabilities. Given your answer to question 2, are the rewards worth the risk?

The below average student will discuss risks and liabilities from a theoretical perspective or argue that there are no real risks associated with this venture since all the information presented leads to a very profitable venture. From their perspective, the rewards are evident and are risk-free.

The average student might start by assuming that Hodgetts and Davis form a LLC in which to run the business and then deed the property over to the LLC. In this situation they would note that the financial risk associated with this business venture would then be limited to those funds invested in the business in order to purchase the residential property (the down payment of $ 8750) and the costs associated with owning a vacant rental property (mortgage, taxes, insurance, and any maintenance expenses i.e. electricity, heating and lawn care, estimated at $5000/year). These students might see the risks as minimal, and given the potential upside (a positive rental cash flow and property appreciation) would argue that the risk is worth the reward.

The above average student would note that the reality is that since the new LLC will have minimal assets and no operating history, the mortgage that will need to be obtained for the home will have to be personally signed for by Hodgetts and/or Davis. They would therefore each be incurring an additional $166,250 debt per person if they both sign for the mortgage. The risk associated with this property and its mortgage, besides the mortgage payment, would be the associated loss, if any, incurred through the liquidation of the property in the case of a non-rental situation or break-up of the LLC. They might also note that Hodgetts and Davis, as owners of the firm, also have potential liability as homeowners (i.e. tenant is injured on the property) which presumably will be covered through homeowners' and business insurances. Here, risk and reward are a muddier issue and students might argue either way in terms of the investment.

The exceptional student might assume a near worst case scenario for Davis and Hodgetts (that the property will yield a break-even cash flow from rental revenues, that the home will be sold through a real estate agent, that the property will accrue in value at 3% per annum, and that the home will take six months to sell), in order to try to quantify the risks involved. Using the above scenario produces a net revenue of $ 2253.58, or a 8.6% annual return on initial cash investment ([$2253.58/3 years]/$8750) as calculated below:

$175,000 compounded by 3% for three years = $191,227.22 - 6% commission = $ 179753.58 - $2,500 (estimated cost of empty property for six months) = $177,253.58 - $175,000 (initial home price)

They might go further and compare the return on no risk or low risk investments (CD's, Tbills, Corporate Bonds) to this investment perhaps using the following August 2002 data: (www.federalreserve.gov/pubs/bulletin/2002 /0802lead.pdf)

3 Month T-Bill = 2% Corp. Bonds (AA 7-10 yrs.) = 6% 2 Yr. T-Bill = 3% 3 year CD's = 3.5% 10 Yr. T-Bill = 5%

These students may conclude that the real estate nearly worst case real estate scenario return on initial cash investment produces a higher rate of return than even longer term T-Bills and AA corporate bonds, and would therefore seem to warrant the additional risk associated with the debt burden.

Many of the students may also point out that from a non-financial perspective, Davis and Hodgetts might feel more empowered and in control of this investment versus their other passive investments and hence might derive a psychological income from managing at least a part of their money.

4. Assuming that Davis and Hodgetts decide to go into this venture, what might be some of their short-term and long-term goals and objectives?

The purpose of this question is to test students' ability to see beyond the immediate initial property investment and to use their creativity in developing longer term goals and objectives. Shorter term goals and objectives should generally deal with the initial investment property. This would include establishing the corporation, locating a property and a suitable renter, obtaining a mortgage, going to closing on the property, signing a lease agreement with the renter, and deciding whether to self-manage the property or contract out services.

Longer term goals should deal with developing a vision and mission for the firm (what should the company look like in five years) including the personal plans of Davis and Hodgetts, instituting growth and profit goals, formalizing a sustainable competitive advantage, and developing a network of contacts in the property rental industry. Very specific questions can be addressed by the students, including:

5. How many rental properties do Hodgetts and Davis envision owning in 1 year, 3 years, five years ...? What is their goal for the size of the business? Does either Hodgetts or Davis envision retiring or leaving academics to run the business full-time? If so, in how many years? Are there related businesses that Hodgetts and Davis should contemplate entering? (I.E. real estate rentals and sales, commercial renting, mortgage lending, and home construction.) Are there family members (spouses, children, sibling, parents, etc. ...) who may have an interest in entering this business? If so, in what capacity and when? When would Davis and Hodgetts like to retire from the business? Is there a succession plan for the firm?

Given the very open ended nature of this question, it is expected that students will develop a myriad of goals and objectives that may go beyond the scope of the answers given in this instructor's manual.

CASE EPILOGUE

Davis and Hodgetts decided to go into the business and formed D & H Reality, LLC with an initial investment of $40,000 each. They decided that they would start the business with at least two homes at around $165,000 each, putting 10% down, with each of them buying a home (and therein obtaining the mortgage) and deeding it over to the company. Davis brought in his wife to manage the rental properties while Hodgetts played banker and loaned the firm additional capital in order to expand the number of managed properties. Within a year's time, the firm had accumulated ten properties, worth approximately $ 1.8 million dollars, had debt of around 1.6 million, and was generating a positive rental cash flow of about $2,000/month.

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Herbert Sherman, Southampton College--Long Island University

Daniel J. Rowley, University of Northern Colorado