I am considering the purchase of a commercial property that totals 30,000 square feet. The owner has not given a price for the building and instead is asking me to put in an offer. The property is currently 80% occupied with an average rental rate of $20/sqft/yr. The leases on average increase in rent by $1.00/sqft/yr. Leases for this property are full pass-through and the operating expenses for this property including taxes and insurance total $6.00/sqft. I have a tenant in mind for the remaining 6,000 unleased square feet but they will not start paying rent for 6 months and I need to invest $20,000 in improvements and lease commissions to bring the tenant in. The rent for this new tenant is $24.00/sqft/yr and is fixed for the duration of it lease term. I will finance the purchase solely with equity (no debt – a cash deal). Once the new tenant is in, the property will be 100% full!! To account for unexpected vacancies and collection issues that may arise, however, I will assume a vacancy/collection reserve of 10% of my gross potential rent throughout my ownership. I will also assume I must invest $60,000 per year fixed for capital items to maintain the property - I cannot recover this capital cost from the tenants.

1. The capitalization rate for similar properties is around 10%. If I base my offer using the cap rate of 10% on the second year NOI (a more stabilized figure), what will my offer be?
2. Let’s assume that my offer in Part A) is accepted. I plan on holding the property for 5 years and will sell the property based on my Year 5 NOI at a capitalization rate of 9%. Assume that the property will be sold at the end of the fifth year. Sales expenses will total 10% of the sale price. Disregarding taxes (look at this from a pre-tax basis and disregard depreciation), what rate of return (use IRR) will this investment yield for me?
3. If your investment depreciates over a 40-year schedule (treat the capital investment of $60,000 per year as unrecoverable expense that reduces taxable income – this is a simplifying assumption! Otherwise things will get complex very fast from the standpoint of preparing a depreciation schedule!!), and your approximate income tax rate is 20%, what is your after-tax rate of return for this investment?

Answer rating: 100% (QA)

A Offer will be 4032000 B IRR 12 C After tax rate of return 12 Stepbystep explanation A ... View the full answer