Reference no: EM133665275
Problem
A broker you often work with calls you with what she says is a great idea. Namely, to buy an office building that is for sale in Durham. The broker says the building is owned by a large institution that is anxious to liquidate its portfolio of foreclosed properties. The office market is currently in flux, so this may be a good time to buy.
The size of the building is 75,000 square feet, and the asking price is $4,500,000. You know that the replacement cost to build an equivalent office building at this location, in this market, is currently more than $175 per square foot (psf). When compared to the psf asking price of other buildings on the market in the city, the price seems low, which would appear to substantiate the seller's determination to unload the building.
The current tenant uses the whole space open (bullpen-style) and without divided offices. You envision dividing the space as you expect your target market to be minimally capitalized tech start-ups as area companies downsize. This means reorganizing the building systems (utilities, HVAC, lighting, etc.) and subdividing and customizing spaces. This costs money. Thus you add to the purchase price another $60 psf in initial renovation costs and another $10 psf in soft costs such as legal, architectural, leasing services, and interim operating costs that cannot be passed on to tenants while the building is being renovated (so add $70 psf total for the initial renovation). You believe that when fixed up and leased out the building will probably sell for over $175 psf. You assume $175 for your sale assessment.
The broker says after completion of renovation (your "magic") she thinks you can get rents of $30 psf foot gross (i.e., before vacancy or operating costs are considered). You think that a 15% vacancy rate is appropriate, and you estimate that the property will cost $10 psf to operate on an annual basis.
You conclude that although your building will be in good shape post-renovation, you had still better set up a reserve for future cap-x costs and leasing costs. Future tenants may require more reconfiguring (tenant improvements, or TI), and you may have to spend TI money to customize the space again for their needs. So you add another $2 psf per year to your operating costs to allow for future cap-x costs and leasing costs.
You next consider the impact of leverage on your returns (i.e., the impact of borrowing some of the purchase price). If the total cost of financing is less than the ROA, then the result is positive leverage, which increases the return on equity (ROE) above the return on assets (ROA). At the time of the call from your broker interest rates are about 4.5 percent, and lenders require a 70% loan to value ratio, which means of course that they will loan you 70% of the purchase price and the initial renovation cost. You pro forma a thirty-year, fixed, level-payment, self-amortizing mortgage, and you calculate debt service assuming monthly payments.
A. What is cash flow from operations?
B. What is cash flow after financing (before tax)?
C. What is your ROA?
D. What is your ROE?
E. What is mortgage constant?
F. Is financing accretive?
G. What is your going-in cap rate? (using CFO)?
H. What is your exit cap rate if you sell for $175 psf? (using CFO)
I. What is ROE if rents are only $25 psf?
J. What is ROE if rents are $25 psf and purchase price $4m?