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650 California Street is a Class A, 33-story office building prominently located at the northwest section of San Francisco’s financial district. The property is an institutional-grade asset measuring approximately 490,000 square feet.

As part of FIN 371 Homework Assignment 2, you prepared a 10-year proforma, and also analyzed prospective tenant leases with Credit Suisse and tabloMedia for a 9,975 square foot vacant space on the 24th floor of the building.

You are now asked to evaluate two asset management strategies for this property, described as follows:

Strategy A

This strategy aims to re-position 650 California Street to directly compete with what is the city’s second tallest office tower, the “Bank of America” building at 555 California Street

• Garage: Convert the existing basement level to a garage with 105 parking stalls for valets to park vehicles. The cost of construction is estimated to be $5.23 million. A survey of current parking fees at nearby buildings and garages indicates that a monthly parking fee of $500 per stall is achievable. There is a 25% San Francisco Parking Tax such that the net income before operating expenses is $400/stall/month. Parking fees are estimated to increase by 3% per year. The cost to operate the garage, including valet parking staff, insurance, etc. is $186,000 per year, increasing by 3% per year.
• Ground Floor Reception: Expand and upgrade the lobby to match the caliber of the building’s extraordinary unobstructed views of both the Bay and San Francisco, as well as its prestigious address. The cost for this work is estimated to be $4.29 million. The return on this investment is expected to be higher market rents and tenant retention.
• Conference Center and Fitness Center: Modify the use of the sub-basement (previously 100% storage space) to include a conference center and fitness center for use by building tenants. The cost of this constructing and furnishing these amenities is estimated at $1.61 million. Similar to the ground floor reception above, the return on these improvements is anticipated to be built into higher market rents and tenant retention.
Strategy B
This strategy continues the existing configuration of 650 California Street “as-is,” hence there are no significant capital improvements required. Rather, the ownership will focus on providing the best possible property management in order to retain the building’s existing tenants, some of whom would be forced to leave if higher market rents were instituted.

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In addition to any assumptions above, use the following assumptions

1) Purchase Price of the Property: $204 million
2) Discount/Exit Cap Rate: 7%

3) Strategy A
a. New Tenant Rental Revenue equal to 1% of Base Rental Revenue per year, beginning Year 2, reflecting overall higher market rents at the building as a result of new lobby and amenities.
b. Absorption & Turnover Vacancy increases by 5% per year in Years 2-6 (e.g., Year 2 absorption & turnover vacancy grows from 2.9% to7.9%) due to existing tenants that cannot afford the building’s higher rental rates and choose to relocate.
c. New Tenant Improvements of $50/square foot are incurred on 24,000 square feet in each of Years 2-4.
d. New Leasing Commissions of $12.50/square foot are incurred on 24,000 square feet in each of Years 2-4.
e. The result of this strategy is a lower exit cap rate of 6.75% (rather than 7%).

4) Strategy B
a. There is no New Tenant Rental Revenue
b. Base Rent Abatements continue in Years 3-11 at an annual amount equal to 1% of Base Rent Revenues because of concessions given to renewing tenants.
c. There are no New Tenant Improvements or New Leasing Commissions.
d. The result of this strategy is a market exit cap rate of 7%.

Questions to be Answered

1) What is the property worth in the two alternative strategies? Calculate the NPV (using 7% discount rate) and IRR of each. (Provide your Excel 11-year proforma for each strategy.)
2) Describe what factors you would consider (other than IRR) in evaluating the two alternative strategies. Which would you recommend, and how did you make that decision? (List and describe the key decision factors you would consider.)
3) What is the maximum loan that could be secured under each strategy at the end of the term? Use Exit Value Values you calculated under each strategy, and assume a maximum loan to value ratio of 75%, minimum debt service coverage ratio of 120% for 11th year NOI.
a. What is maximum loan if the debt service payment is based on 5% interest only.
b. What is maximum loan if the debt service payment is based on 8% interest only?

When done with this course, you will have completed

1) Analysis of two prospective tenant leases for office space
2) Modeling of two alternative asset management strategies for an investment (Case Study) and determined the NPV and IRR’s for each
3) Based on the property’s estimated future value, calculation of the maximum loan that could be borrowed against it (Case Study)

Product code: Strategy-AW719
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