Suppose one of your friends had a summer job at a nearby beach. While there, she came across what may be interesting investment opportunities in real estate. She now needs your help in considering whether to make an investment. A condominium is on the market with an asking price of $550,000. To be conservative, your friend assumes that the first cash inflows she would collect will begin a year from now.
The real estate broker told your friend that the property is likely to produce an annual cash flow of $39,600 for the first year, and that no future growth in cash flow should be expected. Your friend anticipates holding the property for 7 years, then selling it. Your friend believes that potential buyers in the future will have the same forecasts for the condo’s performance.
a. Assuming you think that an annual rate of return of around 9% would be required, should your friend buy the property? Calculate both the NPV and IRR , and ignore taxes.
b. With calculations, determine whether your friend’s plan to sell the property after 7 years is important to the analysis.
Suppose another broker whom your friend met indicated that she should be more optimistic about future changes in the condo’s performance. He suggested it would be reasonable to assume that the property’s cash flows will grow at 3% annually. (This implies that next year’s cash flow would be 3% higher than the initial forecast.) He also recommended that your friend plan to hold the property for just 3 years before selling and buying another one.
Estimate the NPV under these assumptions. Based on this estimate, should your friend buy the condo? Again, assume potential future buyers will have the same forecast.