Question

An income property is under evaluation for purchase with a $455,000 loan (FRM with 8% annual rate for 10 years and payments are by year). We plan to hold the property for 3 years and then sell it at the end of year 3. The NOI for year 1 is 72,000 with a growth rate of 2. The end capitalization rate is 12%. We assume after year 3, the NOI still increases at a rate of 2%.

a. With the overall discount rate of 15%, what is the estimated total property value for today?

b. With the asking price of 413,000, what is the IRR for this investment?

Answer 1

We find the yearly NOI and the terminal value at end of year 3

NOI

Year 1 = 72000

Year 2 = 72000 * (1+2%) = 73440

Year 3 = 73440 (1+2%) = 74908.80

Terminal Value

Using the constant growth model = NOI (1+ Growth ) / (Cap rate - Growth) = 74908.80 (1+2%)/ (12%-2%) = 764069.76

We use the financial calculator to find the present worth of the property, we find the present value of future cash flows at 15% discount rate

Feed, CF1 = 72000,

CF 2 = 73440

CF3 = 74908.80+ 764069.76 = 839005.56

NPV, I/Y = 15%, Compute NPV we get 669,799.66

b) Now if we take the asking price as 413000, we find the IRR using the financial calculator

Feed, CF0 = -413000

CF1 = 72000,

CF 2 = 73440

CF3 = 74908.80+ 764069.76 = 839005.56

IRR, Compute I/Y we get 37.62

Hence IRR for this investment is 37.62%