Suppose you are managing a two-story rental building in uptown. You have a tenan

Question

Suppose you are managing a two-story rental building in uptown. You have a tenant in the first story with $3,000 monthly rent. Currently the monthly maintenance of the building costs $1,200/month, and you are paying $1,600 monthly mortgage payment including insurance and taxes. You are considering a lease on the second floor, but with another tenant you expect the maintenance costs to increase by $500 to $1,700/month, in addition to a $8,000 initial investments to fix up the second floor. Also, your insurance agent told you that a new tenant on the second floor would increase the insurance premium by $120 a month. Given this information, what are the relevant cash flows that you must factor in to come up with a minimum rent that you must charge? You must identify the relevant cash flows and the rationale. How much of monthly rent would you charge, and why?

Explanation / Answer

Answer:

Incremental costs:
a) Maintainence costs = $500
b) Insurance premium = $120
c) Initial investment = $8000. Per month charge = $8000/12 = $666.67
So, the monthly rental that could be charged on the second floor = $500+$120+$666.67 = $1286.67

Only incremental costs to be incurred are taken into account as the existing costs are incurred irrespective of whether the tenant occupies the second floor.

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