The subject is a small, multitenant office building with six tenants and one vacant suite. Leases in this market are typically written for five years at a flat rate, with the tenant paying the increases in expenses over a base year. The base year is established within the first year of the lease based on a percentage of total expenses divided by the tenants percentage of space. These are all full-service leases. The market rents are increasing by 3% compounded annually.

-Suite 100, comprising 2,500 square feet, is leased to a computer hardware distributor on a five-year lease with two years left. The flat rate is $62,500 per year ($25 per square foot per year). There is a high likelihood of a renewal for another five years. If the tenant renews, the market rate should be applicable because the tenant improvements (TIs) would be amortized with little up-front expense. This space has better-than-average finish and features and is right off the lobby, which generally commands a slightly higher rent. Considering the lack of tenant improvement expenses, the space should be renewed at the market rate.

-Suite 101, comprising 3,900 square feet, is leased to an electronic reproduction firm on a seven-year lease at a flat rate of $103,350 per year ($26.50 per square foot per year). This lease has seven years left to run. This space also has better-than-average finish and features. This space is nicer and off the lobby as well, but if the tenant renews, the TIs have been amortized so there will be few up- front expenses with the lease.

-Suite 112 has 4,600 square feet and is vacant. It should lease within a year at or near $25.00 per square foot per year with stan- dard finishing. This space is assumed to be of average finish at that rate. TIs with average finish cost about $20.00 per square foot, all things considered. A new lease for five years can be assumed, and it will roll over at the market rate.

-Suite 114, comprising 4,000 square feet, is leased to a consumer products manufacturer on a five-year lease with only one year left to run. The lease rate is $21.00 per square foot per year. With only one year to go, a big increase in rent and probably some TI expenses are anticipated. This company may or may not stay. The probability of renewal is about 25%.

-Suite 205, comprising 5,000 square feet on the second floor, is leased to an auto manufacturer on a five-year lease with four years remaining at a flat rate of $24.00 per square foot per year. This company may stay or go when its lease runs out. The landlord thinks there is only a 25% chance of a renewal because the tenants have already said they do not need all the space they have. The finish is standard.

-Suite 210, comprising 5,000 square feet on the second floor, is leased to a real estate investment company for five years with four years left. This space also has standard finish and features, and there is an estimated 25% probability of lease renewal because the company just bought an office building site nearby. This lease is at $25.00 per square foot.

-Suite 215 comprises 5,000 square feet on the second floor, and it is leased to a soft drink distributor for five years with only two years left. This space has standard finish. The tenant is fairly happy in the building but not happy with the configuration of the space. There is a high likelihood the tenant will stay, but major expenditures to reconfigure the suite will be needed.

Because the leases are flat rate for several years, there is a fairly large amount of pass-through income. The income in the first year should equal about $49,000 and increase by about 3% compounded each year. Vacancy should be 5% for Years 1, 2, and 6, and 10% for Years 3, 4, and 5 due to rollovers. The collection loss is estimated at only 1% per year because of the quality of the tenants. The suites with leases in place during the lease period are shown in purple in the reconstructed operating statement.

Expenses are listed in the grid. Most are increasing by 3% per year. Tenant improvements are a function of the leases, rollovers, and probability of renewal. Leasing commissions are generally 4% of the total lease amount, and the leases are usually five years. No one in this market pays leasing commissions on renewals. The building will need $25,000 for a new roof in the second year, $35,000 for new HVAC units in the third year, and $42,000 for parking lot resurfacing in the sixth year.

Discount rates on properties like this are generally between 8% and 9%. The terminal capitalization rate (used to estimate the reversion in the fifth year) is 9%. Selling expenses are estimated at 7%. The mathematical formula to find the appropriate discount factor is 1/(1 + i) .

The holding period for this type of investment is five to eight years, with some periods as short as three years. A review of recent sales found that 60% were held for nearly five years.

All the blank spaces in the reconstructed operating statement shown on the following page can be filled in using the information provided above. The Year 1 figures are provided as a starting point.

Review Exercises The reversion of the property is estimated by applying a terminal cap rate of 9% to the last year's income less selling expenses of 7% Reversion of property = Cash flows with reversion Discounted at 8.0% Present value Discounted at 9.0\% Present value - Year 6 Nol is used to calculate the reversion at the end of Year 5. Review Exercises The reversion of the property is estimated by applying a terminal cap rate of 9% to the last year's income less selling expenses of 7% Reversion of property = Cash flows with reversion Discounted at 8.0% Present value Discounted at 9.0\% Present value - Year 6 Nol is used to calculate the reversion at the end of Year 5