Real Estate Finance

Chapter-10
Problems:
1. Zenith Investment Company is considering the purchase of an office property. It has done
an extensive market analysis and has estimated that based on current market
supply/demand relationships, rents, and its estimate of operating expenses, annual NO/ will
be as follows:

Year NOI

1 $1,000,000
2 1,000,000
3 1,000,000
4 1,200,000
5 1,250,000
6 1,300,000
7 1,339,000

8 1,379,170

A market that is currently oversupplied is expected to result in cash flows remaining flat for
the next three years at $1,000,000. During years 4, 5, and 6, market rents are expected to
be higher. It is further expected that beginning in year 7 and every year thereafter, NOI will
tend to reflect a stable, balanced market and should grow at 3 percent per year indefinitely.
Zenith believes that investors should earn a 12 percent return (r) on an investment of this
kind.
a. Assuming that the investment is expected to be owned for seven years, what would be
the value for this property at the end of year 7?
b. What would the terminal capitalization rate (/?r) be at the end of year 7? (Assume no
material economic depreciation.)
c. What would the value be today?
d. What would the capitalization rate (R) be based on year 1 NOI?
2. Ace Investment Company is considering the purchase of the Apartment Arms project. Next
year's NOI and cash flow is expected to be $2,000,000 and based on Ace's economic
forecast, market supply and demand and vacancy levels appear to be in balance and as a
result, NOI should increase at 4 percent each year for the foreseeable future. Ace believes
that it should earn at least a 13 percent return on its investment.
a. Assuming the above facts, what would the estimated value for the property be today?
b. What cap rates should be indicated from recently sold properties that are comparable to
Apartment Arms?
 c. Assume that in part (a), that the required return is 14 percent, what would the value be
today?
d. Assume results in part (c). What must the investor consider relative to "comparable"
sales in (b) that may account for the differences in value?
3. Acme Investors is considering the purchase of the undeveloped Baker Tract of land. It is
currently zoned for agricultural use. If purchased, however, Acme must decide how to have
the property rezoned for commercial use and then how to develop the site. Based on its
market study, Acme has made estimates for the two uses that it deems possible, that is,
office or retail. Based on its estimates, the land could be developed as follows:

Office Retail

Rentable square feet 100,000 80,000

Rents per square foot $24.00 $30.00

Operating expense ratio 40% 50%
Avg. growth in NOI per annum 3% 3%
Required return (f) 13% 14%

Total construction cost per square foot $100 $100

Which would be the highest and best use of this site?

4. Ajax Investment Company is considering the purchase of land that could be developed into
a class A office project. At the present time, Ajax believes that the site could support a
300,000 rentable square foot project with average rents of $20 per square foot and
operating expenses equal to 40 percent of that amount. It also expects rents to grow at 3
percent indefinitely and believes that Ajax should earn a 12 percent return (r) on investment.
The building would cost $100 per square foot to build:
a. What would the estimated property value an d land value be under the above
assumptions?
b. If rents are suddenly expected to grow at 4 percent indefinitely, what would the property
value and land value be now? What percentage change in land value would this be
relative to the land value in (a)?
c. If instead of (6), suppose growth in rents are expected to fall by 2 percent and rents will
grow only by 1 percent because of excessive supply, what would land value be now?
What percentage change would this be relative to the land value in (a)?
d. Suppose the land owner is asking $7,000,000 for the land. Under assumptions in part
(a) would this project be feasible?
e. If the land must be acquired for $7,000,000, returning to the assumptions in (a), how
much of a change in the following would have to occur to make the project feasible?
(Consider each item one at a time and hold all other variables constant.)
(1) Expected return on investment (r).
 (2) Expected (g) or growth in cash flows.
(3) Building cost.
(4) Rents.
5. Armor Investment Company is considering the acquisition of a heavily depreciated building
on 10 acres of land. At some time in the future it will demolish the building and build
something more desirable. In the interim it expects to rent the building as a storage facility
and expects to collect cash flows equal to $100,000 next year. However because
depreciation is expected to increase, Armor expects cash flows to decline at a rate of 4
percent per year indefinitely. Armor expects to earn an IRR on investment return (r) at 13
percent. What is the value of this property?
6. Athena Investment Company is considering the purchase of an office property. After a
careful review of the market and the leases that are in place. Athena believes that next
years cash flow will be $100,000. It also believes that the cash flow will rise in the amount of
$5,000 each year for the foreseeable future. It plans to own the property for at least 10
years. Based on a review of property sales of properties that are now 10 years older than
the subject property, Athena has determined that cap rates are in a range of. 10. Athena
believes that it should earn an IRR (required return) of at least 11 percent.
a. What is the estimated value of this office property (assume a .10 terminal cap rate)?
b. What is the current, or going in, cap rate for this property?
c. What accounts for the difference between the cap rate in (b) and .10 terminal cap rate?
d. What assumptions are being made regarding future economic conditions when using
current comparable sales to estimate terminal cap rates?
7. An investor is considering the purchase of an existing suburban office building
approximately five years old. The building, when constructed, was estimated to have an
economic life of 50 years, and the building-to-value ratio was 80 percent. Based on current
cost estimates, the structure would cost $5 million to reproduce today. The building is
expected to continue to wear out evenly over the 50-year period of its economic life.
Estimates of other economic costs associated with the improvement are as follows:

Repairable physical depreciation $300,000 to repair

Functional obsolescence (repairable) $200,000 to repair
Functional obsolescence (nonrepairable) $ 25,000 per year rent loss

The land value has been established at S1 million by comparable sales in the area. The
investor believes that an appropriate opportunity cost for any deferred outlays or costs
should be 12 percent per year. What would be the estimated value for this property?
8. ABC Residential Investors, LLR is considering the purchase of a 120-unit apartment
complex in Steel City, Pennsylvania. A market study of the area reveals that an average
rental of $600 per month per unit could be realized in the appropriate market area. During
the last six months, two very comparable apartment complexes have sold in the same
market area.
The Oaks, a 140-unit project, sold for $9 million. Its rental schedule indicates that the
average rent per unit is $550 per month. Palms, a 90-unit complex, is presently renting units
at $65 per month, and its selling price was $6.6 million. The mix of number of bedrooms and
 sizes of units for both complexes is very similar to that of the subject property, and both
appear to have normal vacancy rates of about 10 percent annually. All rents are net as
tenants pay all utilities expenses.
a. Based on the data provided here, how would an appraiser establish an estimate of
value?
b. What other information would be desirable in reaching a conclusion about the probable
value for the property?
9. The NOI for a small income property is expected to be $ 150,000 for the first year. Financing
will be based on a 1.2 OCR applied to the first year NOI will have a 10 percent interest rate,
and will be amortized over 20 years with monthly payments. The NOI will increase 3 percent
per year after the first year. The investor expects to hold the property for five years. The
resale price is estimated by applying a 9 percent terminal capitalization rate to the sixth-year
NOI. Investor require a 12 percent rate of return on equity (equity yield rate) for this type of
property.
a. What is the present value of the equity interest in the property?
b. What is the total present value of the property (mortgage and equity interests)?
c. Based on your answer to part (b), what is the implied overall capitalization rate?
10. Sammie s Club wants to buy a 320,000-square-foot distribution facility on the northern edge
of a large mid western city. The subject facility is presently renting for $4 per square foot.
Based on recent market activity, two properties have sold within a two-mile distance from
the subject facility and are very comparable in size, design, and age. One facility is 350,000
square feet and is presently being leased for $3.90 per square foot annually. The second
facility contains 300,000 square feet and is being leased for $4.10 per square foot. Market
data indicate that current vacancies and operating expenses should run approximately 50
percent of gross income for these facilities. The first facility sold for $9.4 million, and the
second sold for S7.9 million.
a. With a direct capitalization rate approach to value, how would you estimate value for the
subject distribution facility?
b. What additional information would be desirable before the final direct rate (R) is
selected?