Unlike residential real estate, commercial real estate’s value is based on the income it produces during the investors holding period. Based on the information below, use the NPV formula to determine if this is a good investment for Henri and Lila.
Scenario: Henri (66) and Lila (58) are looking to purchase the 3Forks restaurant.
They have a current combined income of $2.5 million per year from their current two small retail businesses (there is no outstanding debt on either business) which they bought in 1967 in Austin, Texas which they plan to keep. The price for the current 3Forks property in Tennessee is $2.2 million for the 8,000 square foot property built in 1968.
The property produces $154,000 each year in Net Operating Income (NOI) that is expected to increase by 3% each year over the next 5 years. The bank will make a loan for the restaurant at 60% LTV for 25 years, fully amortized, at 5%. The bank also requires a 1.5% debt service coverage for this type of loan. At the end of the 5-year NPV analysis, the value of the property will be based on the NOI at that time and the same CAP rate as the purchase price. For your NPV formula, the discount rate is the 5% interest rate.
- Based on the information above, provide the capitalization rate (or yield) required by the seller for the purchase of the restaurant.
- Using NPV, explain if this a good deal for the buyer.
- Explain and support your choice from your response to bulleted checklist item #2, showing the calculations used.