Question

Steve Silver purchased a parking lot ten years ago for $100,000. He has earned an average annual net operating income of $14,000 and is now considering selilng the parking lot. Manny Munford likes the parking lot's location and initiates negotiation for its purchase. Silver points out that the city has recently increased parking fees at municipal lots and observes that fees can now be reaised on this lot sufficiently to move the net operating income to about $20,000 annually. He notes that the $14,000 per year he has been earning represents a 14% per annum return on his investment. He thinks this is a good yield and states that Mumford can do equally well, based on the anticipated $20,000 per annum net operating income, by paying about $144,000 for the lot. Mumford retorts that Silver will have an assured rate of return once the lot is sold but that Mumford will be taking a risk that the anticipated cash flow will not materialize. Therefore, says Mumford, she should earn a premium. She suggests an 18% yield and offers a price of about $111,000. Both parties earnestly state their desire to be fair and equitable in establishing a price for this property, but they are at odds as to how a price might best be determined. What do you suggest? Please show all steps.

Answer 1

Steve is right that with the increased city parking fees, even Steve or Mumford can increase the parking fees to earn net operating income of $20000 from $14,000. Also Mumford is right at its standpoint to earn a premium for a risk that he anticipated cash flow will not materialize. Post sales of plot, Steve might be earning a lower return on risk-free investment or taking equal or higher risk that of Mumfold to earn similar or higher returns. Steve is offering a rate of return of 14%, however, Mumford wants a rate of return of 18%. Since, both would be taking certain market risks to earn returns and therefore, should negotiate similar risk and similar rates of returns. Hence, these should negotiate at 16% yield resulting in a plot valuation of $125000. Refer below excel calculation:

For detailed excel calculation, refer below image: