It is late November and you are undertaking an investment analysis of an office property that your firm is considering purchasing at the end of this year. The property has 80,000 square feet of leasable space currently occupied by two tenants each leasing 40,000 square feet. Both tenants have triple-net leases; all operating expenses are passed through to tenants. The owner pays operating expenses associated with vacant space. Current market rent is $20 per square foot on a triple net basis (for leases signed today). Operating expenses for the property are currently $6 per square foot per year.

Tenant #1: has 15 years left on a long-term, fixed payment lease with annual rental payments at $15 per square foot (constant for the next 15 years). This firm has a strong AAA credit rating. Tenant #2: lease expires at the end of the next year and calls for fixed rental payments at $18 per SF. As part of your analysis therefore, you have to estimate vacancy allowance and tenant improvement expenditure line items for year 2. You feel that the probability of the existing tenant renewing its lease is 80 percent. If they do not renew, you anticipate four months of vacancy and that your firm will have to spend $10.00 per square foot to modernize the space for the next tenant. If, on the other hand, the existing tenant renews, your firm will not spend any money on tenant improvements for this space (note, both your vacancy allowance and TI numbers are expected values in the sense they reflect the probability of nonrenewal). Assume any lease signed will have

at least a five-year term and fixed rental payments and that the next tenant would lease the full 40,000 square feet.

a. Determine the market value of the property assuming a five-year holding period with a sale at an anticipated terminal cap rate of 9% and selling expenses of 3%. Market rents are expected to grow by 2% per year, and the typical investor requires a 10.5% total return (market going-in IRR). (10 points)

b. Briefly explain in what sense the 10.5% required IRR is a blended required rate of return and why it might actually be difficult to infer the appropriate discount rate to employ here from recent market activity (i.e., survey and recent transaction information).