Central Business District Offices is a mixed use downtown Santa Barbara property generating NOI1 of $425,000. Today’s cap rate is 5%. NOI and property value should increase at 3%/year for the next 5 years. Paul Brown is considering purchasing the property and needs to determine which of three alternative levels of leverage he should choose. He has a deep pocket and can pay all cash for the property. A second alternative would be a new loan under terms of 50% L/V, 5%, 25 years, monthly. A third financing alternative would be a new loan with terms of 75% L/V, 6%, 25 years, monthly. Ignore transaction costs. Brown’s tax rates are 40% ordinary income and 25% for all capital gains. You have examined the assessor’s tax assessment and determined the land is worth $700,000.
Your task is to build a spreadsheet that analyzes the three levels of leverage by calculating the IRRAT for Mr. Brown for each level. Which financing alternative do you recommend he choose, based solely on the IRRs?