A company is considering of land that could be developed into a class A office p

Question

A company is considering of land that could be developed into a class A office project. At the present time, the company believes that the site could support a 300,000 rentable square foot project with average rents of $ 20 per square foot and operating expenses equal to 40% of that amount. It also expects rents to grow at 3% indefinitely and believes that the coompany should earn a 12% return (r) on investment. The building would cost $100 per square foot to build. Required: a) What would the estimated property value and land value under the above assumptions. b) Suppose the land owner is asking for $12000000 for the land. Under the assumptions in part (a) would this project be feasible? c) if the land must be acquired for $ 12000000, returning to the assumptions in (a), how much of change in the following would have to occur to make the project feasible? ( Consider each item one at a time and hold all other variables constant.) i) Expected return on investment (r) ii) Expected growth in cash flows iii) Building cost iv) Rents

Explanation / Answer

Solution:

a) Calculations of estimated property value and land value under the above assumptions:

Working Note:

Gross Income = 300,000 * 20

Net Operating Income = 6,000,000 * 60%

Cap Rate = 12% - 3%

Construction Cost = 300,000 * 100

b) Suppose the land owner is asking for $12000000 for the land:

Suggestion: The land value in part (a) is only 10,000,000 however, the land owner asks for 12,000,000. So, the project is not feasible.

c) If the land must be acquired for $ 12000000, returning to the assumptions in (a):

i) Expected return on investment (r) & ii) Expected growth in cash flows:

NOI = 3,600,000

Land Value = 12,000,000

Building Cost = 30,000,000

Property Value = 12,000,000 + 30,000,000 = 42,000,000

Cap rate = 3,600,000/ 42,000,000 = 8.57%

So, if expected return on investment "r" changes and other variables hold. r = 3% + 8.57% = 11.57% (decreases by 3.58%) If expected growth in cash flows "g" changes, g = 12% - 8.57% = 3.43% (increases by 14.3%)

iii) Building cost:

Property Value = 40,000,000

Land Value = 12,000,000

So Building Cost = 40,000,000 - 12,000,000 = 28,000,000 (decreases by 6.67%)

iv) Rents:

Let return = R

Gross income = 300,000R

NOI = 300,000R * 60% = 180,000R

Cap rate = 9%

Property Value = 180,000R/ 9% = 2,000,000R

Building cost = 30,000,000

Land value = 12,000,000

PV = 2,000,000R = 30,000,000 + 12,000,000

R = 21 per square foot (increases by 5%)

Use Gross Income Net Operating Income Cap Rate Construction Cost Office         6,000,000                            3,600,000 9%                30,000,000

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