Question: (Participating Mortgage) Bob is thinking of buying a property whose five-year net cash flow projection is shown in the following table (occurring at the end of each year). In addition, at the end of Year 5, the property is expected to be worth 10 times its net cash flow that year.
Year 1 $1,000,000
Year 2 $1,100,000
Year 3 $1,100,000
Year 4 $800,000
Year 5 $1,200,000
Bob can purchase this property for its $11,400,000 market value with an $8,000,000 loan. He has two choices of loans (both five-year interest-only loans with annual payments in arrears). Loan 1 is a straight 8% loan. Loan 2 is a participating mortgage with 7% base interest and 45% kickers on any annual cash flow above $1,000,000 and any resale proceeds (or property appraised value at maturity) above $11,400,000.
a. What is the property market's expected return (going-in IRR) to the underlying property?
b. Ignoring default risk, what is the expected return on loan 1?
c. On loan 2?
d. On Bob's levered equity with loan 1?
e. On Bob's levered equity with loan 2?