Question

You are working for an active investment group, which is very interested in an office property in Tokyo. The property is 16 years old, well (but not spectacularly) located, with good floor plates, and meets earthquake standards.  

The property is available for $100 million (all payments will be in yen, but I’ll express them in dollars to ease your headaches), which is a mere 20% of the value placed on the property in 1991. The property needs about $20 million in improvements to make it competitive with new properties. The property is currently vacant, as it was the headquarters of a recently liquidated bankrupt company. At the all-in-cost of $120 million the property would have a cost equal to roughly 90% replacement cost, though since land costs are 50-60% of replacement costs, and land prices continue to fall, it is hard to be precise on this estimate.

The local rental market for quality properties is fairly strong in spite of the weak Japanese economy, as tenants continue to take advantage of low rents by moving out of poorly located and designed properties into better properties. Leases in Tokyo are only two years in duration, and the tenant typically pays triple net rents. Property values are at levels not seen since the early 1980s. Sales are relatively frequent, but pricing is unpredictable, with American buyers paying 6-8% cap rates, and occasionally Japanese firms paying 3-5% cap rates. Two REITs recently did IPOs at roughly 6% cap rates, but their prices have fallen substantially since their IPOs.

Rents in Tokyo for quality properties continue to fall by 1-2% per year, as new construction continues to generate a modest supply/demand imbalance. This situation, and the general Japanese economic malaise, is expected to continue for the next several years.

You believe that after one year to completing the necessary improvements, you will be able to lease the property for an NOI of $8.4 million (after usual reserves). You can borrow $100 million, non-recourse, 5-year maturity, no points, 30-year amortization, for a fixed interest rate of 2%. To eliminate all currency risks on your investment (let’s not worry about how this is done) will cost $1.2 million per year. Your target rate of return is roughly 17% on your equity for a 5-year hold. What do think (and why)?

Answer 1

Let's prepare the cash flows to figure out the ROE. Please see the table below. Please be guided by the second column titled “Linkage” to understand the mathematics. Figures in parenthesis, if any, mean negative values. All financials are in $ mn.

Parameter	Linkage	$ mn
NOI	A	8.40
Total cost	B	120
Loan	C	100
Equity portion	D = B - C	20
Interest	E	2%
Amortization	F	30
Yearly payment towards loan	G = PMT (E, F, -C, 0)	$4.46
Hedging costs	H	1.2
Net cash flows to equity	I = A - G - H	2.74
Return on equity	J = I / D	13.68%

We are able to generate a Return on Equity (ROE) of 13.68% against our target return of 17%. The property is not performing up to our expectation. We therefore believe the deal is not commensurate with our aspirations, and hence we should not pursue it further.