In: Finance
You buy a recently completed industrial-office building and starting at the beginning of the first year, you put in a single-tenant who pays net rent $50,000 per year at the end of each year on a 5-year triple-net lease. At the end of the fifth year, if all goes well between you and the tenant, you expect to increase the rent to $70,000 per year and put the tenant on a 10-year triple-net lease. After owning the property for 10 years, and just after collecting the rent for that 10th year, you expect to sell the building at a Reversionary Cap Rate of 10%.
A. What is the value of the property if the required initial return is 12 percent per year?
B. If the cap rate on the price you pay when you initially buy the building is in-line with the market cap rate of 10.5%, then what is your IRR on your excellent real estate investment?
Knowledge Required to solve the sum
- triple-net-lease: It is a lease where the expenses related to the property are including property taxes are borne by lessee only.
- Reversionary Cap Rate = {Net Operating income (NOI)/ Expected Sales Price}
or Expected Sales Price = { NOI/ Reversonary Cap Rate }
Answer 1
Expected Sales Price at year 10 end = { NOI/ Reversonary Cap Rate } = 70000/10% = $700000
Value of Property = Present value of cash inflows from property at 12% p.a.
= 50000/(1.12)1 + 50000/(1.12)2 + 50000/(1.12)3 + 50000/(1.12)4 + 50000/(1.12)5 + 70000/(1.12)6 + 70000/(1.12)7+
70000/(1.12)8 + 70000/(1.12)9 + (70000+700000)/(1.12)10
= $548801
Answer 2
Value at time of investment = (50000/10.50%) = $ 476190
Termial Sales price, as computed above = $ 700000
IRR of the investment is the rate of return at which present value of cash outflows is equal to present value of cash inflows.
Let IRR be r
This implies,
476190 = { 50000/(1+r)1 + 50000/(1+r)2 + 50000/(1+r)3 + 50000/(1+r)4 + 50000/(1+r)5 + 70000/(1+r)6 + 70000/(1+r)7+ 70000/(1+r)8 + 70000/(1+r)9 + (70000+700000)/(1+r)10}
This implies IRR = r = 14.32%