Question: You represent a REIT which is considering purchasing a certain lease. You are evaluating the potential transaction using the following given information:
Lease term: Perpetual.
Tenant: Investment grade commercial tenant. This tenant just issued a perpetual bond at a 6 percent yield [interest rate].
No capital expenditures necessary, absolute triple net [NNN] lease.
Rent is fixed at $1,000 per year, payable annually on 12/31.
Your company has access to perpetual debt at 7 percent.
Your company has a corporate WACC of 8 percent based on 50 percent debt/total value with 7 percent costs of debt & 9% target return on stockholder equity. [Recall that REITs are exempt from corporate-level income taxes.]
Market yields in the municipal [tax-exempt] bond market for perpetual debt of similar risk to the lease are currently 4.5%.
[A] What discount rate would you use to determine the market value [MV] of this lease [what your company would have to bid to obtain it]? What is the PV of the lease at that discount rate? [Show your work.] Why is it correct to use the discount rate you selected [1 short sentence answer]?
[B] Suppose the marginal personal tax rate on investment earnings applicable to marginal investors in your REIT's equity shares [traded in the stock market] is 35 percent. [Note that REITs are not subject to the 15 percent limit on dividend taxes.] What discount rate would you use to determine the investment value [IV] of this lease for your REIT [i.e., the likely effect on your REIT's equity value in the stock market]? What is the PV of the lease at this discount rate? [Show your work.] Why did you select the cash flow level & the discount rate that you used [1 short sentence answer]?
[C] Based on YOUR answers in [a] & [b] [whether those answers are right or wrong], should your REIT be buying, or selling, such leases? Why?