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A company is considering the purchase of an office property. After a careful review of the market and the leases that are in place, it believes that next year’s net operating income will be $100,000. It also believes that this cash flow will rise in the amount of $7,000 each year for the foreseeable future. It plans to own the property for 10 years, after which the property value will be determined using information on comparable properties’ going-out cap rates. Based on a review of recent sales of properties that are now 10 years older than the subject property, the company has determined that terminal cap rates are in a range of 10 percent. The company believes that it should earn an internal rate of return (required return) of at least 12 percent.
a. What is the estimated current value of this office property? Calculate and explain.
b. What is the current, or “going-in,” cap rate for this property? Calculate and explain.
c. What accounts for the difference between the cap rate in (b) and the 10 percent terminal cap rate? Explain in words.
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