Fundamental Skills for Real Estate Development Professionals I

Financial AnalysisWednesday,October 26

9:00 a.m. - 10:15 a.m.

Fundamental Skills for Real Estate Development Professionals IFinancial Analysis 9:00-

10:15Mark J. EppliMarquette UniversityCenter for Real Estate

Site Selection and Due Diligence

10:45-12:00

Charles A. LongPresident, Charles A. Long Properties

Fundamental Skills for Real Estate Development Professionals IIStructuring the Deal to be Profitable

1:00-2:15 Tennyson WilliamsFounder/PresidentTennyson Williams Associates

Project Entitlement 2:45-4:00 David FarmerPrincipalCapital Four Advisors

Real Estate Development Workshops

The Real Estate School Finance Track Curriculum Process

Ability Position ULI Course LevelAnalyze Financial Analyst Finance IDecide Manager Finance IIIntegrate Vice President Advanced FinanceLead President Advanced Finance

The Development Process

Findingthe

Opportunity

Control/Acquire

Land

Design &Public

Approvals

Financing Construction Leasing Payday!

1-5 years

Developer goals for each step of the development process:•Create value•Manage risk

Presentation Outline

• Static cash flow analysis– The income proforma

Determine single period income

– Income proforma ratiosEstimate single period valuation and return

• Dynamic cash flow analysis– Multiple period return

Determines multi-period income

– Holding period expected returnsEstimate total rate of return

• Meeting investor goals and objectives

Concept of Real Estate Valuation

Cap Rate Valuation

Value = Property NOI / Cap Rate

Value = Local Property Markets / Capital Markets

Value = Urban Economic / Financial Economics

Value is created through the local property market and risk is managed with the cap rate.

Property Market Attributes

Important Property Underwriting Characteristics:

– Market – Neighborhood– Site– Improvements– Tenants– Management

Mortgage Underwriting and Lender Ratios

• What do commercial lenders look for?– Asset quality

– Qualitative measures– Property Income

– Lease types– Property income statements

– Cash Flow Adequacy– Debt Coverage Ratio (DCR)

– Collateral Protection– Loan-to-Value Ratio (LTVR)

– Investor Return on Equity (ROE)

Property Income Proforma

Gross Rental Income + Expense Reimbursements

+ Miscellaneous Income Gross Potential Income (GPI)

- Vacancy/Credit Loss Effective Gross Income (EGI)

- Operating Expenses (OE)- Real Estate Taxes (RET)

- Management Fee (MF) Net Operating Income (NOI)

- Tenant Improvements (TI)- Leasing Commissions (LC)- Capital Improvements (CI)

Cash Flow from Operations-Debt Service

Cash Flow After Financing

Cash Flow Adequacy

Debt Coverage Ratio – DCRExpressed as

DCR= Cash From Operations /D.S.

•The DCR measures the riskiness of property cash flows•This ratio usually falls in a range of 1.2 to 1.7

Collateral Protection

Loan-to-Value Ratio - LTVR Expressed as:

LTVR = Loan Amount/Property Value

• How far can the value of the property fall, as a percent of the original loan amount, before the lender’s principal is at risk.

Value of an Property

Capitalization Rate Value: Expressed as:

V = NOI/Cap Rate

•The value of the property is based on the cash flow it generates.

Other Lender Ratio??? Equity Ratio???

Return on Equity (ROE), also called “Cash on Cash”Expressed as

ROE = CFAF/Equity Investment

• Measures productivity of your property as a percentage of your equity investment

• While the equity yield rate is an investor return, it behooves the lender to know how well the borrower is doing

A Second Equity Return Ratio

• Equity Build Up (EBU):– Expressed as

EBU = (Debt Service – Interest) / EquityAlternatively:

EBU = Principal Paid / Equity

– Measures the periodic principal paid down of a loan attributable amortization

An Apartment Income Proforma

Revenue 2012Rent Units RentsOne Bedroom 38 1200 547,200Two Bedroom 64 1685 1,294,080Three Bedroon 6 1985 142,920Underground Parking 128 175 268,800Surface Parking 44 75 39,600Vending & Misc. 51,000 Gross Potential Income 2,292,600Vacancy 5.0% 114,630 Effective Gross Income 2,228,970

ExpensesAdministrative and Management 9.8% 218,439Utilities/ Water/ Rubbish 8.6% 191,691Repairs/ Maintenance/ Supplies 7.2% 160,486Insurance and Fees 2.1% 46,808Real Estate Taxes 16.5% 367,780 Total Expenses 44.2% 985,205NOI 54.25% 1,243,765Capital Expenditures 108 450 48,600NOI after Capital Expenditures 1,195,165

3955 N. Murray Street

Determining the Maximum Loan Amount

Maximum Loan Amount Calculation for 3955 N. Murray StreetLTVR Max Loan AmountCap Rate 6.25%Value 19,900,244LTVR 75%Max LA LTVR 14,925,183

DCR Max Loan AmountDCR 1.3010-Yr UST 2.25%Spread 2.00%Mtg Rate 4.25%Mortgage Constant 5.903%Max Loan Amount 15,573,683

14,925,183Maximimum Loan Amount

Determining the Return to the Equity Investor

Required Equity and Other Costs for 3955 N. Murray StreetRequired EquityEquity Investment in Property $4,975,061Purchase Costs 0.75% $149,252Loan Fees 0.02 0.50% $74,626Acquisition Fee 0.02 0.75% $149,252Immediate Capital Improvements $120,000 $120,000Required Equity $5,468,191

Equity ReturnsNOI 1,195,165Debt Service 881,075Cash Flow After Debt Service 314,090Return on equity 5.74%Equity Build Up 4.51% Total Cash Flow Return and Equity Build Up 10.26%

Property Cap Rates and Premium over U.S. Treasury Securities

Sources: St. Louis Federal Reserve, Mortgage Bankers Association, and Marquette University.

Cap Rate vs. P/E Ratio

Cap rate is the inverse of the P/E ratio

Cap rate P/E Ratio

5% 20

6% 16.7

7% 14.3

8% 12.5

10% 10

Limitations of “Single Number” Value Calculations

• Cash-on-Cash and Income Capitalization Approaches have significant limitations.1. Don’t consider income/expense fluctuations

• Variable cash flows vs. a fixed number• Differential rates of income and expense

growth2. Adjustment for risk is a blunt instrument3. Don’t fully consider effects of leverage4. Don’t explicitly consider value appreciation5. Don’t consider tax shelter benefits

So Let’s Look at Total Investment Return

Risk Premium (Based on investment risk: 1 - 7%)

Real Rate of Return (Expected 0.25%, historic +/-2.0%)

Inflation Premium (Expected: 2.0%)

Total Investment Return

Let’s Look to Finance Theory for Some Return Insights

Total Return Stocks = Dividend Yield + growth rate

Total Return Stocks = Dividend / Price + growth rate

9.0% = 2.5% + 6.5%

Total Rate of Return on Real Estate

Total Return = IRR RE = Cap Rate + growth rate

Total Return = IRRRE = NOI / Property Price + growth rate

9.0% = 7.0% + 2.0%

2020202020192019

20182018

20172017

Discounted Cash Flow Analysis

• Measures the present value of the income stream to be generated by the property over the life of the investment

20162016

20152015

20142014

20132013

2012201220112011

Discounted Cash Flow Analysis

• Discounted Cash Flow analysis is the only really valid way to measure project return– Fully accounts for the time value of money– Allows for variable cash flows– Allows for differential growth rates of income and

expense components– Allows explicit & discrete inclusion of tax benefits and

value appreciation (through reversionary value)– Allows incorporation of cash flows pre- AND post-

construction• Yields two key benchmarks

– Net Present Value– Internal Rate of Return

Net Present Value (NPV)

• The value (in terms of today’s dollars) of all future cash flows, positive and negative, from the project as discounted by the required rate of return (aka discount or hurdle rate), minus the cost of acquiring the property.

1 2 3 4

($100.00) ($100.00)$5.36 $6.00$5.58 $7.00$5.69 $8.00

$69.91 $110.00($13.46) = NPV (sum of all PV's)

Income for each periodPresent Value @ i = 12%

Initial investment

Internal Rate of Return (IRR)

• The discount rate (stated as a percentage) at which the present value of future cash flows is exactly equal to the initial capital investment

• i.e.; rate of return where NPV = 0• In this example the IRR of the cash flows is 7.63%

1 2 3 4

($100.00) ($100.00)$5.57 $6.00$6.04 $7.00$6.42 $8.00

$81.97 $110.00$0.00 = NPV (sum of all PV's)

Income for each periodPresent Value @ i = 7.63%

Initial investment

Lets Look at An Office Property Investment

Gateway Business Center -- Unlevered                         

  Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11POTENTIAL GROSS REVENUE                         Base Rental Revenue   $601,403 $631,674 $637,083 $650,476 $661,633 $661,651 $675,565 $679,004 $673,158 $643,616 $650,797 Absorption & Turnover Vacancy       (12,740) (5,988) (4,998) (10,350) (10,704) (7,207) (70,218) (6,300) (14,609) Base Rent Abatements       (4,459) (2,096) (1,749) (3,623) (3,746)   (25,976) (2,430) (6,128)

Scheduled Base Rental Revenue   601,403 631,674 619,884 642,392 654,886 647,678 661,115 671,797 576,964 634,886 630,060

CPI & Other Adjustment Revenue         191 2,580 6,103 11,178 17,917 14,687 19,382 29,091                          

Expense Reimbursement Revenue                         CAM & Utilies   32,055 36,719 36,721 39,061 40,770 41,771 43,855 45,572 46,659 62,719 63,602 Insurance   5,193 5,888 5,889 6,237 6,491 6,642 6,952 7,207 7,231 9,347 9,478 Real Estate Taxes   45,712 54,120 54,123 58,345 61,427 63,232 66,990 70,086 76,072 113,092 114,684 Mang. Fee   17,326 18,905 18,102 19,427 20,227 20,062 21,241 21,963 20,855 32,266 32,340 Total Reimbursement Revenue   100,286 115,632 114,835 123,070 128,915 131,707 139,038 144,828 150,817 217,424 220,104                          TOTAL POTENTIAL GROSS REVENUE 701,689 747,306 734,719 765,653 786,381 785,488 811,331 834,542 742,468 871,692 879,255 General Vacancy     (52,311) (39,582) (48,027) (50,399) (45,359) (46,838) (51,715)   (55,159) (47,961)EFFECTIVE GROSS REVENUE   701,689 694,995 695,137 717,626 735,982 740,129 764,493 782,827 742,468 816,533 831,294

OPERATING EXPENSES                         CAM & Utilies   48,658 50,118 51,621 53,170 54,765 56,408 58,100 59,843 61,638 63,488 65,392 Insurance   7,251 7,469 7,693 7,923 8,161 8,406 8,658 8,918 9,185 9,461 9,745 Real Estate Taxes   87,737 90,369 93,080 95,873 98,749 101,711 104,763 107,905 111,143 114,477 117,911 Mang. Fee   28,068 27,800 27,805 28,705 29,439 29,605 30,580 31,313 29,699 32,661 33,252 TOTAL OPERATING EXPENSES   171,714 175,756 180,199 185,671 191,114 196,130 202,101 207,979 211,665 220,087 226,300                          NET OPERATING INCOME   529,975 519,239 514,938 531,955 544,868 543,999 562,392 574,848 530,803 596,446 604,994                          LEASING & CAPITAL COSTS                         Tenant Improvements   95,460   40,942 19,337 16,220 33,753 23,049   178,145 23,089   Leasing Commissions   11,539   10,199 4,794 4,001 8,286 10,316   69,116 5,559   Capital Reserves   7,251 7,469 7,693 7,923 8,161 8,406 8,658 8,918 9,185 9,461  

TOTAL LEASING & CAPITAL COSTS   114,250 7,469 58,834 32,054 28,382 50,445 42,023 8,918 256,446 38,109                           CASH FLOW BEFORE DEBT SERVICE $415,725 $511,770 $456,104 $499,901 $516,486 $493,554 $520,369 $565,930 $274,357 $558,337  Return on Equity   6.30% 7.75% 6.91% 7.57% 7.83% 7.48% 7.88% 8.57% 4.16% 8.46%  Equity Investment $6,600,000                      Property Sale                     $7,562,425  Sale Transcation Costs                     $151,249  Net Sale Proceeds                     $7,411,177  Property Cash Flows ($6,600,000) $415,725 $511,770 $456,104 $499,901 $516,486 $493,554 $520,369 $565,930 $274,357 $7,969,514  Internal Rate of Return 8.12%                      

We can Analyze the Property with and without Debt

Gateway Business CenterInvestment Analysis using Different Investment Cash Flow and Sale Return Splits

I. IRR -- Unleveraged Investment                    

  0 1 2 3 4 5 6 7 8 9 10Property Purchase 6,600,000                   Cash Flow   415,725 511,770 456,104 499,901 516,486 493,554 520,369 565,930 274,357 558,337Property Sale                     7,411,177Property Cash Flows -6,600,000 415,725 511,770 456,104 499,901 516,486 493,554 520,369 565,930 274,357 7,969,514Return on Equity   6.30% 7.75% 6.91% 7.57% 7.83% 7.48% 7.88% 8.57% 4.16% Internal Rate of Return 8.12%                    

II. IRR -- Leveraged Investment                    Loan to Value Ratio 75.76%                   Loan Amount (calculated) 5,000,000                   Interest Rate (interest Only) 6.50%                     0 1 2 3 4 5 6 7 8 9 10Loan Amount 5,000,000                   Property Cash Flows -6,600,000 415,725 511,770 456,104 499,901 516,486 493,554 520,369 565,930 274,357 7,969,514Debt Service   -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000Mortgage Balance                     -5,000,000Property Cash Flows -1,600,000 90,725 186,770 131,104 174,901 191,486 168,554 195,369 240,930 -50,643 2,644,514Return on Equity   5.67% 11.67% 8.19% 10.93% 11.97% 10.53% 12.21% 15.06% -3.17% Internal Rate of Return 12.45%                   

Sponsors can Provide Investor Preferred Cash Flow Returns

III. IRR -- Leveraged Investment and Equity Investor    

Required Investment  

-6,600,00

0   Equity Investor Preferred Return on Cash flow     8.00%  Mortgage Amount  

5,000,000   

Equity Investor Percent of Cash Flow after Preferred Rtn   60.00% 

Equity Investor Amount  

1,200,000   

Equity Investor Percent of Sale Proceeds     50.00%  Developer     400,000     0 1 2 3 4 5 6 7 8 9 10Cash Flows   415,725 511,770 456,104 499,901 516,486 493,554 520,369 565,930 274,357 558,337

Debt Service   -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000-

325,000 -325,000Cash Flow After Debt Service   90,725 186,770 131,104 174,901 191,486 168,554 195,369 240,930 -50,643 233,337                       Equity Investor Position                      Cash Flow Preferred Return   90,725 96,000 96,000 96,000 96,000 96,000 96,000 96,000 0 96,000Arrears Cash Flow Preferred Return     5,275 0 0 0 0 0 0 0 96,000Cash Flow Split   0 32,097 1,862 28,141 38,092 24,332 40,421 67,758 0 3,171Return of Investment                     1,200,000Reversion Split                     380,267

Equity Investor Proceeds-

1,200,000 90,725 133,372 97,862 124,141 134,092 120,332 136,421 163,758 0 1,775,438Return on Equity   7.56% 11.11% 8.16% 10.35% 11.17% 10.03% 11.37% 13.65% 0.00%  IRR for Equity Investor 11.63%                                          Developer Position                      Cash Flow Return   0 32,000 32,000 32,000 32,000 32,000 32,000 32,000 -50,643 36,051Cash Flow Split   0 21,398 1,242 18,760 25,394 16,222 26,948 45,172 0 2,114Return of Investment                     450,643Reversion Split                     380,267Developer Proceeds -400,000 0 53,398 33,242 50,760 57,394 48,222 58,948 77,172 -50,643 869,076

Return on Equity   0.00% 13.35% 8.31% 12.69% 14.35% 12.06% 14.74% 19.29%-

12.66% IRR 14.55%                   

Sponsors can Also Provide Preferred Total Rates of Return

IV. IRR -- Leveraged Investment and Equity Investor with an IRR Lookback Rate of:   12.00%     Equity Investor Position 0 1 2 3 4 5 6 7 8 9 10Cash Flow Preferred Return   90,725 101,275 96,000 96,000 96,000 96,000 96,000 96,000 0 192,000Cash Flow Split   0 32,097 1,862 28,141 38,092 24,332 40,421 67,758 0 3,171Return of Investment   0 0 0 0 0 0 0 0 0 1,200,000Reversion Split   0 0 0 0 0 0 0 0 0 465,000Equity Investor Proceeds -- with Lookback

-1,200,000 90,725 133,372 97,862 124,141 134,092 120,332 136,421 163,758 0 1,860,171

Equity Investor IRR Look back to: 12.00%                   Reversion Split after 12% IRR lookback                   73,767

Equity Investor Proceeds -

1,200,000 90,725 133,372 97,862 124,141 134,092 120,332 136,421 163,758 0 1,933,938Equity Investor IRR 12.30%                                          Developer Position                      Cash Flow Return   0 32,000 32,000 32,000 32,000 32,000 32,000 32,000 -50,643 36,051Cash Flow Split   0 21,398 1,242 18,760 25,394 16,222 26,948 45,172 0 2,114Return of Investment   0 0 0 0 0 0 0 0 0 450,643Reversion Split   0 0 0 0 0 0 0 0 0 148,000Developer Proceeds -400,000 0 53,398 33,242 50,760 57,394 48,222 58,948 77,172 -50,643 636,809Developer IRR 12.00%                   Reversion Split after 12% IRR lookback                   73,767Developer Proceeds -400,000 0 53,398 33,242 50,760 57,394 48,222 58,948 77,172 -50,643 710,576Developer IRR 12.88%                   

Equity

• Total target return varies by sector.

• Preferred return 6%-9%

• Usually 9% to 12% "target" total annual return.

• Developer usually must co-invest about 10% of equity.

The Equity Property Sale Waterfall

After debt, cash flow pays

1. Return of principal to investors then sponsors

2. A preferred return of 8% to 12% to investors

3. A promotional return to achieve target, with some return to developer.

4. After target is reached, higher return to developer.

Investor Target Returns: Each use is different

Anchor TenantTiming of sale or leaseTarget IRR*Sector

OccasionalLease up after construction7-12%Industrial

DesirablePre-leasing usually req’d7-12%Retail

DesirablePre-leasing desirable7-12%Office

NoneLease-up after construction7.5-11%Multi-family

NonePre-sales for each phase8-20%For-sale residential

Depends on phaseWith phasing20-30%Land Development

*Unleveraged Internal Rate of Return. Higher leverage increases return on equity.

So…

• How much debt should we use?

What is Our Incremental Cost of Debt?

Incremental Cost of FundsAssumptionsLoan Amortization Term 30 30 30Prepayment Year 10 10 10Property Value $30,000 $30,000 $30,000LTVR 70.00% 75.00% 80.00%Loan Fees 0.50% 0.75% 1.25%Incremental Closing Costs 0 100 250UST10 2.25% 2.25% 2.25%Spread 1.80% 2.20% 2.60% Mortgage Interest Rate 4.05% 4.45% 4.85%

Loan and Borrower Cost InformationLoan Amount 21,000 22,500 24,000Points and Increment Costs 105 269 550Funds Disbursed 20,895 22,231 23,450Debt Service 101 113 127Outstanding Loan Balance 16,573 17,991 19,433Borrower Cost of Funds 4.12% 4.61% 5.17%

Incremental Cost of FundsIncremental New Funds 1,336 1,219Incremental Debt Service 12 13Incremental Outstanding Loan Balance 1,419 1,442Incremental Cost of Funds   11.53% 13.96%

Presentation Take Aways

• Real estate investment is about risk and return

• Property markets provide return, discount rates assess risk

• Property NOI includes only income from operations

• Cap rate valuation explicitly measures only cash flow return

• DCF analysis explicitly measures many factors

• Risk and return can be allocated

Fundamental Skills for Real Estate Development Professionals I

Financial AnalysisWednesday,October 26

9:00 a.m. - 10:15 a.m.