Question

You have been approached by General Electric (GE) to develop a 150,000 SF office facility for them in suburban Dallas. They will use the property for “back office” operations and corporate training. After considerable negotiation, you have received their final non-negotiable offer. They would lease the facility for 6 years, at a triple net annual rent of $2,250,000. The rent would remain constant over the term of the lease. GE would also have the option to renew their lease for an additional 6 years for $3,000,000 (triple net). In addition, they would have the option to purchase the property at any time during their lease (including the renewal period if exercised) for the price of $29 million. They insist that the property be completed by 11 months from today. Failure to achieve this completion date would relieve them of the agreement.  

You estimate that the project will cost $25 million (all costs included), and will take 9.5 months from today to complete. You feel that due to the presence of GE as a tenant, you will be able to secure a $20 million loan during the next 3 months, at a 6% interest rate for 3 years with no amortization. You have $2 million in cash available to start the project immediately, and believe that during the next 2 months you will be able to access the remaining $3 million of required equity either by refinancing equity out of other projects you own, selling other properties you own or bringing in a 3rd party as an equity partner. If you provide the entire $5 million of anticipated equity requirements, it will represent 75% of your net worth. You anticipate that you would receive a $1 million development fee upon successful completion (included in the $25 million total costs).  

Your research indicates that currently, market rents are roughly $16 per SF triple net and that development is occurring at a rate roughly commensurate to employment growth. Vacancy rates are roughly 5% in the market and expected to remain stable. Cap rates for “comparable” property sales range from 8%-10%.  

It is decision time. Would you accept their offer? Explain your reasoning.

Answer 1

Considering the facts the case we should not accept the offer.

The decision is be based on the following factors:

Market Rent per year: $ 16 per SF * 150,000 SF
= $2.4 Million

Since Vacancy rates are roughly 5% in the market and expected to remain stable, we can say that roughly the rent will also remain stable in the market at $2.4M.

Actual Rent per year: (first 6 years) : $2.25 Million
(next 6 years in case of renewal) :$ 3 Million

Currently the rent agreed is 6.25% (1- 2.25/2.4)less than the market rates. However if the lease gets renewed the rent is revised to $3 Million which becomes 25% (3/2.4 -1)greater than market rates.

The cap rates range in the market from 8 to 10%, hence net operating income / cost of project should be between 8-10 %.

Assuming all costs are included in $25 Million. We get a cap rate of (2.25/25) ie 9% approx in the first 6 years and (3/25)ie 12% in the next 6 years.

Additionally GE has also got the option for purchasing the property at anytime during the lease for $29 Million which is greater than the net cost of $25 Million. (ignoring time value of money for sale made in subsequent years)

Considering the situation that GE does not purchase the property within 3 years it will be difficult to payoff the loan of $20Million because the loan is for 3 years. SInce the networth given is $6.6 Million (5/0.75), the loan if not repaid will drag us into bankruptcy. Since there is a possibility of not being able to sell the property within 3 years and mint a good amount of money from the property via capital gain it will be detrimental to the going concern of our entity.

Although the cap rate may seem to be within the range and project may seem to be viable otherwise but not being able to payoff the loan is a factor which needs to be strongly considered while making this decision.

Hence considering this situation it will be risky to accept the offer since there is no binding agreement for a selloff within 3 years or extending repayment period of loan/ additional support to refinance the loan etc to safeguard the company against default in its loan repayment.