Description
Three considerations are important and unique about applying the NPV rule to evaluating investment in development projects as compared to investments in stabilized operating properties
1
Chapter 29:
Chapter 29:
Economic Analysis of Investment in Real
Economic Analysis of Investment in Real
Estate Development Projects,
Estate Development Projects,
Part 2
Part 2
2
Three considerations are important and unique about applying the Three considerations are important and unique about applying the NPV rule NPV rule
to evaluating investment in development projects as compared to to evaluating investment in development projects as compared to
investments in stabilized operating properties: investments in stabilized operating properties:
1. 1. “ “Time Time- -to to- -Build Build” ”: : Investment cash outflow occurs Investment cash outflow occurs over time over time, not all at , not all at
once up front, due to the once up front, due to the construction phase construction phase. .
2. 2. Construction loans: Construction loans: Debt financing for the construction phase is Debt financing for the construction phase is almost almost
universal universal (even when the project will ultimately be financed entirely (even when the project will ultimately be financed entirely
by equity). by equity).
3. 3. Phased risk regimes: Phased risk regimes: Investment risk is very different (greater) Investment risk is very different (greater)
between the construction phase (the between the construction phase (the development investment development investment per se) per se)
and the stabilized operational phase. (Sometimes an intermediate and the stabilized operational phase. (Sometimes an intermediate
phase, phase, “ “lease lease- -up up” ”, is also distinguishable.) , is also distinguishable.)
We need to account for these differences in the methodology of h We need to account for these differences in the methodology of how we ow we
apply apply the NPV Rule to development investments. . . the NPV Rule to development investments. . .
3
NPV = Benefits
NPV = Benefits
–
–
Costs
Costs
The benefits and costs must be measured in an
The benefits and costs must be measured in an
“
“
apples
apples
vs
vs
apples
apples
”
”
manner. That is, in dollars:
manner. That is, in dollars:
•
•
As of the
As of the
same
same
point in
point in
time
time
.
.
•
•
That have been adjusted to
That have been adjusted to
account for risk
account for risk
.
.
As with all DCF analyses, time and risk can be accounted for by
As with all DCF analyses, time and risk can be accounted for by
using
using
risk
risk
-
-
adjusted discounting
adjusted discounting
.
.
Key is to identify:
Key is to identify:
opportunity cost of capital
opportunity cost of capital
•
•
Reflects amount of
Reflects amount of
risk
risk
in the cash flows
in the cash flows
•
•
Can be applied to either
Can be applied to either
discount
discount
CFs
CFs
back in time, or
back in time, or
•
•
To
To
grow
grow
(compound)
(compound)
CFs
CFs
forward in time
forward in time
•
•
e.g., to the projected time of completion of the construction
e.g., to the projected time of completion of the construction
phase.
phase.
4
Hereandnow Place:
• Twin buildings, $75,000/mo net rent perpetuity
• OCC = 9%/yr (0.75%/mo, 1.0075
12
– 1 = 9.38% EAR)
•in total, V
0
is:
000 , 000 , 10 $
0075 .
000 , 75 $
0075 . 1
000 , 75 $
0075 . 1
000 , 75 $
2
= = + + L
NPV
0
= V
0
– P
0
= $10,000,000 – $10,000,000 = 0
Futurespace Centre:
• Across the street from Hereandnow.
• Will be same asset as Hereandnow, complete in 12 mos
• Constr cost $1,500,000 X 4 payable @ mos 3, 6, 9, 12.
• First building complete in 6 mos.
• This is definitely HBU of site; irreversible commitment to
develop now is appropriate
Typical investment deal for this stablized property:
5
Development investment valuation question :
What is the price that can be paid today for the
What is the price that can be paid today for the
FutureSpace
FutureSpace
land site such that the development investment will be zero
land site such that the development investment will be zero
NPV?
NPV?
. . .
. . .
This is the value of the land, the price the FutureSpace land
site would presumably sell for in a competitive market.
Hence, equivalently:
What is the NPV of the development project investment
What is the NPV of the development project investment
apart from the land cost? . . .
apart from the land cost? . . .
Answer:
NPV
0
= V
0
– P
0
= V
0
– (K
0
+ Land)
So, what is V
0
?, and what is K
0
? For Futurespace Project . . .
6
000 , 000 , 5 $
0075 .
500 , 37 $
0075 . 1
500 , 37 $
0075 . 1
500 , 37 $
2
= = + + L
First consider V
0
…
In 6 mos Furturespace One will be complete, expected to be worth:
And in 12 mos Futurespace Two is expected to be worth:
000 , 000 , 5 $
0075 .
500 , 37 $
0075 . 1
500 , 37 $
0075 . 1
500 , 37 $
2
= = + + L
Thus, gross PV of project benefit is:
000 , 352 , 9 $
0075 . 1
000 , 000 , 5 $
0075 . 1
000 , 000 , 5 $
12 6
0
= + = V
000 , 352 , 9 $
0075 . 1
000 , 000 , 10 $
0075 . 1
500 , 37 $
12
12
7
0
= + =
?
= t
t
V
Or, equivalently:
Why is Futurespace worth less than Hereandnow ? . . .
Why do we cut off the analysis at month 12 ? . . .
7
Now consider K
0
…
Construction cost is 4 quarterly pmts of $1,500,000 each.
These CFs have very little “risk” as capital mkt defines “risk”:
• Low beta, low correlation w financial mkts.
Hence: OCC for constr CFs near
r
r
f f
, say
3%
3%per annum
(0.25%/mo, 3.04% EAR).*
So, PV of construction costs is:
000 , 889 , 5 $
0025 . 1
000 , 500 , 1 $
0025 . 1
000 , 500 , 1 $
0025 . 1
000 , 500 , 1 $
0025 . 1
000 , 500 , 1 $
12 9 6 3
0
= + + + = K
* Note that by using a lower OCC for construction CFs, we
discount them to a higher PV, thus causing construction costs to
figure more prominently in the development investment decision.
In this sense we are treating construction cost as a greater “risk”
factor to be considered in the decision.
This is not the capital market definition of “risk”, but it is
consistent with common parlance.
8
Thus, excluding Land cost, we have Futurespace project
valuation:
V
0
– K
0
= $9,352,000 – $5,889,000 = $3,463,000.
If the price of the Land is x, then:
NPV
0
= $3,463,000 – x .
For any Land price
Three considerations are important and unique about applying the NPV rule to evaluating investment in development projects as compared to investments in stabilized operating properties
1
Chapter 29:
Chapter 29:
Economic Analysis of Investment in Real
Economic Analysis of Investment in Real
Estate Development Projects,
Estate Development Projects,
Part 2
Part 2
2
Three considerations are important and unique about applying the Three considerations are important and unique about applying the NPV rule NPV rule
to evaluating investment in development projects as compared to to evaluating investment in development projects as compared to
investments in stabilized operating properties: investments in stabilized operating properties:
1. 1. “ “Time Time- -to to- -Build Build” ”: : Investment cash outflow occurs Investment cash outflow occurs over time over time, not all at , not all at
once up front, due to the once up front, due to the construction phase construction phase. .
2. 2. Construction loans: Construction loans: Debt financing for the construction phase is Debt financing for the construction phase is almost almost
universal universal (even when the project will ultimately be financed entirely (even when the project will ultimately be financed entirely
by equity). by equity).
3. 3. Phased risk regimes: Phased risk regimes: Investment risk is very different (greater) Investment risk is very different (greater)
between the construction phase (the between the construction phase (the development investment development investment per se) per se)
and the stabilized operational phase. (Sometimes an intermediate and the stabilized operational phase. (Sometimes an intermediate
phase, phase, “ “lease lease- -up up” ”, is also distinguishable.) , is also distinguishable.)
We need to account for these differences in the methodology of h We need to account for these differences in the methodology of how we ow we
apply apply the NPV Rule to development investments. . . the NPV Rule to development investments. . .
3
NPV = Benefits
NPV = Benefits
–
–
Costs
Costs
The benefits and costs must be measured in an
The benefits and costs must be measured in an
“
“
apples
apples
vs
vs
apples
apples
”
”
manner. That is, in dollars:
manner. That is, in dollars:
•
•
As of the
As of the
same
same
point in
point in
time
time
.
.
•
•
That have been adjusted to
That have been adjusted to
account for risk
account for risk
.
.
As with all DCF analyses, time and risk can be accounted for by
As with all DCF analyses, time and risk can be accounted for by
using
using
risk
risk
-
-
adjusted discounting
adjusted discounting
.
.
Key is to identify:
Key is to identify:
opportunity cost of capital
opportunity cost of capital
•
•
Reflects amount of
Reflects amount of
risk
risk
in the cash flows
in the cash flows
•
•
Can be applied to either
Can be applied to either
discount
discount
CFs
CFs
back in time, or
back in time, or
•
•
To
To
grow
grow
(compound)
(compound)
CFs
CFs
forward in time
forward in time
•
•
e.g., to the projected time of completion of the construction
e.g., to the projected time of completion of the construction
phase.
phase.
4
Hereandnow Place:
• Twin buildings, $75,000/mo net rent perpetuity
• OCC = 9%/yr (0.75%/mo, 1.0075
12
– 1 = 9.38% EAR)
•in total, V
0
is:
000 , 000 , 10 $
0075 .
000 , 75 $
0075 . 1
000 , 75 $
0075 . 1
000 , 75 $
2
= = + + L
NPV
0
= V
0
– P
0
= $10,000,000 – $10,000,000 = 0
Futurespace Centre:
• Across the street from Hereandnow.
• Will be same asset as Hereandnow, complete in 12 mos
• Constr cost $1,500,000 X 4 payable @ mos 3, 6, 9, 12.
• First building complete in 6 mos.
• This is definitely HBU of site; irreversible commitment to
develop now is appropriate
Typical investment deal for this stablized property:
5
Development investment valuation question :
What is the price that can be paid today for the
What is the price that can be paid today for the
FutureSpace
FutureSpace
land site such that the development investment will be zero
land site such that the development investment will be zero
NPV?
NPV?
. . .
. . .
This is the value of the land, the price the FutureSpace land
site would presumably sell for in a competitive market.
Hence, equivalently:
What is the NPV of the development project investment
What is the NPV of the development project investment
apart from the land cost? . . .
apart from the land cost? . . .
Answer:
NPV
0
= V
0
– P
0
= V
0
– (K
0
+ Land)
So, what is V
0
?, and what is K
0
? For Futurespace Project . . .
6
000 , 000 , 5 $
0075 .
500 , 37 $
0075 . 1
500 , 37 $
0075 . 1
500 , 37 $
2
= = + + L
First consider V
0
…
In 6 mos Furturespace One will be complete, expected to be worth:
And in 12 mos Futurespace Two is expected to be worth:
000 , 000 , 5 $
0075 .
500 , 37 $
0075 . 1
500 , 37 $
0075 . 1
500 , 37 $
2
= = + + L
Thus, gross PV of project benefit is:
000 , 352 , 9 $
0075 . 1
000 , 000 , 5 $
0075 . 1
000 , 000 , 5 $
12 6
0
= + = V
000 , 352 , 9 $
0075 . 1
000 , 000 , 10 $
0075 . 1
500 , 37 $
12
12
7
0
= + =
?
= t
t
V
Or, equivalently:
Why is Futurespace worth less than Hereandnow ? . . .
Why do we cut off the analysis at month 12 ? . . .
7
Now consider K
0
…
Construction cost is 4 quarterly pmts of $1,500,000 each.
These CFs have very little “risk” as capital mkt defines “risk”:
• Low beta, low correlation w financial mkts.
Hence: OCC for constr CFs near
r
r
f f
, say
3%
3%per annum
(0.25%/mo, 3.04% EAR).*
So, PV of construction costs is:
000 , 889 , 5 $
0025 . 1
000 , 500 , 1 $
0025 . 1
000 , 500 , 1 $
0025 . 1
000 , 500 , 1 $
0025 . 1
000 , 500 , 1 $
12 9 6 3
0
= + + + = K
* Note that by using a lower OCC for construction CFs, we
discount them to a higher PV, thus causing construction costs to
figure more prominently in the development investment decision.
In this sense we are treating construction cost as a greater “risk”
factor to be considered in the decision.
This is not the capital market definition of “risk”, but it is
consistent with common parlance.
8
Thus, excluding Land cost, we have Futurespace project
valuation:
V
0
– K
0
= $9,352,000 – $5,889,000 = $3,463,000.
If the price of the Land is x, then:
NPV
0
= $3,463,000 – x .
For any Land price