Question

1. You are offered the opportunity to develop a 400,000 sf warehouse facility for General Foods in suburban Philadelphia. Attracted by your expertise as a local warehouse developer, General Foods has offered to sign a triple net lease for seven years at a rent for $2 million per year. They also insist that at the end of the lease term they have the option to purchase the property at $22 million. Their final major condition is that the project be completed and ready for occupancy in 11 months. If it is not complete by that time the deal is void.

You estimate that the property will cost $20 million to complete (including all costs) and that you should be able to complete it within ten months if you commence construction immediately. You believe that you can obtain a construction cost guarantee that should guarantee costs will not exceed $20.5 million. You believe that you will be able to obtain a $14 million to $15 million, seven-year, 25-year amortization loan, at a fixed interest rate of 8%, and a 50 basis point fee. You believe that you can close this loan in six to eight weeks from now.

You believe that your company can access approximately $8 million in equity, assuming that you can successfully tap into appreciated equity positions in three existing properties without triggering capital gains taxes on these positions. Your company will receive a development fee of roughly 3% of project costs (this cost is included in your $20 million cost estimate).

Finally, vacancy rates in the market are approximately 4%, gross rents in the market run $7-9 psf, with operating expenses and taxes running $2-$4 psf. Negotiations are over and it is time to make a decision.

Should you agree to develop the property? Give your reasons.

Answer 1

Cost of Project = $ 20.5 million (max)

Development fee = 0.6 million

Hence maximum expected cost = 19.9 million

Equity infused = $ 8 million

Bank loan that is required = $ 11.9 million

Loan to be sanctioned is for 25 years amotization

Amortization amount for each year =PMT(8%,25,11.9,0,0) = $1.11 million( Excel formula for pmt)

Profit made for first 7 years = number of years * ( rent received - Amortization payment) = $ 6.23 million

Rent received after 7 years = $7-9 psf and operating expenses and taxes = $2-4 psf

Therfore assuming average rent received will be $ 5 psf

Total area = 400000 sf

Rent received per year = 5 * 400000 = $ 2 million

Rent received considering vacancy factor = 2* 0.96 = 1.92 (Given 4% vacancy rate after 7 years, hence 0.96 factor taken)

Total profit made from year 7 to 25 = 18* (1.92 - 1.11) = $ 14.58 million

Total profit = $ 14.58 million + $ 6.23 million = $ 20.81 million

Equity infused = $ 8 million

Hence net profit over 25 years = 20.81 - 8 = $ 12.8 million

Risk of completion will also be not there as project can be started initially with own equity till loan gets sanctioned

Also if GE agrees to buy property after 7 years we would be in profit.

Hence we should agree to develop property as it is profitable.