Question

1.Suppose you are considering the acquisition of an income producing property. The building is currently leased for the next 4 years with annual (year-end) cashflows of $1,500,000. At the end of the current lease, you expect rents to increase to $1,800,000 (annually) for the foreseeable future. You anticipate selling the property ten years from today, at an expected multiple of 10.0 times the prevailing market rent. Market rates (OCC) are currently 5%, but given the uncertainty surrounding future rental rates a 3% risk premium must be added to interlease rates. What is the value of this property (to you) today?

2. Continuing from problem 1, now suppose we have the opportunity to extend our existing tenant lease for an additional two years (at the expected market rate of $1,800,000). How much would the property’s value increase by signing this lease extension?

3. Continuing from problems 1 and 2, at what lease rate should we be indifferent between signing the extension and waiting for market conditions to continue evolving?

Answer 1

Part 1

Year	Cash Flows ($ '000)	Discounting factor @ 8.15%	P.V of Future Cash Flows ($'000)
1	1500	0.925	1386.963
2	1500	0.855	1282.443
3	1500	0.791	1185.801
4	1500	0.731	1096.441
5	1800	0.676	1216.578
6	1800	0.625	1124.899
7	1800	0.578	1040.128
8	1800	0.534	961.746
9	1800	0.494	889.270
10	1800	0.457	822.256
10	15000	0.457	6852.137
Net Present Value of the project	17858.661

Working Note :

Note : Calculation of Discounting Rate
Given Market rate    = 5%
Risk Premium             = 3%
Therefore rate            = [(1+5%) *(1+3%) -1 ]* 100
	˭[(1.05 *1.03)-1 ] *100
	˭8.15%
Calculation of Sale value of Property at Y-10
Market value of rental today       = $1500,000
Multiplier                                             = 10 times
Sale Value after 10 years              = $ 15000,000

Part 2 .

Year	Cash Flows ($ '000)	Discounting factor @ 8.15%	P.V of Future Cash Flows ($'000)
1	1500	0.925	1386.963
2	1500	0.855	1282.443
3	1500	0.791	1185.801
4	1500	0.731	1096.441
5	1800	0.676	1216.578
6	1800	0.625	1124.899
7	1800	0.578	1040.128
8	1800	0.534	961.746
9	1800	0.494	889.270
10	1800	0.457	822.256
11	1800	0.422	760.293
12	1800	0.391	702.998
12	15000	0.391	5858.318
Net Present Value of the project	18328.134