Value-Add Office Acquisition: Yield on Cost, Debt Sizing, and IRR
An investor is under LOI to acquire an 80,000-square-foot suburban office building for $9.5 million. Occupancy is 70%, WALT is 2.1 years, and 30% of GLA rolls in 18 months. In-place NOI is $650,000. The business plan requires $1.8 million for lobby/HVAC upgrades and $1.2 million for TI/LC to reach 92% occupancy in 18 months at market rent of $24 per square foot NNN; operating expenses are $9 per square foot on the whole building. The lender offers 60% LTV at 6.5%, three years interest-only followed by 25-year amortization, with a 1.25x minimum DSCR. Equity funds all capex and lease-up costs. The hold is five years, exit cap is 7.25%, and sale costs are 2%. The investor’s hurdle is a 15% IRR. The investment committee asks for a recommendation.
1. Calculate stabilized NOI, yield on cost, and the going-in cap rate. What does this tell you?
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- Going-in cap rate: $650,000 ÷ $9,500,000 = 6.84%.
- Stabilized occupancy: 80,000 sf × 92% = 73,600 sf.
- Stabilized revenue: 73,600 sf × $24 = $1,766,400.
- Operating expenses: 80,000 sf × $9 = $720,000.
- Stabilized NOI: $1,766,400 − $720,000 = $1,046,400.
- Total cost: $9,500,000 + $1,800,000 + $1,200,000 = $12,500,000.
- Yield on cost: $1,046,400 ÷ $12,500,000 = 8.37%.
The business plan creates about 153 basis points of yield over the going-in cap, but that spread is compensation for 30% rollover, 18 months of execution risk, and $3.0 million of capex and leasing cost. The spread is not large enough by itself to justify a 15% IRR hurdle; the debt and exit assumptions must also work.
2. Size the debt and evaluate DSCR during lease-up and at stabilization. What lender conditions should you expect?
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- Loan: $9,500,000 × 60% = $5,700,000.
- Interest-only annual debt service: $5,700,000 × 6.5% = $370,500.
- In-place DSCR during IO: $650,000 ÷ $370,500 = 1.75x.
- Amortizing annual payment at 6.5%, 25 years ≈ $461,800 (monthly factor about 0.006752).
- Stabilized DSCR after amortization begins: $1,046,400 ÷ $461,800 = 2.27x.
- Debt yield at stabilization: $1,046,400 ÷ $5,700,000 = 18.4%.
- Loan-to-cost: $5,700,000 ÷ $12,500,000 = 45.6%.
The loan passes on stabilized metrics, but the risk is the rollover window. 30% of GLA equals 24,000 sf; at $24/sf, that is $576,000 of revenue at risk. If those tenants vacate and the property carries the full $720,000 of expenses, NOI can fall below the 1.25x threshold even during the interest-only period. Expect the lender to require an interest reserve, a leasing reserve, or a cash-management trigger until occupancy reaches 85% to 90%.
3. Estimate the five-year IRR and make a recommendation against the 15% hurdle.
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- Equity required: $9,500,000 − $5,700,000 + $3,000,000 = $6,800,000.
- Stabilized NOI: $1,046,400.
- Assume no distributions until stabilization. Year 3 cash flow during IO: $1,046,400 − $370,500 = $675,900.
- Years 4 and 5 after amortization: $1,046,400 − $461,800 = $584,600.
- Exit value at 7.25% cap: $1,046,400 ÷ 0.0725 = $14,433,000.
- Sale costs at 2%: $288,700; net sale value ≈ $14,144,000.
- Loan balance after three years IO plus two years amortization ≈ $5.51 million.
- Net sale proceeds ≈ $8,634,000; year 5 total cash flow ≈ $584,600 + $8,634,000 = $9,218,600.
The cash flows are approximately: Year 0 −$6.8 million; Years 1–2 $0; Year 3 $675,900; Year 4 $584,600; Year 5 $9,218,600. The IRR is roughly 9% to 10%, well below the 15% hurdle. To reach 15%, the purchase price would need to fall to roughly $6.4 to $6.5 million, or the capex/lease-up budget would need a comparable reduction without impairing the business plan. Recommendation: re-trade aggressively or pass.