Chapter 29
Chapter 29
Financial Analysis of
Financial Analysis of
Real Estate Development Projects
Real Estate Development Projects
Surely you recall the central role the development industry play
Surely you recall the central role the development industry play
s
s
in our overview of
in our overview of
The Real Estate System
The Real Estate System
(back in Chapter 2)…
(back in Chapter 2)…
Exhibit 2-2: The “Real Estate System”: Interaction of the Space Market, Asset Market, & Development Industry
SPACE MARKET
SUPPLY
(Landlords)
DEMAND
(Tenants)
RENTS
&
OCCUPANCY
LOCAL
&
NATIONAL
ECONOMY
FORECAST
FUTURE
ASSET MARKET
SUPPLY
(Owners
Selling)
DEMAND
(Investors
Buying)
CASH
FLOW
MKT
REQ’D
CAP
RATE
PROPERTY
MARKET
VALUE
DEVELOPMENT
INDUSTRY
IS
DEVELPT
PROFITABLE
?
CONSTR
COST
INCLU
LAND
IF
YES
ADDS
NEW
CAPI
TAL
MKTS
= Causal flows.
= Information gathering & use.
Development is a multi Development is a multi- -disciplinary, iterative process . . . disciplinary, iterative process . . .
The (famous) The (famous) Graaskampian Graaskampian Spiral Spiral. .
Development is important: Development is important:
• • From a finance & investment perspective, but also From a finance & investment perspective, but also
• • From an urban development (physical, social, environmental) From an urban development (physical, social, environmental)
perspective… perspective…
Graaskamp
Graaskamp
also coined the concept that most development
also coined the concept that most development
projects can be characterized as either:
projects can be characterized as either:
•
•
A use looking for a site, or
A use looking for a site, or
•
•
A site looking for a use.
A site looking for a use.
Site Looking for a Use: Site Looking for a Use:
• • Developer tries to determine & build the Developer tries to determine & build the “ “HBU HBU” ”, or , or
• • Public entity seeks developer to build a use determined Public entity seeks developer to build a use determined
through a political process (presumably also through a political process (presumably also “ “HBU HBU” ”). ).
Use Looking for a Site: Use Looking for a Site:
• • Developer has a particular specialization, or Developer has a particular specialization, or
• • Developer is working for a specific Developer is working for a specific user user. .
29.2 Basic Information: Enumerating Project Costs & Benefits
29.2 Basic Information: Enumerating Project Costs & Benefits
Two types of project budgets are important to be developed:
Two types of project budgets are important to be developed:
•
•
Construction & Absorption Budget:
Construction & Absorption Budget:
• • Covers construction (& lease Covers construction (& lease- -up, for up, for “ “spec spec” ” projects); projects);
• • Relates to the Relates to the “ “COST COST” ” side of the NPV Equation. side of the NPV Equation.
•
•
Operating Budget:
Operating Budget:
• • Covers “stabilized” period of building operation after lease Covers “stabilized” period of building operation after lease- -
up is complete; up is complete;
• • Typically developed for a single typical projected “stabilized Typically developed for a single typical projected “stabilized
year”; year”;
• • Relates to the Relates to the “ “BENEFIT BENEFIT” ” side of the NPV Equation. side of the NPV Equation.
NPV = Benefits
NPV = Benefits
–
–
Costs = Value of Bldg
Costs = Value of Bldg
–
–
Cost of
Cost of
Devlpt
Devlpt
.
.
The Operating Budget
The Operating Budget (Recall the items from Chapter 11) (Recall the items from Chapter 11)
:
:
• • Forecast Potential Gross Income (PGI, based on rent analysis) Forecast Potential Gross Income (PGI, based on rent analysis)
• • Less Vacancy Allowance Less Vacancy Allowance
• • = Effective Gross Income (EGI) = Effective Gross Income (EGI)
• • Less forecast operating expenses (& capital reserve) Less forecast operating expenses (& capital reserve)
• • = Net Operating Income (NOI) = Net Operating Income (NOI)
The most important aspect is normally the rent analysis, which i The most important aspect is normally the rent analysis, which is based s based
(more or less formally) on a (more or less formally) on a market analysis market analysis of the space market which the of the space market which the
building will serve. building will serve. (See Chapter 6, or Wheaton’s 11.433 course.) (See Chapter 6, or Wheaton’s 11.433 course.)
The bottom line:
The bottom line:
NOI forecast, combined with NOI forecast, combined with cap rate cap rate analysis (of the asset market): analysis (of the asset market):
NOI / cap rate = Projected Completed Building Value = NOI / cap rate = Projected Completed Building Value = “ “Benefit Benefit” ” of the of the
development project. development project.
The Construction & Absorption Budget:
The Construction & Absorption Budget:
Construction: Construction: “Hard Costs” “Hard Costs”
• • Land cost Land cost
• • Site preparation costs (e.g., excavation, utilities installatio Site preparation costs (e.g., excavation, utilities installation) n)
• • Shell costs of existing structure in rehab projects Shell costs of existing structure in rehab projects
• • Permits Permits
• • Contractor fees Contractor fees
• • Construction management and overhead costs Construction management and overhead costs
• • Materials Materials
• • Labor Labor
• • Equipment rental Equipment rental
• • Tenant finish Tenant finish
• • Developer fees Developer fees
Construction: Construction: “Soft Costs” “Soft Costs”
• • Loan fees Loan fees
• • Construction loan interest Construction loan interest
• • Legal fees Legal fees
• • Soil testing Soil testing
• • Environmental studies Environmental studies
• • Land planner fees Land planner fees
• • Architectural fees Architectural fees
• • Engineering fees Engineering fees
• • Marketing costs including advertisements Marketing costs including advertisements
• • Leasing or sales commissions Leasing or sales commissions
The Construction & Absorption Budget
The Construction & Absorption Budget
(cont.)
(cont.)
:
:
Absorption Budget Absorption Budget (if separate) (if separate): :
• • Marketing costs & advertising Marketing costs & advertising
• • Leasing expenses (commissions) Leasing expenses (commissions)
• • Tenant improvement expenditures Tenant improvement expenditures (“build (“build- -outs”) outs”)
• • Working capital during lease Working capital during lease- -up (until break up (until break- -even) even)
29.3 Construction Budget Mechanics
29.3 Construction Budget Mechanics
Construction Construction takes time takes time (typically several months to several years). (typically several months to several years).
During this period, financial capital is being used to pay for t During this period, financial capital is being used to pay for the construction. he construction.
“Time is money” “Time is money”: The opportunity cost of this capital is part of the real cost : The opportunity cost of this capital is part of the real cost of of
the construction. the construction.
This is true whether or not a construction loan is used to finan This is true whether or not a construction loan is used to finance the ce the
construction process. But: construction process. But:
Construction loans are Construction loans are almost always almost always used (even by equity investors who have used (even by equity investors who have
plenty of cash). plenty of cash).
Why? . . . Why? . . .
The “classical” construction finance structure:
The “classical” construction finance structure:
Phase: Phase:
Financing: Financing:
Construction Construction Lease Lease- -Up Up Stabilized Operation… Stabilized Operation…
C.O. C.O.
Construction Loan Construction Loan Bridge Loan Bridge Loan Permanent Mortgage Permanent Mortgage
Source: Source:
Commercial Commercial
Bank Bank
• • Comm. Bank Comm. Bank
• • Insur Insur Co. Co.
Via Via Mortg Mortg Brkr Brkr
or or Mortg Mortg Banker: Banker:
• • Life Life Insur Insur. Co. . Co.
• • Pension Fund Pension Fund
• • Conduit Conduit CMBS CMBS
Construction lender won’t approve construction Construction lender won’t approve construction
loan until permanent lender has conditionally loan until permanent lender has conditionally
approved a “take approved a “take- -out” loan. out” loan.
The construction loan collapses a series of costs (cash outflows
The construction loan collapses a series of costs (cash outflows
)
)
incurred during the construction process into a
incurred during the construction process into a
single value
single value
as of
as of
a single (future)
a single (future)
point in time
point in time
(the projected completion date of
(the projected completion date of
the construction phase).
the construction phase).
Actual construction expenditures (
Actual construction expenditures (
“draws”
“draws”
on the construction
on the construction
loan) are added to the accumulating
loan) are added to the accumulating
balance
balance
due on the loan,
due on the loan,
and interest is charged and compounded (adding to the balance)
and interest is charged and compounded (adding to the balance)
on all funds drawn out from the loan commitment, from the
on all funds drawn out from the loan commitment, from the
time each draw is made.
time each draw is made.
Thus, interest
Thus, interest
compounds forward
compounds forward
, and the borrower owes no
, and the borrower owes no
payments until the loan is due at the end of construction, when
payments until the loan is due at the end of construction, when
all principle and interest is due.
all principle and interest is due.
Bottom line: Borrower (developer) faces no cash outflows for
Bottom line: Borrower (developer) faces no cash outflows for
construction until the end of the process, when the entire cost
construction until the end of the process, when the entire cost
is
is
paid (including the “cost of capital”).
paid (including the “cost of capital”).
Example:
Example:
Commitment for $2,780,100 of “future advances” in a
Commitment for $2,780,100 of “future advances” in a
construction loan to cover $2,750,000 of actual construction
construction loan to cover $2,750,000 of actual construction
costs over a three month period. 8% interest (nom.ann.),
costs over a three month period. 8% interest (nom.ann.),
compounded monthly, beginning of month draws:
compounded monthly, beginning of month draws:
Month New Draw Current Interest New Loan Balance
1 $500,000 $3,333.33 $503,333.33
2 $750,000 $8,355.55 $1,261,688.88
3 $1,500,000 $18,411.26 $2,780,100.14
4 and so on
Construction schedule must estimate the amount and timing of the Construction schedule must estimate the amount and timing of the draws. draws.
The accumulated interest (8333+8356+18411 = $30,100 in this case The accumulated interest (8333+8356+18411 = $30,100 in this case) is a ) is a
very real part of the very real part of the total cost total cost of construction of construction. AKA . AKA “Financing Cost” “Financing Cost”. .
Typically a “commitment fee” is also required, up front (in cash Typically a “commitment fee” is also required, up front (in cash). ).
29.4 Simple Financial Feasibility Analysis in Current Practice 29.4 Simple Financial Feasibility Analysis in Current Practice
The traditional and most widely employed method for the analysis The traditional and most widely employed method for the analysis of the of the
financial feasibility of development projects will be referred t financial feasibility of development projects will be referred to here as: o here as:
“Simple Financial Feasibility Analysis” (SFFA) “Simple Financial Feasibility Analysis” (SFFA). .
SFFA is based on the commercial mortgage market (for SFFA is based on the commercial mortgage market (for permanent permanent loans). loans).
It assumes the developer will take out the largest permanent loa It assumes the developer will take out the largest permanent loan possible n possible
upon completion of the building. upon completion of the building.
It assumes that the development It assumes that the development costs costs will equal the market will equal the market value value of the of the
property on completion. property on completion.
Obviously, SFFA leaves something to be desired from a normative Obviously, SFFA leaves something to be desired from a normative
perspective, but: perspective, but:
• • It is It is simple simple and easy to understand. and easy to understand.
• • It requires no specialized knowledge of the capital markets ot It requires no specialized knowledge of the capital markets other than her than
familiarity with the commercial mortgage market (does not even r familiarity with the commercial mortgage market (does not even require equire
familiarity with the relevant property asset market). familiarity with the relevant property asset market).
SFFA comes in two modes: SFFA comes in two modes: “Front Door” “Front Door”, & , & “Back Door” “Back Door” . . . . . .
SFFA SFFA “Front Door” “Front Door” Procedure: Procedure:
Start with costs & end with rent required for feasibility… Start with costs & end with rent required for feasibility…
Site Acquisition Costs + Construction Costs Site Acquisition Costs + Construction Costs
= Total Expected Development Cost = Total Expected Development Cost
X Loan to Value Ratio X Loan to Value Ratio
= Permanent Mortgage = Permanent Mortgage
X Annualized Mortgage Constant X Annualized Mortgage Constant
= Cash Required for Debt Service = Cash Required for Debt Service
X Lender Required Debt Service Coverage Ratio X Lender Required Debt Service Coverage Ratio
= Required Net Operating Income or NOI = Required Net Operating Income or NOI
+ Estimated Operating Expenses (Not passed through to tenants) + Estimated Operating Expenses (Not passed through to tenants)
= Required Effective Gross Income = Required Effective Gross Income
÷ ÷ Expected Occupancy Rate Expected Occupancy Rate
= Required Gross Revenue = Required Gross Revenue
÷ ÷ Leasable Leasable Square Feet Square Feet
= Rent Required Per Square Foot = Rent Required Per Square Foot
Question: Is this average required rent per square foot achievab Question: Is this average required rent per square foot achievable? le?
Typical approach for Typical approach for “Site looking for a Use”. “Site looking for a Use”.
Example: Example:
• • Class B office building rehab project: 30,000 SF (of which 27,2 Class B office building rehab project: 30,000 SF (of which 27,200 NRSF). 00 NRSF).
• • Acquisition cost = $660,000; Acquisition cost = $660,000;
• • Rehab construction budget: $400,000 hard costs + $180,000 soft Rehab construction budget: $400,000 hard costs + $180,000 soft costs. costs.
• • Estimated operating costs (to landlord) = $113,000/yr. Estimated operating costs (to landlord) = $113,000/yr.
• • Projected stabilized occupancy = 95%. Projected stabilized occupancy = 95%.
• • Permanent loan available on completion @ 11.5% (20 Permanent loan available on completion @ 11.5% (20- -yr yr amort amort) with 120% DSCR. ) with 120% DSCR.
• • Estimated feasible rents on completion = $10/SF. Estimated feasible rents on completion = $10/SF.
Site and shell costs: Site and shell costs: $ 660,000 $ 660,000
+ Rehab costs: + Rehab costs: 580,000 580,000
= Total costs: = Total costs: $1,240,000 $1,240,000
X Lender required LTV X Lender required LTV x 80% x 80%
= Permanent mortgage amount: $ 992,000 = Permanent mortgage amount: $ 992,000
X Annualized mortgage constant: x 0.127972 X Annualized mortgage constant: x 0.127972
= Cash required for debt svc: = Cash required for debt svc: $ 126,948 $ 126,948
X Lender required DCR: X Lender required DCR: x 1.20 x 1.20
= Required NOI: = Required NOI: $ 152,338 $ 152,338
+ + Estd Estd. . Oper Oper. Exp. (Landlord): . Exp. (Landlord): 113,000 113,000
= Required EGI: = Required EGI: $ 265,338 $ 265,338
÷ ÷ Projected occupancy (1 Projected occupancy (1- -vac): vac): ÷ ÷ 0.95 0.95
= Required PGI: = Required PGI: $ 279,303 $ 279,303
÷ ÷ Rentable area: Rentable area: ÷ ÷ 27200 SF 27200 SF
-------------- -------------- --------- ---------
= Required rent/SF: = Required rent/SF: $10.27 /SF $10.27 /SF
What major What major
issue is left issue is left
out here? out here?
Lender will Lender will
base base mortg mortg on on
Mkt Mkt Val, not Val, not
constr constr cost. cost.
Use Use mkt mkt cap cap
rate info to rate info to
est. bldg val. est. bldg val.
SFFA SFFA “Back Door” “Back Door” Procedure: Procedure:
Start with rents & building, and end with supportable developmen Start with rents & building, and end with supportable development costs… t costs…
Total Total Leaseable Leaseable Square Feet (based on the building efficiency ratio Square Feet (based on the building efficiency ratio
times the gross area) times the gross area)
X Expected Average Rent Per Square Foot X Expected Average Rent Per Square Foot
= Projected Potential Gross Income (PGI) = Projected Potential Gross Income (PGI)
- - Vacancy Allowance Vacancy Allowance
= Expected Effective Gross Income = Expected Effective Gross Income
- - Projected Operating Expenses Projected Operating Expenses
= Expected Net Operating Income = Expected Net Operating Income
÷ ÷ Debt Service Coverage Ratio Debt Service Coverage Ratio
÷ ÷ Annualized Mortgage Constant Annualized Mortgage Constant
÷ ÷ Maximum Loan to Value Ratio Maximum Loan to Value Ratio
= Maximum Supportable Total Project Costs = Maximum Supportable Total Project Costs
(Question: Can it be built for this including all costs?) (Question: Can it be built for this including all costs?)
- - Expected Construction Costs (Other than Site) Expected Construction Costs (Other than Site)
= Maximum Supportable Site Acquisition Cost = Maximum Supportable Site Acquisition Cost
Question: Can the site be acquired for this or less? Question: Can the site be acquired for this or less?
Typical approach for Typical approach for “Use looking for a Site”. “Use looking for a Site”.
Example: Example:
• • Office building 35,000 SF (GLA), 29,750 SF (NRA) Office building 35,000 SF (GLA), 29,750 SF (NRA) (85% “Efficiency Ratio”) (85% “Efficiency Ratio”). .
• • $12/SF (/yr) realistic rent (based on market analysis, pre $12/SF (/yr) realistic rent (based on market analysis, pre- -existing tenant wants space). existing tenant wants space).
• • Assume 8% vacancy (typical in market, due to extra space not pr Assume 8% vacancy (typical in market, due to extra space not pre e- -leased). leased).
• • Preliminary design construction cost budget (hard + soft) = $2, Preliminary design construction cost budget (hard + soft) = $2,140,000. 140,000.
• • Projected operating expenses (not passed through) = $63,000. Projected operating expenses (not passed through) = $63,000.
• • Permanent mortgage on completion available at 9% (20 Permanent mortgage on completion available at 9% (20- -yr yr amort amort), 120% DCR. ), 120% DCR.
• • Site has been found for $500,000: Site has been found for $500,000: Is it feasible? Is it feasible?
Potential Gross Revenue = 29,750 x $12 = Potential Gross Revenue = 29,750 x $12 = $ 357,000 $ 357,000
Less Vacancy at 8% = Less Vacancy at 8% = - - 28,560 28,560
= Effective Gross Income = Effective Gross Income $ 328,440 $ 328,440
Less Operating Expenses Less Operating Expenses - - 63,000 63,000
= Net Operating Income = Net Operating Income $ 265,000 $ 265,000
÷ ÷ 1.20 = Required Debt Svc: 1.20 = Required Debt Svc: $ 221,200 $ 221,200
÷ ÷ 12 = Monthly debt svc: 12 = Monthly debt svc: $ 18,433 $ 18,433
Supportable mortgage amount = Supportable mortgage amount = $ 2,048,735 $ 2,048,735
÷ ÷ 0.75 LTV = Min. 0.75 LTV = Min. Reqd Reqd. Value: . Value: $ 2,731,647 $ 2,731,647
Less Construction Cost Less Construction Cost - - 2,140,000 2,140,000
------------ ------------ ----------- -----------
Supportable site acquisition Supportable site acquisition cost cost: : $ 591,647. $ 591,647.
So, the project seems feasible. So, the project seems feasible.
(
(
¸
(
¸
|
|
.
|
\
|
+
? =
240
12
09 .
1
1
1
12 / 09 .
18433
But again, something seems left out… Project may be feasible, But again, something seems left out… Project may be feasible, but… but…
Problems with the SFFA:
Problems with the SFFA:
•
•
Just because a project is financially
Just because a project is financially
feasible
feasible
, does not necessarily
, does not necessarily
mean that it is
mean that it is
desirable
desirable
.
.
•
•
Just because a project is
Just because a project is
not feasible
not feasible
using debt financing, does
using debt financing, does
not necessarily mean that it is
not necessarily mean that it is
undesirable
undesirable
:
:
• • A project may appear unfeasible with debt financing, yet it mig A project may appear unfeasible with debt financing, yet it might be a ht be a
desirable project from a total return to investment perspective desirable project from a total return to investment perspective (and (and
might obtain equity financing). might obtain equity financing).
Don’t confuse an SFFA feasibility analysis with a normatively
Don’t confuse an SFFA feasibility analysis with a normatively
correct assessment of the
correct assessment of the
desirability
desirability
of a development project
of a development project
from a financial economic investment perspective.
from a financial economic investment perspective.
SFFA does not compute the SFFA does not compute the value of the completed property value of the completed property. .
Hence, does not compute the NPV of the development investment de Hence, does not compute the NPV of the development investment decision: cision:
NPV = Value NPV = Value – – Cost . Cost .
SFFA merely computes whether it is possible to take out a perman SFFA merely computes whether it is possible to take out a permanent loan to finance ent loan to finance
(most of) the development costs. (most of) the development costs.
The
The
correct
correct
way to evaluate the financial economic
way to evaluate the financial economic
desirability
desirability
of
of
a development project investment:
a development project investment:
“THE NPV INVESTMENT DECISION RULE”:
1) MAXIMIZE THE NPV ACROSS ALL
MUTUALLY-EXCLUSIVE ALTERNATIVES;
AND
2) NEVER CHOOSE AN ALTERNATIVE THAT
HAS: NPV < 0.
(Recall Chapter 10.)
For development investments:
For development investments:
NPV = Benefit
NPV = Benefit
–
–
Cost = Value of Bldg
Cost = Value of Bldg
–
–
Cost of
Cost of
Devlpt
Devlpt
.
.
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. . .
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
.
.
Indeed, using the
Indeed, using the
opportunity cost of capital
opportunity cost of capital
(reflecting the
(reflecting the
amount of risk in the cash flows being discounted), the discount
amount of risk in the cash flows being discounted), the discount
rate can be applied to either discount cash flows back in time,
rate can be applied to either discount cash flows back in time,
or
or
to grow (compound) them forward in time (e.g., to the projected
to grow (compound) them forward in time (e.g., to the projected
time of completion of the construction phase, as in the projecte
time of completion of the construction phase, as in the projecte
d
d
balance due on the construction loan).
balance due on the construction loan).
Simplify the analysis by working with only two points in time:
Simplify the analysis by working with only two points in time:
•
•
The present (
The present (
time “zero”
time “zero”
), when the development
), when the development
investment decision must be made, and
investment decision must be made, and
•
•
The projected time of completion of the construction
The projected time of completion of the construction
phase (
phase (
time “T”
time “T”
).
).
Project cash flows can generally be most accurately and convenie Project cash flows can generally be most accurately and conveniently ntly
estimated as of these two points in time: estimated as of these two points in time:
• • Land cost and other up Land cost and other up- -front expenditures: as of front expenditures: as of time 0 time 0. .
• • Completed building value and construction costs (including Completed building value and construction costs (including
financing costs via the construction budget, excluding land cost financing costs via the construction budget, excluding land costs): as s): as
of of time T time T. .
The projected values as of The projected values as of time T time T can then be discounted to can then be discounted to time 0 time 0 using using
appropriate risk appropriate risk- -adjusted discount rates (OCC). adjusted discount rates (OCC).
The crucial NPV calculation is then made as of The crucial NPV calculation is then made as of time 0 time 0, the time when the , the time when the
investment decision must be made. investment decision must be made.
Note that in this approach, there is no need to Note that in this approach, there is no need to pre pre- -assume assume what type of what type of
permanent financing will be used for the completed project. permanent financing will be used for the completed project.
There is no assumption at all about what will be done with the c There is no assumption at all about what will be done with the completed ompleted
project at project at time T time T. It may be: . It may be:
• • Financed with a permanent mortgage, Financed with a permanent mortgage,
• • Financed or sold (wholly or partly) tapping external equity, or Financed or sold (wholly or partly) tapping external equity, or
• • Held without recourse to external capital. Held without recourse to external capital.
Project evaluation is independent of project financing, as it sh Project evaluation is independent of project financing, as it should be.* ould be.*
* Unless subsidized (non * Unless subsidized (non- -market market- -rate) financing is available contingent on rate) financing is available contingent on
project acceptance: Recall Chapter 14, the “APV” (Adjusted Prese project acceptance: Recall Chapter 14, the “APV” (Adjusted Present Value) nt Value)
approach to incorporating financing in the investment evaluation approach to incorporating financing in the investment evaluation. .
Another important reason for this approach: Another important reason for this approach:
• • Risk Risk characteristics of characteristics of development phase development phase different different from risk from risk
characteristics of characteristics of stabilized phase stabilized phase. .
• • Thus, Thus, different different OCCs OCCs, therefore: , therefore:
• • Two phases must be analyzed in two Two phases must be analyzed in two separate steps separate steps. .
“Adjusted Present Value” (APV) Decision Rule (Ch.14)…
“Adjusted Present Value” (APV) Decision Rule (Ch.14)…
Like NPV, only accounts for financing… Like NPV, only accounts for financing…
APV(equity) = NPV(property) + NPV(financing) APV(equity) = NPV(property) + NPV(financing)
Based on the Value Based on the Value Additivity Additivity Principle: Principle:
Prop.Val = Equity Val + Dbt Val
V = E + D
Where: V = Value of the property,
E = Value of the equity,
D = Value of the debt.
Define: P = Price paid for the property,
L = Amount of the loan…
V-P = E+D – P
= E+D – ((P-L)+L)
= E-(P-L) + D-L
= E-(P-L) – (L-D)
Thus: E-(P-L) = (V-P) + (L-D)
Or: APV(Equity) = NPV(Prop)+ NPV(Fin)
Note: Arbitrage basis of Value Additivity applies to MV, but the common sense of
Value Additivity can be applied to IV as well.
Recall from Chapter 14…
Unless subsidized financing is available,
Unless subsidized financing is available,
NPV(financing) = 0 on a MV basis (IV basis too unless investor
NPV(financing) = 0 on a MV basis (IV basis too unless investor
is
is
“
“
intra
intra
-
-
marginal”).
marginal”).
Thus,
Thus,
Normally, APV(equity) = NPV(property), and we can evaluate
Normally, APV(equity) = NPV(property), and we can evaluate
the development project independent of how (or whether) the
the development project independent of how (or whether) the
completed project will be financed with or without debt:
completed project will be financed with or without debt:
•
•
Evaluate investment
Evaluate investment
“as if all equity”
“as if all equity”
financing.
financing.
•
•
If subsidized debt,
If subsidized debt,
add NPV(financing)
add NPV(financing)
.
.
Two approaches for applying the
Two approaches for applying the
“2
“2
-
-
time
time
-
-
point NPV procedure”
point NPV procedure”
:
:
•
•
Discount
Discount
separately
separately
back to
back to
time 0
time 0
the
the
time T
time T
gross values
gross values
of the completed building (
of the completed building (
V
V
T T
) and of the construction cost
) and of the construction cost
(the construction loan balance due:
(the construction loan balance due:
L
L
T T
), employing
), employing
separate discount rates (
separate discount rates (E[r
V
] and E[r
D
],
respectively)
respectively)
reflecting the risk in the building value and in the
reflecting the risk in the building value and in the
construction cost:
construction cost: ( (E[r
D
] = OCC for construction CFs. E[r
V
] = =
expected return (going expected return (going- -in IRR) on in IRR) on unlevered unlevered investment in stabilized investment in stabilized
property, or a bit more for property, or a bit more for “spec” “spec” projects without pre projects without pre- -leasing. Normally: leasing. Normally:
E[r
V
] > E[r
D
].) )
•
•
Discount the
Discount the
time T
time T
net
net
value to
value to
time 0
time 0
using a (higher)
using a (higher)
OCC reflecting the levered nature of that net value (i.e.,
OCC reflecting the levered nature of that net value (i.e.,
the development investment OCC, that is, the OCC of the
the development investment OCC, that is, the OCC of the
construction phase investment per se:
construction phase investment per se: E[r
C
]
).
).
In principle, these two approaches are equivalent. They should
In principle, these two approaches are equivalent. They should
give the same NPV result as of
give the same NPV result as of
time 0
time 0
.
. (This principle can be used to (This principle can be used to
determine the internal consistency of the discount rates employe determine the internal consistency of the discount rates employed.) d.)
Let: Let: B
0
= Time 0 risk-adjusted valuation of project benefits.
C
0
= Time 0 risk-adjusted valuation of project costs.
V
T
= Projected time T valuation of the completed building.
L
T
= Projected time T value of construction cost (brought forward to T using E[r
D
]).
NPV(cons)
T
= Projected time T net difference between completed bldg value and construction
cost.
LAND = Market value (MV ) of land (or investment value if IV > MV ) as of time 0 (e.g., as
discussed in Ch.28).
FEES = Other up-front expenditures (besides land) required to begin project as of time 0.
V = Time 0 present value of projected time T value of completed building (same as V in
Chapter 28).
K = Time 0 present value of development costs exclusive of land (same as K in Chapter 28).
Then: Then:
( ) ( )
( )
( ) ( )
( )
( ) ( ) ( )
( ) NPV C B LAND K V LAND K V
LAND K
r E
V
LAND FEES
r E
L
r E
V
FEES LAND
r E
L
r E
V
FEES LAND
r E
L V
C
r E
cons NPV
C B NPV
T
V
T
T
D
T
T
V
T
T
D
T
T
V
T
T
C
T T
T
C
T
= ? = + ? = ? ? =
? ?
+
= ?
|
|
.
|
\
|
+
+
?
+
=
+ ?
+
?
+
=
+ ?
+
?
= ?
+
= ? =
0 0
0 0 0
] [ 1 ] [ 1 ] [ 1
] [ 1 ] [ 1
] [ 1 ] [ 1
) (
Where E[r
V
], E[r
D
], and E[r
C
] are appropriate discount rates (OCC ) for V
T
, L
T
, and
(V
T
– L
T
), respectively. (In general: E[r
D
] < E[r
V
] < E[r
C
].) .)
The second method
The second method
(discounting the
(discounting the
net
net
time T
time T
value,
value, NPV(cons) NPV(cons)
T T
=
=
V
V
T T
–
–
L
L
T T
,
,
using a single levered discount rate)
using a single levered discount rate)
is most common
is most common
in practice,
in practice,
Perhaps because investors in development projects like to think
Perhaps because investors in development projects like to think
in terms of the return on their equity capital invested during t
in terms of the return on their equity capital invested during t
he
he
development phase. (Development investment has different
development phase. (Development investment has different
levels of risk and expected return than other types of investmen
levels of risk and expected return than other types of investmen
t,
t,
and investors in development typically are seeking precisely tha
and investors in development typically are seeking precisely tha
t
t
level of risk and return.)
level of risk and return.)
How may we estimate reasonable levels of expected return (OCC),
How may we estimate reasonable levels of expected return (OCC),
E[r
C
], for development investments? . . .
Two methods, closely related, should give similar results:
Two methods, closely related, should give similar results:
1.
1.
Equilibrium relation between PV(V
Equilibrium relation between PV(V
T T
), PV(L
), PV(L
T T
), & PV(V
), & PV(V
T T
-
-
L
L
T T
);
);
2.
2.
“WACC Formula” based on leverage in the
“WACC Formula” based on leverage in the
devlpt
devlpt
project.
project.
Method 1 for determining Method 1 for determining E E[ [r r
C C
]: ]:
Using Equilibrium Across the Markets for Stabilized Property, Co Using Equilibrium Across the Markets for Stabilized Property, Construction nstruction
Debt, and Land… Debt, and Land…
( ) ( ) ( )
T
D
T
T
V
T
T
C
T T
r E
L
r E
V
r E
L V
] [ 1 ] [ 1 ] [ 1 +
?
+
=
+
?
The basic idea is that equilibrium requires: The basic idea is that equilibrium requires:
Thus, if you have knowledge of: Thus, if you have knowledge of:
• • V V
T T
= Expected value of completed stabilized property at time T; = Expected value of completed stabilized property at time T;
• • L L
T T
= Expected balance due on construction loan at time T (all cons = Expected balance due on construction loan at time T (all construction costs truction costs
including financing costs); including financing costs);
• • E E[ [r r
V V
] ] = Market expected total rate of return (going = Market expected total rate of return (going- -in IRR) on investments in in IRR) on investments in
completed properties of the type to be built; completed properties of the type to be built;
• • E E[ [r r
D D
] ] = Market expected return on construction loans (< loan interest = Market expected return on construction loans (< loan interest rate). rate).
Then you can solve the above equation for Then you can solve the above equation for E E[ [r r
C C
] to obtain: ] to obtain:
Otherwise, superior risk Otherwise, superior risk- -adjusted returns (ex ante) could be made by investing in some adjusted returns (ex ante) could be made by investing in some
combination of stabilized property ( combination of stabilized property (V V
T T
), construction debt ( ), construction debt (L L
T T
), or developable land ), or developable land (V (V
T T
- -L L
T T
) ). .
Presumably, equilibrium across markets drives market prices in t Presumably, equilibrium across markets drives market prices in these asset classes to be hese asset classes to be
such that superior returns are not possible, and the above relat such that superior returns are not possible, and the above relationship tends to hold. ionship tends to hold.
( )( ) ( )
( ) ( )
( )
1
] [ 1 ] [ 1
] [ 1 ] [ 1
] [
1
?
(
¸
(
¸
+ ? +
+ + ?
=
T
T
T
V T
T
D
T
D
T
V T T
C
L r E V r E
r E r E L V
r E
Method 1 for determining Method 1 for determining E E[ [r r
C C
]… ]…
Example: Project to build an apartment building…
Example: Project to build an apartment building…
• • Construction will take 1 year ( Construction will take 1 year (T T=1 =1). ).
• •Similar stabilized properties are currently worth $10,000,000. E Similar stabilized properties are currently worth $10,000,000. Expected xpected
appreciation in this type of property over the next year = 0%. H appreciation in this type of property over the next year = 0%. Hence, ence,
V V
T T
=$10,000,000 =$10,000,000. .
• • Construction cost is $7,680,000 (fixed Construction cost is $7,680,000 (fixed- -price contract to be paid on price contract to be paid on
completion, including construction interest). Hence, completion, including construction interest). Hence, L L
T T
=$7,680,000 =$7,680,000. .
• • Going Going- -in in IRRs IRRs for stabilized properties of the type to be built are around for stabilized properties of the type to be built are around
8%. Hence, 8%. Hence, E E[ [r r
V V
]=8% ]=8%. .
• • Expected return on construction loan is 5.8%. Hence, Expected return on construction loan is 5.8%. Hence, E E[ [r r
D D
]=5.8% ]=5.8%. .
Thus:
Thus:
( )( )( )
( ) ( )
% 16 1
68 . 7 08 . 1 10 058 . 1
058 . 1 08 . 1 68 . 7 10
] [ = ?
?
?
=
C
r E
The development investment should provide an expected return of The development investment should provide an expected return of 16%. 16%.
The The WACC WACC Formula is a useful approximation to see how big the Formula is a useful approximation to see how big the
development phase development phase equity equity return should be relative to: return should be relative to:
• • The stabilized property (i.e., The stabilized property (i.e., underlying asset, e.g., NCREIF underlying asset, e.g., NCREIF) return, ) return,
• • The construction cost (i.e., The construction cost (i.e., debt debt) return. ) return.
Recall (from Ch.13): Recall (from Ch.13):
Where:
r
C
=Return on devlpt project up-front investment (construction phase).
LR=Effective leverage in the devlpt project (V
T
/E) = Completed stabilized property
value divided by up-front land cost (& fees).
r
V
= Total return on stabilized property during development phase (as if it existed
completed already).
r
D
= Total return on construction debt.
( )LR r r r r
D V D C
? + =
Method 2 for determining Method 2 for determining E E[ [r r
C C
]: ]:
Using the WACC & Knowledge of Land Value… Using the WACC & Knowledge of Land Value…
Apply the WACC to the Apply the WACC to the ex ante ex ante risk premium: risk premium:
LR RP E RP E RP E RP E
D V D C
]) [ ] [ ( ] [ ] [ ? + =
Example. Example. If: If:
E[RP
V
] = 300 bp
(Typical for E[RP
NCREIF
], more for spec)
E[RP
D
] = 100 bp
(Remember: E[r], not “stated interest”, See Ch.18)
LR = 5
Then: Then:
bp bp bp bp RP E
C
1100 5 * ) 100 300 ( 100 ] [ = ? + =
e.g., If T e.g., If T- -Bills are yielding 5%, then the expected return on the Bills are yielding 5%, then the expected return on the
construction project is 16%: construction project is 16%:
% 16 % 11 % 5 ] [ = + =
C
r E
Note: If E
Note: If E
[
[
r
r
C C
]
]
is to be a
is to be a
market
market
opportunity cost of capital (OCC),
opportunity cost of capital (OCC),
as it should be, then LR must be based on current
as it should be, then LR must be based on current
market value
market value
of
of
the land: LR=V
the land: LR=V
T T
/ E, where E = LAND+FEES time 0 market val.
/ E, where E = LAND+FEES time 0 market val.
Method 2 for determining Method 2 for determining E E[ [r r
C C
]… ]…
Recall:
Recall:
The Fundamental Nature of Real Estate Development Investment:
The Fundamental Nature of Real Estate Development Investment:
•
•
A
A
forward
forward
purchase commitment in a stabilized fully
purchase commitment in a stabilized fully
operational (leased up) property:
operational (leased up) property:
• • Buy (incur opportunity cost of) land Buy (incur opportunity cost of) land now now, ,
• • Get stabilized property Get stabilized property later later. .
•
•
A
A
levered
levered
investment in the stabilized (core) property:
investment in the stabilized (core) property:
• • Up front the only cost is the purchase of (or incurring the Up front the only cost is the purchase of (or incurring the
opportunity cost of) opportunity cost of) the the land land. .
• •This can be viewed as the This can be viewed as the equity equity investment to obtain ( investment to obtain (a long a long
position in position in) the future stabilized property ( ) the future stabilized property (a volatile asset a volatile asset), ),
• • Subject to Subject to the payment of construct costs the payment of construct costs ( (a relatively fixed outlay a relatively fixed outlay
that will occur in the future, i.e., subsequent to the time when that will occur in the future, i.e., subsequent to the time when the land the land
cost is incurred cost is incurred). ).
• • The development investment is thus equivalent to having a The development investment is thus equivalent to having a long long
position in the stabilized property combined with a position in the stabilized property combined with a short short position in position in
the construction costs. the construction costs.
The Fundamental Nature of Real Estate Development Investment The Fundamental Nature of Real Estate Development Investment… …
Let: Let: “ “E E” ” = = Up front investment in Up front investment in devlpt devlpt project project (E= LAND+FEES); (E= LAND+FEES);
“ “V V” ” = Time 0 = Time 0 PV of PV of time T time T completed property value completed property value (V=PV(V (V=PV(V
T T
)=V(0)); )=V(0));
“ “D D” ” = Time 0 = Time 0 PV of construction cost exclusive of land PV of construction cost exclusive of land (D=K (D=K- -FEES). FEES).
Then: Then:
E = V-D
D
D
E
D
V
V
E
V
D
D
E
D
V
V
E
V
E
D
E
V
E
E ?
?
?
=
?
?
?
=
?
?
?
=
?
?
|
.
|
\
|
?
?
?
+
?
=
?
|
.
|
\
|
? ?
?
=
? ?
?
?
=
?
?
D
D
V
V
E
V
D
D
D
D
E
V
V
V
E
V
D
D
E
E V
V
V
E
V
E
E
1
) (
( )LR g g g g LR g LR g
WACC
D V D D V E
? + = ? + =
?
) 1 ( ) (
:
r
E
=Return on devlpt project up-front investment (purely appreciation, g
E
, no income).
LR=Effective leverage in the devlpt project (V
T
/E) (= Completed stabilized property
value divided by up-front land cost).
g
V
= Appreciation return on stabilized property during development phase (as if it
existed completed already).
g
D
= Percentage change in total (final) construction cost (exclusive of land) during
development phase (e.g. zero for guaranteed fixed-price contract).
( )LR g g g g LR g LR g r
WACC
D V D D V E E
? + = ? + = =
?
) 1 ( ) (
:
The Fundamental Nature of Real Estate Development Investment The Fundamental Nature of Real Estate Development Investment… …
Numerical Example
Numerical Example
…
…
• • Project to build an apartment building. Project to build an apartment building.
• • Similar (stabilized) properties are currently worth Similar (stabilized) properties are currently worth $10,000,000 $10,000,000. .
• • Construction will take Construction will take 1 year 1 year. .
• • Construction cost is Construction cost is $7,680,000 $7,680,000 (fixed (fixed- -price contract to be paid on price contract to be paid on
completion). completion).
• • Land Land (opportunity value, i.e., what land could be sold for) & up (opportunity value, i.e., what land could be sold for) & up- -
front fees (e.g., architect) cost front fees (e.g., architect) cost $2,000,000 $2,000,000. .
• • Assuming expected appreciation in this property type is zero ov Assuming expected appreciation in this property type is zero over er
the next year, expected return on the development investment is the next year, expected return on the development investment is 16% 16%: :
( )
000 , 000 , 2 $
000 , 000 , 2 $ 000 , 680 , 7 $ 000 , 000 , 10 $ ] [
% 16
? ?
=
?
=
BegVal
BegVal EndVal E
Numerical Example (cont.)
Numerical Example (cont.)
…
…
• • Now suppose between now and next year apartment property values Now suppose between now and next year apartment property values
take an unexpected plunge of take an unexpected plunge of 10% 10%, to , to $9,000,000 $9,000,000. .
• • For an For an unlevered unlevered investor in pre investor in pre- -existing stabilized property the existing stabilized property the
return hit is just this 10% loss. return hit is just this 10% loss.
• • But to our development investment our But to our development investment our loss is magnified loss is magnified to to 50% 50%
below the previous +16% expectation (as below the previous +16% expectation (as – –34% is 50 points below 34% is 50 points below
+16%): +16%):
( )
000 , 000 , 2 $
000 , 680 $
000 , 000 , 2 $
000 , 000 , 2 $ 000 , 680 , 7 $ 000 , 000 , 9 $
% 34
?
=
? ?
= ?
• • The reason for the magnification of the impact on the return is The reason for the magnification of the impact on the return is that that
the construction cost ($7,680,000) did not change with the chang the construction cost ($7,680,000) did not change with the change in e in
stabilized property value (from $10,000,000 to $9,000,000). stabilized property value (from $10,000,000 to $9,000,000).
• • The reason the magnification was The reason the magnification was 5 5- -times ( times (- -50%/ 50%/- -10%) is because 10%) is because
the effective the effective Leverage Ratio Leverage Ratio in the development is in the development is 5 5 (in this case): (in this case):
LR LR = = V V
T T
/ E / E = $10,000,000 / $2,000,000 = = $10,000,000 / $2,000,000 = 5 5. .
The effective operational leverage will not be so great if som The effective operational leverage will not be so great if some of the e of the
construction cost is paid by the equity investor up front or dur construction cost is paid by the equity investor up front or during the ing the
construction phase (e.g., no construction loan, contractor requi construction phase (e.g., no construction loan, contractor requires payments res payments
as costs are incurred). as costs are incurred).
e.g., in the previous example, suppose half the fixed e.g., in the previous example, suppose half the fixed- -price construction cost price construction cost
had to be paid up had to be paid up- -front (but it was still the same $7,680,000 amount)… front (but it was still the same $7,680,000 amount)…
Then the original expected return would have been 5.5%: Then the original expected return would have been 5.5%:
( )
000 , 840 , 3 $ 000 , 000 , 2 $
) 000 , 840 , 3 $ 000 , 000 , 2 ($ 000 , 840 , 3 $ 000 , 000 , 10 $ ] [
% 5 . 5
+
+ ? ?
=
?
=
BegVal
BegVal EndVal E
And the loss to the development investor caused by the And the loss to the development investor caused by the 10% 10%drop in drop in
apartment values would have been only apartment values would have been only 17.1% 17.1%, reflecting the effective , reflecting the effective
leverage ratio leverage ratio 1.71 1.71 (= $10,000,000 / $5,840,000), as (= $10,000,000 / $5,840,000), as - -11.6% is 17.1% below the 11.6% is 17.1% below the
previous expectation of 5.5%: previous expectation of 5.5%:
( )
000 , 840 , 3 $ 000 , 000 , 2 $
) 000 , 840 , 3 $ 000 , 000 , 2 ($ 000 , 840 , 3 $ 000 , 000 , 9 $ ] [
% 6 . 11
+
+ ? ?
=
?
= ?
BegVal
BegVal EndVal E
But note there is still leverage even here. And of course in the But note there is still leverage even here. And of course in the real world, most development is real world, most development is
financed by construction loans covering 100% of construction cos financed by construction loans covering 100% of construction costs (for a variety of reasons), ts (for a variety of reasons),
loans that are paid off by the developer (the equity development loans that are paid off by the developer (the equity development investor) only upon completion investor) only upon completion
of construction, thereby maximizing leverage. of construction, thereby maximizing leverage.
Realized development project investment returns are: Realized development project investment returns are:
• • Highly correlated Highly correlated with stabilized property appreciation returns. with stabilized property appreciation returns.
• • More volatile More volatile than stabilized property appreciation returns. than stabilized property appreciation returns.
Therefore, development investment is Therefore, development investment is more risky more risky than investment in than investment in
stabilized pre stabilized pre- -existing property existing property (no surprise) (no surprise). .
But note that: But note that:
Risk is Risk is added by added by leverage leverage, and thus: , and thus:
• • Would exist even for pre Would exist even for pre- -leased projects leased projects (i.e., development risk is not (i.e., development risk is not
caused caused only only by speculation) by speculation), and would exist even in the absence of a , and would exist even in the absence of a
wide wide- -amplitude development demand cycle. amplitude development demand cycle.
• •Added risk implies development should have a higher Added risk implies development should have a higher risk premium risk premium
than stabilized investment, in the than stabilized investment, in the ex ante (“going ex ante (“going- -in”) IRR in”) IRR (and on (and on
average over the long run, average over the long run, ex post ex post as well). as well).
• • WACC formula can be useful in estimating appropriate risk premi WACC formula can be useful in estimating appropriate risk premium um
for development investment, relating development phase RP to typ for development investment, relating development phase RP to typical ical
stabilized property stabilized property- -level RP. level RP.
The Fundamental Nature of Real Estate Development Investment The Fundamental Nature of Real Estate Development Investment… …
Implications of development Implications of development’ ’s operational leverage: s operational leverage:
The framework described here can be used, in conjunction with an The framework described here can be used, in conjunction with an index of index of
periodic appreciation returns to stabilized property (such as th periodic appreciation returns to stabilized property (such as the NCREIF e NCREIF
Index), to simulate what the ex post Index), to simulate what the ex post IRRs IRRs to typical development to typical development
investments would have been, during specific historical periods investments would have been, during specific historical periods of time… of time…
The Fundamental Nature of Real Estate Development Investment The Fundamental Nature of Real Estate Development Investment… …
Rolling Simulated 1-Yr IRR Cohorts
-100%
-75%
-50%
-25%
0%
25%
50%
75%
1
9
7
8
4
1
9
8
0
4
1
9
8
2
4
1
9
8
4
4
1
9
8
6
4
1
9
8
8
4
1
9
9
0
4
1
9
9
2
4
1
9
9
4
4
1
9
9
6
4
1
9
9
8
4
2
0
0
0
4
Ending Year
S
i
m
u
l
a
t
e
d
C
o
h
o
r
t
I
R
R
NPI 1Yr TWRR
1Yr5TLR Cohort
1Yr3TLR Cohort
1Yr1TLR Cohort
Comparing
Comparing
Method 1
Method 1
and
and
Method 2
Method 2
for estimating development
for estimating development
phase OCC:
phase OCC:
•
•
Method 1 is theoretically at least as sound as Method 2.
Method 1 is theoretically at least as sound as Method 2.
•
•
Method 1 does not require knowledge of the current market
Method 1 does not require knowledge of the current market
value of the land (which may often be difficult to accurately
value of the land (which may often be difficult to accurately
estimate).
estimate).
•
•
Method 1 does not depend on the simple return (1
Method 1 does not depend on the simple return (1
-
-
period,
period,
not compounded) WACC formula approximation of the
not compounded) WACC formula approximation of the
construction phase IRR (a multi
construction phase IRR (a multi
-
-
period, compounded rate of
period, compounded rate of
return), an approximation that breaks down for long
return), an approximation that breaks down for long
duration construction projects (e.g., multi
duration construction projects (e.g., multi
-
-
year projects).
year projects).
Due to all of these advantages,
Due to all of these advantages,
Method 1
Method 1
is probably generally
is probably generally
preferable to
preferable to
Method 2
Method 2
: Estimate development phase OCC
: Estimate development phase OCC
based on internal consistency between E[
based on internal consistency between E[
r
r
V V
], E[
], E[
r
r
D D
], and E[
], and E[
r
r
C C
].
].
What about the
What about the
lease
lease
-
-
up
up
phase? . . .
phase? . . .
•
•
Not relevant for pre
Not relevant for pre
-
-
leased or owner
leased or owner
-
-
occupied
occupied
developments.
developments.
•
•
In spec projects, if lease
In spec projects, if lease
-
-
up is projected to be of significant
up is projected to be of significant
duration, then it is most correct to treat it as a separate
duration, then it is most correct to treat it as a separate
phase, with its own separate OCC:
phase, with its own separate OCC:
• • Three points in time: Time 0 (present), CO Time (T), Three points in time: Time 0 (present), CO Time (T),
Stabilization Time (S). Stabilization Time (S).
• • Three phases each with separate OCC (discount rate) because of Three phases each with separate OCC (discount rate) because of
different risk: Construction Phase (most risky), Lease different risk: Construction Phase (most risky), Lease- -up Phase up Phase
(intermediate risk), Stabilized Operation Phase (least risk). (intermediate risk), Stabilized Operation Phase (least risk).
•
•
OCC in lease
OCC in lease
-
-
up phase typically 50
up phase typically 50
-
-
200
200
bp
bp
> Stabilized
> Stabilized
property OCC.
property OCC.
In principle, the lease In principle, the lease- -up phase OCC is similar to the up phase OCC is similar to the “inter “inter- -lease lease discount rate” discount rate”
introduced in Chapter 10. introduced in Chapter 10.
The procedure presented in Study Question 10.23 (p.857) can be u The procedure presented in Study Question 10.23 (p.857) can be used to estimate sed to estimate
lease lease- -up OCC ( up OCC (r r) based on knowledge of: ) based on knowledge of:
• • Typical lease term length in new leases in the relevant space m Typical lease term length in new leases in the relevant space market ( arket (T T); );
• • Typical tenant borrowing rate ( Typical tenant borrowing rate (intra intra- -lease lease discount rate) ( discount rate) (r r
L L
); );
• • Prevailing cap rate (current cash yield) in the relevant proper Prevailing cap rate (current cash yield) in the relevant property asset market ty asset market
( (k k); );
• • Realistic expected long Realistic expected long- -term average growth rate in rents chargeable by a term average growth rate in rents chargeable by a
given building ( given building (g g). ).
The formula The formula presented there presented there for a single for a single- -tenant space with the lease just signed and tenant space with the lease just signed and
for lease payments in arrears is: for lease payments in arrears is:
( )
( )
( )
1
) 1 /( ) 1 ( 1
) 1 /( ) 1 ( 1
1
1 1
1
?
¦
)
¦
`
¹
¦
¹
¦
´
¦
(
¸
(
¸
+ + ?
+ + ?
+
? + =
T
L
T
L
L
r g
r g
r
k
g r
The formula if the lease has not yet been signed and 1 The formula if the lease has not yet been signed and 1
st st
payment in 1 yr is a payment in 1 yr is a
polynomial that can easily be solved numerically in Excel by ite polynomial that can easily be solved numerically in Excel by iteration: ration:
( ) ( )
|
|
.
|
\
|
+
+
?
(
(
¸
(
¸
|
|
.
|
\
|
+
+
? = + + ? +
?
L
T
L
T T
r
g
r
g
k r g r
1
1
1
1
1
1 1 1 1
1
The typical property market can be assumed to be bracketed by th The typical property market can be assumed to be bracketed by these two extreme ese two extreme
cases (lease just signed, lease just expired), so the average be cases (lease just signed, lease just expired), so the average between these two tween these two
estimates of estimates of r r could be used. could be used.
Numerical example (from book): Numerical example (from book):
• • Market value of land is $2,000,000 ( Market value of land is $2,000,000 (LAND LAND = $2 million). = $2 million).
• • Fees that must also be paid up front ( Fees that must also be paid up front (time 0 time 0 ) are $200,000. ) are $200,000.
• • Total construction cost is projected to be $4,500,000 (not incl Total construction cost is projected to be $4,500,000 (not including financing cost), and uding financing cost), and
construction is expected to take 3 years ( construction is expected to take 3 years (T T = 3), with payments for work done owed to = 3), with payments for work done owed to
the contractor projected to occur in 3 equal installments of $1, the contractor projected to occur in 3 equal installments of $1,500,000 each at the ends 500,000 each at the ends
of years 1, 2, and 3. of years 1, 2, and 3.
• • A construction loan covering all the above A construction loan covering all the above- -noted construction costs can (and will) be noted construction costs can (and will) be
used, at 7.5% interest, requiring a $20,000 up used, at 7.5% interest, requiring a $20,000 up- -front origination fee in cash. Loan will be front origination fee in cash. Loan will be
due upon completion of construction at the end of Year 3. due upon completion of construction at the end of Year 3.
• • The opportunity cost of capital (OCC) for investments in develo The opportunity cost of capital (OCC) for investments in development projects of this pment projects of this
nature is assumed to be 20% per annum ( nature is assumed to be 20% per annum (E E[ [r r
C C
]=20%) ]=20%). .
• • Construction completion is expected to be followed by 2 years o Construction completion is expected to be followed by 2 years of absorption (lease f absorption (lease- -up), up),
including two projected net cash flows of: including two projected net cash flows of: - -$100,000 at end of Yr.4 (when building will $100,000 at end of Yr.4 (when building will
still be mostly empty), and +$400,000 at end of Yr.5 (more tenan still be mostly empty), and +$400,000 at end of Yr.5 (more tenants, less leasing ts, less leasing
expenses). OCC for lease expenses). OCC for lease- -up phase assumed to be 300bp greater than OCC for up phase assumed to be 300bp greater than OCC for
stabilized investment. stabilized investment.
• • Stabilized operation (beginning Yr.6) projected NOI = $800,000/ Stabilized operation (beginning Yr.6) projected NOI = $800,000/yr with projected yr with projected
growth of 1% per year thereafter based on rental market projecti growth of 1% per year thereafter based on rental market projections. OCC (going ons. OCC (going- -in in
IRR) for investments in stabilized property projected to be 9% p IRR) for investments in stabilized property projected to be 9% per annum. er annum.
Step 1: Step 1: Estimate Stabilized Property Value at Project Completion… Estimate Stabilized Property Value at Project Completion…
08 . 0
000 , 800 $
01 . 0 09 . 0
000 , 800 $
09 . 1
000 , 800 $ ) 01 . 1 (
09 . 1
000 , 800 )$ 01 . 1 (
09 . 1
000 , 800 $
000 , 000 , 10 $
2
2
2
5
=
?
=
+ + + = = K V
Step 2: Step 2: Estimate Physically Complete Building Value at End of Constructi Estimate Physically Complete Building Value at End of Construction on
Phase… Phase…
Note: OCC = 9% + 300bp = 12%. Note: OCC = 9% + 300bp = 12%.
2
3
12 . 1
000 , 000 , 10 $ 000 , 400 $
12 . 1
000 , 100 $
531 , 201 , 8 $
+
+
?
= = V
Step 3: Step 3: Estimate Construction Cost As of Time of Construction Completion Estimate Construction Cost As of Time of Construction Completion… …
( ) ( ) 000 , 500 , 1 075 . 1 000 , 500 , 1 $ 075 . 1 000 , 500 , 1 $ 938 , 845 , 4 $
2
+ + = =
T
L
Step 4: Step 4: Calculate Projected Construction Phase Net… Calculate Projected Construction Phase Net…
593 , 355 , 3 $ 938 , 845 , 4 $ 531 , 201 , 8 $ ) ( = ? = ? =
T T T
L V cons NPV
3
0
20 . 1
593 , 355 , 3 $
894 , 941 , 1 $ = = B
Step 5: Step 5: Estimate Estimate Time 0 Time 0 PV of the Construction Net… PV of the Construction Net…
This is the benefit of the development project, measured in This is the benefit of the development project, measured in time 0 time 0, ,
risk risk- -adjusted dollars. adjusted dollars.
Step 6: Step 6: Subtract Subtract Time 0 Time 0 Cost to Determine NPV Measured in Cost to Determine NPV Measured in Time 0 Time 0 Risk Risk- -
adjusted Dollars… adjusted Dollars…
106 , 278 $ 000 , 220 , 2 $ 894 , 941 , 1 $
0 0 0
? = ? = ? = C B NPV
As the NPV is negative, this development project is obviously As the NPV is negative, this development project is obviously not not a a
good investment at this time. good investment at this time.
What is an obvious problem with this project? What is an obvious problem with this project?
29.5.4 Summarizing the advantages of the recommended procedure: 29.5.4 Summarizing the advantages of the recommended procedure:
Consistent with underlying theory. (i.e., consistent with NPV Rule, based on
Wealth Maximization Principle.)
Simplicity. Avoids need to make assumptions about permanent loan or form of
permanent financing (equity vs debt).
Explicit identification of the relevant OCC. Identifies explicit expected return
(OCC) to each phase (each risk regime) of the investment: Development,
Lease-up, Stabilized operation.
Explicit identification of land value. Procedure requires explicit identification
of current opportunity value of the land.
“Front-door” or “Back-door” flexibility possible. Procedure amenable to
“backing into” any one unknown variable. E.g., if you know the land value
and the likely rents, you can back into the required construction cost. If you
know (or posit) all of the costs and values, then you can back into the
expected return on the developer's equity contribution for the development
phase.
Do developers really use the “NPV Rule”? . . .
Do developers really use the “NPV Rule”? . . .
• • Most don’t use NPV Most don’t use NPV explicitly explicitly. .
• • But remember: NPV But remember: NPV Wealth Maximization Wealth Maximization. .
• • By definition, By definition, successful successful developers maximize their wealth. developers maximize their wealth.
• • Thus, Thus, implicitly implicitly (if not explicitly), (if not explicitly), successful successful developers must (somehow) developers must (somehow)
be employing the NPV Rule: be employing the NPV Rule:
• • e.g., in deciding e.g., in deciding which projects which projects to pursue, to pursue,
• • An intuitive sense of correctly rank An intuitive sense of correctly rank- -ordering mutually ordering mutually- -exclusive exclusive
projects by NPV, and picking those with the highest NPV (they projects by NPV, and picking those with the highest NPV (they
may think of it as “best profit potential”), must be employed (b may think of it as “best profit potential”), must be employed (by y
the most successful developers). the most successful developers).
• • Suggestion in Ch.29 is that by making this process more explicit Suggestion in Ch.29 is that by making this process more explicit, it may , it may
be executed better, or by more developers (i.e., making more dev be executed better, or by more developers (i.e., making more developers elopers
“successful”), “successful”),
• • The NPV approach also should improve the ability of the develop The NPV approach also should improve the ability of the development ment
industry to “communicate” project evaluation in the industry to “communicate” project evaluation in the “language of Wall “language of Wall
Street” Street” (e.g., “NPV”, “OCC”). (e.g., “NPV”, “OCC”).
doc_445548295.pdf
Chapter 29
Financial Analysis of
Financial Analysis of
Real Estate Development Projects
Real Estate Development Projects
Surely you recall the central role the development industry play
Surely you recall the central role the development industry play
s
s
in our overview of
in our overview of
The Real Estate System
The Real Estate System
(back in Chapter 2)…
(back in Chapter 2)…
Exhibit 2-2: The “Real Estate System”: Interaction of the Space Market, Asset Market, & Development Industry
SPACE MARKET
SUPPLY
(Landlords)
DEMAND
(Tenants)
RENTS
&
OCCUPANCY
LOCAL
&
NATIONAL
ECONOMY
FORECAST
FUTURE
ASSET MARKET
SUPPLY
(Owners
Selling)
DEMAND
(Investors
Buying)
CASH
FLOW
MKT
REQ’D
CAP
RATE
PROPERTY
MARKET
VALUE
DEVELOPMENT
INDUSTRY
IS
DEVELPT
PROFITABLE
?
CONSTR
COST
INCLU
LAND
IF
YES
ADDS
NEW
CAPI
TAL
MKTS
= Causal flows.
= Information gathering & use.
Development is a multi Development is a multi- -disciplinary, iterative process . . . disciplinary, iterative process . . .
The (famous) The (famous) Graaskampian Graaskampian Spiral Spiral. .
Development is important: Development is important:
• • From a finance & investment perspective, but also From a finance & investment perspective, but also
• • From an urban development (physical, social, environmental) From an urban development (physical, social, environmental)
perspective… perspective…
Graaskamp
Graaskamp
also coined the concept that most development
also coined the concept that most development
projects can be characterized as either:
projects can be characterized as either:
•
•
A use looking for a site, or
A use looking for a site, or
•
•
A site looking for a use.
A site looking for a use.
Site Looking for a Use: Site Looking for a Use:
• • Developer tries to determine & build the Developer tries to determine & build the “ “HBU HBU” ”, or , or
• • Public entity seeks developer to build a use determined Public entity seeks developer to build a use determined
through a political process (presumably also through a political process (presumably also “ “HBU HBU” ”). ).
Use Looking for a Site: Use Looking for a Site:
• • Developer has a particular specialization, or Developer has a particular specialization, or
• • Developer is working for a specific Developer is working for a specific user user. .
29.2 Basic Information: Enumerating Project Costs & Benefits
29.2 Basic Information: Enumerating Project Costs & Benefits
Two types of project budgets are important to be developed:
Two types of project budgets are important to be developed:
•
•
Construction & Absorption Budget:
Construction & Absorption Budget:
• • Covers construction (& lease Covers construction (& lease- -up, for up, for “ “spec spec” ” projects); projects);
• • Relates to the Relates to the “ “COST COST” ” side of the NPV Equation. side of the NPV Equation.
•
•
Operating Budget:
Operating Budget:
• • Covers “stabilized” period of building operation after lease Covers “stabilized” period of building operation after lease- -
up is complete; up is complete;
• • Typically developed for a single typical projected “stabilized Typically developed for a single typical projected “stabilized
year”; year”;
• • Relates to the Relates to the “ “BENEFIT BENEFIT” ” side of the NPV Equation. side of the NPV Equation.
NPV = Benefits
NPV = Benefits
–
–
Costs = Value of Bldg
Costs = Value of Bldg
–
–
Cost of
Cost of
Devlpt
Devlpt
.
.
The Operating Budget
The Operating Budget (Recall the items from Chapter 11) (Recall the items from Chapter 11)
:
:
• • Forecast Potential Gross Income (PGI, based on rent analysis) Forecast Potential Gross Income (PGI, based on rent analysis)
• • Less Vacancy Allowance Less Vacancy Allowance
• • = Effective Gross Income (EGI) = Effective Gross Income (EGI)
• • Less forecast operating expenses (& capital reserve) Less forecast operating expenses (& capital reserve)
• • = Net Operating Income (NOI) = Net Operating Income (NOI)
The most important aspect is normally the rent analysis, which i The most important aspect is normally the rent analysis, which is based s based
(more or less formally) on a (more or less formally) on a market analysis market analysis of the space market which the of the space market which the
building will serve. building will serve. (See Chapter 6, or Wheaton’s 11.433 course.) (See Chapter 6, or Wheaton’s 11.433 course.)
The bottom line:
The bottom line:
NOI forecast, combined with NOI forecast, combined with cap rate cap rate analysis (of the asset market): analysis (of the asset market):
NOI / cap rate = Projected Completed Building Value = NOI / cap rate = Projected Completed Building Value = “ “Benefit Benefit” ” of the of the
development project. development project.
The Construction & Absorption Budget:
The Construction & Absorption Budget:
Construction: Construction: “Hard Costs” “Hard Costs”
• • Land cost Land cost
• • Site preparation costs (e.g., excavation, utilities installatio Site preparation costs (e.g., excavation, utilities installation) n)
• • Shell costs of existing structure in rehab projects Shell costs of existing structure in rehab projects
• • Permits Permits
• • Contractor fees Contractor fees
• • Construction management and overhead costs Construction management and overhead costs
• • Materials Materials
• • Labor Labor
• • Equipment rental Equipment rental
• • Tenant finish Tenant finish
• • Developer fees Developer fees
Construction: Construction: “Soft Costs” “Soft Costs”
• • Loan fees Loan fees
• • Construction loan interest Construction loan interest
• • Legal fees Legal fees
• • Soil testing Soil testing
• • Environmental studies Environmental studies
• • Land planner fees Land planner fees
• • Architectural fees Architectural fees
• • Engineering fees Engineering fees
• • Marketing costs including advertisements Marketing costs including advertisements
• • Leasing or sales commissions Leasing or sales commissions
The Construction & Absorption Budget
The Construction & Absorption Budget
(cont.)
(cont.)
:
:
Absorption Budget Absorption Budget (if separate) (if separate): :
• • Marketing costs & advertising Marketing costs & advertising
• • Leasing expenses (commissions) Leasing expenses (commissions)
• • Tenant improvement expenditures Tenant improvement expenditures (“build (“build- -outs”) outs”)
• • Working capital during lease Working capital during lease- -up (until break up (until break- -even) even)
29.3 Construction Budget Mechanics
29.3 Construction Budget Mechanics
Construction Construction takes time takes time (typically several months to several years). (typically several months to several years).
During this period, financial capital is being used to pay for t During this period, financial capital is being used to pay for the construction. he construction.
“Time is money” “Time is money”: The opportunity cost of this capital is part of the real cost : The opportunity cost of this capital is part of the real cost of of
the construction. the construction.
This is true whether or not a construction loan is used to finan This is true whether or not a construction loan is used to finance the ce the
construction process. But: construction process. But:
Construction loans are Construction loans are almost always almost always used (even by equity investors who have used (even by equity investors who have
plenty of cash). plenty of cash).
Why? . . . Why? . . .
The “classical” construction finance structure:
The “classical” construction finance structure:
Phase: Phase:
Financing: Financing:
Construction Construction Lease Lease- -Up Up Stabilized Operation… Stabilized Operation…
C.O. C.O.
Construction Loan Construction Loan Bridge Loan Bridge Loan Permanent Mortgage Permanent Mortgage
Source: Source:
Commercial Commercial
Bank Bank
• • Comm. Bank Comm. Bank
• • Insur Insur Co. Co.
Via Via Mortg Mortg Brkr Brkr
or or Mortg Mortg Banker: Banker:
• • Life Life Insur Insur. Co. . Co.
• • Pension Fund Pension Fund
• • Conduit Conduit CMBS CMBS
Construction lender won’t approve construction Construction lender won’t approve construction
loan until permanent lender has conditionally loan until permanent lender has conditionally
approved a “take approved a “take- -out” loan. out” loan.
The construction loan collapses a series of costs (cash outflows
The construction loan collapses a series of costs (cash outflows
)
)
incurred during the construction process into a
incurred during the construction process into a
single value
single value
as of
as of
a single (future)
a single (future)
point in time
point in time
(the projected completion date of
(the projected completion date of
the construction phase).
the construction phase).
Actual construction expenditures (
Actual construction expenditures (
“draws”
“draws”
on the construction
on the construction
loan) are added to the accumulating
loan) are added to the accumulating
balance
balance
due on the loan,
due on the loan,
and interest is charged and compounded (adding to the balance)
and interest is charged and compounded (adding to the balance)
on all funds drawn out from the loan commitment, from the
on all funds drawn out from the loan commitment, from the
time each draw is made.
time each draw is made.
Thus, interest
Thus, interest
compounds forward
compounds forward
, and the borrower owes no
, and the borrower owes no
payments until the loan is due at the end of construction, when
payments until the loan is due at the end of construction, when
all principle and interest is due.
all principle and interest is due.
Bottom line: Borrower (developer) faces no cash outflows for
Bottom line: Borrower (developer) faces no cash outflows for
construction until the end of the process, when the entire cost
construction until the end of the process, when the entire cost
is
is
paid (including the “cost of capital”).
paid (including the “cost of capital”).
Example:
Example:
Commitment for $2,780,100 of “future advances” in a
Commitment for $2,780,100 of “future advances” in a
construction loan to cover $2,750,000 of actual construction
construction loan to cover $2,750,000 of actual construction
costs over a three month period. 8% interest (nom.ann.),
costs over a three month period. 8% interest (nom.ann.),
compounded monthly, beginning of month draws:
compounded monthly, beginning of month draws:
Month New Draw Current Interest New Loan Balance
1 $500,000 $3,333.33 $503,333.33
2 $750,000 $8,355.55 $1,261,688.88
3 $1,500,000 $18,411.26 $2,780,100.14
4 and so on
Construction schedule must estimate the amount and timing of the Construction schedule must estimate the amount and timing of the draws. draws.
The accumulated interest (8333+8356+18411 = $30,100 in this case The accumulated interest (8333+8356+18411 = $30,100 in this case) is a ) is a
very real part of the very real part of the total cost total cost of construction of construction. AKA . AKA “Financing Cost” “Financing Cost”. .
Typically a “commitment fee” is also required, up front (in cash Typically a “commitment fee” is also required, up front (in cash). ).
29.4 Simple Financial Feasibility Analysis in Current Practice 29.4 Simple Financial Feasibility Analysis in Current Practice
The traditional and most widely employed method for the analysis The traditional and most widely employed method for the analysis of the of the
financial feasibility of development projects will be referred t financial feasibility of development projects will be referred to here as: o here as:
“Simple Financial Feasibility Analysis” (SFFA) “Simple Financial Feasibility Analysis” (SFFA). .
SFFA is based on the commercial mortgage market (for SFFA is based on the commercial mortgage market (for permanent permanent loans). loans).
It assumes the developer will take out the largest permanent loa It assumes the developer will take out the largest permanent loan possible n possible
upon completion of the building. upon completion of the building.
It assumes that the development It assumes that the development costs costs will equal the market will equal the market value value of the of the
property on completion. property on completion.
Obviously, SFFA leaves something to be desired from a normative Obviously, SFFA leaves something to be desired from a normative
perspective, but: perspective, but:
• • It is It is simple simple and easy to understand. and easy to understand.
• • It requires no specialized knowledge of the capital markets ot It requires no specialized knowledge of the capital markets other than her than
familiarity with the commercial mortgage market (does not even r familiarity with the commercial mortgage market (does not even require equire
familiarity with the relevant property asset market). familiarity with the relevant property asset market).
SFFA comes in two modes: SFFA comes in two modes: “Front Door” “Front Door”, & , & “Back Door” “Back Door” . . . . . .
SFFA SFFA “Front Door” “Front Door” Procedure: Procedure:
Start with costs & end with rent required for feasibility… Start with costs & end with rent required for feasibility…
Site Acquisition Costs + Construction Costs Site Acquisition Costs + Construction Costs
= Total Expected Development Cost = Total Expected Development Cost
X Loan to Value Ratio X Loan to Value Ratio
= Permanent Mortgage = Permanent Mortgage
X Annualized Mortgage Constant X Annualized Mortgage Constant
= Cash Required for Debt Service = Cash Required for Debt Service
X Lender Required Debt Service Coverage Ratio X Lender Required Debt Service Coverage Ratio
= Required Net Operating Income or NOI = Required Net Operating Income or NOI
+ Estimated Operating Expenses (Not passed through to tenants) + Estimated Operating Expenses (Not passed through to tenants)
= Required Effective Gross Income = Required Effective Gross Income
÷ ÷ Expected Occupancy Rate Expected Occupancy Rate
= Required Gross Revenue = Required Gross Revenue
÷ ÷ Leasable Leasable Square Feet Square Feet
= Rent Required Per Square Foot = Rent Required Per Square Foot
Question: Is this average required rent per square foot achievab Question: Is this average required rent per square foot achievable? le?
Typical approach for Typical approach for “Site looking for a Use”. “Site looking for a Use”.
Example: Example:
• • Class B office building rehab project: 30,000 SF (of which 27,2 Class B office building rehab project: 30,000 SF (of which 27,200 NRSF). 00 NRSF).
• • Acquisition cost = $660,000; Acquisition cost = $660,000;
• • Rehab construction budget: $400,000 hard costs + $180,000 soft Rehab construction budget: $400,000 hard costs + $180,000 soft costs. costs.
• • Estimated operating costs (to landlord) = $113,000/yr. Estimated operating costs (to landlord) = $113,000/yr.
• • Projected stabilized occupancy = 95%. Projected stabilized occupancy = 95%.
• • Permanent loan available on completion @ 11.5% (20 Permanent loan available on completion @ 11.5% (20- -yr yr amort amort) with 120% DSCR. ) with 120% DSCR.
• • Estimated feasible rents on completion = $10/SF. Estimated feasible rents on completion = $10/SF.
Site and shell costs: Site and shell costs: $ 660,000 $ 660,000
+ Rehab costs: + Rehab costs: 580,000 580,000
= Total costs: = Total costs: $1,240,000 $1,240,000
X Lender required LTV X Lender required LTV x 80% x 80%
= Permanent mortgage amount: $ 992,000 = Permanent mortgage amount: $ 992,000
X Annualized mortgage constant: x 0.127972 X Annualized mortgage constant: x 0.127972
= Cash required for debt svc: = Cash required for debt svc: $ 126,948 $ 126,948
X Lender required DCR: X Lender required DCR: x 1.20 x 1.20
= Required NOI: = Required NOI: $ 152,338 $ 152,338
+ + Estd Estd. . Oper Oper. Exp. (Landlord): . Exp. (Landlord): 113,000 113,000
= Required EGI: = Required EGI: $ 265,338 $ 265,338
÷ ÷ Projected occupancy (1 Projected occupancy (1- -vac): vac): ÷ ÷ 0.95 0.95
= Required PGI: = Required PGI: $ 279,303 $ 279,303
÷ ÷ Rentable area: Rentable area: ÷ ÷ 27200 SF 27200 SF
-------------- -------------- --------- ---------
= Required rent/SF: = Required rent/SF: $10.27 /SF $10.27 /SF
What major What major
issue is left issue is left
out here? out here?
Lender will Lender will
base base mortg mortg on on
Mkt Mkt Val, not Val, not
constr constr cost. cost.
Use Use mkt mkt cap cap
rate info to rate info to
est. bldg val. est. bldg val.
SFFA SFFA “Back Door” “Back Door” Procedure: Procedure:
Start with rents & building, and end with supportable developmen Start with rents & building, and end with supportable development costs… t costs…
Total Total Leaseable Leaseable Square Feet (based on the building efficiency ratio Square Feet (based on the building efficiency ratio
times the gross area) times the gross area)
X Expected Average Rent Per Square Foot X Expected Average Rent Per Square Foot
= Projected Potential Gross Income (PGI) = Projected Potential Gross Income (PGI)
- - Vacancy Allowance Vacancy Allowance
= Expected Effective Gross Income = Expected Effective Gross Income
- - Projected Operating Expenses Projected Operating Expenses
= Expected Net Operating Income = Expected Net Operating Income
÷ ÷ Debt Service Coverage Ratio Debt Service Coverage Ratio
÷ ÷ Annualized Mortgage Constant Annualized Mortgage Constant
÷ ÷ Maximum Loan to Value Ratio Maximum Loan to Value Ratio
= Maximum Supportable Total Project Costs = Maximum Supportable Total Project Costs
(Question: Can it be built for this including all costs?) (Question: Can it be built for this including all costs?)
- - Expected Construction Costs (Other than Site) Expected Construction Costs (Other than Site)
= Maximum Supportable Site Acquisition Cost = Maximum Supportable Site Acquisition Cost
Question: Can the site be acquired for this or less? Question: Can the site be acquired for this or less?
Typical approach for Typical approach for “Use looking for a Site”. “Use looking for a Site”.
Example: Example:
• • Office building 35,000 SF (GLA), 29,750 SF (NRA) Office building 35,000 SF (GLA), 29,750 SF (NRA) (85% “Efficiency Ratio”) (85% “Efficiency Ratio”). .
• • $12/SF (/yr) realistic rent (based on market analysis, pre $12/SF (/yr) realistic rent (based on market analysis, pre- -existing tenant wants space). existing tenant wants space).
• • Assume 8% vacancy (typical in market, due to extra space not pr Assume 8% vacancy (typical in market, due to extra space not pre e- -leased). leased).
• • Preliminary design construction cost budget (hard + soft) = $2, Preliminary design construction cost budget (hard + soft) = $2,140,000. 140,000.
• • Projected operating expenses (not passed through) = $63,000. Projected operating expenses (not passed through) = $63,000.
• • Permanent mortgage on completion available at 9% (20 Permanent mortgage on completion available at 9% (20- -yr yr amort amort), 120% DCR. ), 120% DCR.
• • Site has been found for $500,000: Site has been found for $500,000: Is it feasible? Is it feasible?
Potential Gross Revenue = 29,750 x $12 = Potential Gross Revenue = 29,750 x $12 = $ 357,000 $ 357,000
Less Vacancy at 8% = Less Vacancy at 8% = - - 28,560 28,560
= Effective Gross Income = Effective Gross Income $ 328,440 $ 328,440
Less Operating Expenses Less Operating Expenses - - 63,000 63,000
= Net Operating Income = Net Operating Income $ 265,000 $ 265,000
÷ ÷ 1.20 = Required Debt Svc: 1.20 = Required Debt Svc: $ 221,200 $ 221,200
÷ ÷ 12 = Monthly debt svc: 12 = Monthly debt svc: $ 18,433 $ 18,433
Supportable mortgage amount = Supportable mortgage amount = $ 2,048,735 $ 2,048,735
÷ ÷ 0.75 LTV = Min. 0.75 LTV = Min. Reqd Reqd. Value: . Value: $ 2,731,647 $ 2,731,647
Less Construction Cost Less Construction Cost - - 2,140,000 2,140,000
------------ ------------ ----------- -----------
Supportable site acquisition Supportable site acquisition cost cost: : $ 591,647. $ 591,647.
So, the project seems feasible. So, the project seems feasible.
(
(
¸
(
¸
|
|
.
|
\
|
+
? =
240
12
09 .
1
1
1
12 / 09 .
18433
But again, something seems left out… Project may be feasible, But again, something seems left out… Project may be feasible, but… but…
Problems with the SFFA:
Problems with the SFFA:
•
•
Just because a project is financially
Just because a project is financially
feasible
feasible
, does not necessarily
, does not necessarily
mean that it is
mean that it is
desirable
desirable
.
.
•
•
Just because a project is
Just because a project is
not feasible
not feasible
using debt financing, does
using debt financing, does
not necessarily mean that it is
not necessarily mean that it is
undesirable
undesirable
:
:
• • A project may appear unfeasible with debt financing, yet it mig A project may appear unfeasible with debt financing, yet it might be a ht be a
desirable project from a total return to investment perspective desirable project from a total return to investment perspective (and (and
might obtain equity financing). might obtain equity financing).
Don’t confuse an SFFA feasibility analysis with a normatively
Don’t confuse an SFFA feasibility analysis with a normatively
correct assessment of the
correct assessment of the
desirability
desirability
of a development project
of a development project
from a financial economic investment perspective.
from a financial economic investment perspective.
SFFA does not compute the SFFA does not compute the value of the completed property value of the completed property. .
Hence, does not compute the NPV of the development investment de Hence, does not compute the NPV of the development investment decision: cision:
NPV = Value NPV = Value – – Cost . Cost .
SFFA merely computes whether it is possible to take out a perman SFFA merely computes whether it is possible to take out a permanent loan to finance ent loan to finance
(most of) the development costs. (most of) the development costs.
The
The
correct
correct
way to evaluate the financial economic
way to evaluate the financial economic
desirability
desirability
of
of
a development project investment:
a development project investment:
“THE NPV INVESTMENT DECISION RULE”:
1) MAXIMIZE THE NPV ACROSS ALL
MUTUALLY-EXCLUSIVE ALTERNATIVES;
AND
2) NEVER CHOOSE AN ALTERNATIVE THAT
HAS: NPV < 0.
(Recall Chapter 10.)
For development investments:
For development investments:
NPV = Benefit
NPV = Benefit
–
–
Cost = Value of Bldg
Cost = Value of Bldg
–
–
Cost of
Cost of
Devlpt
Devlpt
.
.
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. . .
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
.
.
Indeed, using the
Indeed, using the
opportunity cost of capital
opportunity cost of capital
(reflecting the
(reflecting the
amount of risk in the cash flows being discounted), the discount
amount of risk in the cash flows being discounted), the discount
rate can be applied to either discount cash flows back in time,
rate can be applied to either discount cash flows back in time,
or
or
to grow (compound) them forward in time (e.g., to the projected
to grow (compound) them forward in time (e.g., to the projected
time of completion of the construction phase, as in the projecte
time of completion of the construction phase, as in the projecte
d
d
balance due on the construction loan).
balance due on the construction loan).
Simplify the analysis by working with only two points in time:
Simplify the analysis by working with only two points in time:
•
•
The present (
The present (
time “zero”
time “zero”
), when the development
), when the development
investment decision must be made, and
investment decision must be made, and
•
•
The projected time of completion of the construction
The projected time of completion of the construction
phase (
phase (
time “T”
time “T”
).
).
Project cash flows can generally be most accurately and convenie Project cash flows can generally be most accurately and conveniently ntly
estimated as of these two points in time: estimated as of these two points in time:
• • Land cost and other up Land cost and other up- -front expenditures: as of front expenditures: as of time 0 time 0. .
• • Completed building value and construction costs (including Completed building value and construction costs (including
financing costs via the construction budget, excluding land cost financing costs via the construction budget, excluding land costs): as s): as
of of time T time T. .
The projected values as of The projected values as of time T time T can then be discounted to can then be discounted to time 0 time 0 using using
appropriate risk appropriate risk- -adjusted discount rates (OCC). adjusted discount rates (OCC).
The crucial NPV calculation is then made as of The crucial NPV calculation is then made as of time 0 time 0, the time when the , the time when the
investment decision must be made. investment decision must be made.
Note that in this approach, there is no need to Note that in this approach, there is no need to pre pre- -assume assume what type of what type of
permanent financing will be used for the completed project. permanent financing will be used for the completed project.
There is no assumption at all about what will be done with the c There is no assumption at all about what will be done with the completed ompleted
project at project at time T time T. It may be: . It may be:
• • Financed with a permanent mortgage, Financed with a permanent mortgage,
• • Financed or sold (wholly or partly) tapping external equity, or Financed or sold (wholly or partly) tapping external equity, or
• • Held without recourse to external capital. Held without recourse to external capital.
Project evaluation is independent of project financing, as it sh Project evaluation is independent of project financing, as it should be.* ould be.*
* Unless subsidized (non * Unless subsidized (non- -market market- -rate) financing is available contingent on rate) financing is available contingent on
project acceptance: Recall Chapter 14, the “APV” (Adjusted Prese project acceptance: Recall Chapter 14, the “APV” (Adjusted Present Value) nt Value)
approach to incorporating financing in the investment evaluation approach to incorporating financing in the investment evaluation. .
Another important reason for this approach: Another important reason for this approach:
• • Risk Risk characteristics of characteristics of development phase development phase different different from risk from risk
characteristics of characteristics of stabilized phase stabilized phase. .
• • Thus, Thus, different different OCCs OCCs, therefore: , therefore:
• • Two phases must be analyzed in two Two phases must be analyzed in two separate steps separate steps. .
“Adjusted Present Value” (APV) Decision Rule (Ch.14)…
“Adjusted Present Value” (APV) Decision Rule (Ch.14)…
Like NPV, only accounts for financing… Like NPV, only accounts for financing…
APV(equity) = NPV(property) + NPV(financing) APV(equity) = NPV(property) + NPV(financing)
Based on the Value Based on the Value Additivity Additivity Principle: Principle:
Prop.Val = Equity Val + Dbt Val
V = E + D
Where: V = Value of the property,
E = Value of the equity,
D = Value of the debt.
Define: P = Price paid for the property,
L = Amount of the loan…
V-P = E+D – P
= E+D – ((P-L)+L)
= E-(P-L) + D-L
= E-(P-L) – (L-D)
Thus: E-(P-L) = (V-P) + (L-D)
Or: APV(Equity) = NPV(Prop)+ NPV(Fin)
Note: Arbitrage basis of Value Additivity applies to MV, but the common sense of
Value Additivity can be applied to IV as well.
Recall from Chapter 14…
Unless subsidized financing is available,
Unless subsidized financing is available,
NPV(financing) = 0 on a MV basis (IV basis too unless investor
NPV(financing) = 0 on a MV basis (IV basis too unless investor
is
is
“
“
intra
intra
-
-
marginal”).
marginal”).
Thus,
Thus,
Normally, APV(equity) = NPV(property), and we can evaluate
Normally, APV(equity) = NPV(property), and we can evaluate
the development project independent of how (or whether) the
the development project independent of how (or whether) the
completed project will be financed with or without debt:
completed project will be financed with or without debt:
•
•
Evaluate investment
Evaluate investment
“as if all equity”
“as if all equity”
financing.
financing.
•
•
If subsidized debt,
If subsidized debt,
add NPV(financing)
add NPV(financing)
.
.
Two approaches for applying the
Two approaches for applying the
“2
“2
-
-
time
time
-
-
point NPV procedure”
point NPV procedure”
:
:
•
•
Discount
Discount
separately
separately
back to
back to
time 0
time 0
the
the
time T
time T
gross values
gross values
of the completed building (
of the completed building (
V
V
T T
) and of the construction cost
) and of the construction cost
(the construction loan balance due:
(the construction loan balance due:
L
L
T T
), employing
), employing
separate discount rates (
separate discount rates (E[r
V
] and E[r
D
],
respectively)
respectively)
reflecting the risk in the building value and in the
reflecting the risk in the building value and in the
construction cost:
construction cost: ( (E[r
D
] = OCC for construction CFs. E[r
V
] = =
expected return (going expected return (going- -in IRR) on in IRR) on unlevered unlevered investment in stabilized investment in stabilized
property, or a bit more for property, or a bit more for “spec” “spec” projects without pre projects without pre- -leasing. Normally: leasing. Normally:
E[r
V
] > E[r
D
].) )
•
•
Discount the
Discount the
time T
time T
net
net
value to
value to
time 0
time 0
using a (higher)
using a (higher)
OCC reflecting the levered nature of that net value (i.e.,
OCC reflecting the levered nature of that net value (i.e.,
the development investment OCC, that is, the OCC of the
the development investment OCC, that is, the OCC of the
construction phase investment per se:
construction phase investment per se: E[r
C
]
).
).
In principle, these two approaches are equivalent. They should
In principle, these two approaches are equivalent. They should
give the same NPV result as of
give the same NPV result as of
time 0
time 0
.
. (This principle can be used to (This principle can be used to
determine the internal consistency of the discount rates employe determine the internal consistency of the discount rates employed.) d.)
Let: Let: B
0
= Time 0 risk-adjusted valuation of project benefits.
C
0
= Time 0 risk-adjusted valuation of project costs.
V
T
= Projected time T valuation of the completed building.
L
T
= Projected time T value of construction cost (brought forward to T using E[r
D
]).
NPV(cons)
T
= Projected time T net difference between completed bldg value and construction
cost.
LAND = Market value (MV ) of land (or investment value if IV > MV ) as of time 0 (e.g., as
discussed in Ch.28).
FEES = Other up-front expenditures (besides land) required to begin project as of time 0.
V = Time 0 present value of projected time T value of completed building (same as V in
Chapter 28).
K = Time 0 present value of development costs exclusive of land (same as K in Chapter 28).
Then: Then:
( ) ( )
( )
( ) ( )
( )
( ) ( ) ( )
( ) NPV C B LAND K V LAND K V
LAND K
r E
V
LAND FEES
r E
L
r E
V
FEES LAND
r E
L
r E
V
FEES LAND
r E
L V
C
r E
cons NPV
C B NPV
T
V
T
T
D
T
T
V
T
T
D
T
T
V
T
T
C
T T
T
C
T
= ? = + ? = ? ? =
? ?
+
= ?
|
|
.
|
\
|
+
+
?
+
=
+ ?
+
?
+
=
+ ?
+
?
= ?
+
= ? =
0 0
0 0 0
] [ 1 ] [ 1 ] [ 1
] [ 1 ] [ 1
] [ 1 ] [ 1
) (
Where E[r
V
], E[r
D
], and E[r
C
] are appropriate discount rates (OCC ) for V
T
, L
T
, and
(V
T
– L
T
), respectively. (In general: E[r
D
] < E[r
V
] < E[r
C
].) .)
The second method
The second method
(discounting the
(discounting the
net
net
time T
time T
value,
value, NPV(cons) NPV(cons)
T T
=
=
V
V
T T
–
–
L
L
T T
,
,
using a single levered discount rate)
using a single levered discount rate)
is most common
is most common
in practice,
in practice,
Perhaps because investors in development projects like to think
Perhaps because investors in development projects like to think
in terms of the return on their equity capital invested during t
in terms of the return on their equity capital invested during t
he
he
development phase. (Development investment has different
development phase. (Development investment has different
levels of risk and expected return than other types of investmen
levels of risk and expected return than other types of investmen
t,
t,
and investors in development typically are seeking precisely tha
and investors in development typically are seeking precisely tha
t
t
level of risk and return.)
level of risk and return.)
How may we estimate reasonable levels of expected return (OCC),
How may we estimate reasonable levels of expected return (OCC),
E[r
C
], for development investments? . . .
Two methods, closely related, should give similar results:
Two methods, closely related, should give similar results:
1.
1.
Equilibrium relation between PV(V
Equilibrium relation between PV(V
T T
), PV(L
), PV(L
T T
), & PV(V
), & PV(V
T T
-
-
L
L
T T
);
);
2.
2.
“WACC Formula” based on leverage in the
“WACC Formula” based on leverage in the
devlpt
devlpt
project.
project.
Method 1 for determining Method 1 for determining E E[ [r r
C C
]: ]:
Using Equilibrium Across the Markets for Stabilized Property, Co Using Equilibrium Across the Markets for Stabilized Property, Construction nstruction
Debt, and Land… Debt, and Land…
( ) ( ) ( )
T
D
T
T
V
T
T
C
T T
r E
L
r E
V
r E
L V
] [ 1 ] [ 1 ] [ 1 +
?
+
=
+
?
The basic idea is that equilibrium requires: The basic idea is that equilibrium requires:
Thus, if you have knowledge of: Thus, if you have knowledge of:
• • V V
T T
= Expected value of completed stabilized property at time T; = Expected value of completed stabilized property at time T;
• • L L
T T
= Expected balance due on construction loan at time T (all cons = Expected balance due on construction loan at time T (all construction costs truction costs
including financing costs); including financing costs);
• • E E[ [r r
V V
] ] = Market expected total rate of return (going = Market expected total rate of return (going- -in IRR) on investments in in IRR) on investments in
completed properties of the type to be built; completed properties of the type to be built;
• • E E[ [r r
D D
] ] = Market expected return on construction loans (< loan interest = Market expected return on construction loans (< loan interest rate). rate).
Then you can solve the above equation for Then you can solve the above equation for E E[ [r r
C C
] to obtain: ] to obtain:
Otherwise, superior risk Otherwise, superior risk- -adjusted returns (ex ante) could be made by investing in some adjusted returns (ex ante) could be made by investing in some
combination of stabilized property ( combination of stabilized property (V V
T T
), construction debt ( ), construction debt (L L
T T
), or developable land ), or developable land (V (V
T T
- -L L
T T
) ). .
Presumably, equilibrium across markets drives market prices in t Presumably, equilibrium across markets drives market prices in these asset classes to be hese asset classes to be
such that superior returns are not possible, and the above relat such that superior returns are not possible, and the above relationship tends to hold. ionship tends to hold.
( )( ) ( )
( ) ( )
( )
1
] [ 1 ] [ 1
] [ 1 ] [ 1
] [
1
?
(
¸
(
¸
+ ? +
+ + ?
=
T
T
T
V T
T
D
T
D
T
V T T
C
L r E V r E
r E r E L V
r E
Method 1 for determining Method 1 for determining E E[ [r r
C C
]… ]…
Example: Project to build an apartment building…
Example: Project to build an apartment building…
• • Construction will take 1 year ( Construction will take 1 year (T T=1 =1). ).
• •Similar stabilized properties are currently worth $10,000,000. E Similar stabilized properties are currently worth $10,000,000. Expected xpected
appreciation in this type of property over the next year = 0%. H appreciation in this type of property over the next year = 0%. Hence, ence,
V V
T T
=$10,000,000 =$10,000,000. .
• • Construction cost is $7,680,000 (fixed Construction cost is $7,680,000 (fixed- -price contract to be paid on price contract to be paid on
completion, including construction interest). Hence, completion, including construction interest). Hence, L L
T T
=$7,680,000 =$7,680,000. .
• • Going Going- -in in IRRs IRRs for stabilized properties of the type to be built are around for stabilized properties of the type to be built are around
8%. Hence, 8%. Hence, E E[ [r r
V V
]=8% ]=8%. .
• • Expected return on construction loan is 5.8%. Hence, Expected return on construction loan is 5.8%. Hence, E E[ [r r
D D
]=5.8% ]=5.8%. .
Thus:
Thus:
( )( )( )
( ) ( )
% 16 1
68 . 7 08 . 1 10 058 . 1
058 . 1 08 . 1 68 . 7 10
] [ = ?
?
?
=
C
r E
The development investment should provide an expected return of The development investment should provide an expected return of 16%. 16%.
The The WACC WACC Formula is a useful approximation to see how big the Formula is a useful approximation to see how big the
development phase development phase equity equity return should be relative to: return should be relative to:
• • The stabilized property (i.e., The stabilized property (i.e., underlying asset, e.g., NCREIF underlying asset, e.g., NCREIF) return, ) return,
• • The construction cost (i.e., The construction cost (i.e., debt debt) return. ) return.
Recall (from Ch.13): Recall (from Ch.13):
Where:
r
C
=Return on devlpt project up-front investment (construction phase).
LR=Effective leverage in the devlpt project (V
T
/E) = Completed stabilized property
value divided by up-front land cost (& fees).
r
V
= Total return on stabilized property during development phase (as if it existed
completed already).
r
D
= Total return on construction debt.
( )LR r r r r
D V D C
? + =
Method 2 for determining Method 2 for determining E E[ [r r
C C
]: ]:
Using the WACC & Knowledge of Land Value… Using the WACC & Knowledge of Land Value…
Apply the WACC to the Apply the WACC to the ex ante ex ante risk premium: risk premium:
LR RP E RP E RP E RP E
D V D C
]) [ ] [ ( ] [ ] [ ? + =
Example. Example. If: If:
E[RP
V
] = 300 bp
(Typical for E[RP
NCREIF
], more for spec)
E[RP
D
] = 100 bp
(Remember: E[r], not “stated interest”, See Ch.18)
LR = 5
Then: Then:
bp bp bp bp RP E
C
1100 5 * ) 100 300 ( 100 ] [ = ? + =
e.g., If T e.g., If T- -Bills are yielding 5%, then the expected return on the Bills are yielding 5%, then the expected return on the
construction project is 16%: construction project is 16%:
% 16 % 11 % 5 ] [ = + =
C
r E
Note: If E
Note: If E
[
[
r
r
C C
]
]
is to be a
is to be a
market
market
opportunity cost of capital (OCC),
opportunity cost of capital (OCC),
as it should be, then LR must be based on current
as it should be, then LR must be based on current
market value
market value
of
of
the land: LR=V
the land: LR=V
T T
/ E, where E = LAND+FEES time 0 market val.
/ E, where E = LAND+FEES time 0 market val.
Method 2 for determining Method 2 for determining E E[ [r r
C C
]… ]…
Recall:
Recall:
The Fundamental Nature of Real Estate Development Investment:
The Fundamental Nature of Real Estate Development Investment:
•
•
A
A
forward
forward
purchase commitment in a stabilized fully
purchase commitment in a stabilized fully
operational (leased up) property:
operational (leased up) property:
• • Buy (incur opportunity cost of) land Buy (incur opportunity cost of) land now now, ,
• • Get stabilized property Get stabilized property later later. .
•
•
A
A
levered
levered
investment in the stabilized (core) property:
investment in the stabilized (core) property:
• • Up front the only cost is the purchase of (or incurring the Up front the only cost is the purchase of (or incurring the
opportunity cost of) opportunity cost of) the the land land. .
• •This can be viewed as the This can be viewed as the equity equity investment to obtain ( investment to obtain (a long a long
position in position in) the future stabilized property ( ) the future stabilized property (a volatile asset a volatile asset), ),
• • Subject to Subject to the payment of construct costs the payment of construct costs ( (a relatively fixed outlay a relatively fixed outlay
that will occur in the future, i.e., subsequent to the time when that will occur in the future, i.e., subsequent to the time when the land the land
cost is incurred cost is incurred). ).
• • The development investment is thus equivalent to having a The development investment is thus equivalent to having a long long
position in the stabilized property combined with a position in the stabilized property combined with a short short position in position in
the construction costs. the construction costs.
The Fundamental Nature of Real Estate Development Investment The Fundamental Nature of Real Estate Development Investment… …
Let: Let: “ “E E” ” = = Up front investment in Up front investment in devlpt devlpt project project (E= LAND+FEES); (E= LAND+FEES);
“ “V V” ” = Time 0 = Time 0 PV of PV of time T time T completed property value completed property value (V=PV(V (V=PV(V
T T
)=V(0)); )=V(0));
“ “D D” ” = Time 0 = Time 0 PV of construction cost exclusive of land PV of construction cost exclusive of land (D=K (D=K- -FEES). FEES).
Then: Then:
E = V-D
D
D
E
D
V
V
E
V
D
D
E
D
V
V
E
V
E
D
E
V
E
E ?
?
?
=
?
?
?
=
?
?
?
=
?
?
|
.
|
\
|
?
?
?
+
?
=
?
|
.
|
\
|
? ?
?
=
? ?
?
?
=
?
?
D
D
V
V
E
V
D
D
D
D
E
V
V
V
E
V
D
D
E
E V
V
V
E
V
E
E
1
) (
( )LR g g g g LR g LR g
WACC
D V D D V E
? + = ? + =
?
) 1 ( ) (
:
r
E
=Return on devlpt project up-front investment (purely appreciation, g
E
, no income).
LR=Effective leverage in the devlpt project (V
T
/E) (= Completed stabilized property
value divided by up-front land cost).
g
V
= Appreciation return on stabilized property during development phase (as if it
existed completed already).
g
D
= Percentage change in total (final) construction cost (exclusive of land) during
development phase (e.g. zero for guaranteed fixed-price contract).
( )LR g g g g LR g LR g r
WACC
D V D D V E E
? + = ? + = =
?
) 1 ( ) (
:
The Fundamental Nature of Real Estate Development Investment The Fundamental Nature of Real Estate Development Investment… …
Numerical Example
Numerical Example
…
…
• • Project to build an apartment building. Project to build an apartment building.
• • Similar (stabilized) properties are currently worth Similar (stabilized) properties are currently worth $10,000,000 $10,000,000. .
• • Construction will take Construction will take 1 year 1 year. .
• • Construction cost is Construction cost is $7,680,000 $7,680,000 (fixed (fixed- -price contract to be paid on price contract to be paid on
completion). completion).
• • Land Land (opportunity value, i.e., what land could be sold for) & up (opportunity value, i.e., what land could be sold for) & up- -
front fees (e.g., architect) cost front fees (e.g., architect) cost $2,000,000 $2,000,000. .
• • Assuming expected appreciation in this property type is zero ov Assuming expected appreciation in this property type is zero over er
the next year, expected return on the development investment is the next year, expected return on the development investment is 16% 16%: :
( )
000 , 000 , 2 $
000 , 000 , 2 $ 000 , 680 , 7 $ 000 , 000 , 10 $ ] [
% 16
? ?
=
?
=
BegVal
BegVal EndVal E
Numerical Example (cont.)
Numerical Example (cont.)
…
…
• • Now suppose between now and next year apartment property values Now suppose between now and next year apartment property values
take an unexpected plunge of take an unexpected plunge of 10% 10%, to , to $9,000,000 $9,000,000. .
• • For an For an unlevered unlevered investor in pre investor in pre- -existing stabilized property the existing stabilized property the
return hit is just this 10% loss. return hit is just this 10% loss.
• • But to our development investment our But to our development investment our loss is magnified loss is magnified to to 50% 50%
below the previous +16% expectation (as below the previous +16% expectation (as – –34% is 50 points below 34% is 50 points below
+16%): +16%):
( )
000 , 000 , 2 $
000 , 680 $
000 , 000 , 2 $
000 , 000 , 2 $ 000 , 680 , 7 $ 000 , 000 , 9 $
% 34
?
=
? ?
= ?
• • The reason for the magnification of the impact on the return is The reason for the magnification of the impact on the return is that that
the construction cost ($7,680,000) did not change with the chang the construction cost ($7,680,000) did not change with the change in e in
stabilized property value (from $10,000,000 to $9,000,000). stabilized property value (from $10,000,000 to $9,000,000).
• • The reason the magnification was The reason the magnification was 5 5- -times ( times (- -50%/ 50%/- -10%) is because 10%) is because
the effective the effective Leverage Ratio Leverage Ratio in the development is in the development is 5 5 (in this case): (in this case):
LR LR = = V V
T T
/ E / E = $10,000,000 / $2,000,000 = = $10,000,000 / $2,000,000 = 5 5. .
The effective operational leverage will not be so great if som The effective operational leverage will not be so great if some of the e of the
construction cost is paid by the equity investor up front or dur construction cost is paid by the equity investor up front or during the ing the
construction phase (e.g., no construction loan, contractor requi construction phase (e.g., no construction loan, contractor requires payments res payments
as costs are incurred). as costs are incurred).
e.g., in the previous example, suppose half the fixed e.g., in the previous example, suppose half the fixed- -price construction cost price construction cost
had to be paid up had to be paid up- -front (but it was still the same $7,680,000 amount)… front (but it was still the same $7,680,000 amount)…
Then the original expected return would have been 5.5%: Then the original expected return would have been 5.5%:
( )
000 , 840 , 3 $ 000 , 000 , 2 $
) 000 , 840 , 3 $ 000 , 000 , 2 ($ 000 , 840 , 3 $ 000 , 000 , 10 $ ] [
% 5 . 5
+
+ ? ?
=
?
=
BegVal
BegVal EndVal E
And the loss to the development investor caused by the And the loss to the development investor caused by the 10% 10%drop in drop in
apartment values would have been only apartment values would have been only 17.1% 17.1%, reflecting the effective , reflecting the effective
leverage ratio leverage ratio 1.71 1.71 (= $10,000,000 / $5,840,000), as (= $10,000,000 / $5,840,000), as - -11.6% is 17.1% below the 11.6% is 17.1% below the
previous expectation of 5.5%: previous expectation of 5.5%:
( )
000 , 840 , 3 $ 000 , 000 , 2 $
) 000 , 840 , 3 $ 000 , 000 , 2 ($ 000 , 840 , 3 $ 000 , 000 , 9 $ ] [
% 6 . 11
+
+ ? ?
=
?
= ?
BegVal
BegVal EndVal E
But note there is still leverage even here. And of course in the But note there is still leverage even here. And of course in the real world, most development is real world, most development is
financed by construction loans covering 100% of construction cos financed by construction loans covering 100% of construction costs (for a variety of reasons), ts (for a variety of reasons),
loans that are paid off by the developer (the equity development loans that are paid off by the developer (the equity development investor) only upon completion investor) only upon completion
of construction, thereby maximizing leverage. of construction, thereby maximizing leverage.
Realized development project investment returns are: Realized development project investment returns are:
• • Highly correlated Highly correlated with stabilized property appreciation returns. with stabilized property appreciation returns.
• • More volatile More volatile than stabilized property appreciation returns. than stabilized property appreciation returns.
Therefore, development investment is Therefore, development investment is more risky more risky than investment in than investment in
stabilized pre stabilized pre- -existing property existing property (no surprise) (no surprise). .
But note that: But note that:
Risk is Risk is added by added by leverage leverage, and thus: , and thus:
• • Would exist even for pre Would exist even for pre- -leased projects leased projects (i.e., development risk is not (i.e., development risk is not
caused caused only only by speculation) by speculation), and would exist even in the absence of a , and would exist even in the absence of a
wide wide- -amplitude development demand cycle. amplitude development demand cycle.
• •Added risk implies development should have a higher Added risk implies development should have a higher risk premium risk premium
than stabilized investment, in the than stabilized investment, in the ex ante (“going ex ante (“going- -in”) IRR in”) IRR (and on (and on
average over the long run, average over the long run, ex post ex post as well). as well).
• • WACC formula can be useful in estimating appropriate risk premi WACC formula can be useful in estimating appropriate risk premium um
for development investment, relating development phase RP to typ for development investment, relating development phase RP to typical ical
stabilized property stabilized property- -level RP. level RP.
The Fundamental Nature of Real Estate Development Investment The Fundamental Nature of Real Estate Development Investment… …
Implications of development Implications of development’ ’s operational leverage: s operational leverage:
The framework described here can be used, in conjunction with an The framework described here can be used, in conjunction with an index of index of
periodic appreciation returns to stabilized property (such as th periodic appreciation returns to stabilized property (such as the NCREIF e NCREIF
Index), to simulate what the ex post Index), to simulate what the ex post IRRs IRRs to typical development to typical development
investments would have been, during specific historical periods investments would have been, during specific historical periods of time… of time…
The Fundamental Nature of Real Estate Development Investment The Fundamental Nature of Real Estate Development Investment… …
Rolling Simulated 1-Yr IRR Cohorts
-100%
-75%
-50%
-25%
0%
25%
50%
75%
1
9
7
8
4
1
9
8
0
4
1
9
8
2
4
1
9
8
4
4
1
9
8
6
4
1
9
8
8
4
1
9
9
0
4
1
9
9
2
4
1
9
9
4
4
1
9
9
6
4
1
9
9
8
4
2
0
0
0
4
Ending Year
S
i
m
u
l
a
t
e
d
C
o
h
o
r
t
I
R
R
NPI 1Yr TWRR
1Yr5TLR Cohort
1Yr3TLR Cohort
1Yr1TLR Cohort
Comparing
Comparing
Method 1
Method 1
and
and
Method 2
Method 2
for estimating development
for estimating development
phase OCC:
phase OCC:
•
•
Method 1 is theoretically at least as sound as Method 2.
Method 1 is theoretically at least as sound as Method 2.
•
•
Method 1 does not require knowledge of the current market
Method 1 does not require knowledge of the current market
value of the land (which may often be difficult to accurately
value of the land (which may often be difficult to accurately
estimate).
estimate).
•
•
Method 1 does not depend on the simple return (1
Method 1 does not depend on the simple return (1
-
-
period,
period,
not compounded) WACC formula approximation of the
not compounded) WACC formula approximation of the
construction phase IRR (a multi
construction phase IRR (a multi
-
-
period, compounded rate of
period, compounded rate of
return), an approximation that breaks down for long
return), an approximation that breaks down for long
duration construction projects (e.g., multi
duration construction projects (e.g., multi
-
-
year projects).
year projects).
Due to all of these advantages,
Due to all of these advantages,
Method 1
Method 1
is probably generally
is probably generally
preferable to
preferable to
Method 2
Method 2
: Estimate development phase OCC
: Estimate development phase OCC
based on internal consistency between E[
based on internal consistency between E[
r
r
V V
], E[
], E[
r
r
D D
], and E[
], and E[
r
r
C C
].
].
What about the
What about the
lease
lease
-
-
up
up
phase? . . .
phase? . . .
•
•
Not relevant for pre
Not relevant for pre
-
-
leased or owner
leased or owner
-
-
occupied
occupied
developments.
developments.
•
•
In spec projects, if lease
In spec projects, if lease
-
-
up is projected to be of significant
up is projected to be of significant
duration, then it is most correct to treat it as a separate
duration, then it is most correct to treat it as a separate
phase, with its own separate OCC:
phase, with its own separate OCC:
• • Three points in time: Time 0 (present), CO Time (T), Three points in time: Time 0 (present), CO Time (T),
Stabilization Time (S). Stabilization Time (S).
• • Three phases each with separate OCC (discount rate) because of Three phases each with separate OCC (discount rate) because of
different risk: Construction Phase (most risky), Lease different risk: Construction Phase (most risky), Lease- -up Phase up Phase
(intermediate risk), Stabilized Operation Phase (least risk). (intermediate risk), Stabilized Operation Phase (least risk).
•
•
OCC in lease
OCC in lease
-
-
up phase typically 50
up phase typically 50
-
-
200
200
bp
bp
> Stabilized
> Stabilized
property OCC.
property OCC.
In principle, the lease In principle, the lease- -up phase OCC is similar to the up phase OCC is similar to the “inter “inter- -lease lease discount rate” discount rate”
introduced in Chapter 10. introduced in Chapter 10.
The procedure presented in Study Question 10.23 (p.857) can be u The procedure presented in Study Question 10.23 (p.857) can be used to estimate sed to estimate
lease lease- -up OCC ( up OCC (r r) based on knowledge of: ) based on knowledge of:
• • Typical lease term length in new leases in the relevant space m Typical lease term length in new leases in the relevant space market ( arket (T T); );
• • Typical tenant borrowing rate ( Typical tenant borrowing rate (intra intra- -lease lease discount rate) ( discount rate) (r r
L L
); );
• • Prevailing cap rate (current cash yield) in the relevant proper Prevailing cap rate (current cash yield) in the relevant property asset market ty asset market
( (k k); );
• • Realistic expected long Realistic expected long- -term average growth rate in rents chargeable by a term average growth rate in rents chargeable by a
given building ( given building (g g). ).
The formula The formula presented there presented there for a single for a single- -tenant space with the lease just signed and tenant space with the lease just signed and
for lease payments in arrears is: for lease payments in arrears is:
( )
( )
( )
1
) 1 /( ) 1 ( 1
) 1 /( ) 1 ( 1
1
1 1
1
?
¦
)
¦
`
¹
¦
¹
¦
´
¦
(
¸
(
¸
+ + ?
+ + ?
+
? + =
T
L
T
L
L
r g
r g
r
k
g r
The formula if the lease has not yet been signed and 1 The formula if the lease has not yet been signed and 1
st st
payment in 1 yr is a payment in 1 yr is a
polynomial that can easily be solved numerically in Excel by ite polynomial that can easily be solved numerically in Excel by iteration: ration:
( ) ( )
|
|
.
|
\
|
+
+
?
(
(
¸
(
¸
|
|
.
|
\
|
+
+
? = + + ? +
?
L
T
L
T T
r
g
r
g
k r g r
1
1
1
1
1
1 1 1 1
1
The typical property market can be assumed to be bracketed by th The typical property market can be assumed to be bracketed by these two extreme ese two extreme
cases (lease just signed, lease just expired), so the average be cases (lease just signed, lease just expired), so the average between these two tween these two
estimates of estimates of r r could be used. could be used.
Numerical example (from book): Numerical example (from book):
• • Market value of land is $2,000,000 ( Market value of land is $2,000,000 (LAND LAND = $2 million). = $2 million).
• • Fees that must also be paid up front ( Fees that must also be paid up front (time 0 time 0 ) are $200,000. ) are $200,000.
• • Total construction cost is projected to be $4,500,000 (not incl Total construction cost is projected to be $4,500,000 (not including financing cost), and uding financing cost), and
construction is expected to take 3 years ( construction is expected to take 3 years (T T = 3), with payments for work done owed to = 3), with payments for work done owed to
the contractor projected to occur in 3 equal installments of $1, the contractor projected to occur in 3 equal installments of $1,500,000 each at the ends 500,000 each at the ends
of years 1, 2, and 3. of years 1, 2, and 3.
• • A construction loan covering all the above A construction loan covering all the above- -noted construction costs can (and will) be noted construction costs can (and will) be
used, at 7.5% interest, requiring a $20,000 up used, at 7.5% interest, requiring a $20,000 up- -front origination fee in cash. Loan will be front origination fee in cash. Loan will be
due upon completion of construction at the end of Year 3. due upon completion of construction at the end of Year 3.
• • The opportunity cost of capital (OCC) for investments in develo The opportunity cost of capital (OCC) for investments in development projects of this pment projects of this
nature is assumed to be 20% per annum ( nature is assumed to be 20% per annum (E E[ [r r
C C
]=20%) ]=20%). .
• • Construction completion is expected to be followed by 2 years o Construction completion is expected to be followed by 2 years of absorption (lease f absorption (lease- -up), up),
including two projected net cash flows of: including two projected net cash flows of: - -$100,000 at end of Yr.4 (when building will $100,000 at end of Yr.4 (when building will
still be mostly empty), and +$400,000 at end of Yr.5 (more tenan still be mostly empty), and +$400,000 at end of Yr.5 (more tenants, less leasing ts, less leasing
expenses). OCC for lease expenses). OCC for lease- -up phase assumed to be 300bp greater than OCC for up phase assumed to be 300bp greater than OCC for
stabilized investment. stabilized investment.
• • Stabilized operation (beginning Yr.6) projected NOI = $800,000/ Stabilized operation (beginning Yr.6) projected NOI = $800,000/yr with projected yr with projected
growth of 1% per year thereafter based on rental market projecti growth of 1% per year thereafter based on rental market projections. OCC (going ons. OCC (going- -in in
IRR) for investments in stabilized property projected to be 9% p IRR) for investments in stabilized property projected to be 9% per annum. er annum.
Step 1: Step 1: Estimate Stabilized Property Value at Project Completion… Estimate Stabilized Property Value at Project Completion…
08 . 0
000 , 800 $
01 . 0 09 . 0
000 , 800 $
09 . 1
000 , 800 $ ) 01 . 1 (
09 . 1
000 , 800 )$ 01 . 1 (
09 . 1
000 , 800 $
000 , 000 , 10 $
2
2
2
5
=
?
=
+ + + = = K V
Step 2: Step 2: Estimate Physically Complete Building Value at End of Constructi Estimate Physically Complete Building Value at End of Construction on
Phase… Phase…
Note: OCC = 9% + 300bp = 12%. Note: OCC = 9% + 300bp = 12%.
2
3
12 . 1
000 , 000 , 10 $ 000 , 400 $
12 . 1
000 , 100 $
531 , 201 , 8 $
+
+
?
= = V
Step 3: Step 3: Estimate Construction Cost As of Time of Construction Completion Estimate Construction Cost As of Time of Construction Completion… …
( ) ( ) 000 , 500 , 1 075 . 1 000 , 500 , 1 $ 075 . 1 000 , 500 , 1 $ 938 , 845 , 4 $
2
+ + = =
T
L
Step 4: Step 4: Calculate Projected Construction Phase Net… Calculate Projected Construction Phase Net…
593 , 355 , 3 $ 938 , 845 , 4 $ 531 , 201 , 8 $ ) ( = ? = ? =
T T T
L V cons NPV
3
0
20 . 1
593 , 355 , 3 $
894 , 941 , 1 $ = = B
Step 5: Step 5: Estimate Estimate Time 0 Time 0 PV of the Construction Net… PV of the Construction Net…
This is the benefit of the development project, measured in This is the benefit of the development project, measured in time 0 time 0, ,
risk risk- -adjusted dollars. adjusted dollars.
Step 6: Step 6: Subtract Subtract Time 0 Time 0 Cost to Determine NPV Measured in Cost to Determine NPV Measured in Time 0 Time 0 Risk Risk- -
adjusted Dollars… adjusted Dollars…
106 , 278 $ 000 , 220 , 2 $ 894 , 941 , 1 $
0 0 0
? = ? = ? = C B NPV
As the NPV is negative, this development project is obviously As the NPV is negative, this development project is obviously not not a a
good investment at this time. good investment at this time.
What is an obvious problem with this project? What is an obvious problem with this project?
29.5.4 Summarizing the advantages of the recommended procedure: 29.5.4 Summarizing the advantages of the recommended procedure:
Consistent with underlying theory. (i.e., consistent with NPV Rule, based on
Wealth Maximization Principle.)
Simplicity. Avoids need to make assumptions about permanent loan or form of
permanent financing (equity vs debt).
Explicit identification of the relevant OCC. Identifies explicit expected return
(OCC) to each phase (each risk regime) of the investment: Development,
Lease-up, Stabilized operation.
Explicit identification of land value. Procedure requires explicit identification
of current opportunity value of the land.
“Front-door” or “Back-door” flexibility possible. Procedure amenable to
“backing into” any one unknown variable. E.g., if you know the land value
and the likely rents, you can back into the required construction cost. If you
know (or posit) all of the costs and values, then you can back into the
expected return on the developer's equity contribution for the development
phase.
Do developers really use the “NPV Rule”? . . .
Do developers really use the “NPV Rule”? . . .
• • Most don’t use NPV Most don’t use NPV explicitly explicitly. .
• • But remember: NPV But remember: NPV Wealth Maximization Wealth Maximization. .
• • By definition, By definition, successful successful developers maximize their wealth. developers maximize their wealth.
• • Thus, Thus, implicitly implicitly (if not explicitly), (if not explicitly), successful successful developers must (somehow) developers must (somehow)
be employing the NPV Rule: be employing the NPV Rule:
• • e.g., in deciding e.g., in deciding which projects which projects to pursue, to pursue,
• • An intuitive sense of correctly rank An intuitive sense of correctly rank- -ordering mutually ordering mutually- -exclusive exclusive
projects by NPV, and picking those with the highest NPV (they projects by NPV, and picking those with the highest NPV (they
may think of it as “best profit potential”), must be employed (b may think of it as “best profit potential”), must be employed (by y
the most successful developers). the most successful developers).
• • Suggestion in Ch.29 is that by making this process more explicit Suggestion in Ch.29 is that by making this process more explicit, it may , it may
be executed better, or by more developers (i.e., making more dev be executed better, or by more developers (i.e., making more developers elopers
“successful”), “successful”),
• • The NPV approach also should improve the ability of the develop The NPV approach also should improve the ability of the development ment
industry to “communicate” project evaluation in the industry to “communicate” project evaluation in the “language of Wall “language of Wall
Street” Street” (e.g., “NPV”, “OCC”). (e.g., “NPV”, “OCC”).
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