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Course: Finance and capital markets > Unit 7
Lesson 5: Investment and consumptionBack-of-envelope office space conundrum
Back of the envelope calculation of which office space to rent. Created by Sal Khan.
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- Having just seen the wealth destruction videos, would it be reasonable to say that (besides the personal financial savings) in scenario 1 ($2000) you are practicing consumption (personal enjoyment) while in scenario 2 ($1000) you are generating wealth (even though it's the landlord who get's the advantage) because at the end of that scenario there exist 2 office spaces worth $2000/ mo?(11 votes)
- Yes. You end up paying $34,000 for scenario 2 and getting the same outputs as scenario 1 while saving also $8,000 ($42,000 cost of scenario 1 - $34,0000 = $8,000). You managed to avoid wealth destruction.(1 vote)
- Wouldn't you also take into consideration the opportunity cost of the 1 month unusable rental space?(1 vote)
- If the landlord plans to raise the rent after the initial 24 month lease, and Khan academy is forced to move due to the higher rent prices, would the move factor into the calculation of effective gross rent for option 2?
Also, I would like to know what kind of commercial leas you were looking at, (No Net, Single Net, Double Net, Triple Net) as this would play a huge factor into the costs that would be associated with EGR (effective gross rent).(1 vote)- it would depend on the contract . if you signed a contract for six dollars a year , and the landlord plans to raise the rent , you get paid back a little .(1 vote)
- Is it possible, at the end of 25 months, if you would like to renew the lease, the price increasing too much because of your house remodelations?(0 votes)
- If that were to happen, there is always the option of relocating to the former office space or a new one.(2 votes)
- Shouldn't the nominal discount rate be considered if you considering which investment is better?(0 votes)
- Strictly speaking it should, but this is a 'back of the envelope' calculation meaning that he doesn't do a deep dig down.(3 votes)
- Based on the math it makes sense to go with the dingy office option. However, isn't that dependent on the dingy office becoming the equivalent of the $2,000/month office after the $10,000 investment in the dingy office? If the dingy office owner is a little difficult to deal with - as Sal mentioned - it would seem that you have to be able to trust that the $10,000 investment will really put the dingy office on a par with the $2,000/month office. Maybe agree to pay $1,000 for the first month while the renovation is being completed and then have the option to get out of the remaining 24 months of the lease if you're not satisfied with the renovation (?)(0 votes)
- But you end up losing $1k+ $10k = $11k in the process. how does that work.(2 votes)
Video transcript
What I want to do
in this video is kind of give a back
of the envelope way for thinking about a
conundrum that the Khan Academy is facing right now. And you could do
a little bit more of a precise way with present
valuing and all of that. But this will give you
a pretty good sense of how to make this decision. So we're seriously
looking at office space. I've changed these numbers to
simplify things a little bit. But there's a nice
office, and it's going for $2,000 per month. And then there's
this dingy office. It's really too dingy. It's a converted nightclub
and it's really too dingy to be a respectable place to
work, but it's going for $1,000 a month. And I talked to a contractor. And once again, I'm
simplifying these numbers. These numbers aren't
the exact numbers, but it makes the math
a little bit simpler. The contractor says it
would cost us about $10,000 to get this dingy office to the
condition of the nice office. And in either situation, we
are thinking about a 24 month lease, so a two year lease. And the contractor said it
would take one month of work to get the dingy office
space up to speed. So the nice office
space landlord he says, look, it'll be a 24 month lease. You could just occupy it. It's ready to go. The dingy office
space, I talked him about this idea of us investing
money in repairing it. He's like, OK, if you
need to repair it-- he's kind not the easiest
person to deal with-- he says, I'm going to charge you
an extra month of rent. So even while I'm repairing
it, I have to pay rent. So he'll say, I'm willing
to do a 25 month contract, a 25 month lease with you. So you could still, once
you repair it, you still get two years of service
from the dingy office. So which one should I do? And I'll tell you
my emotions, I want to do the nice one because I
don't want to spend $10,000 and make this all nice and then
two years later, the landlord could raise the rent. But let's just think
about it rationally. Which one makes sense? And the easiest way
to think about that is, what is the
effective amount of rent, in a very back of
the envelope way, that we're paying
for the dingy office? So if you think about it
over the entire lease, we're going to have 25 months. We're going to pay
$1,000 per month. So it's going to be $25,000
plus $10,000 to repair it. So plus $10,000. I'll just write 10k
like I did before. Plus 10k. And in terms of the useful
life, because over here when we're saying per month,
every month here is useful. So how many useful
months are here? Well we're going to spend
one month to repair it. We only get 24 useful months. So we only get 24 useful months. So if you view it this way,
not doing any fancy present valuing, just back
of the envelope, it is $35,000 over 24 months. And so let's get
our calculator out. I guess it's not pure
back of the envelope, but pretty close to pure
back of the envelope. 35,000 divided by 24
is equal to 1,458. So this is equal to
approximately $1,458 per month. So even though I don't want
to invest in this property, and I'm only going to
be able to use two years and this person's going
to be able to raise the rent after that, it actually
still makes a lot of sense. It still makes actually
almost $500 a month of sense or more than $500
a month of sense in this kind of back
of the envelope way to get the dingy
office and repair it.