5.17. Consider two undeveloped land sites. At site 1, the highest and best use (HBU) is...

5.17. Consider two undeveloped land sites. At site 1, the highest and best use (HBU) is a warehouse that would cost $1 million to build (exclusive of land cost) and would then generate annual net rents of $150,000, which are expected to grow al 3% per year. At site 2, the HBU is an apartment building that can generate net rents of $800,000, projected to grow at 1% per year, with construction cost of $5 million. Suppose investors buying built properties (that is, properties already developed and in operation) require an initial annual return (in the form of current net income) of 12% minus the expected annual growth rate in the net income, as a percent of the investment cost. For example, they would want an initial yield or cap rate of 9% for the warehouse (12% -- 3% = 9%). Suppose the land value for site | is $1 million and the land value for site 2 is $2 million. On which of these sites (1, 2, both, or neither) is it currently profitable to undertake construction? Show your reasoning.

Solutions

Expert Solution

From the question above we can infer the following information:

Particulars	Site 1	Site 2
Land value for site	$1million	$2million
Cost of build	$1 million	$5 million
Rent rents annual	$150000	$800000
Growth rate	3%	1%
Required rate of return	12-3=9%	12-1=11%

Based on the above information we can calculate the cash flows as follows:

Particulars	site1	Site 2
1. Cash flows in yeae 0 =cost of build and land value	$(1+1=2) million	$(5+2)=7million
2. Annual rent received	$150000/year	$800000/year
3. Present value of perpetual rent= annual rent/(rate of return-growth rate)	150000/(9-3)%=2500000$	800000/(11-1)%=800000
4. Net cash flow (3-1)	500000$	1000000$

Site 2 is more profitable by difference between the net cashflows ($1000000-500000) =$500000.

If the sites are evaluated individually, both sites are profitable. If projects are mutually inclusive, site 2 is more profitable.

jeff jeffy answered 1 year ago

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