10. Market values (S11.2) You are asked to value a large building in northern New Jersey. The valuation is needed for a railroad bankruptcy settlement. Here are the facts:

• The settlement requires that the building’s value equal the PV of the net cash proceeds the railroad would receive if it cleared out the building and sold it for its highest and best nonrailroad use, which is as a warehouse.

• The building has been appraised at $1 million. This figure is based on actual recent selling prices of a sample of similar New Jersey buildings used as, or available for use as, warehouses.

• If rented today as a warehouse, the building could generate $80,000 per year. This cash flow is calculated after out-of-pocket operating expenses and after real estate taxes of

$50,000 per year:

Gross rents $180,000 Operating expenses 50,000 Real estate taxes 50,000 Net $80,000 Gross rents, operating expenses, and real estate taxes are uncertain but are expected to grow with inflation.

• However, it would take one year and $200,000 to clear out the railroad equipment and prepare the building for use as a warehouse. The $200,000 would have to be invested immediately.

• The property will be put on the market when ready for use as a warehouse. Your real estate adviser says that properties of this type take, on average, one year to sell after they 322 Part Three Best Practices in Capital Budgeting are put on the market. However, the railroad could rent the building as a warehouse while waiting for it to sell.

• The opportunity cost of capital for investment in real estate is 8% in real terms.

• Your real estate adviser notes that selling prices of comparable buildings in northern New Jersey have declined, in real terms, at an average rate of 2% per year over the last 10 years.

• A 5% sales commission would be paid by the railroad at the time of the sale.

• The railroad pays no income taxes. It would have to pay property taxes.