Question

James Scheidt is looking at a free-standing retail center that is subject to a triple net lease to DrugSmart. The property’s lease payment for the first three years is $250,000 per year. In lieu of percentage rent, the rent contractually increase 2% per year starting in year-four. James investment period is five years and he intends to sell the property at market rate pricing at the end of year-five. The market requires a real rate of return of 7% on similar real estate investments.

Question 1.   Assuming that there is no vacancy or credit risk associated with expected NOI stream, what is the terminal cap rate (associated with year 6 NOI) for the property? (2 pts)

Question 2.   How much should James be expected to sell the property at the end of year five? (2 pts)

At the end of year three, DrugSmart announced on its earning call, that it has been struggling with increased drug prices and that it would material affect its financial health going forward. It’s corporate bonds were immediately downgraded to BB and the market risk premium increased by 300 bps from 7% to 10%.

Question 3.   What effect, if any, does the increased credit risk have on the sale price of the property James was expecting and why? (2pts)

Question 4. How does this effect the terminate cap rate? Calculate the terminal cap rate. (2pts)

In an effort to keep DrugSmart from filing bankruptcy, landlords including James Scheidt, agreed to lower the contractual rent increases to 1%.

Question 5. Under this scenario, what is the expected sales price of the property at the end of year five? (2 pts)

Answer 1

Sol 1. NOI for Year 6 should be $ 265302.00 with no sale value provided in the question to calculate terminal cap rate is not realistic thus we are assuming that expected market value is calculated on $2,50,000.00 @7% real rate of return which comes to be $35,71,429.00 if I now correlate this sale value with Year 6 NOI then Cap Rate is equal to 7.43%.

Sol 2. At the end of Year 5 James NOI is $2,60,100 and Terminal Rate is assumed at Rate of Return i.e. 7% thus Sale Value= NOI/Terminal Rate= $ 37,15,714.00.

Sol 3. Sale price what James is expecting will come down drastically from $37,15,714.00 to $26,01,000.00 due to increased risk perception by the market.

Sol 4. Terminal rate will increase to 10.40% if the sale value @ 2,50,000 is calculated using 10% rate of return assumed as cap rate. for fifth year NOI i.e .$2,60,100 when divided by $25,00,000 then terminal cap rate of 10.40% is arrived at.

Sol 5. The expected sale price at end of year 5 is NOI of $2,55,025 divided by Rate of 10% which gives sale price as $2,55,0250.00