Zenith Corp is considering the purchase of an office building for $8.0 million t
ID: 2719662 • Letter: Z
Question
Zenith Corp is considering the purchase of an office building for $8.0 million that they wish to sell in two years time at a terminal cap rate of 11.44% (a 5% selling cost applies). It will be financed in part by a 20-year, 8% CPM mortgage on the basis of 1.27 DCR. A property management company manages the property for an annual management fee 0f 5% of EGI, and the vacancy and credit losses are negligible. The building has 50,000 sft of gross space and non-rentable space is 10%. The building is currently fully occupied by two tenants with equal rentable space. Tenant 1 currently pays $30/Yr per sft of base rent with an expense stop of $10/Yr per sft, and there is 1 year remaining in their lease. Tenant 2 has just signed a new 5-year lease at $33/Yr per sft of base rent with an expense stop of $12/Yr per sft. A 50% CPI Adjustment applies to all existing and future leases. New leases are for 5 years and are made at the prevailing market rent as the base rent with expense stop set at the operating expenditure/Yr per sft of the first year of new lease.
1)Assume that CPI, Market Rent and Operating Expenditures will increase at 3%/Yr. Calculate the Before Tax IRR, %, rounded to two decimal places, on Zenith Corporation’s equity investment.
Note: Although new lease/renewal will be for 5 years, we do not know when the pre-existing leases commenced, and we do not also know the actual CPI rates for the past years. Hence, we apply CPI adjustment to the base rent for the pre-existing leases without any compounding for Year 1.
2) Other things remaining the same, what terminal cap rate would make the investment zero NPV for Zenith if Zenith requires a minimum return (IRR) of 20% on its equity investment?
Explanation / Answer
Cost of Office Building 8000000 Annual Management fee 5% of Expected Gross Income Selling Cost 5% Terminal Cap rate 11.44% Coupon rate 8% Period of Loan 20 Years Total Space of building 50000 sq ft Non-rentable space 10% Rentable space = 50000*(1-10%) =50000*0.90 45000 sq ft Fot Tenant 1 Space rented 45000 sq ft /2 = 22500 sq ft Base rent 30 yr/sq ft expense stop 10 yr/sq ft CPI adjustment 50% Growth rate of CPI, base rent, expenses 3% Lease period remaining 1 year Base rent adjusted for CPI =30+30*3%*0.5 = 30.45 Total rental income = 22500 * 30.45 = 685125.00 Maximum operating expenses = 22500 * 10 = 225000.00 calculation of lease rental receivable in year 2 for the property vacated by tenant 1 and from tenant 2 Space rented 22500 sq ft year1 year2 Base rent 33 sq ft/ year =33.50+33.50*3%*50% = 34.00 expense stop 12 sq ft/ year = 12 + 12 * 3% = 12.36 growth rate 3% CPI adjustment 50% Base rent adjusted for CPI =33+(33*3%*50%) Rent for first year 33.50 Recent receivable for first year from Tenant 2 = 22500 * 33.50 = 753637.50 Maximum operating Expenses = 22500 * 12 270000.00 Rent receivable for second year from New Tenant1 = 22500 * 34 = 764942.06 Rent receivable for second year from Tenant2 = 22500 * 34 = 764942.06 Maximum operating expenses recovable from tenenats in year 2 = 22500 * 12.36 = 278100 Gross Rent receivable Year I Year 2 From Tenant 1 / New Tenant 685125.00 764942.06 From Tenant 2 753637.50 764942.06 Gross Rent receivable for year 1 1438762.50 1529884.13 Annual Management charges 71938.13 76494.21 Expenses receivable Tenant 1/ New Tenant 225000.00 278100.00 Tenant 2 270000.00 278100 We assume that the expense stops for the tenants cover the operating expenses plus the annual management charges. Then the EBIT will be equal to Gross rent receivable. Based on the first year gross rent and the DCR of 1.27 the debt service payments can be be estimated as follows DCR = EBIT / Debt Services Debt Services include annual coupon payments and principal payments 1.27 = 1438762.5 / Debt Services Debt Services = 1438762.50/1.27 1132883.858 Since the mortgage taken is a constant payment mortgage the above instalment will be constant over the loan period Calculation of Net operating Income of the Leases Year 1 Year 2 Gross rent receivable 1438762.50 1529884.13 Operating Expenses receivable 495000.00 556200.00 Less Operating Expenses 423061.88 479705.79 Property Management Fee 71938.13 76494.21 Net Operating Income 1438762.50 1529884.13 Terminal Cap rate 11.44% Net Operating Income in year 2 1529884.13 Gross Sales value Net operating Income in year 2 / terminal cap rate = 397000.27/0.1144 13373112.98 Less sales expesnes at 5% 668655.65 Net Sales Value 12704457.33 Answer (1) Calculation of Cash flows year 0 year 1 year 2 Initial Investment -8000000 Net Operating Income 1438762.50 1529884.13 Net Sales value 12704457.33 Total Cash Flows -8000000 1438762.5 14234341.46 Internal rate of return 42.69% Answer (2) Minimum required return 20% Let net sales amount X Then -8000000 + 1438762.5/1.20 + 1529884.13/1.20^2 + X/1.20^2 = 0 -8000000 + 1438762.5 * 0.83333 + 1529884.13 * 0.694444 + X * 0.694444 = 0 -8000000 + 1198965.95 + 1062418.85 + 0.694444 * X = 0 0.694444*X = 5738615.20 X = 5738615.20/0.694444 = 8263611.18 Net Sales Value 8263611.18 Add Sales Expenses 434926.90 Gross Sales Value 8698538.08 Net operating income in year 2 1529884.13 Terminal Cap rate 0.175878304 or 17.59%
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