Ab Landlord owns a dilapidated 30- year- old apartment building in Los Angeles. The net cash flow from renting the apartments last year was $ 200,000. She expects that inflation will cause the net cash flows from renting the apartments to increase at a rate of 10 percent per year ( next year’s net cash flows will be $ 220,000, the following year’s $ 242,000, etc.). The remaining useful life of the apartment building is 10 years. A developer wants to buy the apartment building from
Landlord, demolish it, and construct luxury condominiums. He offers Landlord $ 1.5 million for the apartments. Assume there are no taxes. The market rate of return for investments of this type is 16 percent and is expected to remain at that level in the future. The 16 percent interest rate includes an expected inflation rate of 10.5 percent. The real rate of interest is 5 percent:
1.16 = (1.05)( 1.105)
a. Evaluate the developer’s offer and make a recommendation to Landlord. Support your conclusions with neatly labeled calculations where possible. Note that the $ 1.5 million purchase offer would be paid immediately, whereas the first cash flow from retaining the building is not received until the end of the first year.
b. Suppose that Los Angeles imposes rent controls, so that Landlord will not be able to increase her rents except to the extent justified by increases in costs such as maintenance. Effectively, the future net cash flows from rents will remain constant at $ 200,000 per year. Does the imposition of rent controls change Landlord’s decision on the developer’s offer? Support your answer with neatly labeled calculations where possible.