Kathy Waterhouse has $750,000 to invest and has been approached with two alternatives. Since Kathy knows nothing about the world of “high finance” she has asked you to analyze these two alternatives. Today is January 1, 2015.
The first option is for Kathy is to invest $750,000 in a State of Illinois bond which will pay 8% interest and mature in 7 years. She will reinvest the after tax interest earned into a taxable corporate bond investment earning 9% interest per annum payable semi-annually on the last day of June and December.
The second option is to purchase a small office building for $2,430,000 by paying $750,000 down and financing the remaining purchase price with a 9% non-recourse 30-year loan. Kathy will make annual payments each December 31 which will pay $56,000 on the principal plus whatever interest is due on the balance of the loan for that period. If this alternative is selected, Kathy expects to sell the office building on December 31, 2023 after making that year’s annual payment on the loan and using the sales proceeds to pay off the mortgage balance on 12/31/2023.
The real estate agent who is offering Kathy the property has prepared the following projection for 2015 with the following annual increases for the next year: rental income 6%, real estate taxes 3.5%, repairs 5%, insurance 2.5% and maintenance 5.8%.
2015
Rental Income $290,000
Real Estate Taxes $ 35,000 (paid semi-annually)
Repairs $ 5,000 (paid on December 31st each year)
Insurance $ 8,000 (paid on January 1st each year)
Mgmt. Fees $15,000 (paid on January 1st each year)
The expected market value of the property is expected to increase at 4% per year.
Whatever is left in after tax dollars will be reinvested in qualified stock paying an annual taxable dividend of 5% each December 31st.
Kathy is single and is in the 39.6% marginal tax bracket. Please evaluate each of the alternatives from both a financial and tax standpoint.
Finally, rank the alternatives from best to worst and address the risks there are in each alternative. Remember that comparative rankings must all be done on the same future date.
If alternative two is not the worst alternative, how much decline per year would there need to be in order for it to become the worst?