Verratti Inc. owns a vacant parcel of land and is trying to determine whether to build a retail shopping center. Using the following information, answer the questions below:
| Category | Details |
| Building Size | 125,000 net leasable square feet |
| Land Cost | $1,500,000 |
| Construction Cost per Square Foot | $43 |
| Rent per Square Foot (Year 1) | $9.50 (increasing at 6% per annum thereafter) |
| Common Area Maintenance (CAM) Charges | Each tenant pays 85% of their pro-rata share of expenses based on proportion of net leasable square footage |
| Real Estate Taxes (Year 1) | $1.29 per square foot of leasable area (increasing at 5.5% annually) |
| Vacancy Rates | Year 1: 12%, Year 2: 15%, Year 3: 13%, Year 4: 8% |
| Operating Expenses (Year 1) | $3.25 per square foot of leasable area (growing at 6% annually) |
| Depreciation Period | 39 years (straight-line) |
| Mortgage Information | 75% loan-to-value ratio, 8.5% interest for 25 years (compounded annually) |
| Property Sale (End of Year 4) | Property sold for 10 times NOI, with 4% selling expenses |
| Required Rate of Return | 12% |
| Investor’s Marginal Income Tax Rate | 36% |
| Capital Gains Tax Rate | 20% |
| Depreciation Recapture Rate | 25% |
Questions
- Estimate the before-tax cash flow for the property for years 1 through 4.
- What proportion of the before-tax market value is from cash flows and what proportion is from reversion?
- What is the value of the property using the Discounted Cash Flow (DCF) Method?
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Solution – Verratti Inc. owns a vacant parcel of land
Step 1: Rental Income Calculation
The rental income is the cash collected from tenants. It increases by 6% per year and in calculating this we will account for vacancy rates.
| Year | Rent per sq. ft. | Vacancy Rate | Leasable Area (sq. ft.) | Rental Income |
|---|---|---|---|---|
| 1 | $9.50 | 12% | 125,000 | $1,045,000 |
| 2 | $10.07 | 15% | 125,000 | $1,070,144 |
| 3 | $10.68 | 13% | 125,000 | $1,160,625 |
| 4 | $11.32 | 8% | 125,000 | $1,302,800 |
Step 2: Calculate Operating Expenses
Operating expenses include all the costs incurred to keep the property running, like utilities and repairs. They increase by 6% per year.
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