Question

First, you could build an office building on the site. You’ve spoken with a broker who tells you that you can expect to earn around $60 /sf/year on new office space in the market. The site is currently zoned for residential, but the city has granted variances to nearby parcels allowing for office development. You’re optimistic that the city will grant you a similar variance allowing a 25,000 sf office building on your lot. You’ve spoken to a banker who offered you a loan with a loan-to-value ratio of 85% (a 30-year fixed rate mortgage at 9% APR with annual debt service payments of $38 /sf/year). You anticipate operating expenses will be around $5 /sf/year. Once the building is stabilized, you expect that it will have a value of $460 /sf. Second, you could build a 100-unit apartment building on the site without changing the current zoning. Once you take into consideration average vacancy rates, similar buildings rent for around $15,000 unit/year with operating expenses around $3,000 /unit/year. For an apartment building, the banker offers a loan with a 95% loan-to-value ratio based on an estimated building value of $144,000 /unit (similarly a 30-year fixed rate mortgage, but with 6% APR and an annual debt service of $1,500 /unit/year). Calculate the Cash-on-Cash and Return on Assets for each project. Based on this analysis alone, which project produces a better financial return?

Answer 1

Cash on Cash Return = Annual Pre-tax Cash Flow/Total Cash Invested

ROI = Annual Cash Flow / Invested Equity

OPTION - 1
Plot area (sf)	25000
Office rental ($/sf/year)	60
Operating Expenses ($/sf/year)	5
Annual debt service payments ($/sf/year)	38
Annual Cash Flow ($/year)	425000
L/V ratio	85%
Term period (years)	30
APR	9%
Value of building ($/sf)	460
Total Value of Building ($)	11500000
Loan principal amount ($)	9775000
Total Cash Invested ($)	1725000
Cash-on-Cash Return	24.64%
ROI
Annual Interest Payment	-547068
Annual Principal Payment	-325833
Annual Debt Service	-872902
Annual Cash Flow	425000
plus Annual principal pay down	325833
Annual Cash Flow (Interest Only)	750833
Invested Equity (equal to Down payment)	1725000
ROI	43.53%

OPTION - 2
No. of Units	100
Rentals ($/unit/year)	15000
Operating Expenses ($/unit/year)	3000
Annual debt service payments ($/unit/year)	1500
Annual Cash Flow ($/year)	1050000
L/V ratio	95%
Term period (years)	30
APR	6%
Value of building ($/unit)	144000
Total Value of Building ($)	14400000
Loan principal amount ($)	13680000
Total Cash Invested ($)	720000
Cash-on-Cash Return	145.83%
ROI
Annual Interest Payment	-481582
Annual Principal Payment	-456000
Annual Debt Service	-937582
Annual Cash Flow	1050000
plus Annual principal pay down	456000
Annual Cash Flow (Interest Only)	1506000
Invested Equity (equal to Down payment)	720000
ROI	209.17%