1. Zenith Investment Company is considering the purchase of an office property. It has done an extensive market analysis and has estimated that based on current market supply/demand relationships, rents, and its estimate of operating expenses, annual NOI will be as follows: Year NOI 1 $1,000,000 2 1,000,000 3 1,000,000 4 1,200,000 5 1,250,000 6 1,300,000 7 1,339,000 8 1,379,170 A market that is currently oversupplied is expected to result in cash flows remaining flat for the next three years at $1,000,000. During years 4, 5, and 6, market rents are expected to be higher. It is further expected that beginning in year 7 and every year thereafter, NOI will tend to reflect a stable, balanced market and should grow at 3 percent per year indefinitely. Zenith believes that investors should earn a 12 percent return (r) on an investment of this kind.

a) Assuming that the investment is expected to produce NOI in years 1-8, is expected to be owned for seven years and then sold, what would be the value for this property today? (Hint: Begin by estimating the reversion value at the end of year 7. Recall that the expected IRR=12% and the growth rate (g) in year and beyond is estimated to remain level at 3%.)

b) What would be the terminal capitalization rate (RT) be at the end of year 7?

c) What would be the going-in capitalization rate (R) be based on year 1 NOI? d) What explains the difference between the going-in and going-out (terminal) cap rates?