office building for the next five years:

Net lease with steps. Rent will be Kshs $15$ per square foot the first year and will increase by Kshs $1\mathrm{.}50$ per square foot each year until the end of the lease. All operating expenses will be paid by the tenant.

Net lease with CPI adjustments. The rent will be Kshs $16$ per square foot the first year. After the first year, the rent will be increased by the amount of any increase in the CPI. The CPI is expected to increase $3$ percent per year.

Gross lease. Rent will be Kshs $30$ per square foot each year with the lessor responsible for payment of all operating expenses. Expenses are estimated to be Kshs $9$ during the first year and increase by Kshsl per year thereafter.

Gross lease with expense stop and CPI adjustment. Rent will be Kshs $22$ the first year and increase by the full amount of any change in the CPI after the first year with an expense stop at Kshs $9$ per square foot. The CPI and operating expenses are assumed to ehange by the same amount as outlined above.

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i$)$ Calculate the effective rent to the owner $($after expenses$)$ for each lease alternative using a $10$ percent discount rate.

$(3$ marks$)$

ii$)$ How$-$would you rank the altematives in terms of risk to the property owner?

$(2$ marks$)$

iii$)$ Considering your answers to parts $($i$)$ and $($ii$),$ how would you compare the four alternatives?

$(3$ marks$)$

b$)$ Riehard Rambo presently owns the Marine Tower office building, which is $20$ years old, and is considering renovating it$.$ He purchased the property two years ago for Kshs $800,000$ and financed it with a $20-$year, $75$ percent loan at $10$ percent interest $($monthly payments$).$ Of the Kshs $800,000,$ the appraiser indicated that the land was worth Kshs $200,000$ and the building Kshs $600,000.$ Rambo has been using straight$-$line depreciation over $39$ years $(\frac{1}{39}$ per year for simplicity$).$ At the present time Marine Tower is producing Kshs $90,000$ in NOI, and the NOI and property value are expected to increase $2$ percent per year. The current market value of the property is Kshs $820,000.$ Rambo estimates that if the Marine Tower office building is renovated at a cost of Kshs $200,000,$ NOI will be about $20$ percent higher next year $($Kshs $108,000$ versus Kshs $90,000)$ due to higher rents and lower expenses. He also expects that with the renovation the NOI will increase $3$ percent per year instead of $2$ percent. Furthermore, Rambo believes that after five years, a new investor will purchase the Marine Tower office building at a price based on capitalizing the projected NOI six years from now at a $10$ percent capitalization rate. Selling costs would be $6$ percent of the sale price. Rambo is in the $28$ percent tax bracket and expects to continue to be in that bracket. He also would not be subject to any passive activity loss limitations$.$ If Rambo does the renovation, he believes he could obtain a new loan at an $11$ percent interest rate and a $20-$year loan term $($monthly payments$).$

i$)$ Assume that if Rambo does the renovation, he will be able to obtain a new loan that is equal to the balance of the existing loan plus $75$ percent of the renovation costs. What is the incremental return for doing the renovation versus not doing the renovation? Assume a five$-$year holding period.

$(3$ marks$)$