You are considering the purchase of a small office building in Brooklyn. The pro
ID: 2789770 • Letter: Y
Question
You are considering the purchase of a small office building in Brooklyn. The property contains 20,000 square feet of rentable space and is currently occupied by multiple tenants each with differing maturities on their respective leases. The vacancy rate is 6%. No lease is currently shorter than 1 year. The annual rent in the 1st year of ownership is $45/sq ft. You will hire a management firm to collect the rent which will charge you collection costs of 2% per dollar of rent.
1. What is the Potential Gross Income (PGI) for the first year?
2. What is the Effective Gross Income (EGI) for the first year?
3. If operating expenses are expected to be 40% of EGI, what is the Net Operating Income (NOI) generated by the property in the 1st year of ownership?
4. You decide you want to take out a loan to finance the purchase of this property. It will be an IO loan at a rate of 6.25%, compounded annually, with annual payments. The lender will provide financing up to a minimum Debt Service Coverage Ratio (DSCR) of 1.2 based off of the 1st year NOI. What is the largest annual loan payment the lender will allow you to make based on the DSCR?
5. If you get a loan that corresponds to the largest annual loan payment the lender will allow you to make based on the DSCR (computed in part 4), what will be your net income in the first year?
6. What is the largest loan a lender is willing to provide you with based on question 4? (Use the fact that this is an IO loan at 6.25%. Also use the loan payment from question 4.)
7. The seller’s asking price for the property is $7,000,000. If the lender has a maximum 70% LTV requirement what is the most the bank will lend you? (Only based on the LTV requirement.)
8. The loan must satisfy both the minimum DSCR of 1.2 and maximum LTV of 70%. What is the biggest loan the borrower can get?
9. If you buy the property at the asking price of $7,000,000 using the biggest loan you can get (from question 8), what will your down payment be?
10. What is the annual mortgage payment on the loan in question 8?
11. If you buy the property at the asking price of $7,000,000, what will your ‘going in’ Cap Rate be?
12. If the annual irr for this property is 8.5%, then based on the cap rate in question 11, what does this imply is expected NOI growth rate for this property?
13. You do research and find that similar properties are selling at a 6% cap rate. Using a 6% cap rate, what price would you offer for this property?
14. Suppose you buy the property at the asking price of $7,000,000 and own it for exactly 1 year. You make the down-payment in part (9). You collect the NOI in part (3). You make the annual mortgage payment in part (10). In two years, the NOI is expected to be the same. You sell the property at the end of year 1, at a cap rate of 50 basis points below the cap rate in part (11) and you pay off the loan balance when you sell. Compute the IRR on this investment.
Explanation / Answer
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1. Potential Gross Income (PGI) on year 1 = Total area in sq ft * Rent per sq ft
= 20,000 * $45 = $900,000
2. Effective Gross Income (EGI) = PGI less the vacancy rate of 6% less the collection charges of 2%
= 900,000 - 0.06*900,000 - 0.02*900,000
= $828,000
3. Operation Expenses (OE) = 0.40 * 828000
= $331200
NOI = EGI - OE = 828000-331200
= $496,800
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4. DSCR = NOI / Payment >= 1.2
which means that Payment <= NOI / 1.2 = 496800/1.2 =
= $ 414000
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5.
Net Income (NI) = NOI - payment made out
= 496800 - 414000 = $82,800
IO = Interest Only Mortgage loans
6.
Payment = (0.0625) * largets Loan (LL)
Hence LL = Payment / 0.0625
= 414000/0.0625 = $6,624,000
7.
LTV = Loan to Value Ratio, if the property is worth $100, they usually lend just 60 to 70% of the value - so they may lend $60 to $70 for a property worth $100
Likely loan / 7000000 <= 70% <= 0.7
hence likely loan <= 7000000 * 0.7 = $4,900,000
Hence more likely the maximum amount that the bank may lend you is $4.9 million
8.
The biggest loan borrowable is the
minimum of likely loan of $4.9 million
and the largest loan of $6624000
minimum ($4.9 million, $6,624,000)
= $4.9 million
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9.
Down payment = asking price - biggest loan obtainable
= $7 million - $4.9 million = $2.1 million
10.
Mortgage payment per annum = 0.0625 * $4.9 million
= $306,250
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11. Cap Rate going in = NOI / asking price
= 496,800 / 7000000
= 0.0709714 = 7.09714% = 7.1%
Cap rate = 0.0709714 = 7.1%
12.
Cap rate = IRR - Growth
So,
Growth = IRR - Cap
= 8.5% - 7.1% = 1.4%
hence this property is expected to grow at the rate of 1.4%
13.
Cap = NOI / price
price = NOI / Cap = 496,800 / 0.06 = $8,280,000
But as this price offer able is more than the asking price of $7 million, it would be a good bargain to buy it at the asking price
as the property is valued at $1,280,000 above the asking price
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14.
Cap rate during the sales is reduced from 7.1% to 7.1% less 50 basis points
that is
7.1% - 0.5% = 6.6% = 0.066
cap = NOI / Price
0.066 = 496800/Price
Price = 496800/0.066
Price = $7,527,272.7
Net Present value = NPV = - Down payment +
(NOI - Annual mortgage payment ) / (1+IRR)
+ (price - biggest borrowable loan amount ) / (1+IRR) = 0
NPV = - 2.1 m + ($496,800-306,250)/(1+IRR) + ($7,527,272.7 - $4.9 m) /(1+IRR) = 0
1 + IRR = - 2.1 m + ($496,800-306,250)/(1+IRR) + ($7,527,272.7 - $4.9 m) /(1+IRR)
= -( (1+IRR)*2.1 m + ($496,800-306,250) + ($7,527,272.7 - $4.9 m) ) /(1+IRR)
7527272.7-4900000 = 2627272.7
1+IRR = -2.1m + 190550/(1+IRR)+2627272.7/(1+IRR)
1 + IRR = 2817822.7/$2.1m
= 2817822.7/2100000
= 1.341
1+IRR = 1.341
IRR = 1.341 - 1 = 0.341
= 34.1%
Hence the IRR = 34.1%
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