A company is considering the purchase of an office property. It has done an extensive market analysis and has estimated that based on current market supply/demand relationships, rents, and its estimate of operating expenses, annual net operation income amounts will be as follows: A market that is currently oversupplied is expected to result in cash flows remaining flat for the next three years at $500,000. During years 4, 5, and 6, market rents are expected to be higher, increasing by $50,000, $80,000, and $100,000 in the respective years. It is further expected that after year 6 net operation income will tend to reflect a stable, balanced market and should grow at 2 percent per year indefinitely. The company believes that investors should earn a 13 percent return on an investment of this kind.
Assuming that the investment is expected to be owned for seven years and then sold, what would be the value for this property today? Calculate and explain.
What would the terminal capitalization rate be at the end of year 7? Calculate and explain.
What would the “going-in” capitalization rate be? Calculate and explain.
What explains the difference between the “going-in” and “going-out” cap rates for this property?