Construction Project in Heidelberg, Germany
You have recently joined an investment team that operates a well-diversified portfolio of investment properties located in tourist destinations throughout the world. The group’s portfolio of assets consists of office, retail, and residential properties located primarily in North America and Europe. The group is considering the construction of a mixed use office-apartment building located in Heidelberg, Germany. The site has recently been razed, and the prior usage was two residential properties that were owned by professors from Heidelberg University. The site is located on Neuenheim Landstrasse, a primary corridor in the city which has a scenic view of the Neckar River. The site is on the opposite side of the river from the famous castle in Heidelberg, and is near “Philosopher’s Way”, a trail made famous by German philosophers such as Hegel and Nietzsche. In years past, philosophers such as these would traverse the trail, contemplating philosophical questions. Now the path is occupied primarily by tourists, hoping for similar deep insights.
Given the scenic view from the proposed new mixed use property, the project will be known as “King’s View Park”, and will consist of a two story building on site where the two residential houses once stood. The top floor of the building will contain three apartment units (two bedroom, one bath), while the bottom floor will consist of four office units.
Based on your firm’s market research in conjunction with local real estate professionals, it has been determined that the apartment vacancy in the city of Heidelberg is essentially zero at the present time. Some competing units are being constructed currently, but none with the scenic view of the subject property. Your firm has also determined that the existing office market vacancy rate in the Rhein-Neckar metropolitan region is approximately 10%.
Given the strong level of occupancy in the Heidelberg apartment market, you have been able to obtain letters of intent for each of the three apartments, as well as three of the four office units.
Each apartment is 1,400 sq. ft., and will rent for $4,250 per month. The letters of intent have been signed for 1 year, which will begin once construction is complete and the property is ready for occupancy.
The rent roll for the office spaces is shown below:
One of the office units will be occupied by a retired professor, who will use the space as his personal office while he writes his memoirs and updates his previously published textbooks which are in various stages of completion. He has signed a pre-lease agreement for a 2 year term. Two other office suites will be occupied by Heidelberg University. Since the University has grown in recent years, these offices will be occupied by university staff. They have signed a letter of intent for 4 years. The final office space has yet to be leased, but given that 85% of the total square footage of the property has been pre-leased prior to commencement of construction, your firm believes that this property will be fully and quickly absorbed by the market prior to completion.
Your firm typically assigns a replacement reserve of 1% of EGI annually for projects of this age and condition. Additionally, you have contracted with Dahler & Co. GmbH, a well known real estate brokerage and management firm, for a management contract of 3 years, with compensation equal to 3% of the effective gross income of the property.
Additionally, you have estimated the following expenses for the first 3 years for the project:
Total project construction costs are estimated at $3,500,000, and you have requested a loan to cost of 75%. Your firm already owns the land. A local bank has offered 25 year financing at 7% interest.
Your assignment is to develop a discounted cash flow analysis (DCF) for this property. Assume a 10 year holding period, which is consistent with your firm’s investment horizon for this project. Given the strong location, a 5% annual appreciation rate is expected for this property, and selling costs run 3.5% in this market. Your projections should include a most likely case which assumes annual GPI increases of 2.5%, and a best case which assumes annual GPI increases of 5%. Assume a 9% discount rate, and a terminal cap rate of 8%. Your DCF should take the market intelligence, your projections of income and expense associated with this project, and lease rollover risk into account.