Problem:
Bob is considering acquiring a commercial property for $100,000. He expects the property will generate NOIs of $10,000 in year 1, $11,000 in year 2, $12,000 in year 3 and $12,500 in year 4. He wants you to do a three-year cash flow simulation. He expects the cap rate on the property in three years to be the same as the one at purchase. He is offered an $80,000 interest only 3-year participating mortgage with annual payments of 7% interest plus 50% kickers on any annual cash flow above $11,000 and property value at maturity above $100,000.
Required:
Question 1: What is the property expected return?
Question 2: What is the yield to maturity (YTM) on the loan assuming Bob will not default on the loan?
Question 3: What is the return on Bob's levered equity assuming he takes the loan?
Question 4: The lender may be interested in offering a convertible mortgage with 7% interest payments rather than the participating mortgage. What is the highest proportion of property equity Bob can offer to the lender at the end of year 3 in exchange for the mortgage balance, in order to make the effective cost of the convertible mortgage identical to the effective cost of the participating mortgage?
Note: Show supporting computations in good form.