Question

You are considering the purchase of a small office building. The office building specializes in offering facilities to small startup firms who are looking to avoid long-term commitments while their businesses are growing. Tenants sign one-year leases and may renew at market rates, if they so desire. The building is configured with 25 suites. Five (5) suites each have 4,000 useable square feet and ten (10) each have 2,500 usable square feet. The remaining ten (10) suites each have 1,000 useable square feet. The building has 10,000 square feet of common area. In addition, a food truck pays $6,000 per year to operate in the parking lot during lunch hours. Market rents are $27.50 per square foot per year, based on total leased space. As there are only a few similar facilities in the market, market rents are expected to increase 3% per year indefinitely. Property taxes are $225,000 per year and increases are capped at 2% per year. Other operating expenses total $250,000 per year and are expected to increase at the rate of inflation, estimated at 3% per year. In most years, capital expenditures equal 4% of effective gross income, although the roof will need to be replaced just before the expected sale at the end of year 5, at an estimated cost of $175,000 at that time. You estimate that 5% of the space will be vacant, on average, and that collection losses will total 2% of rent collected on occupied space. Your market review indicates this property will sell at a price yielding a going-in capitalization rate of 6.5%. You believe the cap rate will increase to 7.5% at the time of a sale. Selling costs at that time are expected to be 5% of the gross sales price. This building is suitable for professional investors, who view capital expenses as a "below the line" item. Based on these parameters, the unleveraged property returns exceed your required returns and you decide to seek mortgage financing. Local lenders are willing to lend up to 70% of the value of the building provided that debt service coverage exceeds 1.5x. Because of the relatively short holding period, lenders are willing to provide interest-only financing at 4.5% with total fees of 1.5%. You expect to close on the purchase on January 1. The land value is estimated at 20% of the purchase price. Because of the start-up nature of the tenants, there is effectively no personal property. Ordinary income is taxed at 30%, while capital gains are taxed at 15%. The depreciation recapture rate is 25%. Your brother will invest with you on a pro rata basis, provided his after-tax returns are projected to exceed 15%. 1. Based on the lenders' underwriting requirements, what is the maximum amount, in dollars, they will lend?

Answer 1

Market rent are $27.50 per square foot which is expected to increase 3% per year indefinitely. Therefore, Market rent for 5 years will be as follows:

Year 1 = $27.50

Year 2 = $28.325 ($27.5*1.03)

Year 3 = $29.17475 ($28.325*1.03)

Year 4 = $30.04999 ($29.17475*1.03)

Year 5 = $30.95149 ($30.04999*1.03)

Maximum amount lenders will lend = 70% of total value

= 70% of $3,066,025

= $2,146,218