Dr. Marilyn Davis, a single, 34-year-old heart specialist, is considering the purchase of a small office condo. She wants to add some diversity to her investment portfolio, which now contains only corporate bonds and preferred stocks. In addition, because of her high federal tax bracket of 33%, Marilyn wants an investment that produces a good after-tax rate of return.

A real estate market and financial consultant has estimated that Marilyn could buy the office condo for \($200,000.\) In addition, this consultant analyzed the property’s rental potential with respect to trends in demand and supply. He discussed the following items with Marilyn: 

(1) The office condo was occupied by a tenant, who had 3 years remaining on her lease, 

(2) it was only 4 years old, was in excellent condition, and was located near a number of major thoroughfares.

For her purposes, Marilyn decided the office condo should be analyzed on the basis of a 3-year holding period. The gross rents in the most recent year were \($32,000,\) and operating expenses were \($15,000.\) The consultant pointed out that the lease had a built-in 10% per year rent escalation clause and that he expected operating expenses to increase by 8% per year. He further expected no vacancy or collection loss because the tenant was an excellent credit risk.

Marilyn’s accountant estimated that annual depreciation would be \($7,272\) in each of the next 3 years. To finance the purchase of the office condo, Marilyn has considered a variety of alternatives, one of which would involve assuming the existing \($120,000\) mortgage. On the advice of a close friend, a finance professor at the local university, Marilyn decided to arrange a \($150,000,\) 10.5%, 25-year mortgage from the bank at which she maintains her business account.

The annual loan payment would total \($16,995.\) Of this, the following breakdown between interest and principal would apply in each of the first 3 years:

The loan balance at the end of the 3 years would be \($145,631.\) The consultant expects the property to appreciate by about 9% per year to \($259,000\) at the end of 3 years. Marilyn would incur a 5% sales commission expense on this assumed sale price. The office condo’s book value at the end of 3 years would be \($178,184.\) The net proceeds on the sale would be taxed at Marilyn’s 15% long-term capital gains rate for any capital gains and a 25% rate for recaptured depreciation.

Questions

a. What is the expected annual after-tax cash flow for each of the 3 years (assuming Marilyn has other passive income that can be used to offset any losses from this property)?

b. At a 15% required rate of return, will this investment produce a positive net present value?

c. What is the estimated IRR for this proposed investment?

d. Could Marilyn increase her returns by assuming the existing mortgage at a 9.75% interest rate rather than arranging a new loan? What measure of return do you believe Marilyn should use to make this comparison?

e. Do you believe Marilyn has thought about her real estate investment objectives enough? Why or why not?

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Year Interest Principal Total 1 $15,688 $1,307 $16,995 2 $15,544 $1,451 $16,995 3 $15,384 $1,611 $16,995