You are evaluating an acquisition opportunity on behalf of your employer, a private real estate investment manager. The property in question lies on a prominent site overlooking the prestigious St James's Square in London, UK. The property is being sold by a well-known real estate and asset management firm, who is looking to dispose of the property after investing substantial capital into refurbishments and marketing. The property, which comprises two adjacent buildings consisting entirely of grade A office space, last transacted four years ago for 60 million, but has since been updated significantly. The buildings were recently featured in the press for having achieved some of the highest rents for offices anywhere in London. The listing broker has supplied you with an acquisition brochure, which provides details on the property's condition, location, and most importantly, tenancy schedule. The broker is quoting a price of 157 million for the property. Your job is to evaluate the opportunity. You must determine an appropriate value for the property, incorporate the use of debt and assess the impact of leverage on the investment's return, and suggest whether or not a bid should be made and at what price. As a matter of practice, your employer expects to hold these investments for 5 years and requires a minimum IRR of 10%.

The Property

St James's House is a stunning modern office property fronted by two listed Georgian buildings, with superb views directly across the square. Originally built as two separate houses, the property now comprises a net internal area of 81,842 square feet of institutional specification Grade A offices. The property provides today's modern office occupier with all of the necessary functionality of Grade A institutional quality offices, along with the style and grandeur of impressive period meeting rooms, commensurate with the image and positioning that a St James's Square address conveys, being one of the world's finest office locations. The property was comprehensively redesigned and redeveloped just four years ago. The building gives a striking first impression with its imposing Georgian entrance hall complete with an elegant, perfectly preserved central staircase. The polished limestone floors, dramatic staircase and stunning high ceiling period rooms sit at ease with modern features including a back-lit glass reception desk, soaring full-height atrium, spectacular sculptural artwork and exposed brick walls. The impressive central atrium provides a natural division of the classically proportioned Georgian rooms to the front and the open plan floorplate offices to the rear. The atrium provides excellent natural light to the offices and a focal point to the building. Three high-speed elevators serve all floors and allow simple access to both the modern floorplates at the rear and the period offices at the front. The highly specified offices offer a working environment which combines Georgian grandeur with modern efficiency. The period rooms are high, wide and beautifully finished, with great presence and commanding views over the square. These rooms benefit from a Grade A specification similar to those of the modern floorplates behind. The property is held freehold, comprising a site area of approximately 0.52acres. The vendor is offering sale of shares in a special purpose vehicle (SPV), within which the property is the sole asset; therefore, its cash flow from operations is non-taxable.

Accommodation and Tenancy Schedule

St James's House's net internal area is described in Table 1. The property is multi-let to two hedge funds, two management consultants and an auction house. The details of the leases are presented in Table 2.

All of these leases are triple net (full repairing and insuring), meaning the rent figures given may be treated as net operating income for the property owner. Rent payments are due annually.

Property Market

The prospects for future rent growth in St James Grade A office rents are excellent. The highly restrictive development pipeline in the area, coupled with low levels of existing supply, has resulted in significant growth in Grade A rents over the current year. The highest rents in the area, outside of St James's House, are now 100 per square foot and rental values for the very best accommodation are forecast to rise to approximately 130 per square foot by the end of 2015. The expected rental growth rates, according to the listing broker, are listed in Table 3.

In your experience, rents for space on Ground and Lower Ground floors are approximately half of those in the upper floors. The figures in Table 4 refer to upper floor offices. The broker has also supplied you with a few recent transactions concerning similar properties. These are listed in in Table 5.

Net Operating Income

Based upon the current tenancy schedule, expected growth in rents over the next five years, your interpretation of break clauses and rent reviews incorporated in the current leases, and your expectations regarding leasing the vacant space, you have formed the following opinion of the property's pro forma net operating income:

Capital Market

A bank has agreed to extend a first lien mortgage in conjunction with the purchase of St James's House. The terms are as follows: APR=4.25%; amortization term=25 years; maturity= 5years; a1.00% upfront fee; and, annual payments in arrears. As the amortization term exceeds the maturity of the loan, there will be a large principal payment due at maturity. The banker has indicated that the maximum loan-to-value ratio is 60%, meaning you may borrow up to60%of the property's purchase price.

Answer the following: For simplicity, you should assume cash flows occur at the end of each year.

1. The broker is asking157million for the property. What is the cap rate at this price?

2. Construct a DCF model to calculate the property's present value. Assume7.75%cost of capital and long-term rent growth of 2.5%per year beyond Year-6. What is the value of the property? How much should you bid based on this value assuming purchase costs of 5.80%?

3. What value does your DCF model imply if you increase your long-term growth assumption from 2.50%to3.50%.

Comment on the sensitivity of your model to changes in this parameter.

4. Use the comparable transactions listed in Table 4 to calculate the implied value of the property assuming the average cap rate is applicable. How does this direct capitalization approach compare with your earlier DCF analysis and the broker's quoted price of157million? Why might this line of analysis be misleading?

5. What is the unlevered property-level IRR assuming a purchase price of 157million, purchaser's costs of 5.80%, a sale of the property five years from now at a cap rate of5.25%, and seller's costs of 1.00%.

6. Continuing the previous scenario, now account for the effect of financial leverage using the first lien mortgage at 60%loan-to-value. What is the IRR for the equity cash flow? Comment on the use of debt in relation to returns on equity.

7. Given your analysis, would you recommend bidding on this property; and, if so, what would you bid?

Table 1: Accommodation \begin{tabular}{llr} \hline \hline Floor & Use & Square feet \\ \hline Sixth & Offices & 7,289 \\ Fifth & Offices & 11,346 \\ Fourth & Offices & 11,974 \\ Third & Offices & 10,673 \\ Second & Offices & 11,809 \\ First & Offices & 9,007 \\ Ground & Offices & 10,885 \\ Ground & Reception & 841 \\ Ground & Storage & 228 \\ Lower Ground & Offices & 6,851 \\ Lower Ground & Storage & 713 \\ Lower Ground & Building Office & 226 \\ \hline Total & & 81,842 \\ \hline \hline \end{tabular} Table 2: Tenancy Schedule Table 3: Rental Growth Forecast \begin{tabular}{lll} \hline \hline Year & Rental growth rate & Year-end Rent per square foot \\ \hline Year 0 (actual) & & 100.00 \\ Year 1 & 4.6% & 105.00 \\ Year 2 & 5.7% & 111.00 \\ Year 3 & 5.9% & 117.00 \\ Year 4 & 6.0% & 124.00 \\ Year 5 & 4.0% & 130.00 \\ \hline \hline \end{tabular} Table 4: Comparable Property Transactions Table 5: Net Operating Income Projections \begin{tabular}{lrrrrrrr} \hline \hline Floor & Square feet & Year 1 & Year 2 & Year 3 & Year 4 & Year 5 & Year 6 \\ \hline Sixth & 7,289 & 1,030,446 & 1,030,446 & 1,030,446 & 1,030,446 & 1,030,446 & 1,030,446 \\ Fifth & 11,346 & 1,478,384 & 1,478,384 & 1,478,384 & 1,478,384 & 1,478,384 & 1,478,384 \\ Fourth & 11,974 & 1,506,808 & 1,506,808 & 1,506,808 & 1,506,808 & 1,506,808 & 1,506,808 \\ Third & 10,673 & 1,237,428 & 1,237,428 & 1,237,428 & 1,237,428 & 1,237,428 & 1,237,428 \\ Second & 11,809 & 1,284,465 & 1,310,799 & 1,310,799 & 1,310,799 & 1,310,799 & 1,310,799 \\ First & 9,007 & 607,973 & 607,973 & 607,973 & 558,434 & 558,434 & 558,434 \\ Part Ground A & 1,490 & 149,000 & 149,000 & 149,000 & 184,760 & 184,760 & 184,760 \\ Part Ground B & 9,395 & 798,575 & 798,575 & 1,099,215 & 1,099,215 & 1,099,215 & 1,099,215 \\ Part Lower Ground A & 1,491 & 85,733 & 85,733 & 85,733 & 85,733 & 85,733 & 85,733 \\ Part Lower Ground B & 5,360 & 297,105 & 297,105 & 313,560 & 313,560 & 313,560 & 313,560 \\ \hline Total & 79,834 & 8,475,915 & 8,502,249, & 8,819,345 & 8,805,566 & 8,805,566 & 8,805,566 \\ \hline \hline \end{tabular} Table 1: Accommodation \begin{tabular}{llr} \hline \hline Floor & Use & Square feet \\ \hline Sixth & Offices & 7,289 \\ Fifth & Offices & 11,346 \\ Fourth & Offices & 11,974 \\ Third & Offices & 10,673 \\ Second & Offices & 11,809 \\ First & Offices & 9,007 \\ Ground & Offices & 10,885 \\ Ground & Reception & 841 \\ Ground & Storage & 228 \\ Lower Ground & Offices & 6,851 \\ Lower Ground & Storage & 713 \\ Lower Ground & Building Office & 226 \\ \hline Total & & 81,842 \\ \hline \hline \end{tabular} Table 2: Tenancy Schedule Table 3: Rental Growth Forecast \begin{tabular}{lll} \hline \hline Year & Rental growth rate & Year-end Rent per square foot \\ \hline Year 0 (actual) & & 100.00 \\ Year 1 & 4.6% & 105.00 \\ Year 2 & 5.7% & 111.00 \\ Year 3 & 5.9% & 117.00 \\ Year 4 & 6.0% & 124.00 \\ Year 5 & 4.0% & 130.00 \\ \hline \hline \end{tabular} Table 4: Comparable Property Transactions Table 5: Net Operating Income Projections \begin{tabular}{lrrrrrrr} \hline \hline Floor & Square feet & Year 1 & Year 2 & Year 3 & Year 4 & Year 5 & Year 6 \\ \hline Sixth & 7,289 & 1,030,446 & 1,030,446 & 1,030,446 & 1,030,446 & 1,030,446 & 1,030,446 \\ Fifth & 11,346 & 1,478,384 & 1,478,384 & 1,478,384 & 1,478,384 & 1,478,384 & 1,478,384 \\ Fourth & 11,974 & 1,506,808 & 1,506,808 & 1,506,808 & 1,506,808 & 1,506,808 & 1,506,808 \\ Third & 10,673 & 1,237,428 & 1,237,428 & 1,237,428 & 1,237,428 & 1,237,428 & 1,237,428 \\ Second & 11,809 & 1,284,465 & 1,310,799 & 1,310,799 & 1,310,799 & 1,310,799 & 1,310,799 \\ First & 9,007 & 607,973 & 607,973 & 607,973 & 558,434 & 558,434 & 558,434 \\ Part Ground A & 1,490 & 149,000 & 149,000 & 149,000 & 184,760 & 184,760 & 184,760 \\ Part Ground B & 9,395 & 798,575 & 798,575 & 1,099,215 & 1,099,215 & 1,099,215 & 1,099,215 \\ Part Lower Ground A & 1,491 & 85,733 & 85,733 & 85,733 & 85,733 & 85,733 & 85,733 \\ Part Lower Ground B & 5,360 & 297,105 & 297,105 & 313,560 & 313,560 & 313,560 & 313,560 \\ \hline Total & 79,834 & 8,475,915 & 8,502,249, & 8,819,345 & 8,805,566 & 8,805,566 & 8,805,566 \\ \hline \hline \end{tabular}