An investor is interested in purchasing a multi-tenant office building in Miami, which has an asking price of $110 per SF. Assume that, apart from 2% purchasing cost, there are no additional acquisition-related costs. The building size is 60,390 SF. It is currently leased to three tenants:

• The first tenant is renting 24,156 SF for $25/SF/year. The lease will expire in 2 years.
• The second tenant is renting 10,266.3 SF for $23.5/SF/year. The lease will expire in 4 years and has an annual rent increase of 3%.
• The third tenant is occupying the remaining space for $22/SF/year and the lease will expire in 6 years. Rental increases of $2 per SF will occur at the beginning of the 2nd and 4th year.

After the first lease expires, assume a V&C of 5% of the PGI each year, which will increase to 10% once the second lease expires. The market rent is currently $19/SF/year and is expected to decrease by 4% each year for the next 3 years and then increase again at 2.25% each year for the next 4 years.

Operating expenses for all leases are $8.5/SF/year and will increase annually by 2% (i.e. with inflation). All three leases are leases with operating expense recovery, which amounts to a recovery of 75% of the operating expenses. The landlord covers the remaining 25% of operating expenses and an additional $2/SF/year in non-operating expenses. Non-operating expenses are expected to remain the same. You may assume different lease terms with regard to operating expenses for new leases. Please state your assumptions in the Excel spreadsheet if they differ from the old leases. A capital expenses reserve of $3/SF/year is furthermore required.

The building is depreciated over 39 years (mid-year convention for first and last year) and the value of improvements (building) is considered to be 80% of the purchasing price. The going out cap rate is 8.80% and the investor requires a return of 10%. Selling costs are 2% of the sales price. The investor expects to hold the building for 5 years. Assume an income tax of 35% and a capital gains tax of 15%.

Part 1 (Investment analysis without debt financing): Assuming that the investor wants to hold the property for 5 years, conduct a discounted cash flow analysis (DCF) to calculate the IRR and NPV (based on NOI and net selling price) for this investment.

• Based on these metrics, is the investment worth undertaking?

Part 2 (Investment analysis with fixed rate mortgage): The investor received a lender's offer for a 30year mortgage at 7% (compounded monthly) with a loan to value ratio (LTV) of 70%. No financing costs (e.g. origination fees) or discount points occur.

• Considering this FRM, what are the after-tax NPV and IRR? Is this investment still worth undertaking?

Part 3 (Investment analysis with adjustable rate mortgage):

The investor also has received offers for adjustable rate mortgages by three lenders.  All have annual interest rate adjustments. All mortgages assume a LTV of 70% and 30 years maturity. For simplicity, use annual compounding. State your assumption on how you treat discount points.

Interest rates are expected to change as follows over the next 5 years:

• Calculate the payments for all three mortgages, i.e. calculate the initial cash inflow from the mortgage, the annual payments and ending balance after 5 years.
• Calculate the interest rate you are effectively paying (IRR) for each of the three mortgages. Which mortgage has the lowest effective rate?
• Redo your investment analysis with the ARM you chose as having the lowest effect rate. What are the after-tax IRR and NPV? Is this investment still worth undertaking? Should the investor choose the FRM or ARM?

Part 4 (Investment analysis with participating mortgage):

The investor is also approached by a lender, who is interested in providing a 30yr FRM with a 3.5% interest rate (monthly compounding) and LTV of 85%. However, the lender requires an equity participation of 30% in each year's before tax cash flow (BTCF) and 35% in the before tax equity reversion (BTER).  What are the after-tax IRR and NPV? Is this investment still worth undertaking? Considering the FRM, ARM and participating mortgage, which option would you recommend the investor and why?