Question: (NPV of Development with a Lease-Up Phase) Consider a speculative development project with the following characteristics: The current (time 0) market value of the land is $2,000,000 and there are $200,000 in up-front design fees and developer costs attributable to time 0. Construction is expected to take three years, and the construction contractor is to be paid in three equal annual payments estimated to be $1,500,000 at the ends of Years 1 through 3. While the exact amounts may vary ex post due to change orders, these costs are largely fixed by the pre-existing physical design of the structure. A construction loan will be obtained at a projected interest rate of 7.5% plus a $20,000 up-front origination fee (assume the construction loan is riskless so that E[rD] ¼ rD). The construction loan will cover all of the projected $4,500,000 direct construction cost, and the loan will be due in its entirety at the end of Year 3. The opportunity cost of equity capital invested in the development phase is estimated to be 20% per annum.
The construction phase is expected to be followed by two years of absorption, with two annual net cash flows during this phase, at the end of Years 4 and 5. The expected net cash flow during Year 4 is $100,000, as the building is expected still to be largely empty and to be incurring substantial tenant build-out and leasing expenses during that year. The expected cash flow in Year 5 is þ $400,000, reflecting more rental revenue and fewer leasing expenses as the building fills up that year. This lease-up phase is less risky than the development phase, but more risky than the stabilized operating phase. The OCC for the absorption phase is estimated at 300 basis points higher than that for the fully operational property (details on this below). The lease-up phase is followed by the long-term fully operational phase of the completed project, starting from Year 6 and extending indefinitely into the future. Net property cash flows from this phase are expected to start out at $800,000 per year and grow annually each year thereafter at a rate of 1% per year. From the perspective of the beginning of Year 6 when the building has first become stabilized, these expected future cash flows have the risk of an unlevered investment in a fully-operational property. This is an amount of risk that warrants a 9% discount rate (go ingin IRR from that time forward). Determine the time zero NPV of the proposed development.