You are an employee of University Consultants, Ltd. and have been given the following assignment. You are to present an investment analysis of a small income-producing office property for sale to a potential investor. The asking price for the property is $1,250,000; rents are estimated at $200,000 during the first year and are expected to grow at 3 percent per year thereafter. Vacancies and collection losses are expected to be 10 percent of the rents. Operating expenses will be 35% of effective gross income. A fully amortizing 70 percent loan can be obtained at an 11 percent interest for 30 years. The loan requires constant monthly payments and is a fixed rate mortgage. The mortgage has no prepayment penalties. Interest accrues on a monthly basis. The property is expected to appreciate in value at 3 percent per year and is expected to be owned for three years and then sold.

You determine that the building represents 90% of the acquisition price. The building should be depreciated using the straight line method over 39 years. The potential investor indicates that she is in the 36 percent tax bracket and has enough passive income from other activities so that any passive losses from this activity would not be subject to any passive activity loss limitations.

Capital gains from price appreciation will be taxed at 20 percent and depreciation recapture will be taxed at 25%.

1. What is the investors after tax internal rate of return (ATIRR) on equity invested?
2. The investor has an alternative investment opportunity of similar risk that brings her an annualized after-tax return of 15%. Should she invest in this office building? Describe the rationale behind your recommendation.
3. What is the NPV of this investment, assuming a 15% discount rate?
4. What is the going-in capitalization rate? What is the terminal or going-out capitalization rate?

Now assume the investment is financed with a 70% loan-to-value ratio interest-only mortgage. The interest rate on this mortgage will remain at 11%.

5. Find the IRR under this alternative assumption?