Fundamental Skills for Real Estate Development Professionals I
Financial AnalysisWednesday,October 26
9:00 a.m. - 10:15 a.m.
Fundamental Skills for Real Estate Development Professionals IFinancial Analysis 9:00-
10:15Mark J. EppliMarquette UniversityCenter for Real Estate
Site Selection and Due Diligence
10:45-12:00
Charles A. LongPresident, Charles A. Long Properties
Fundamental Skills for Real Estate Development Professionals IIStructuring the Deal to be Profitable
1:00-2:15 Tennyson WilliamsFounder/PresidentTennyson Williams Associates
Project Entitlement 2:45-4:00 David FarmerPrincipalCapital Four Advisors
Real Estate Development Workshops
The Real Estate School Finance Track Curriculum Process
Ability Position ULI Course LevelAnalyze Financial Analyst Finance IDecide Manager Finance IIIntegrate Vice President Advanced FinanceLead President Advanced Finance
The Development Process
Findingthe
Opportunity
Control/Acquire
Land
Design &Public
Approvals
Financing Construction Leasing Payday!
1-5 years
Developer goals for each step of the development process:•Create value•Manage risk
Presentation Outline
• Static cash flow analysis– The income proforma
Determine single period income
– Income proforma ratiosEstimate single period valuation and return
• Dynamic cash flow analysis– Multiple period return
Determines multi-period income
– Holding period expected returnsEstimate total rate of return
• Meeting investor goals and objectives
Concept of Real Estate Valuation
Cap Rate Valuation
Value = Property NOI / Cap Rate
Value = Local Property Markets / Capital Markets
Value = Urban Economic / Financial Economics
Value is created through the local property market and risk is managed with the cap rate.
Property Market Attributes
Important Property Underwriting Characteristics:
– Market – Neighborhood– Site– Improvements– Tenants– Management
Mortgage Underwriting and Lender Ratios
• What do commercial lenders look for?– Asset quality
– Qualitative measures– Property Income
– Lease types– Property income statements
– Cash Flow Adequacy– Debt Coverage Ratio (DCR)
– Collateral Protection– Loan-to-Value Ratio (LTVR)
– Investor Return on Equity (ROE)
Property Income Proforma
Gross Rental Income + Expense Reimbursements
+ Miscellaneous Income Gross Potential Income (GPI)
- Vacancy/Credit Loss Effective Gross Income (EGI)
- Operating Expenses (OE)- Real Estate Taxes (RET)
- Management Fee (MF) Net Operating Income (NOI)
- Tenant Improvements (TI)- Leasing Commissions (LC)- Capital Improvements (CI)
Cash Flow from Operations-Debt Service
Cash Flow After Financing
Cash Flow Adequacy
Debt Coverage Ratio – DCRExpressed as
DCR= Cash From Operations /D.S.
•The DCR measures the riskiness of property cash flows•This ratio usually falls in a range of 1.2 to 1.7
Collateral Protection
Loan-to-Value Ratio - LTVR Expressed as:
LTVR = Loan Amount/Property Value
• How far can the value of the property fall, as a percent of the original loan amount, before the lender’s principal is at risk.
Value of an Property
Capitalization Rate Value: Expressed as:
V = NOI/Cap Rate
•The value of the property is based on the cash flow it generates.
Other Lender Ratio??? Equity Ratio???
Return on Equity (ROE), also called “Cash on Cash”Expressed as
ROE = CFAF/Equity Investment
• Measures productivity of your property as a percentage of your equity investment
• While the equity yield rate is an investor return, it behooves the lender to know how well the borrower is doing
A Second Equity Return Ratio
• Equity Build Up (EBU):– Expressed as
EBU = (Debt Service – Interest) / EquityAlternatively:
EBU = Principal Paid / Equity
– Measures the periodic principal paid down of a loan attributable amortization
An Apartment Income Proforma
Revenue 2012Rent Units RentsOne Bedroom 38 1200 547,200Two Bedroom 64 1685 1,294,080Three Bedroon 6 1985 142,920Underground Parking 128 175 268,800Surface Parking 44 75 39,600Vending & Misc. 51,000 Gross Potential Income 2,292,600Vacancy 5.0% 114,630 Effective Gross Income 2,228,970
ExpensesAdministrative and Management 9.8% 218,439Utilities/ Water/ Rubbish 8.6% 191,691Repairs/ Maintenance/ Supplies 7.2% 160,486Insurance and Fees 2.1% 46,808Real Estate Taxes 16.5% 367,780 Total Expenses 44.2% 985,205NOI 54.25% 1,243,765Capital Expenditures 108 450 48,600NOI after Capital Expenditures 1,195,165
3955 N. Murray Street
Determining the Maximum Loan Amount
Maximum Loan Amount Calculation for 3955 N. Murray StreetLTVR Max Loan AmountCap Rate 6.25%Value 19,900,244LTVR 75%Max LA LTVR 14,925,183
DCR Max Loan AmountDCR 1.3010-Yr UST 2.25%Spread 2.00%Mtg Rate 4.25%Mortgage Constant 5.903%Max Loan Amount 15,573,683
14,925,183Maximimum Loan Amount
Determining the Return to the Equity Investor
Required Equity and Other Costs for 3955 N. Murray StreetRequired EquityEquity Investment in Property $4,975,061Purchase Costs 0.75% $149,252Loan Fees 0.02 0.50% $74,626Acquisition Fee 0.02 0.75% $149,252Immediate Capital Improvements $120,000 $120,000Required Equity $5,468,191
Equity ReturnsNOI 1,195,165Debt Service 881,075Cash Flow After Debt Service 314,090Return on equity 5.74%Equity Build Up 4.51% Total Cash Flow Return and Equity Build Up 10.26%
Property Cap Rates and Premium over U.S. Treasury Securities
Sources: St. Louis Federal Reserve, Mortgage Bankers Association, and Marquette University.
Cap Rate vs. P/E Ratio
Cap rate is the inverse of the P/E ratio
Cap rate P/E Ratio
5% 20
6% 16.7
7% 14.3
8% 12.5
10% 10
Limitations of “Single Number” Value Calculations
• Cash-on-Cash and Income Capitalization Approaches have significant limitations.1. Don’t consider income/expense fluctuations
• Variable cash flows vs. a fixed number• Differential rates of income and expense
growth2. Adjustment for risk is a blunt instrument3. Don’t fully consider effects of leverage4. Don’t explicitly consider value appreciation5. Don’t consider tax shelter benefits
So Let’s Look at Total Investment Return
Risk Premium (Based on investment risk: 1 - 7%)
Real Rate of Return (Expected 0.25%, historic +/-2.0%)
Inflation Premium (Expected: 2.0%)
Total Investment Return
Let’s Look to Finance Theory for Some Return Insights
Total Return Stocks = Dividend Yield + growth rate
Total Return Stocks = Dividend / Price + growth rate
9.0% = 2.5% + 6.5%
Total Rate of Return on Real Estate
Total Return = IRR RE = Cap Rate + growth rate
Total Return = IRRRE = NOI / Property Price + growth rate
9.0% = 7.0% + 2.0%
2020202020192019
20182018
20172017
Discounted Cash Flow Analysis
• Measures the present value of the income stream to be generated by the property over the life of the investment
20162016
20152015
20142014
20132013
2012201220112011
Discounted Cash Flow Analysis
• Discounted Cash Flow analysis is the only really valid way to measure project return– Fully accounts for the time value of money– Allows for variable cash flows– Allows for differential growth rates of income and
expense components– Allows explicit & discrete inclusion of tax benefits and
value appreciation (through reversionary value)– Allows incorporation of cash flows pre- AND post-
construction• Yields two key benchmarks
– Net Present Value– Internal Rate of Return
Net Present Value (NPV)
• The value (in terms of today’s dollars) of all future cash flows, positive and negative, from the project as discounted by the required rate of return (aka discount or hurdle rate), minus the cost of acquiring the property.
1 2 3 4
($100.00) ($100.00)$5.36 $6.00$5.58 $7.00$5.69 $8.00
$69.91 $110.00($13.46) = NPV (sum of all PV's)
Income for each periodPresent Value @ i = 12%
Initial investment
Internal Rate of Return (IRR)
• The discount rate (stated as a percentage) at which the present value of future cash flows is exactly equal to the initial capital investment
• i.e.; rate of return where NPV = 0• In this example the IRR of the cash flows is 7.63%
1 2 3 4
($100.00) ($100.00)$5.57 $6.00$6.04 $7.00$6.42 $8.00
$81.97 $110.00$0.00 = NPV (sum of all PV's)
Income for each periodPresent Value @ i = 7.63%
Initial investment
Lets Look at An Office Property Investment
Gateway Business Center -- Unlevered
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11POTENTIAL GROSS REVENUE Base Rental Revenue $601,403 $631,674 $637,083 $650,476 $661,633 $661,651 $675,565 $679,004 $673,158 $643,616 $650,797 Absorption & Turnover Vacancy (12,740) (5,988) (4,998) (10,350) (10,704) (7,207) (70,218) (6,300) (14,609) Base Rent Abatements (4,459) (2,096) (1,749) (3,623) (3,746) (25,976) (2,430) (6,128)
Scheduled Base Rental Revenue 601,403 631,674 619,884 642,392 654,886 647,678 661,115 671,797 576,964 634,886 630,060
CPI & Other Adjustment Revenue 191 2,580 6,103 11,178 17,917 14,687 19,382 29,091
Expense Reimbursement Revenue CAM & Utilies 32,055 36,719 36,721 39,061 40,770 41,771 43,855 45,572 46,659 62,719 63,602 Insurance 5,193 5,888 5,889 6,237 6,491 6,642 6,952 7,207 7,231 9,347 9,478 Real Estate Taxes 45,712 54,120 54,123 58,345 61,427 63,232 66,990 70,086 76,072 113,092 114,684 Mang. Fee 17,326 18,905 18,102 19,427 20,227 20,062 21,241 21,963 20,855 32,266 32,340 Total Reimbursement Revenue 100,286 115,632 114,835 123,070 128,915 131,707 139,038 144,828 150,817 217,424 220,104 TOTAL POTENTIAL GROSS REVENUE 701,689 747,306 734,719 765,653 786,381 785,488 811,331 834,542 742,468 871,692 879,255 General Vacancy (52,311) (39,582) (48,027) (50,399) (45,359) (46,838) (51,715) (55,159) (47,961)EFFECTIVE GROSS REVENUE 701,689 694,995 695,137 717,626 735,982 740,129 764,493 782,827 742,468 816,533 831,294
OPERATING EXPENSES CAM & Utilies 48,658 50,118 51,621 53,170 54,765 56,408 58,100 59,843 61,638 63,488 65,392 Insurance 7,251 7,469 7,693 7,923 8,161 8,406 8,658 8,918 9,185 9,461 9,745 Real Estate Taxes 87,737 90,369 93,080 95,873 98,749 101,711 104,763 107,905 111,143 114,477 117,911 Mang. Fee 28,068 27,800 27,805 28,705 29,439 29,605 30,580 31,313 29,699 32,661 33,252 TOTAL OPERATING EXPENSES 171,714 175,756 180,199 185,671 191,114 196,130 202,101 207,979 211,665 220,087 226,300 NET OPERATING INCOME 529,975 519,239 514,938 531,955 544,868 543,999 562,392 574,848 530,803 596,446 604,994 LEASING & CAPITAL COSTS Tenant Improvements 95,460 40,942 19,337 16,220 33,753 23,049 178,145 23,089 Leasing Commissions 11,539 10,199 4,794 4,001 8,286 10,316 69,116 5,559 Capital Reserves 7,251 7,469 7,693 7,923 8,161 8,406 8,658 8,918 9,185 9,461
TOTAL LEASING & CAPITAL COSTS 114,250 7,469 58,834 32,054 28,382 50,445 42,023 8,918 256,446 38,109 CASH FLOW BEFORE DEBT SERVICE $415,725 $511,770 $456,104 $499,901 $516,486 $493,554 $520,369 $565,930 $274,357 $558,337 Return on Equity 6.30% 7.75% 6.91% 7.57% 7.83% 7.48% 7.88% 8.57% 4.16% 8.46% Equity Investment $6,600,000 Property Sale $7,562,425 Sale Transcation Costs $151,249 Net Sale Proceeds $7,411,177 Property Cash Flows ($6,600,000) $415,725 $511,770 $456,104 $499,901 $516,486 $493,554 $520,369 $565,930 $274,357 $7,969,514 Internal Rate of Return 8.12%
We can Analyze the Property with and without Debt
Gateway Business CenterInvestment Analysis using Different Investment Cash Flow and Sale Return Splits
I. IRR -- Unleveraged Investment
0 1 2 3 4 5 6 7 8 9 10Property Purchase 6,600,000 Cash Flow 415,725 511,770 456,104 499,901 516,486 493,554 520,369 565,930 274,357 558,337Property Sale 7,411,177Property Cash Flows -6,600,000 415,725 511,770 456,104 499,901 516,486 493,554 520,369 565,930 274,357 7,969,514Return on Equity 6.30% 7.75% 6.91% 7.57% 7.83% 7.48% 7.88% 8.57% 4.16% Internal Rate of Return 8.12%
II. IRR -- Leveraged Investment Loan to Value Ratio 75.76% Loan Amount (calculated) 5,000,000 Interest Rate (interest Only) 6.50% 0 1 2 3 4 5 6 7 8 9 10Loan Amount 5,000,000 Property Cash Flows -6,600,000 415,725 511,770 456,104 499,901 516,486 493,554 520,369 565,930 274,357 7,969,514Debt Service -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000Mortgage Balance -5,000,000Property Cash Flows -1,600,000 90,725 186,770 131,104 174,901 191,486 168,554 195,369 240,930 -50,643 2,644,514Return on Equity 5.67% 11.67% 8.19% 10.93% 11.97% 10.53% 12.21% 15.06% -3.17% Internal Rate of Return 12.45%
Sponsors can Provide Investor Preferred Cash Flow Returns
III. IRR -- Leveraged Investment and Equity Investor
Required Investment
-6,600,00
0 Equity Investor Preferred Return on Cash flow 8.00% Mortgage Amount
5,000,000
Equity Investor Percent of Cash Flow after Preferred Rtn 60.00%
Equity Investor Amount
1,200,000
Equity Investor Percent of Sale Proceeds 50.00% Developer 400,000 0 1 2 3 4 5 6 7 8 9 10Cash Flows 415,725 511,770 456,104 499,901 516,486 493,554 520,369 565,930 274,357 558,337
Debt Service -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000-
325,000 -325,000Cash Flow After Debt Service 90,725 186,770 131,104 174,901 191,486 168,554 195,369 240,930 -50,643 233,337 Equity Investor Position Cash Flow Preferred Return 90,725 96,000 96,000 96,000 96,000 96,000 96,000 96,000 0 96,000Arrears Cash Flow Preferred Return 5,275 0 0 0 0 0 0 0 96,000Cash Flow Split 0 32,097 1,862 28,141 38,092 24,332 40,421 67,758 0 3,171Return of Investment 1,200,000Reversion Split 380,267
Equity Investor Proceeds-
1,200,000 90,725 133,372 97,862 124,141 134,092 120,332 136,421 163,758 0 1,775,438Return on Equity 7.56% 11.11% 8.16% 10.35% 11.17% 10.03% 11.37% 13.65% 0.00% IRR for Equity Investor 11.63% Developer Position Cash Flow Return 0 32,000 32,000 32,000 32,000 32,000 32,000 32,000 -50,643 36,051Cash Flow Split 0 21,398 1,242 18,760 25,394 16,222 26,948 45,172 0 2,114Return of Investment 450,643Reversion Split 380,267Developer Proceeds -400,000 0 53,398 33,242 50,760 57,394 48,222 58,948 77,172 -50,643 869,076
Return on Equity 0.00% 13.35% 8.31% 12.69% 14.35% 12.06% 14.74% 19.29%-
12.66% IRR 14.55%
Sponsors can Also Provide Preferred Total Rates of Return
IV. IRR -- Leveraged Investment and Equity Investor with an IRR Lookback Rate of: 12.00% Equity Investor Position 0 1 2 3 4 5 6 7 8 9 10Cash Flow Preferred Return 90,725 101,275 96,000 96,000 96,000 96,000 96,000 96,000 0 192,000Cash Flow Split 0 32,097 1,862 28,141 38,092 24,332 40,421 67,758 0 3,171Return of Investment 0 0 0 0 0 0 0 0 0 1,200,000Reversion Split 0 0 0 0 0 0 0 0 0 465,000Equity Investor Proceeds -- with Lookback
-1,200,000 90,725 133,372 97,862 124,141 134,092 120,332 136,421 163,758 0 1,860,171
Equity Investor IRR Look back to: 12.00% Reversion Split after 12% IRR lookback 73,767
Equity Investor Proceeds -
1,200,000 90,725 133,372 97,862 124,141 134,092 120,332 136,421 163,758 0 1,933,938Equity Investor IRR 12.30% Developer Position Cash Flow Return 0 32,000 32,000 32,000 32,000 32,000 32,000 32,000 -50,643 36,051Cash Flow Split 0 21,398 1,242 18,760 25,394 16,222 26,948 45,172 0 2,114Return of Investment 0 0 0 0 0 0 0 0 0 450,643Reversion Split 0 0 0 0 0 0 0 0 0 148,000Developer Proceeds -400,000 0 53,398 33,242 50,760 57,394 48,222 58,948 77,172 -50,643 636,809Developer IRR 12.00% Reversion Split after 12% IRR lookback 73,767Developer Proceeds -400,000 0 53,398 33,242 50,760 57,394 48,222 58,948 77,172 -50,643 710,576Developer IRR 12.88%
Equity
• Total target return varies by sector.
• Preferred return 6%-9%
• Usually 9% to 12% "target" total annual return.
• Developer usually must co-invest about 10% of equity.
The Equity Property Sale Waterfall
After debt, cash flow pays
1. Return of principal to investors then sponsors
2. A preferred return of 8% to 12% to investors
3. A promotional return to achieve target, with some return to developer.
4. After target is reached, higher return to developer.
Investor Target Returns: Each use is different
Anchor TenantTiming of sale or leaseTarget IRR*Sector
OccasionalLease up after construction7-12%Industrial
DesirablePre-leasing usually req’d7-12%Retail
DesirablePre-leasing desirable7-12%Office
NoneLease-up after construction7.5-11%Multi-family
NonePre-sales for each phase8-20%For-sale residential
Depends on phaseWith phasing20-30%Land Development
*Unleveraged Internal Rate of Return. Higher leverage increases return on equity.
So…
• How much debt should we use?
What is Our Incremental Cost of Debt?
Incremental Cost of FundsAssumptionsLoan Amortization Term 30 30 30Prepayment Year 10 10 10Property Value $30,000 $30,000 $30,000LTVR 70.00% 75.00% 80.00%Loan Fees 0.50% 0.75% 1.25%Incremental Closing Costs 0 100 250UST10 2.25% 2.25% 2.25%Spread 1.80% 2.20% 2.60% Mortgage Interest Rate 4.05% 4.45% 4.85%
Loan and Borrower Cost InformationLoan Amount 21,000 22,500 24,000Points and Increment Costs 105 269 550Funds Disbursed 20,895 22,231 23,450Debt Service 101 113 127Outstanding Loan Balance 16,573 17,991 19,433Borrower Cost of Funds 4.12% 4.61% 5.17%
Incremental Cost of FundsIncremental New Funds 1,336 1,219Incremental Debt Service 12 13Incremental Outstanding Loan Balance 1,419 1,442Incremental Cost of Funds 11.53% 13.96%
Presentation Take Aways
• Real estate investment is about risk and return
• Property markets provide return, discount rates assess risk
• Property NOI includes only income from operations
• Cap rate valuation explicitly measures only cash flow return
• DCF analysis explicitly measures many factors
• Risk and return can be allocated
Fundamental Skills for Real Estate Development Professionals I
Financial AnalysisWednesday,October 26
9:00 a.m. - 10:15 a.m.