(solution) Zenith Corp is considering the purchase of an office building for

(solution) Zenith Corp is considering the purchase of an office building for

Zenith Corp is considering the purchase of an office building for $8.0 million that they wish to sell in two years time at a terminal cap rate of 11.44% (a 5% selling cost applies). It will be financed in part by a 20-year, 8% CPM mortgage on the basis of 1.27 DCR.  A property management company manages the property for an annual management fee 0f 5% of EGI, and the vacancy and credit losses are negligible. The building has 50,000 sft of gross space and non-rentable space is 10%. The building is currently fully occupied by two tenants with equal rentable space. Tenant 1 currently pays $30/Yr per sft of base rent with an expense stop of $10/Yr per sft, and there is 1 year remaining in their lease. Tenant 2 has just signed a new 5-year lease at $33/Yr per sft of base rent with an expense stop of $12/Yr per sft. A 50% CPI Adjustment applies to all existing and future leases. New leases are for 5 years and are made at the prevailing market rent as the base rent with expense stop set at the operating expenditure/Yr per sft of the first year of new lease.

1)Assume that CPI, Market Rent and Operating Expenditures will increase at 3%/Yr. Calculate the Before Tax IRR, %, rounded to two decimal places, on Zenith Corporation?s equity investment.

Note: Although new lease/renewal will be for 5 years, we do not know when the pre-existing leases commenced, and we do not also know the actual CPI rates for the past years. Hence, we apply CPI adjustment to the base rent for the pre-existing leases without any compounding for Year 1.
2)  Other things remaining the same, what terminal cap rate would make the investment zero NPV for Zenith if Zenith requires a minimum return (IRR) of 20% on its equity investment?