**1.**An office building has three floors of rentable space with a single tenant on each floor. The first floor has 20,000 square feet of rentable space and is currently renting for $15 per square foot. Three years remain on the lease. The lease has an expense stop at $4 per square foot. The second floor has 15,000 square feet of rentable space and is leasing for $15.50 per square foot and has four years remaining on the lease. This lease has an expense stop at $4.50 per square foot. The third floor has 15,000 square feet of leasable space and a lease just signed for the next five years at a rental rate of $17 per square foot, which is the current market rate. The expense stop is at $5 per square foot, which is what expenses per square foot are estimated to be during the next year (excluding management). Management expenses are expected to be 5 percent of effective gross income and are not included in the expense stop. Each lease also has a CPI adjustment that provides for the base rent to increase at half the increase in the CPI. The CPI is projected to increase 3 percent per year. Estimated operating expenses for the next year include the following:

All expenses are projected to increase 3 percent per year. The market rental rate at which leases are expected to be renewed is also projected to increase 3 percent per year. When a lease is renewed, it will have an expense stop equal to operating expenses per square foot during the first year of the lease. To account for any time that may be necessary to find new tenants after the first leases expire, vacancy is estimated to be 10 percent of EGI for the last two years (years 4 and 5).

**a.**Project the effective gross income (EGI) for the next five years.

**b.**Project the expense reimbursements for the next five years.

**c.**Project the net operating income (NOI) for the next five years.

**d.**How much does the NOI increase (average compound rate) over the five years?

**e.**Assuming the property is purchased for $5 million, what is the overall capitalization rate (“going-in” rate)?

**1ii.** What are the primary benefits of investing in real estate income property?

**2i.** You are an employee of University Consultants, Ltd., and have been given the following assignment. You are to present an investment analysis of a new small residential income producing property for sale to a potential investor. The asking price for the property is $1,250,000; rents are estimated at $200,000 during the first year and are expected to grow at 3 percent per year thereafter. Vacancies and collection losses are expected to be 10 percent of rents. Operating expenses will be 35 percent of effective gross income. A 70 percent loan can be obtained at 11 percent interest for 30 years. The property is expected to appreciate in value at 3 percent per year and is expected to be owned for five years and then sold.

**a.**What is the investor’s expected before-tax internal rate of return on equity invested (BTIRR)?

**b.**What is the first-year debt coverage ratio?

**c.**What is the terminal capitalization rate?

**d.**What is the NPV using a 14 percent discount rate? What does this mean?

**e.**What is the profitability index using a 14 percent discount rate? What does this mean?

**2ii.** What factors affect a property’s projected NOI?

**3i.** (Extension of problem 2) You are still an employee of University Consultants, Ltd. The investor tells you she would also like to know how tax considerations affect your investment analysis. You determine that the building represents 90 percent of value and would be depreciated over 39 years (use 1/39 per year). The potential investor indicates that she is in the 36 percent tax bracket and has enough passive income from other activities so that any passive losses from this activity would not be subject to any passive activity loss limitations. Capital gains from price appreciation will be taxed at 20 percent and depreciation recapture will be taxed at 25 percent.

**a.**What is the investor’s expected after-tax internal rate of return on equity invested (ATIRR)? How does this compare with the before-tax IRR (BTIRR) calculated earlier?

**b.**What is the effective tax rate and before-tax equivalent yield?

**c.**How would you evaluate the tax benefits of this investment?

**d.**Recalculate the ATIRR in part (a) under the assumption that the investor cannot deduct any of the passive losses (they all become suspended) until the property is sold after five years.

(For Reference Problem 2)

You are an employee of University Consultants, Ltd., and have been given the following assignment. You are to present an investment analysis of a new small residential income producing property for sale to a potential investor. The asking price for the property is $1,250,000; rents are estimated at $200,000 during the first year and are expected to grow at 3 percent per year thereafter. Vacancies and collection losses are expected to be 10 percent of rents. Operating expenses will be 35 percent of effective gross income. A 70 percent loan can be obtained at 11 percent interest for 30 years. The property is expected to appreciate in value at 3 percent per year and is expected to be owned for five years and then sold.

**a.** What is the investor’s expected before-tax internal rate of return on equity invested (BTIRR)?

**b.**What is the first-year debt coverage ratio?

**c.**What is the terminal capitalization rate?

**d.**What is the NPV using a 14 percent discount rate? What does this mean? e. What is the profitability index using a 14 percent discount rate? What does this mean?

**3ii.** What factors would result in a property increasing in value over a holding period?

**4i. Excel.** Refer to the Monument Office example. Assume the capital gain tax rate is lowered to 5 percent for all capital gain (price increase and depreciation recapture). How does this affect the investor’s after-tax IRR?.

**4ii.** How do you think expense stops and CPI adjustments in leases affect the riskiness of the lease from the lessor’s point of view?

**5.**ARGUS. Refer to the Monument Office Building example. Suppose market rents do not increase over time for lease renewals. How does this affect the unleveraged IRR?

(For Reference ARGUS The Monument Office Building example)

**6i.** Small City currently has 1 million square feet of office space, of which 900,000 square feet is occupied by 3,000 employees who are mainly involved in professional services such as finance, insurance, and real estate. Small City’s economy has been fairly strong in recent years, but due to the current global recession, employment growth is expected to be somewhat low over the next few years, with projections of an increase of just 100 additional employees per year for the next three years. The amount of space per employee is expected to remain the same. However, a new 50,000 square-foot office building was started before the recession and its space is expected to become available at the end of the current year (one year from now). No more space is expected to become available after that for quite some time.

**a.**What is the current occupancy rate for office space in Small City?

**b.**How much office space will be absorbed each year for the next three years?

**c.**What will the occupancy rate be at the end of each of the next three years?

**d.**Based on the above analysis, do you think it is more likely that office rental rates will rise or fall over the next three years?

**6ii. **What is meant by equity?

**7.**What are the similarities and differences between an overall rate and an equity dividend rate?

**8.**What is the significance of a debt coverage ratio?

**9.**What is meant by tax shelter?

**10.**How is the gain from the sale of real estate taxed?

**11.**What is meant by an effective tax rate? What does it measure?

**12.**Do you think taxes affect the value of real estate versus other investments?

**13.**What is the significance of the passive activity loss limitation (PALL) rules for real estate investors?

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