Economics 434 Financial Markets Professor Burton University of Virginia Fall 2015 November 19, 2015

The Example of Commercial Real Estate Imagine a building with zero net income – Meaning total rent revenue minus all expenses is zero – Every year (nothing changes) What would be the value of that building? – Zero? Imagine that you found out that the owner paid $ 1 million for that building just a few years ago How is this set of facts possible, if nothing has changed since the building was purchased and the owner of the building says he is very satisfied with his acquisition of the building? November 19, 2015

Take a Look at the Income Statement November 19, 2015 Rental Income $75,000 Utilities, Etc. 25,000 Net Rental Income $ 50,000 Suppose the building has a “useful life” of 20 years, the depreciation would be 1/20 of The $1 million purchase price, or $ 50,000 per year Less Depreciation $ 50,000 Net Income zero

So Zero Net Income, so Taxes Will Be Zero How much cash can be withdrawn each year by the owner? – $50,000 – All Tax Free So, the building has a tax free return of 5 %, even though net income is zero November 19, 2015

So, What Would You Pay for This Building Depends upon Financing Cost November 19, 2015