with NOI given for year $1=1,127500$ year $2=1,177,400$ year $3=1,051,200$ year $4=1,110,800$ year $5999,500$ year $6998,700$

BACKGROUND

An institutional investor is interested in purchasing a multi$-$tenant office building in

Portland, OR which has an asking price of $$210$ per SF$.$ Assume that, apart from the $2\%$

purchasing cost, there are no additional acquisition$-$related costs. The building size is

$62,250$ SF$.$ It is currently leased to three tenants:

$$ The first tenant occupies $25,450$ SF and currently pays $$24/$SF$/$year$.$ The lease will

expire at the end of year $2.$ There will be no rental increase for the first two years. Based

on conversations with the tenant, you can assume that the lease renewal probability is

$40\%.$

$$ The second tenant occupies $10,700$ SF and currently pays $$25/$SF$/$year$.$ The lease will

expire at the end of year $4$ and has annual rent increases of $4\%.$ Based on conversations

with the tenant, you can assume that the lease renewal probability is $25\%.$

FIN$457$ Project $1$

Real Estate Investment

$2$

$$ The third tenant occupies the remaining space, and their current rent is $$20/$SF$/$year$.$

The lease will expire at the end of year $6.$ Rental increases of $$1\mathrm{.}5$ per SF will occur at

the beginning of year $2,$ year $3,$ and year $4.$ There are no increases for years $5$ and $6.$

Note: Assume the current contract rents as the basis for your year $1$ potential gross income.

V&C for the first two years is assumed to be $1\%.$ From year three assume a V&C of $6\%$

of the PGI each year, which will increase to $10\%$ from year $4.$ The average market rent for

office is currently $$23/$SF$/$year$,$ and it is forecasted to decrease by $5\%$ each year for two

years and then increase again at $3\%$ each year for the subsequent years. Renewing tenants

receive a $$1/$SF discount to the market rental rate.

The landlord covers $$4/$SF of operating expenses, which increase by $4\%$ each year $($expense

inflation$).$ The roof has to be replaced in year $3.$ The total estimated cost is $$400,000$ with

a reserve of $$200,000$ created in years $1$ and $2.$ For simplicity, no other capital expenses

are assumed, and no tenant improvements and leasing commissions are incurred for new

or renewing tenants.

Assume that the building is bought in January $2023$ and sold in December $2027,$ i$.$e$.,$ the

investor expects to hold the building for $5$ years. The building is depreciated over $39$ years

$($mid$-$month convention for first and last year$)$ and the value of improvements $($building$)$ is

considered to be $85\%$ of the purchasing price. The new roof is depreciated over $39$ years

$($mid$-$month convention$).$

The going$-$out cap rate is $6\mathrm{.}5\%$ and the investor requires a return of $12\%.$ Selling costs are

$2\mathrm{.}5\%$ of the sales price.

Assume an income tax of $35\%$ and a capital gains tax of $15\%.$ Make sure you tax the

depreciation recapture and capital gain with the appropriate tax rates.

Assume the investment is financed using Mortgage Option A $($the fixed rate mortgage in

Part $2).$

FIN$457$ Project $1$

Real Estate Investment

$3$

ASSIGNMENTS

Part $1$:

Assuming that the investor wants to hold the property for $5$ years, create the proformas for

cash flows from operations and equity reversion until the NOI and net selling price level

respectively.

Conduct a discounted cash flow analysis $($DCF$)$ to calculate the IRR and NPV based on

NOI and net selling price for this investment. Is this investment worth undertaking?

Why$/$why not?

For this and other parts$/$sections$,$ you can add your answers to my questions to the

respective spreadsheet and do not need to prepare a separate file.

Part $2$:

Mortgage Option A $($Fixed rate mortgage$)$: The investor received a lender$$s offer for a

$25-$year mortgage at $7\%($compounded monthly$)$ with a loan$-$to$-$value ratio $($LTV$)$ of $80\%.$

No financing costs $($e$.$g$.,$ origination fees$)$ or discount points occur.

$$ Calculate the after$-$tax NPV and IRR for this option. Is this investment on its own

worth undertaking? Why$/$why not?

$$ Calculate the annual cash$-$on$-$cash yield. What is the average cash$-$on$-$cash return for

the holding period? Would you consider it attractive to investors? Why$/$why not?

$$ Calculate the annual debt service coverage ratio $($DSCR$).$ Assuming the lender

requires a minimum DSCR of $1\mathrm{.}25,$ does it meet this requirement?

Mortgage Option B $($Floating rate mortgage$)$: The investor also has received offers for

floating rate mortgages from two lenders. All have annual interest rate adjustments. All

mortgages assume an LTV of $75\%$ and a $25-$year maturity.

For simplicity, use annual mortgage payments in the payment schedules.

FIN$457$ Project $1$

Real Estate Investment

$4$

Floating Rate Mortgage $1$ Floating Rate Mortgage Initial interest $4\%($teaser rate$)3/1$ mortgage; initial interest is fixed for $3$ years and only interest is paid.

Amortization begins in year $4.$

The initial interest rate is $5\%.$

Margin $1\mathrm{.}5\%2\%$

Caps Periodic payment cap of $2\%$ Periodic interest ceiling: $1\%$

Periodic interest floor: $1\%$

Prepayment penalty None $2\mathrm{.}5\%$

Discount Points $3\%$ None

Interest rates are expected