Consider a 100,000 square foot office building with one tenant and an additional
ID: 2819879 • Letter: C
Question
Consider a 100,000 square foot office building with one tenant and an additional “lease in hand”. The current tenant leases 50,000 square feet at market rent, which is $12/ft./yr. fixed, and the lease has a remaining term of 4 years. The lease in hand is a binding commitment to lease 35,000 square feet at $14/ft./yr. fixed for 5 years with the lease starting in exactly 2 years (first rent payment at the end of year 3). Average (market) rent is currently 13/ft./yr., and historically has increased at 2% per year.
A) Ignoring operating and capital costs and assuming that rent is paid at the end of the year, use DCF over a 5 year investment window to find the value of the property. Assume that the property currently under lease is re-let at the same rent at the end of the current lease, the discount rate is 9% and the expected cap rate for the property at the end of 5 years is the current stabilized cap rate of 7%. Using the price you derive from DCF, what is the property’s current cap rate? Why isn’t it the current market cap rate of 7%?
B) Now suppose that the leases in part a) are “triple nets” under which operating costs (CAM, insurance, and property taxes) are reimbursed by the tenant on a pro rata basis. (Each tenant’s share of the expenses is the % of the total leasable space that it leases.) CAM, real estate taxes, and insurance are estimated to be $1.50/ft./yr., $2.50/ft./yr., and $.15/ft./yr., respectively. As the owner you pay all capital costs, which are estimated as a reserve of $.25/ft./yr. You also pay $5/ft. in tenant improvement at the start of the second lease (end of year 2), $2/ft. in TI when the first lease rolls over, and you pay lease commissions of 6% of all base rent revenue over the life of the second lease at the end of year 2. Find the value of the property using DCF. Discount at 9% as above. (Best to do this in a spreadsheet.)
Explanation / Answer
Particulars Unit Office Building Space Sq. Ft. 100000 Existing leased by Tenant Sq. Ft. 50000 Lease in Hand Sq. Ft. 35000 Vacant Space Sq. Ft. 15000 Market Rent - Existing Lease $ per Ft/Year 12 Current rate - Existing Lease $ per Ft/Year 13 Rental Escalation Rate Per Annum 2% Proposed Lease rate $ per Ft/Year 14.00 Discount Rate % 9% CAM $ per Ft/Year 1.50 Note: CAM expense has not been taken in the valuation of the property as it is bear by the tenant Insurance $ per Ft/Year 0.15 Note: Insurance expenses has not been taken in the valuation of the property as it is bear by the tenant Property Taxes $ per Ft/Year 2.50 Note: Property Taxes has not been taken in the valuation of the property as it is bear by the tenant Capital Costs $ per Ft/Year 0.25 Tenant Improvement at the end of year 2 $ per Ft 5.00 Tenant Improvement when the first lease rolls over $ per Ft 2.00 Lease Commissions of all base rent revenue for the second property % 6% Answer (A) Unit Year 1 2 3 4 5 6 7 Market Rent Existing Lease (a) $/Sq. Ft./Year 12 12 12 12 12 12 12 Existing leased space (b) Sq. Ft. 50000 50000 50000 50000 50000 50000 50000 Rent from Existing leased space (i)= (a) X (b) $ 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 Lease offered starting year 3 '(c) $/Sq. Ft./Year - - 14 14 14 14 14 Lease in Hand (d) Sq. Ft. 35000 35000 35000 35000 35000 35000 35000 Proposed lease rent from new lease (ii) = '(c) X (d) $ - - 4,90,000 4,90,000 4,90,000 4,90,000 4,90,000 Total Rental received (Net Operating Income) (i) + (ii) $ 6,00,000 6,00,000 10,90,000 10,90,000 10,90,000 10,90,000 10,90,000 PVIF = (1/((1+Discount rate)^year)) 0.92 0.84 0.77 0.71 0.65 0.60 0.55 Present Value of free cash flows = PVIF X Total rental received $ 5,50,458.72 5,05,008.00 8,41,679.99 7,72,183.48 7,08,425.21 1,03,22,767.36 Property Value as per DCF $ 1,37,00,522.76 Cap Rate = Net Operating Income/Property value 4.38% Note: terminal value is calculated at the end of year 5 of the future cash flows = Free cash Flows X (1+Growth rate) / (Discount rate - Growth rate) Ans. The value is different from the current cap rate of 7% because the Net operating Income is not stabilised to achieve the value of the property. Stabilisation means recalculating the value of the property as if the whole space is rented out. Answer (B) Unit Year 1 2 3 4 5 6 7 Market Rent Existing Lease (a) $/Sq. Ft./Year 12 12 12 12 12 12 12 Existing leased space (b) Sq. Ft. 50000 50000 50000 50000 50000 50000 50000 Rent from Existing leased space (i)= (a) X (b) $ 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 Lease offered starting year 3 '(c) $/Sq. Ft./Year - - 14 14 14 14 14 Lease in Hand (d) Sq. Ft. - - 35000 35000 35000 35000 35000 Proposed lease rent from new lease (ii) = '(c) X (d) $ - - 4,90,000 4,90,000 4,90,000 4,90,000 4,90,000 Total Lease rental (i) + (ii) = (h) $ 6,00,000 6,00,000 10,90,000 10,90,000 10,90,000 10,90,000 10,90,000 Total Leased space (z) Sq. Ft. 50,000 50,000 85,000 85,000 85,000 85,000 85,000 Operating Expenses Capital Cost '(e) = (z) X Capital cost/sq.ft 12,500 12,500 21,250 21,250 21,250 21,250 21,250 Tenant Improvement (f) = (z) X Tenant Improvement expense 1,75,000 1,00,000 Lease Commission (g) = (z) X Tenant Improvement expense 1,47,000 Total Operating Expenses '(e) + (f) +(g) = (J) 12,500 3,34,500 21,250 1,21,250 21,250 21,250 21,250 Net Operating Income (h)-(J) 5,87,500 2,65,500 10,68,750 9,68,750 10,68,750 10,68,750 10,68,750 PVIF = (1/((1+Discount rate)^year)) 0.92 0.84 0.77 0.71 0.65 0.60 0.55 Present Value of free cash flows = PVIF X Total rental received 5,38,990.83 2,23,466.04 8,25,271.09 6,86,286.92 6,94,614.17 1,01,21,520.75 Property Value as per DCF 1,30,90,149.80 Note: terminal value is calculated at the end of year 5 of the future cash flows = Free cash Flows X (1+Growth rate) / (Discount rate - Growth rate) Assumptions: (i) The tenant improvement expense has been considered at the end of year 4 where the first lease is ending (ii) Lease commissions are considered over the life of the lease that is 5 years
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