Question

An investor has just inherited $605,000. A local commercial real estate broker has presented her with the following opportunity to purchase a small office building for $1,500,000.

There are four existing leases:

A bank rents the 9,500 square feet on the first floor for $10,500 per month with level payments for three more years. Thereafter, the bank is expected to renew for 10 years at $12,000 per month.

An insurance company rents 6,200 square feet on the second floor for a fixed $12.85 per square foot per year (current market rate). The lease will expire at the end of two years. She expects to rent this space for the market rental rate at that time. Current market rents are expected to increase at 4 percent per year for the next five years and then zero percent per years for the following seven years.  

A lawyer leases the 2,500 remaining square feet on the second floor at $2,750 per month for the next 10 years with annual increases based on 50 percent of the increases in market rents.

An accounting firm rents 9,950 square feet on the third floor at $.94 per square foot per month. These payments will increase 1 percent for year two, followed by a 2 percent per year increase for years three and four, and then 3 percent per year increases for the remaining six years on the lease.

Office buildings in the area typically have 5 percent vacancy. The building is currently 100 percent leased, but there is still the possibility of a tenant leaving before the lease expires. Thus, she projects a vacancy and credits an allowance of 3 percent in the first two years and 5 percent in the years thereafter.

Projections for operating expenses include management fees based on 7 percent of effective gross income (EGI). Property taxes are $20,000 for the first two years with a 15 percent increase in the third year with no further increases thereafter. Utility expenses are based on $1.50 per square foot of gross building area increasing at 5.5 percent per year. Insurance is based on an $.18 per square foot of rentable area increasing at 4 percent per year. Janitorial expenses are projected at $.75 per square foot of gross area increasing by 6 percent per year. Maintenance allowances of $.25 per square foot of gross area is projected with a 4 percent annual increase. Other expenses total $39,000 per year and are expected to increase at 3 percent per year for three years, 2.5 percent for the following year, and 2 percent thereafter.

The parking lot likely will need repaving on a rotating basis every 12 years at a cost of $12,000. Therefore, a yearly reserve replacement account of $1,000 per year should be established.

Other Information

Building Gross Area 31,150

Non-financing acquisition costs                     $135,000

Other Income

            Paid parking spaces                                        30

            Monthly rent per space                                   $150

            Monthly vending income                                $200

            Growth rate for other income                         0%

Financing Information

            LTV 70%

            Interest rate                                                     8%

            Term                                                               20 years

            Financing costs (paid up front) 2%

Depreciation Information                  

            Land-to-Value ratio                                        15%

            Depreciable life                                              39

Tax Rate Information

            Ordinary income marginal tax rate                 33%

            Capital gains tax rate 15%

            Rate on Recaptured Depreciation                   25%

Future selling information

            Expected cap rate at time of sale                    8.5%

            Selling expenses 7.5%

            Expected holding period                                 5

Required Rate of Return on Equity (after-tax) 15%

Assume a 5-Year holding period and estimate all the after-tax cash flows for the period along with an estimated after-tax NPV and IRR. Should you make the investment?

Answer 1

Particulars	0	1	2	3	4	5
Income
Bank		$          126,000	$        126,000	$        126,000	$        126,000	$            126,000
Insurance		$            79,670	$          79,670	$          82,857	$          86,171	$              89,618
Lawyer		$            33,000	$          33,660	$          34,333	$          35,020	$              35,720
Accounting Firm		$          112,236	$        113,358	$        115,626	$        117,938	$            121,476
		$          350,906	$        352,688	$        358,816	$        365,129	$            372,814
Other Income
Parking Rent		$              4,500	$            4,500	$            4,500	$            4,500	$                4,500
Vending Machine		$                  200	$                200	$                200	$                200	$                    200
Less
Allowance (vacancy)		$      10,527.18	$    10,580.65	$    17,940.78	$    18,256.45	$        18,640.72
Effective Gross Income		$    345,078.82	$ 346,807.71	$ 345,574.75	$ 351,572.53	$      358,873.64
Less
Management Fees		$      24,155.52	$    24,276.54	$    24,190.23	$    24,610.08	$        25,121.15
Property Tax		$      20,000.00	$    20,000.00	$    23,000.00	$    23,000.00	$        23,000.00
Utility Exp		$      46,725.00	$    49,294.88	$    52,006.09	$    54,866.43	$        57,884.08
Insurance		$        5,067.00	$      5,269.68	$      5,480.47	$      5,699.69	$          5,927.67
Janitorial Exp		$      23,362.50	$    24,764.25	$    26,250.11	$    27,825.11	$        29,494.62
Maitainence allowance		$        7,787.50	$      8,099.00	$      8,422.96	$      8,759.88	$          9,110.27
Other Expenses		$      39,000.00	$    40,170.00	$    41,375.10	$    42,409.48	$        43,257.67
Parking reserve replacement		$        1,000.00	$      1,000.00	$      1,000.00	$      1,000.00	$          1,000.00
Loan EMI		$      52,500.00	$    52,500.00	$    52,500.00	$    52,500.00	$        52,500.00
Non-financing acquisition costs		$    135,000.00
Upfront Financing cost		$      21,000.00
Future Selling Cost						$      112,500.00
EBITDA		$    (30,518.70)	$ 121,433.36	$ 111,349.79	$ 110,901.87	$            (921.83)
Less Depreciation (1500000*(1/39))		$      38,461.54	$    38,461.54	$    38,461.54	$    38,461.54	$        38,461.54
EBIT		$    (68,980.24)	$    82,971.83	$    72,888.25	$    72,440.33	$      (39,383.37)
Less Interest		$      84,000.00	$    79,800.00	$    75,600.00	$    71,400.00	$        67,200.00
Profit Before Tax		$ (152,980.24)	$      3,171.83	$    (2,711.75)	$      1,040.33	$   (106,583.37)
Less Tax		$                     -	$      1,046.70	$                   -	$          343.31	$                       -
Profit after tax		$ (152,980.24)	$      2,125.12	$    (2,711.75)	$          697.02	$   (106,583.37)
Gains on Building (Note 1)		$                     -	$                   -	$                   -	$                   -	$ 1,917,162.28
Add Depreciation		$      38,461.54	$    38,461.54	$    38,461.54	$    38,461.54	$        38,461.54
Cash Flow after tax	$ (1,500,000.00)	$ (114,518.70)	$    40,586.66	$    35,749.79	$    39,158.56	$ 1,849,040.45
NPV	($524,954.03)
IRR	4%

Note 1	Since cap rate is 8.5% Cumulative sale price of Building would be
Expeted Sale Price with 8.5% annual return	$                                                                                                            2,255,485.04
Less Capital Gains Tax	$                                                                                                                338,322.76
	$                                                                                                            1,917,162.28

Looking at Negative NPV and loww IRR i would not recommend to invest in this Building