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A Local 20,000 square foot retail building is 100% occupied by a single tenant. The lease started last week and continues for 10 years. The rent is $7.00 per square foot per year. The landlord pays all the expenses associated with the building. The expenses total $2.00 per square foot per year, and we have determined that they are market-oriented. From a market survey, it is our opinion that 5% is a reasonable vacancy allowance and 2% is a reasonable allowance for collection loss. The market expects a 9% return on investment (overall rate) for investments like this.

1. The potential gross income of the property?

2. The effective gross income of the property?

3. The total expenses are:

4. The net operating income of the property?

5. What is the value of the property using the direct capitalization method of the income capitalization approach?

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Jean Keeling
Jean KeelingLv2
28 Sep 2019
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You are considering the purchase of a small office building. The office building specializes in offering facilities to small startup firms who are looking to avoid long-term commitments while their businesses are growing. Tenants sign one-year leases and may renew at market rates, if they so desire. The building is configured with 20 suites. Five (5) suites have 4,000 useable square feet and five (5) have 2,500 usable square feet. The remaining 10 suites each have 1,000 useable square feet. The building has 7,500 square feet of common area. In addition, a food truck pays $5,000 per year to operate in the parking lot during lunch hours.

Market rents are $35 per square foot, based on total leased space. As this is the only similar facility in the market, market rents are expected to increase 4% per year indefinitely. Property taxes are $250,000 per year and increases are capped at 2% per year. Other operating expenses total $280,000 per year and are expected to increase at the rate of inflation, estimated at 3% per year. In most years, capital expenditures equal 4% of effective gross income, although the roof will need to be replaced just before the expected sale at the end of year 5, at an estimated cost of $175,000. You estimate that 5% of the space will be vacant, on average, and that collection losses will total 2% of occupied space.
Your market review indicates this property will sell at a price yielding a going-in capitalization rate of 8%. You believe the cap rate will increase to 8.5% at the time of a sale. Selling costs are expected to be 5% of the gross sales price. This building is suitable for professional investors, who view capital expenses as a "below the line" item. Based on these parameters, the unleveraged property returns exceed your required returns and you decide to seek mortgage financing. Local lenders are willing to lend up to 65% of the value of the building provided that debt service coverage exceeds 1.35x. Because of the relatively short holding period, lenders are willing to provide interest-only financing at 5.5% with total fees of 1.5%.

You expect to close on the purchase on January 1. The land value is estimated at 20% of the purchase price. Because of the start-up nature of the tenants, there is effectively no personal property. Ordinary income is taxed at 30%, while capital gains are taxed at 15%. The depreciation recapture rate is 25%. Your brother will invest with you on a pro rata basis, provided his after-tax returns are projected to exceed 15%.

1) Based on this scenario, what is the investor's pre-tax levered retrun expectation, in percent.

2) Based on the lenders' underwriting requirements, what is the maximum amount, in dollars, they will lend?

How do I calculate Investor Return on Equity, Debt Coverage Ratio, Investor IRR Levered and Investor IRR Unlevered?

Grand Avenue Tower
Rent Assumptions Rent Square Feet Growth Assumptions
Rent Tenant #1 $29.00 20,000 Income Growth 2.00%
Rent Tenant #2 $30.00 15,000 Expense Growth 2.50%
Rent Tenant #3 $32.00 15,000 Tenant 1 Escalator 2.00%
Expense Stop for Tenant #1 $5.50 20,000 Tenant 2 Escalator 2.50%
Expense Stop for Tenant #2 $7.00 15,000 Tenant 3 Escalator 0.00%
Expense Stop for Tenant #3 $9.00 15,000
Building Net Rentable Area 50,000 Financing Assumptions
Debt (30 year amortization) $10,000,000
Miscellaneous Income 28,000 Interest Rate (assume annual pmt) 5.50%
Vacancy 7.00% Annnual Payment $688,054
Management Fee 4.50% Equity $4,000,000
Tenant 3 Tenant Improvements $24.00 Purchase Price $14,000,000
Tenant 3 Leasing Commissions (per yr of lease) 2.50% Sale Cap Rate 7.00%
Revenue Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Rent Tenant #1 580,000 591,600 603,432 615,501 627,811 640,367
Rent Tenant #2 450,000 461,250 472,781 484,601 496,716 509,134
Rent Tenant #3 480,000 480,000 480,000 480,000 480,000 480,000
Expense Pass-through Tenant #1 90,000 95,000 100,125 105,378 110,763 116,282
Expense Pass-through Tenant #2 45,000 48,750 52,594 56,534 60,572 64,711
Expense Pass-through Tenant #3 15,000 18,750 22,594 26,534 30,572 34,711
Miscellaneous Income 28,000 28,560 29,131 29,714 30,308 30,914
Gross Potential Income 1,688,000 1,723,910 1,760,657 1,798,261 1,836,741 1,876,119
Vacancy 118,160 120,674 123,246 125,878 128,572 131,328
Effective Gross Income 1,569,840 1,603,236 1,637,411 1,672,382 1,708,169 1,744,791
Expenses
Real Estate Taxes 200,000 205,000 210,125 215,378 220,763 226,282
Insurance 20,000 20,500 21,013 21,538 22,076 22,628
Utilities 150,000 153,750 157,594 161,534 165,572 169,711
Janitorial 50,000 51,250 52,531 53,845 55,191 56,570
Maintenance 80,000 82,000 84,050 86,151 88,305 90,513
Management Fee 70,643 72,146 73,683 75,257 76,868 78,516
Total Expenses 570,643 584,646 598,996 613,703 628,774 644,220
Net Operating Income 999,197 1,018,591 1,038,415 1,058,680 1,079,395 1,100,571
Tenant Improvments 360,000
Leasing Commissions 72,000
Cash Flow Available for Debt Service 567,197 1,018,591 1,038,415 1,058,680 1,079,395
Debt Service 688,054 688,054 688,054 688,054 688,054
Cash Flow After Debt Service -120,857 330,537 350,361 370,626 391,341
Sale Price 15,722,442
Outstanding Loan Balance 9,229,509
Net Sale Proceeds 6,492,933
Investor Cash Flows Levered -4,000,000 -120,857 330,537 350,361 370,626 6,884,274
Investor Cash Flows Unlevered (14,000,000) 567,197 1,018,591 1,038,415 1,058,680 16,801,837
Investor Return on Equity -3.0% 8.3% 8.8% 9.3% 9.8%
Debt Coverage Ratio 0.82 1.48 1.51 1.54 1.57
Investor IRR Levered 15.06%
Investor IRR Unlevered 8.74%

Ms. June Cleaver is considering investing in an apartment complex in Tucson, Arizona, to provide her with some retirement income and her son, Theodore, with a job as the maintenance superintendent since he’s been unable to find a job in this tough economy for some time. She’s currently doing her due diligence on the property and has employed you to help her “run the numbers” and examine the records.

The seller is asking $700,000 for the property and is willing to carry a $550,000 note (seller financed) at 11% for 30 years. The building will be depreciated using the straight--line method over 27.5 years with a depreciation expense of approximately $22,641 this year. The complex has 15 one bedroom units renting for $350.00 a month and 10 two-bedroom units that go for $450.00. The unit also has some laundry and vending machine income of approximately $1,000 a month, give or take a variance of 10% each month. An extensive examination of the books reveals that vacancy and collection rates have averaged about 7% of potential gross income with operating expenses and property taxes averaging about $44,250 a year. Furthermore, your research reveals capitalization rates on similar properties are about 12%. Please assist Ms. Cleaver is evaluating the property and deciding if it’s a good investment. She can’t afford to lose money in her retirement.

a) Should she buy the property at the asking price using the Net Operating Income Approach?

b) What other factors should be considered when making such a large potential investment?

c) What other types of businesses could the NOI Income Approach be used in the valuation process?

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