Conversion of the Pilgrim Building - Coursework Example

Pilgrim Assurance building case study Bailey wants to purchase the Pilgrim Assurance building through a competitive bidding. In doing this, he has to ensure that he pays the most rational bid that will enable him win the purchase of the building. From his perception, the building is of great importance to his real estate business. First, he has estimated the gains to be made from the building in terms of profit. He has also done an internal and external analysis of his real estate company in relation to the transaction he is about to make. The building being offered for sale has been estimated to cost around $15 million. This is the basis of bidding. Just like other bidding competitions, the highest bidder will be the buyer of the building. Bailey, just like his competitors, is required to pay commitment fee of $1 million. This was to act as a deposit to show that he was committed to purchasing the building (Greenhood, David and Segel). In his internal environment analysis, Bailey has assessed the capability of his company to undertake the purchase without jeopardizing the financial position of his company. First, Bailey has been able to evaluate the capability of his company to manage an extra building. According to his, his company has been able to manage several other residential and office building. His company is based on real estate business; therefore, purchase of the Pilgrim Assurance building will not be out of area of operation. Also, he has a well-equipped and experienced staffs that will help him handle the new building, if he succeeds in buying it. During the internal evaluation of his company, Bailey has identified strengths that are likely to give him an upper hand in the market competition. First, he has a network of labourers that will assist his reduce the renovation costs. As explained by him, a normal buyer of the building is likely to use $50000 to renovate each of the 20 bathrooms in the Pilgrim Building. This translates to a total cost of $1 million. In the case of Bailey, his cost of renovating a single bathroom is lower at $35000. This amounts to a total of $700000. This means that Bailey is likely to save up to $300000 from the renovation of the bathrooms. Similarly, the lobby will be renovated by the new buyer. The market price of renovating the lobby has been approximated at $200000. Due to Bailey’s experience in the real estate business, he is likely to save $50000 from renovating this lobby. These form part of the factors which have motivated Bailey to consider the purchase of the Pilgrim Building (Greenhood, David and Segel). The building, as identified by Baileys can offer additional room for extra rental space. Bailey has estimated that an extra rental space can be obtained by restructuring the Pilgrim building. According to him, this is likely to generate an extra revenue of $2000000 worth of rent income from the extra 10000 SF created. Another are of opportunity identified by Bailey in his consideration is the management costs. A normal real estate company will use $1.25 per Square Feet (SF) in managing the building annually. Due to the experience attributed to Bailey’s company, these management costs have been estimated to decrease to lows of $0.50 per SF. This is a significant saving on Bailey’s side that gives him an absolute competitive advantage over the other bidders. Bailey’s objective is to purchase the building and convert it into either office rentals or Condominiums. Converting the building into rental office space costs differently from converting them into condominiums. The returns from the two ventured have also been deemed to be different. Firstly, the condominium conversion has been deemed to be more risky, but with high returns. In contrary, the use of the new building as office rental space is less risky and less profitable. This poses a critical area of evaluation for Bailey. To determine the profitability of the house, we will have to determine the outcome from each of these ventures. Conversion into office space Expense Amount Renovation (bathroom) 700 000 Renovation (lobby) 150 000 Selling and marketing - Cost of creating additional 10000 SF 100 000 Management cost $0.50/SF per year 100 000 Total expenses 1,050,000 Revenues Rent income $20 Per SF 4 000 000 Gross profit 2 950 000 This represents the gross profit before taxation and the cost of the building have been deducted. At this point depreciation and other expenses have been ignored due to their insignificance in this calculation. Conversion into condominiums Expenses Amount Renovation $200/SF * 159000 SF 31 800 000 Sales commission 5% 4 770 000 Management cost $0.50/SF per year 87500 Total expenses 36 657 500 Revenues Rental revenue ($600/SF) * 159000 95 400 000 Gross profit 58 742 500 From the above calculation, conversion of the Pilgrim Building into residential condos is deemed to be profitable compared to office use. These high returns have been associated with the high market risks. For instance, the residential house costs have been predicted to reduce since the market is already in its peak. The restructuring of this building is likely to take 18 months with an additional 6 months of legalization. This period is long owing to the fact that rent income will be forgone had the building been used as office rental space. Bailey should take the risk since it will yield him more income. Bailey will therefore maximize his revenue and also recover the expenses incurred in purchasing the building by constructing and selling the 150 condos. Valuation of the building The seller of the building has estimated the minimum selling price of the building at $15 million. This is the value of the Pilgrim Building and the ½ acre piece of land. This building was constructed in 1920s and has been renovated ever since. For Bailey to bid, he has to determine the market value of the structure and hence the amount which he is willing to bid. According to the seller, the value of the building was estimated as follows. Land cost = $5 million Cost of building $10 million Total value of the building = 15 Million This was designated as the value of the building the seller was willing to accept from the buyers. However, the building could be valued differently by the different competitors. According to Bailey, valuation could be done based on the profitability of the building. Taking a profit period of 3 years, the following valuation can be made by Baileys. Cost of land - $5 million Cost of building – $10 Million Cost of renovation - $850 000 (cost of renovating the lobby and bathrooms) for office use Cost of acquiring an additional rental space – $100 000 Total amount required by Bailey is $15 950 000. This is the amount required by baileys to make the building profitable to his company. However, the seller requires a minimum bid of $15 million. This means that Bailey has to quote a bid price higher enough to hedge the competitors. Following the repayment valuation method for the next three years, the value of the building, according to the various investors is as follows: Bailey Ask price $5 million Rent income anticipated by Bailey is as follows: He anticipates to sell 70 000 of the 75000 SF by the end of the first five years. This will follow an annual rate of 14000 SF per year. 1st year rent income = 14 000 * $20= $280000, since the rest of the 100 000 SF will be occupied by the Pilgrim Insurance company; they will lease this space for 10 years. The cost of the lease is 100 000 SF * $26 * 10 = 26 000 000. This will be apportioned to each of the years yielding an annual rent income of $2600000. 2nd year rent income = 28000 SF* $20 = $560000 3rd year rent income 42000 SF* $20 = $ 820000. Rent income for the first 3 years = 820000 + 560000 + 280000 + (200000*3) = $2,260,000 The building can also be valued using the free cash flow method. This valuation will be done based on the type of use the building will be purchased for. Office use Revenues: these are deemed to arise from the rental office space. Revenues will also arise from capital gains and increase in the value of assets. Lease with bump = 100 000 SF * $20 = $2000000 Remaining rental space at the rate of 14000 SF per year = 14 000 * $20 = $280000. Additional rental space 10000 SF = $20000 to be rented at a rate of 2000 SF per year = $4000 per year. Total revenue= $2284000 Depreciation on building is calculated as follows: Present book value of land = $10 million, and is estimated to last for 39½ years. Yearly depreciation = 10 million ÷ 39.5 = $253165 Depreciation on renovation is calculated as follows: Renovation cost is $0.50 per SF. Apparently; the total rental space is 185000 SF. Therefore the total Cost of renovation is $92500. Since this cost is depreciated on a straight line method, 92500/39.5 = $2342 Total depreciation= $255507 Operating expenses are computed as follows: Management cost = $0.50 per SF * 175 000 SF = $87500 Additional management cost for the 10000 SF to be created = $5000 Capital expenditure includes the renovation costs Cost of creating additional space = $10000 Repair costs of $0.50 per SF = $92500 Revenue 2284000 Less operating expenses (92500) EBITDA 2191500 Less depreciation (255507) EBIT 1935993 Less 35% tax (677597) EBIAT 1258396 Less Capital expenditure (102500) Add back depreciation 255507 Free Cash Flows 1411403 The amount presented above represents the returns anticipated from the use of the building as rental space for offices. Capital expenditure: Cost of conversion of $200 per SF = $11800000 and repair cost of $0.50 per SF = $87500 Total capital expenditure = $11887500 Management cost $0.50 per SF = $87500. This represents the total rentable area initially offered by the seller. Revenue: $600 per SF for 159 000 SF = $95400000 Revenue 95400000 Less Operating expenses (87500) EBITDA 95312500 Less depreciation (255507) EBIT 95056993 Less 35% tax (33269948) EBIAT 61787045 Less capital expenditure (11887500) Add back depreciation 255507 Free cash flows 50155052 Conversion into condominiums will be the best venture for Bailey if his bid is to succeed since it yields more revenue than use for office rental purpose. The market for rental office space has been volatile over the last five years. Prices have been on the decrease but the last year, 2003-2004 has seen a lesser decrease in the rent paid for office space in Boston. There is sign that the market is going to recover, but this is not certain. Converting the building into office space is a profitable venture for Bailey (Greenhood, David and Segel). Discounting these free cash flows for the period of 5 years, the net present value of the building can be obtained as follows. Free cash flows (FCF) * 5{() + ()2 + ()3 + ()4 + ()5 250775260 (0.95 + 0.90 + 0.85 + 0.81 + 0.77) 250775260 (4.28) = $1,073,318,113 this is Net present Value (NPV) of the building for a period of five years. This is a case in which the house is converted to condos. In the case where the building is to be leased for office space, the net present value is obtained as follows: NPV = (1411403 * 5) (4.28) = $ 30,204,024.2 Base on the discount cash flow me method, the present value of future returns, calculated for the five years; conversion into a condo is more viable than renting the building as office space. However, there are many risks associated with converting the building into condos. First, the housing market has been on the rise. It has been predicted that this market is on its peak and may fall anytime soon. This will mean that the prevailing condo prices will fall once the market is saturated. For Bailey, this is bad new if he decided to venture into selling condos. Another issue is that Bailey will only benefit from the condo business after a period of two years. This is likely to be a disadvantageous for Bailey owing to the fact that the market is about to worsen. If it takes him a longer time to sell the condos, he will be exposed to greater risks. Provided evidence fully support conversion of the building into condos. First, evidence from exhibit 8 indicates that people are now moving to downtown apartments due to the convenience they have attached to staying in the down town region. The surrounding region, where the building lies is slowly being converted into a residential zone, with more apartments being constructed for residential purposes. In fact, statistics indicate that around 14000 units are being constructed (Greenhood, David and Segel). Bailey should not just offer this price and relax; the competitors are also aiming to hedge him in the purchase of this house. Bailey should take competition seriously by taking actions to hedge them. Most of the identified competitors have experience in the real estate industry. They understand the underlying issues in building valuation and the bidding process. Many will want to bid the highest possible price based on the benefits they deem to arise from the purchase of the house. The competitors are well informed about the advantages attached purchasing the building. They are well conversant with the market trends and transformations that are likely to affect the real estate industry. The REIT, for instance, have specialized in tax expense reduction in their operation. Tax reduction is a form of saving for these firms. They therefore stand an advantage of gaining more revenue through tax reduction compared to the other competitors. To counter this, Bailey has also seen opportunities that are likely to generate additional revenue from the building. His plan is to either venture in residential apartments of restructure the building thereby creating more rental space. This is an opportunity exclusive only to him. Therefore, the net worth of the house will be different according to these two competitors. The bids received by the seller from the different competitors for this building are expected to be of different values. This is because each of the bidders has attached a different value to the building. As explained earlier, each of the bidders attaches a value to the building based on the gains they deem to receive from the building. Each of the buyers has seen opportunities through which they want to capitalize on. The highest bidder, therefore, will be the one that has seen many benefits hence wants to pay the highest price for the benefits speculated. Bailey’s edge Bailey stands to benefit more from his experience on real estate management if his bid is to win in the purchase of the Pilgrim Building. As discussed earlier, he has vast experience and a good network of associates in the real estate industry. These have positioned him in a good place to make the purchase of the building more profitable compared to his competitors. Bailey’s edge can be summarized by the table below. Bailey Other Bidders Management fees $0.50 per SF $1.25 per SF Renovation of the lobby $150 $200 Renovation of the bathrooms $700 $1000 Creation of extra space (Atrium ) 100 - As evident from the above table, Bailey will best manage the building. Apart from profit maximization, Bailey seeks to gain from cost minimization. Through reducing the costs associated with the building, he shall be capable of generating more revenue, something his competitors cannot do. This places Bailey at a better position to offer a higher bid owing to the fact that he is able to recover the cost of the building faster than any of the bidders. Bailey’s creativity in terms of cost reduction and maximum use of the property is a tool, which he will use to his advantage to ensure the purchase value is regained as soon as possible by his company (Greenhood, David and Segel). Unlike his competitors who have little knowledge on cost minimization, Bailey’s real estate skills stand out in this venture. For instance, none of the investors can realize that part of the building was designed as a warehouse hence could be restructured to create more space for rent. Bailey was able to identify this opportunity from the skills he possesses on real estate development and management. Based on the skills possessed by Bailey, he is likely to win the bid. His competitors; REITS, pension funds, institutional investors and others in the bidding race do not invest in condos. Bailey likes to diversify his assets in the real estate industry so as he can benefit from maximum gains. Due to the fact that the other bidders have internal restrictions on the use of the Pilgrim building, they are likely to offer lower bids compared to Bailey. The competitors have only statistical data at their disposal where Bailey has real valuations in the real estate business. Capital The best way to make this purchase, while taking care of risk and uncertainty is through a mixed capital structure. This house has been valued highly and it will be sold to the highest bidder. Due to the short notice of the bidding process, it will be difficult for Bailey’s company to acquire the building using its internal funds. This will make debt capital a necessity to this transaction. From the calculation above, Bailey can balance the debt capital and equity capital. The debt capital will be serviced by the free cash flows received annually. This building, whether subjected to office use or sold as apartments, will be able to service any amount of debt acquired to purchase the building. Capitalization rate Yearly income (for the office use) = $1411403 Price 15 million Capitalization rate = 1411403/15million = 0.094 = 9.4% For the condo option = 50155052/ 15million = 33.4% This means that the condo business is likely recover the purchase price faster than the office use. Bailey’s competitors have determined their capitalization rate based on the prevailing market conditions and statistical data available. They require a capitalization rate of 7% compared to Bailey’s estimated 9%. This means that their bid will be lower hence Bailey is likely to win. Works Cited Greenhood, R., S. David and A. Segel. "Pilgrim Assurance Building." Harvard Busines School 27 April 2007. Web . Greenwood, Robin. "The Pilgrim Assurance Building Courseware." Harvard Business School Spreadsheet Supplement 209-706, July 2008. Read More