Question

Zenith Corp is considering the purchase of an office building for $8.0 million that they wish to sell in two years time at a terminal cap rate of 11.44% (a 5% selling cost applies). It will be financed in part by a 20-year, 8% CPM mortgage on the basis of 1.27 DCR. A property management company manages the property for an annual management fee 0f 5% of EGI, and the vacancy and credit losses are negligible. The building has 50,000 sft of gross space and non-rentable space is 10%. The building is currently fully occupied by two tenants with equal rentable space. Tenant 1 currently pays $30/Yr per sft of base rent with an expense stop of $10/Yr per sft, and there is 1 year remaining in their lease. Tenant 2 has just signed a new 5-year lease at $33/Yr per sft of base rent with an expense stop of $12/Yr per sft. A 50% CPI Adjustment applies to all existing and future leases. New leases are for 5 years and are made at the prevailing market rent as the base rent with expense stop set at the operating expenditure/Yr per sft of the first year of new lease.

1)Assume that CPI, Market Rent and Operating Expenditures will increase at 3%/Yr. Calculate the Before Tax IRR, %, rounded to two decimal places, on Zenith Corporation’s equity investment.

Note: Although new lease/renewal will be for 5 years, we do not know when the pre-existing leases commenced, and we do not also know the actual CPI rates for the past years. Hence, we apply CPI adjustment to the base rent for the pre-existing leases without any compounding for Year 1.
2) Other things remaining the same, what terminal cap rate would make the investment zero NPV for Zenith if Zenith requires a minimum return (IRR) of 20% on its equity investment?