Review Exercises Case Study: Analysis of an Office Building Investment The subject is a small, multitenant office building with six tenants and company may stay or go when its lease runs out. The landlord thinks one vacant suite. Leases in this market are typically written for five there is only a 25% chance of a renewal because the tenant already years at a flat rate, with the tenant paying the increases in expenses says it does not need all the space it has. The finish is standard. over a base year. The base year is established within the first year of Suite 210, comprising 5,000 square feet on the second floor, is the lease based on a percentage of total expenses divided by the ten leased to a real estate investment company for five years with four ant's percentage of space. These are all full-service leases. The market years left. This space also has standard finish and features, and rents are increasing by 3% compounded annually. there is an estimated 25% probability of lease renewal because the Suite 100, comprising 2,500 square feet, is leased to a computer company just bought an office building site nearby. This lease is at hardware distributor on a five-year lease with two years left. The flat $23.50 per square foot. rate is $62,500 per year ($25 per square foot per year). There is Suite 215 comprises 5,000 square feet on the second floor, and it a high likelihood of a renewal for another five years. If the tenant is leased to a soft drink distributor for five years with only two years renews, the market rate should be applicable because the tenant left. This space has standard finish. The tenant is fairly happy in the improvements (Tls) would be amortized with little up-front expense. building but not happy with the configuration of the space. There This space has better-than-average finish and features and is right is a high likelihood the tenant will stay, but major expenditures to off the lobby, which generally commands a slightly higher rent. Con- reconfigure the suite will be needed. sidering the lack of tenant improvement expenses, the space should Because the leases are flat rate for several years, there is a fairly be renewed at the market rate. large amount of pass-through income. The first year it should equal Suite 101, comprising 3,900 square feet, is leased to an electronic about $49,000 and increase by about 3% compounded each year. reproduction firm on a seven-year lease at a flat rate of $103,350 Vacancy should be 5% for Years 1, 2, and 6, and 10% for Years 3, 4, per year ($26.50 per square foot per year). This lease has seven and 5 due to rollovers. The collection loss is estimated at only 1% per years left to run. This space also has better-than-average finish and year because of the quality of the tenants. The suites with leases in features. This space is nicer and off the lobby as well, but if the place during the lease period are shown in red in the reconstructed tenant renews, the Tls have been amortized so there will be few up operating statement front expenses with the lease. Expenses are listed in the grid. Most are increasing by 3% per year. Suite 112 has 4,600 square feet and is vacant. It should lease Tenant improvements are a function of the leases, rollovers, and prob- within a year at or near $25.00 per square foot per year with ability of renewal. Leasing commissions are generally 4% of the total standard finishing. This space is assumed to be of average finish lease amount, and the leases are usually five years. No one in this at that rate. Tls with average finish cost about $20.00, all things market pays leasing commissions on renewals. The building will need considered. A new lease can be assumed to be for five years, and it $25,000 for a new roof in the second year, $35,000 for new HVAC will roll over at the market rate. units in the third year, and $42,000 for parking lot resurfacing in the Suite 114, comprising 4,000 square feet, is leased to a consumer sixth year. products manufacturer on a five-year lease with only one year left to Discount rates on properties like this are generally between 8% and run. The lease rate is $21.00 per square foot per year, but with only 9%. The terminal capitalization rate (used to estimate the reversion in one year to go a big increase in rent and probably some Tl expenses the fifth year) is 9%. The mathematical formula to find the appropriate are anticipated. This company may or may not stay. The probability discount factor is 1/(1+i)". The holding period for this type of invest- of renewal is about 25%. ment is five to eight years with some periods as short as three years. A Suite 205, comprising 5,000 square feet on the second floor, is review of recent sales found that 60% were held for nearly five years. leased to an auto manufacturer on a five-year lease with four years All the blank spaces in the reconstructed operating statement remaining at a flat rate of $24.00 per square foot per year. This shown on the following page can be filled in using the information provided above. The Year 1 figures are provided as a starting point. Sq. Ft. Leased Rate Year 1 Year 2 Year 3 Year 4 Year 5 Year 6* Suite 100 2,500 2,500 25.00 62,500 Suite 101 3,900 3,900 26.50 103,350 Suite 112 4,600 0 25.00 115,000 Suite 114 4,000 4,000 21.00 84,000 Suite 205 5,000 5,000 24.00 120,000 Suite 210 5,000 5,000 23.50 125,000 Suite 215 5,000 5,000 22.00 110,000 Total >>> 30,000 25,400 84.67% Pass-through = $49,000 Potential gross income = 768,850 Estimated market (roll over) rate= $25.00 Vacancy loss -6% Effective gross income $722,719 Expense items (Rate of increase in expenses = 3.00%) All utilities $1.50/ occupied sq. ft. 42,750 Management expense 5.00% of EGI 36,136 Maintenance salary $0.50/sq.ft. 15,000 Taxes, insurance, and licenses $1.25/sq. ft. 37,500 Maintenance (snow, trash, etc.) $0.75/sq.ft. 22,500 Contract cleaning, etc. $1.50/occupied sq.ft. 42,750 Supplies (HVAC, janitorial, etc.) $0.50/sq. ft. 15,000 Total expenses from operations $211,636 Operating expenses per sq. ft. $7.05 Build-out and leasing expenses New space build-out $92,000 Leasing commissions $23,000 Capital replacements (HVAC, roof) Total build-out/reserves expense $115,000 Build-out per sq. ft. GFA $3.83 Total all expenses $326,636 All expenses per sq. ft. $10.89 Income overall (1) $396,083 The reversion of the property is estimated by applying a terminal cap rate of 9% to the last year's income less selling expenses Reversion of property = Cash flows with reversion $396,083 Discounted at 8.0% 0.925926 0.857339 0.793832 0.735030 0.680583 Value Present value $366,744 Discounted at 9.0% 0.917431 0.841680 0.772183 0.708425 0.649931 Value Present value $363,379 Year 6 NOI is used to calculate the reversion at the end of Year 5. Review Exercises Case Study: Analysis of an Office Building Investment The subject is a small, multitenant office building with six tenants and company may stay or go when its lease runs out. The landlord thinks one vacant suite. Leases in this market are typically written for five there is only a 25% chance of a renewal because the tenant already years at a flat rate, with the tenant paying the increases in expenses says it does not need all the space it has. The finish is standard. over a base year. The base year is established within the first year of Suite 210, comprising 5,000 square feet on the second floor, is the lease based on a percentage of total expenses divided by the ten leased to a real estate investment company for five years with four ant's percentage of space. These are all full-service leases. The market years left. This space also has standard finish and features, and rents are increasing by 3% compounded annually. there is an estimated 25% probability of lease renewal because the Suite 100, comprising 2,500 square feet, is leased to a computer company just bought an office building site nearby. This lease is at hardware distributor on a five-year lease with two years left. The flat $23.50 per square foot. rate is $62,500 per year ($25 per square foot per year). There is Suite 215 comprises 5,000 square feet on the second floor, and it a high likelihood of a renewal for another five years. If the tenant is leased to a soft drink distributor for five years with only two years renews, the market rate should be applicable because the tenant left. This space has standard finish. The tenant is fairly happy in the improvements (Tls) would be amortized with little up-front expense. building but not happy with the configuration of the space. There This space has better-than-average finish and features and is right is a high likelihood the tenant will stay, but major expenditures to off the lobby, which generally commands a slightly higher rent. Con- reconfigure the suite will be needed. sidering the lack of tenant improvement expenses, the space should Because the leases are flat rate for several years, there is a fairly be renewed at the market rate. large amount of pass-through income. The first year it should equal Suite 101, comprising 3,900 square feet, is leased to an electronic about $49,000 and increase by about 3% compounded each year. reproduction firm on a seven-year lease at a flat rate of $103,350 Vacancy should be 5% for Years 1, 2, and 6, and 10% for Years 3, 4, per year ($26.50 per square foot per year). This lease has seven and 5 due to rollovers. The collection loss is estimated at only 1% per years left to run. This space also has better-than-average finish and year because of the quality of the tenants. The suites with leases in features. This space is nicer and off the lobby as well, but if the place during the lease period are shown in red in the reconstructed tenant renews, the Tls have been amortized so there will be few up operating statement front expenses with the lease. Expenses are listed in the grid. Most are increasing by 3% per year. Suite 112 has 4,600 square feet and is vacant. It should lease Tenant improvements are a function of the leases, rollovers, and prob- within a year at or near $25.00 per square foot per year with ability of renewal. Leasing commissions are generally 4% of the total standard finishing. This space is assumed to be of average finish lease amount, and the leases are usually five years. No one in this at that rate. Tls with average finish cost about $20.00, all things market pays leasing commissions on renewals. The building will need considered. A new lease can be assumed to be for five years, and it $25,000 for a new roof in the second year, $35,000 for new HVAC will roll over at the market rate. units in the third year, and $42,000 for parking lot resurfacing in the Suite 114, comprising 4,000 square feet, is leased to a consumer sixth year. products manufacturer on a five-year lease with only one year left to Discount rates on properties like this are generally between 8% and run. The lease rate is $21.00 per square foot per year, but with only 9%. The terminal capitalization rate (used to estimate the reversion in one year to go a big increase in rent and probably some Tl expenses the fifth year) is 9%. The mathematical formula to find the appropriate are anticipated. This company may or may not stay. The probability discount factor is 1/(1+i)". The holding period for this type of invest- of renewal is about 25%. ment is five to eight years with some periods as short as three years. A Suite 205, comprising 5,000 square feet on the second floor, is review of recent sales found that 60% were held for nearly five years. leased to an auto manufacturer on a five-year lease with four years All the blank spaces in the reconstructed operating statement remaining at a flat rate of $24.00 per square foot per year. This shown on the following page can be filled in using the information provided above. The Year 1 figures are provided as a starting point. Sq. Ft. Leased Rate Year 1 Year 2 Year 3 Year 4 Year 5 Year 6* Suite 100 2,500 2,500 25.00 62,500 Suite 101 3,900 3,900 26.50 103,350 Suite 112 4,600 0 25.00 115,000 Suite 114 4,000 4,000 21.00 84,000 Suite 205 5,000 5,000 24.00 120,000 Suite 210 5,000 5,000 23.50 125,000 Suite 215 5,000 5,000 22.00 110,000 Total >>> 30,000 25,400 84.67% Pass-through = $49,000 Potential gross income = 768,850 Estimated market (roll over) rate= $25.00 Vacancy loss -6% Effective gross income $722,719 Expense items (Rate of increase in expenses = 3.00%) All utilities $1.50/ occupied sq. ft. 42,750 Management expense 5.00% of EGI 36,136 Maintenance salary $0.50/sq.ft. 15,000 Taxes, insurance, and licenses $1.25/sq. ft. 37,500 Maintenance (snow, trash, etc.) $0.75/sq.ft. 22,500 Contract cleaning, etc. $1.50/occupied sq.ft. 42,750 Supplies (HVAC, janitorial, etc.) $0.50/sq. ft. 15,000 Total expenses from operations $211,636 Operating expenses per sq. ft. $7.05 Build-out and leasing expenses New space build-out $92,000 Leasing commissions $23,000 Capital replacements (HVAC, roof) Total build-out/reserves expense $115,000 Build-out per sq. ft. GFA $3.83 Total all expenses $326,636 All expenses per sq. ft. $10.89 Income overall (1) $396,083 The reversion of the property is estimated by applying a terminal cap rate of 9% to the last year's income less selling expenses Reversion of property = Cash flows with reversion $396,083 Discounted at 8.0% 0.925926 0.857339 0.793832 0.735030 0.680583 Value Present value $366,744 Discounted at 9.0% 0.917431 0.841680 0.772183 0.708425 0.649931 Value Present value $363,379 Year 6 NOI is used to calculate the reversion at the end of Year 5