Fin 4071011/04/2013

Admin Reading – Linneman chapter 13Short homework assignment development

pro forma; due Wednesday? Eddy Street and future development - master

plan: N:\Private\Fin 40710\F2012\Readings and Miscellaneous\2011.07.01 MASTER.pdf

In the news?

Development Economics(previous slides)

Investment analysis for stabilized properties is relatively straightforward DCF analysis –

Usually you forecast cash flow based on leases and lease turnover Based on end of investment period income (NOI), estimate sale

price of property with simple method (direct capitalization) Discount cash flow to find present value

Cap rate = NOI/(property price); cap rate is similar to interest rate or rate of return (income over cost of investment) Basic idea – cap rates should be similar for similar properties;

observe prices, NOI for similar, recently traded properties and compute cap rate

Use cap rate from “comparables” and NOI from target property to estimate target property value

Development is somewhat different; First, it is much riskierSecond, there is less value in forecasting NOI

out multiple periods because of the lack of lease encumbrances

In development, you have forecasts of stabilized (post development) NOI and total project cost:Compute something like cap ratio: (unlevered)

yield = development cap rate = NOI/project cost;Like market cap, development cap is something of a

rate of return on investmentIf the development cap (think return on project) is

higher than the market cap (think market return on stabilized real estate investment), then the project is a money maker

Development is risky – how much higher does dev. cap have to be?

Good question –it depends on the perceived risks of the project; generally, for a retail development, development cap (yield) is expected to be at least 250-300 bps. higher than the market cap rate

The math – the implied % capital gain (value-added) on the development investment:

Market cap = NOI/price; Dev cap = NOI/cost(Dev cap)/(Market cap) = price/cost = 1 + (price – cost)/cost = 1 +% capital gain

If the yield is 9% and the cap rate is 6%:% capital gain = 9%/6% - 1 = 50%

How does this relate to standard economic

analysis?First, it is just a rule of thumb – we have no

objective measure of the cost of capital, nor do we have a time value of money analysis

Note that debt costs are considered part of the project cost (they are capitalized and included), but that equity capital costs are not included as project costs

The implied investment horizon is the construction and stabilization period (i.e., we are assuming asset sale upon stabilization); will this be in the interests of your capital partner?

Computing rate of returnSuppose that the forecasted development cap is 9% and that

the market cap is 7%; Value/cost is 9%/7% = 128.6%; thus each $1 of cost generates $1.286 in market value; 9%/7% - 1 = 28.6% is the capital gain (value-added);

What is the return on the equity investment in the development project? We need some additional informationSuppose the development is financed with 25% equity capital and

the remainder construction debt; Also suppose that the equity “comes in first” (it is invested before

you receive construction debt funding) and the equity is invested at the start of the project (land take down)

Assume that project takes 3 years from land acquisition (financed with equity) to stabilization and that revenues and operating costs are negligible until stabilization, what is the return on equity (IRR)?

At the end of the 3 year development period, assume we sell the development for $1.286/per dollar of cost,

Debt financing is $.75; leaving $.536 for the equity holders

Solve for IRR: $.25 = $.536/(1+IRR)3; IRR = 29% - what do you think?

Required development returnDevelopers tend to use the development cap/market

cap spread as their metric of valueReturn requirements are often defined in terms of the

spread –Office building spreads are usually at least 200 bps; Retail spreads are usually 250 bps -300 bpsNote: equity IRR is sensitive to the development time

horizon; thus there is usually an implied development period in these spreads (24-36 months)

Question – suppose you were doing a “build-to-suit” in which the building in custom built for a tenant and leases prior to construction; what should the spread be?

Residual land valuationLand is often valued as a residual - essentially

total value of project net of other development costs (including a fair return on costs)

In this spirit, a common way of setting up development pro forma – find the maximum land value consistent with the required dev. cap/market cap spread

Overland Park illustration - N:\Private\Fin 70710\Overland Park Master Proforma 21407 B.xls

Residual land valuationLand is often valued as a residual - essentially

total value of project net of other development costs (including a fair return on costs)

In this spirit, a common way of setting up development pro forma – find the maximum land value consistent with the required dev. cap/market cap spread

Overland Park illustration - N:\Private\Fin 40710\Overland Park Master Proforma 21407 B.xls

Debt financeWhy Borrow?

Shortage of capital – debt is just another form of capital; Debt allows up to stretch our equity capital

Developers are usually project equity investors but are often small organizations with very limited capital;

In the typical development project involving a small developer and an equity capital partner, the developer may be no more than 5% of the equity; if the project can be financed with 75% debt (the good old days), then the developer is responsible for no more than (.25)(.05) = 1.25% of the project cost

Debt allows developers to chase many projects (and the development fees!); developers and their partners can diversify their portfolios

The Joy of leverageYet, even large, well capitalized investors choose

to borrow to finance real estate; Prudential Real Estate Investors (the RE arm of Pru finance) borrows

most common reason to borrow – the chance to make a bundle (high return on equity)Debt capital investors (i.e., lenders) earn a fixed

return, (unless times become really bad in which case they earn less);

Thus, the more debt finance, the fewer dollars of equity to share the upside (also the few dollars to share the downside)

Consider a simple forecast: Rents - $1,000,000 (gross lease – no reimbursements)

Operating expenses - $340,000 (ignore reservable expenses)

NOI = $1,000,000 - $340,000 = $660,000

Purchase price @ 9% cap: = $660,000/.09 = $7,333,333.

Forecasted Return on Assets = ROA = Net income/Assets = $660,000/$7,333,333 = 9% = cap rate

Finance 65% of purchase with 6% 1st mortgage = $4,766,667

Equity investment = $2,566,667

What is return on equity (ROE) = Net income/equity?

Ignoring taxes (assume that the investment is held in an LLC which pays no corporate income tax)

Net Income = Rent – Operating expenses - Interest

= $1,000,000 - $340,000 - $286,000 = $374,000

ROE = $374,000/$2,566,667 = 14.6%;

What happens if you lose a couple of key tenants? Suppose rent drops by $300,000 and operating expense drops only marginally (why?) by $30,000

Net income drops from $374,000 to $104,000ROE = $104,000/$2,566,667 = 4.05%

If there had been no leverage, originally ROE would been 9%; after the drop in income ROE is $370,000/$7,333,333 = 5.05%; note that leverage made things worse (because ROA < 6% = loan interest rate)

Plus, leverage creates return volatility, i.e., risk

The general relationship between leverage and single period ROE

Some general relationships between leverage, equity returns and risk

Consider a simple one period investment with:purchase price = A (for asset)NOI = net operating income (still ignoring

tenant improvement, leasing, cap ex)Debt rate = rD

Return on equity = rE = (equity cash flow)/E Return on assets = (asset cash flow)/A = NOI/A

= α;

Equity cash flow = asset cash flow (NOI) – debt cash flow = αA – rDD;

ROE = (αA – rDD)/E = (αA – rDD)/(A-D); for a given asset, when does an increase in debt, D, cause ROE to be higher?

d(ROE)/dD = -rD/(A-D) + (αA – rDD)/(A-D)2

= A(α – rD)/(A-D)2 this is > 0 when α – rD > 0What this says is that debt is good as long as the return

on assets is greater than the cost of debt; this makes sense; Think of assets as being financed with debt $s and equity $s. Equity receives the return on the $s of assets it finances + the extra return (above the cost of debt) on the assets being financed with debt $s.