An investor is considering buying an office building for $3 million with a going-in cap rate of 7 percent and selling it in year 10 with a going-out cap rate of 8 percent. The NOI is $210,000 for the first year and is expected to increase by 1 percent each year for the next 11 years, but there could be a rent decline in year 6. (Assume there are no major capital expenditures anticipated for the property during the 10 year holding period.) The investor can obtain a $2.4 million interest-only 10-year mortgage at a market interest rate of 6.5 percent. The investor wants to have a 9 percent equity return on his investment.

a. Construct a 10 year pro forma on the property and compute the NOI and the present value of the future cash flows if there is no rent decline. What is the equity return or IRR if the investor does an all cash deal and pays $3 million in cash for the property?

b. What is the equity amount by the investor required for purchase the property if the investor takes out the loan for $2.4 million? Construct a 10-year pro forma on the property and compute the debt service ratio for each year with no rent decline and steady increases of 1 percent per year. What is the IRR for the levered equity investment? How does this compare with the all cash equity return?

c. Compute the debt service ratio for each year. Is this loan likely to meet the lenders debt service requirement that NOI > 1.30 DS for each year? Why or why not?

d. What if the NOI decreases by 10 percent in the sixth year (due to a change in the market) and there is no further increase in the NOI for years 710. Does the investor still meet the debt service requirement? How could the loan be structured by the lender to meet the debt service requirement and avoid potential NOI declines of this magnitude from the lenders perspective?

e. Does this seem like a good investment for the investor in terms of the equity return with the $2.4 million loan? Does it appear to be a risky investment for the investor if there is a rent decline in year 6? Why or why not?