Question

A company is considering the purchase of a 5-year old office building. After a careful review of the market and the leases that are in place, it believes that next year’s net operating income will be $100,000. It also believes that this cash flow will rise in the amount of $5,000 each year for the first 6 years after the first year, after which it is expected to grow by 4 percent per year in the foreseeable future. It plans to own the property for 10 years at which point it will be sold, with the estimated selling price determined using information on three applicable comparable properties’ going-out cap rates. The three chosen applicable comps are considered equally important for estimating the subject property’s expected future reversion value. Below is the information on five comparable office buildings that recently sold in the area

	Comp #1	Comp #2	Comp #3	Comp #4	Comp #5
Building age today	15 y.o.	15 y.o.	5 y.o.	10 y.o.	15 y.o.
Recent sale price	$1,000,000	$900,000	$1,000,000	$1,100,000	$1,200,000
1st year Net Operating Income	$120,000	$90,000	$80,000	$110,000	$60,000

The company believes that it should earn an internal rate of return (required return) of at least 11 percent.

a) What is the subject property’s estimated terminal value? Calculate and explain.

b) What is the estimated current value of this office property? Calculate and explain.

c) What is the current, or “going-in,” cap rate for this property? Calculate and explain.

d) What explains the difference between the subject property’s going-in cap rate and the terminal cap rate that you calculated earlier? Explain in words why it makes sense that one (which one?) is greater than the other (which one?), without doing any math.

Answer 1

Particulars	Amount ($)
a: The average price of the buildings with 15 year age at the current date has been considered as the terminal value since the building is currently aged 5 years and will be sold after a period of 10 years.
Average value of the properties with 15 years age	1033333
b: Similarly the current value has been considered by talking into consideration the value of the building at present of a 5 year old building
Average value of the properties with 5 years age	1000000
c: The 5 year old building’s value has been considered for the purpose.
The property with 5 year age at current date	1000000

d:

The difference between the going in cap rate and the terminal value is due to the wear and tear in the property with the passage of time. Ordinarily referred to as depreciation, it is the reason for the difference between the two prices.

The passage of time will obviously take its toll on the building also thus, the value of the building with passage of time will decrease due to the normal wear and tear to the building.