You are offered the opportunity to develop a 400,000 sf warehouse facility for a large food manufacturer in suburban Philadelphia. Attracted by your expertise as a local warehouse developer, the potential client has offered to sign a triple net lease for seven years at a rent for $2 million per year. They also insist that at the end of the lease term they have the option to purchase the property at $22 million. Their final major condition is that the project be completed and ready for occupancy in 11 months. If it is not complete by that time the deal is void. You estimate that the property will cost $20 million to complete (including land costs of $1million) and that you should be able to complete it within ten months if you commence construction immediately. You believe that you will be able to obtain a $14 million, seven-year, 25-year amortization loan, at a fixed interest rate of 8%, and a 50 basis point fee. You believe that your company can access approximately $6 million in equity. Your company will receive a development fee of roughly 3% of project costs (this cost is included in your $20 million cost estimate) payable at the completion of the development. Finally, vacancy rates in the market are approximately 4%, gross rents in the market run $7-9 psf, with operating expenses and taxes running $2-$4 psf. Negotiations are over and it is time to make a decision.

There are three options:

a. Build and lease, according to the plan above

b. Build and lease to others (with a disposition seven years after completion such that you can sell the property at the same cap as you enter with. The cap rate is based on the value of land plus structure).

c. Forget the whole thing.

Tax implications: You are in the top tax bracket. Depreciation basis is the cost of construction.

Assume the capital gains tax rate is 15% Which do you choose? Build out a spreadsheet for scenarios (a) and (b). Calculate the IRR for each. Are these satisfactory for you to go ahead with either plan?