Consider an office building which is available for sale at $$\$ 3,200,000$$, plus $$\$ 150,000$$ of acquisition costs. The property is leased to a variety of tenants under short leases which permit regular reviews of rent to the current market level. Fully leased, the building would earn rents of $$\$ 287,000$$ in the first year but the current vacancy level of $4 \%$ is likely to be typical over the holding period. Operating expenses, including property taxes and management fees, are estimated to be $$\$ 76,000$$. Market rents are expected to increase at $6 \%$ per annum for the next four years. Operating expenses are expected to increase at $3 \%$ per annum during the period of analysis.
The property is entitled to depreciation allowances for tax purposes of $$\$ 94,000$$ per annum which will not be reclaimed upon resale of the property. It is believed that the property will be saleable after three years for $$\$ 3,750,000$$, less selling costs of $1.5 \%$ of the resale price.
(a) Use the equity cash flows after tax to evaluate the returns over the next three years, assuming that $$\$ 1,340,000$$ is borrowed on a monthly amortizing loan over fifteen years at an interest rate of $8 \%$ per annum with no loan fees. The investor pays tax at a rate of $30 \%$ and has a required return on the equity after tax of $9 \%$. Should the investor proceed with the acquisition at this price?
(b) Now, assume that the building can be acquired vacant and is suitable for the occupation of a company in need of this additional accommodation. The prices, rental value and resale value are as above.
Apply the company's weighted average cost of capital after tax to the property cash flows after tax over the next three years to evaluate the purchase of the property over a three-year period of analysis. The company plans to retain its current $40 \%$ debt-to-asset values. It can borrow at an effective fixed interest rate of $8 \%$ per annum. It can issue shares provided that investors believe they will earn $11 \%$ per annum. The company pays tax at a rate of $30 \%$.
Given these assumptions, would it be better to lease the property rather than buy it?