REFM's How Developers Price The Dirt

Instruc(on by Bruce Kirsch Principal, Real Estate Financial Modeling

Copyright © 2012 by Real Estate Financial Modeling, LLC. All Rights Reserved.

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Real Estate Financial Modeling’s

How Real Estate Developers Price The Dirt: Residual Land Valua>on and Comparable Sales

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Real Estate Financial Modeling – Model For Success

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To What Extent Can The Developer Control The Following?

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•  Hard Costs •  Global Commodi(es Prices •  Construc(on Labor Costs

•  SoO Cost Service Provider Costs

•  Cost of Construc(on Debt

•  Investor Returns Requirements

•  Land Cost


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•  Hard Costs – Very Licle •  Global Commodi(es Prices •  Construc(on Labor Costs

•  SoO Cost Service Provider Costs – Licle

•  Cost of Construc(on Debt – Licle

•  Investor Returns Requirements – Licle

•  Land Cost – Poten>ally More Than A Licle



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•  Hard Costs – Very Licle •  Global Commodi(es Prices •  Construc(on Labor Costs

•  SoO Cost Service Provider Costs – Licle

•  Cost of Construc(on Debt – Licle

•  Investor Returns Requirements – Licle

•  Land Cost – Poten>ally More Than A Licle



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How Is Land Different From Other Development Costs?

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•  No site receives a constant, high volume of purchase offers every month of every year •  Every site is unique with respect to loca(on, and physically, and sites oOen have zoning restric(ons limi(ng the allowable uses that can exist on the site

•  Because the real estate market operates within a cycle


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In Other Words…

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•  Land is the ul>mate illiquid asset

•  Land sellers should feel very lucky when they get a offer that would actually go to closing at the price offered!


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Residual Land Valua>on Basics

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•  Developers use residual land valua(on as one method of deciding what to pay for a development site

Element

Estimated Incomeless Estimated Cost excl. Landless Required Equity Return= Residual Land Value


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Element

Estimated Income What can I build? What can I get in income (rent/sales)?less Estimated Cost excl. Land What will it cost me in total to build, operate and lease up/sell out?less Required Equity Return What pre-‐tax margin do I and my investors need to make? *= Residual Land Value This is what the land is worth for the contemplated project

* For income-‐producing properties, this is measured as Yield on Cost: NOI / Total Project Cost For unit-‐sales projects, this is measured as Profit Margin: Net Cash Flow / Gross Sales Proceeds

Developer's Internal Monologue


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Residual Land Valua>on Process

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•  First pass: Back Of The Envelope analysis (also known as a “sta(c” analysis, meaning that we are not taking the passage of (me into account). •  Make inputs for all variables, including Land Cost •  Make changes to Land Cost input un(l the target returns

thresholds are met (i.e., the economics of the project work).

•  If this Land Cost is not something you think the land seller will entertain as the purchase price, move on to evalua(ng the next site.

•  If the Land Cost is something that you think the land seller will entertain, proceed to running a mul>-‐year projec>on model, also known as a pro-‐forma, that will allocate project costs and asset-‐generated income over (me, and use the Net Present Value and Internal Rate of Return measurements to fine-‐tune the amount which you will offer as the land Purchase Price.


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Residual Land Valua>on Process

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Back Of The

Envelope Analysis

Iterate By Changing Variables

Promising?

Run DCF Analysis


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Residual Land Valua>on Process – DCF Analysis

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Property Address % Total $/Unit $/GSF TotalLot Square Footage 14,000 SF Land and Acquisition Costs 16.82% $96,154 $59.52 $3,750,000Allowable FAR 4.5 FAR Hard Costs excl. Contingency 53.83% $307,692 $190.48 $12,000,000Total Above-Grade Gross SF Stories 8 Stories Addt'l Market Rate Unit Finishes 1.10% $6,282 $3.89 $245,000Retail A 4,000 GSF Hard Costs Contingency 5.49% $31,397 $19.44 $1,224,500Retail B 4,000 GSF Total Retail Land and Total Base Building Hard Costs 60.43% $345,372 $213.80 $13,469,500Retail C 4,000 GSF 12,000 GSF Retail Tenant Improvements and Leasing Commissions 1.77% $395,200Residual Gross Square Feet of Residential 51,000 GSF Soft Costs incl. Contingency 13.46% $76,923 $47.62 $3,000,000Salable Square Feet of Residential 43,350 SSF Total Units Developer Fee 2.77% $15,857 $9.82 $618,441Residential Units * Affordable 4 Units Market Rate 35 Units 39 Units FF& E 0.45% $2,564 $1.59 $100,000

Average SF 525 SF Average SF 775 SF 749 SF Financing Costs excl. any Operating Deficit 4.29% $24,547 $15.20 $957,323Podium/Garage Parking 48 Spaces Total Uses of Funds 100.00% $571,550 $347.54 $22,290,464Surface Parking 0 Spaces Operating Deficit (including Deficits Paid by Cash Flow) $0Number of Storage Units 30 Units Total Uses of Funds with Operating Def. $353.82 $22,290,464* See Unit Mix and Pricing Tab Total Uses of Funds including Deficits funded by Property Cash Flow $22,663,107

Value Value Month # DateAnalysis Start Date Mo. 1 11/1/2011 % of Developer % of Total Initial Share of any % of Total EquityDate of Land Contract Execution 1/1/2012 Equity Equity Equity Investment Deficits * Cost w/DeficitsLand Deposit Date 1/1/2012 Sponsor/Developer 25.00% 4.17% $200,000 $18,392 $218,392Land Closing Date 4/1/2013 Equity Partner (if Any) 75.00% 12.50% $600,000 $55,177 $655,177# Months of Pre-Construction After Analysis Start 24 Months Third Party Investor 83.33% $4,000,000 $367,850 $4,367,850# of Months of Pre-sale Closings 2 Months Sponsor Land Equity Contribution 0.00% $0 $0 $0Construction Duration/Construction Start 12 Months Mo. 25 2/1/14 Equity Total 100.00% $4,800,000 $441,420 23.51% $5,241,420

Pre-Sales Begin Mo. 0 NA Debt Closing Date % of TotalPre-Sales Duration/End Month 0 Months Mo. 0 NA Land Loan 4/1/2013 9.0% Interest Cost $300,000

Pre-Sales % Sold/Velocity/# Units 0% 0 Un its /Mo . 0 Units Mortgage Recording Tax 1.00%Origination Cost - Paid in Cash 1.00%

Market Sales Velocity/Begin 5/Month Mo. 35First C of O Received Mo. 35 9/1/14 Mezzanine Loan 1/1/2014 12.0% Interest 8.97% $2,000,000Sales Through the Month Prior to First C of O 0% Total 0 Units Mezzanine Loan Broker Fee 1.00%

Sales Duration/Velocity 35 Months 0/Month Loan Fees - Front End 1/1/2014 1.00%Final C of O Received/End of Construction Mo. 37 11/1/14First Move-Ins Mo. 36 9/1/14 Senior Loan ** 2/1/2014 5.0% Interest 67.51% $15,049,045Sales After First C of O 100% Total 35 Units Mortgage Recording Tax 1.25%

Sales Duration/Velocity 9 Months 3.89/Month Loan Fees - Front End 0.25%Loan Fees - At Draws 1.00%

Market Sales Velocity/ Completion Timing 4.88/Month Mo. 43 5/1/15Sell Out # Months from First C of O / Total Sell Out Period 8 Months 52 Months Debt Total (excludes any Land Loan) 76.49% $17,049,045

Total Sources of Funds (excludes any Land Loan) 100.00% $22,290,464

DEVELOPMENT SOURCES OF FUNDS

3.00% of Land/Hard/Soft

123 Main Street, Chicago, ILCondominium Building Development Assumptions - 4/9/2012

DEVELOPMENT USES OF FUNDSBUILDING INFORMATION123 Main Street, Chicago, IL

63,000 GSF

6.00% Deposit

10.00%$7,000/Unit Premium

Current PMTs

85.0% Efficiency

PROJECT TIMING AND SALES VELOCITY ASSUMPTIONS

Sample REFM Excel Model Template


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Residual Land Valua>on Process – DCF Analysis

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Sample REFM Excel Model Template

Residential Units Average SF Existing Rental Property Annual NOI $0Pre-Sale (All Market) 0 Units $0 $0 PSF 775 SSF Annual Growth Rate 1.00%Market Rate 35 Units $525,000 $677 PSF 775 SSF Annual Inflation Rate for Operating Expenses/Deficit 3.00%Affordable 4 Units $300,000 $571 PSF 525 SSF Annual Operating Expenses/Unit after First C of O $5,000Total 39 Units Real Estate Taxes on Residential Units

Blended Non Pre-Sales * $501,923 $670 PSF 749 SSF Average Assessed Value $400,000* Market & Affordable Tax Rate 1.27%

Annual Real Estate Taxes/Unit after First C of O $5,080Revenue Deposit Amount 5.00% AmountResidential Units Excluding Options Pre-Sales Discount 10.00% $19,575,000Options Income All Units $10,000/Unit $390,000Podium/Garage Parking 48 Spaces $40,000 $1,920,000Surface Parking 0 Spaces $0 $0Storage Units 30 Units $5,000 $150,000Gross Revenues $22,035,000 Equity Investment $200,000 $600,000 $4,000,000 $4,800,000Selling Costs 5.00% ($1,101,750) Net Return on Equity $356,293 $105,682 $1,396,870 $1,753,163Total Residential Component Revenues, Net $20,933,250 Multiple on Equity 1.41x 1.38x 1.32x 1.33x

IRR 10.30% 9.88% 11.56% 11.27%NPV off of Monthly CFs 8.00% $403,407

NNN Rent TI Allowance TI Start Month # TI Schedule IRR Kicker Return Hurdle 1.00%Retail A $25.00 $15.00 Month 24 2 Months Land Owner Participation % 0.00%Retail B $20.00 $25.00 Month 26 3 MonthsRetail C $32.00 $35.00 Month 28 2 Months

Leasing Commissions TermRetail A 4.00% 7 YearsRetail B 4.00% 5 YearsRetail C 4.00% 10 YearsLC Payment Lead Time * 3 Months* # of months prior to TI Start Month

NOI Start Month Sale of Retail in Month Month 52Retail A Month 26 Cap Rate at Sale 9.00%Retail B Month 29 Selling Costs 4.00%Retail C Month 30 Retail Condo. Net Proceeds $3,319,982

Third Party Investor

Total Project

NOTES

RETURNS (CALCULATED OFF OF MONTHLY CASH FLOWS)

RESIDENTIAL COMPONENT REVENUES

123 Main Street, Chicago, ILCondominium Building Revenue and Operating Assumptions - 4/9/2012

BUILDING OPERATING ASSUMPTIONS

Average Price

RETAIL COMPONENT INCOME, TI AND LC ASSUMPTIONS

Sponsor/Developer

Equity Partner


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Element


Element

Estimated Incomeless Estimated Costless Residual Land Value= Required Equity Return


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Element


Element



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Element


Element



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Element


Element


How Our Back Of The Envelope Models Work


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How Our Back Of The Envelope Models Work

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Element



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Example 1: Office Building

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ValueWhat Can I Build? What Is Required?Lot Square Footage 25,000 SFTotal Allowable FAR 8.0 FAR 200,000 FARLess Retail Square Footage 12,000 SFResidual Office GSF 188,000 GSFRentable Office SF 91% Efficiency 171,080 RSFRequired Parking Spots per 1,000 RSF 1.20 205 spots

What Could I Generate In Net Operating Income?Average Annual Rent PSF Full Service -‐ today's value $65.00 PSFAverage Monthly Parking Rent per Spot -‐ today's value $200.00

Gross Potential Annual Operating Income -‐ Office $11,120,200Gross Potential Annual Operating Income -‐ Parking $492,710Less Annual Vacancy 5.00% ($580,646)Total Annual Revenue, Net $11,032,265

AnnualOperating Expenses -‐ today's value $17.00 PSF ($2,908,360)Real Estate Taxes -‐ today's value $15.00 PSF ($2,566,200)Total Operating and Taxes $32.00 PSF ($5,474,560)

Retail Component NNN Rent -‐ today's value $35.00 $420,000

"Current" Stabilized Net Operating Income (NOI) $5,977,705


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How Long Would It Take To Build And Stabilize? / What Would It Cost To Develop?Pre-‐Construction Duration 18 monthsConstruction Schedule 24 monthsPost-‐Construction Lease-‐Up Duration 21 monthsTotal Project Timeline 63 months

% TPCBase Building Hard Cost & Contingency -‐ today's value $225.00 PSF 45.7% $45,000,000Office Tenant Improvements (TIs) and LCs -‐ today's value $50.00 PSF 8.7% $8,554,000Retail TIs and LCs -‐ today's value $25.00 PSF 0.3% $300,000Soft Cost % Hard Costs, Contingency & TIs 35.00% 19.2% $18,848,900Senior Construction Loan to Total Project Cost 65.00%Construction Loan Interest and Operating Deficit 6.00% 12.4% $12,186,935Land Cost $67.50/FAR 13.7% $13,500,000Total Project Cost (TPC) 100.0% $98,389,835Per GSF $492

"Current" Stabilized NOI Yield on Cost (Cap Rate) 6.08%

How Would I Fund It?Senior Construction Loan Amount 65.00% $63,953,393Mezzanine Loan Amount 20.00% $19,677,967Required Equity Amount 15.00% $14,758,475

$98,389,835


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Income Annual Inflation Factor 3.00%Expenses, Taxes & CapEx Annual Inflation 3.00%Years to Stabilization 6.00 years

Annual Capital Expenditures Budget per Office RSF $0.30

Future Stabilized NOI after CapEx for Valuation $7,288,701Future Stabilized Yield on Cost (Cap Rate) 7.41%

Asset Sale Capitalization Rate 6.00%Future Gross Capitalized Value $121,478,349Selling Costs 4.00% ($4,859,134)Sale Proceeds, Net $116,619,215Pre-‐Tax Profit on Sale (excludes interim year cash flows) $18,229,380Pre-‐Tax Profit Margin (excludes interim year cash flows) 18.53%Multiple on Invested Equity (excludes interim year cash flows) 2.24x

> Go To Excel


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Example 2: Residen>al Condominiums

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What Can I Build? What Is Required?Ratio Value

Lot Acreage 3.00 acresMaximum Allowable Residential Units 50.0 units/acre 150 unitsParking Spots -‐ Greater of Zoning and Market 1.20/unit 180 spots

Average Unit Size -‐ Affordable Units 650 SFAverage Unit Size -‐ Market Rate Units 800 SF

Required Affordable Unit Percentage 8% of units 12 unitsResidual Market Rate Units: 138 units


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What Could I Generate In Income?Duration Rate

Market Rate Product Pre-‐Sold 10% 14 units 3 months 5 units/mo.Market Rate Product Sold in Regular Sales 124 units 15 months 8 units/mo.Total Residential Units 150 unitsStorage Units 50 units

10% DiscountResidential Component Sales Price Schedule Pre-‐Sold Regular Market Affordable Gross Proceeds

Residential Units $450,000 $500,000 $175,000 $70,400,000$563 PSF $625 PSF $269 PSF

Parking Spaces $36,000 $40,000 $7,128,000Storage $4,500 $5,000 $247,500

Selling Costs 4.00% ($3,111,020)Net Proceeds $74,664,480

Per Condominium Unit $497,763Retail Condominium ComponentRentable SF 12,000 SFAnnual NNN Rent PSF $35.00 PSF Annual Rent $420,000Retail Cap Rate at Sale 8.00%Selling Costs 3.00%Retail Net Proceeds $5,092,500

Total Net Proceeds, Residential and Retail Combined $79,756,980


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How Long Would It Take To Build And Stabilize? / What Would It Cost To Develop?End Date

Pre-‐Construction Period (starts at Today's Date) 15 months 6/6/2013Construction Schedule 20 months 2/6/2015Post-‐Construction Sales Period ("Regular" Sales) 15 months 5/6/2016Total Project Timeline Through Final Unit Closing 50 months

Average % TPCBase Building Hard Cost & Contingency $200,000/unit $250.00 PSF $30,000,000 48.8%Retail Tenant Improvements $55.00 PSF $660,000 1.1%Soft Costs % Hard Cost & Contingency & TIs 35.00% $10,731,000 17.5%Senior Construction Loan to Total Project Cost 65.00%Construction Loan Interest & Operating Deficit 6.00% $6,600,643 10.7%Land Cost $90,000/unit $13,500,000 22.0%Total Project Cost (TPC) $61,491,643 100.0%Per Condominium Unit $409,944


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How Would I Fund It?Construction Loan Proceeds $39,969,568 65.0%Equity Required $21,522,075 35.0%Total Sources of Funds $61,491,643 100.0%

Pre-‐Tax Profit $18,265,337Profit Margin 23.48%Multiple on Invested Equity 1.85x


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Comparable Sales Method

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•  The other method of development site valua(on is the Comparable Sales (“Comps”) method

•  What similar sites have traded recently, and at what price? •  “Similar” means: •  Same uses allowed •  Same submarket •  Similarly-‐sophis(cated buyer and seller

•  Where do you get land comps?

•  Can you trust them?


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Residual Valua>on And Comparable Sales Method

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•  Residual valua(on and comparable sales should be used in concert with one another …Neither is “right” or “wrong”

•  Use them as a sanity check against one another


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REFM's How Developers Price The Dirt