Tenant Demising Buildout with No Sales Event - IRR or Other Calc?

[Kim Hopkins]

Hello!

We are long-term holders of industrial property. I.e. we have no intention of selling. We are contemplating building out an existing single-tenant 20,000 SF building into multiple units. Say Scenario A is no buildout and Scenario B is buildout.

• Both scenarios will take us roughly the same amount of time to lease up from today. 
• Scenario A is going to yield us less rent but cost less money (no buildout). Scenario B will yield a higher rental rate but cost us a lot of money. 
• Scenario A will result in overall higher vacancy over the life of the property since it takes much longer to find a tenant of that size than smaller tenants. 
• We don't plan to sell the property. 

I'm trying to understand the best way to analyze these two scenarios financially.

The IRR calculation with a 10 year hold and conservative cap rate shows 13% for Scenario A and 18% for Scenario B. However, it seems that the primary reason the IRR for Scenario B is higher is because of the much higher sales price, since it's driven by the higher NOI. Since we don't plan to sell the building, this calculation seems inaccurate to me. Here's a picture of the projected cash on cash over the next 7 years. You can see that the cash on cash is initially much lower for Scenario B but ends up higher in the end. However, that does not tell me which Scenario is a better return overall. The bottom COC number is the average over the 7 years, but again, the choice of 7 years was arbitrary and I'm not sure the average is even the right figure to use.

How would you compare these two scenarios financially?

Thank you very much in advance!

Kim