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Fundamental Skills for Real Estate Development Professionals I – Financial Analysis (Mark Eppli) - ULI Fall Meeting 102611

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  • Financial Analysis 9:45 – 11:00 a.m. Learn step-by-step the process for developing the skills necessary to critically analyze a development project. The session will cover projecting and analyzing return on investment, the use of leverage, mortgage types and uses, and pro forma building and analysis. Site Selection and Due Diligence – 11:30-12:45 The importance of insuring a sufficient due diligence period, securing the appropriate team members, and performing a thorough effort cannot be overstated. These steps provide the developer with the final opportunity to rescind the transaction before closing on the purchase. Learn how to avoid post-closing conditions that could destroy the viability and profitability of a project. Structuring the Deal to be Profitable 1:30 – 2:45 The way a transaction is structured at the outset has a direct impact on the profitability of a project. The probability of achieving the project's financial goals can be enhanced by the way in which the deal is structured. This session will teach you the key elements involved in structuring the successful development project. Project Entitlement 3:00 – 4:15 Entitlement includes project permitting, growth management and land use regulations, as well as such concepts as sustainable development, smart growth, green development, and compact urban mixed-use development. The entitlements process may be the most rapidly changing part of the real estate development process today. Everyone in the development field, regardless of their experience, needs updating on a regular basis.
  • December 1&2, 2008 San Francisco Crafting Successful Public Private Parnerships
  • December 1&2, 2008 San Francisco Crafting Successful Public Private Parnerships
  • December 1&2, 2008 San Francisco Crafting Successful Public Private Parnerships
  • Transcript

    • 1.
      • Fundamental Skills for Real Estate Development Professionals I
      • Financial Analysis
      • Wednesday, October 26
      • 9:00 a.m. - 10:15 a.m.
    • 2. Real Estate Development Workshops Fundamental Skills for Real Estate Development Professionals I Financial Analysis 9:00-10:15 Mark J. Eppli Marquette University Center for Real Estate Site Selection and Due Diligence 10:45-12:00 Charles A. Long President, Charles A. Long Properties Fundamental Skills for Real Estate Development Professionals II Structuring the Deal to be Profitable 1:00-2:15 Tennyson Williams Founder/President Tennyson Williams Associates Project Entitlement 2:45-4:00 David Farmer Principal Capital Four Advisors
    • 3. The Real Estate School Finance Track Curriculum Process
      • Ability Position ULI Course Level
      • Analyze Financial Analyst Finance I
      • Decide Manager Finance II
      • Integrate Vice President Advanced Finance
      • Lead President Advanced Finance
    • 4. The Development Process Finding the 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
    • 5. Presentation Outline
      • Static cash flow analysis
        • The income proforma
          • Determine single period income
        • Income proforma ratios
          • Estimate single period valuation and return
      • Dynamic cash flow analysis
        • Multiple period return
          • Determines multi-period income
        • Holding period expected returns
          • Estimate total rate of return
      • Meeting investor goals and objectives
    • 6. 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.
    • 7. Property Market Attributes
      • Important Property Underwriting Characteristics:
        • Market
        • Neighborhood
        • Site
        • Improvements
        • Tenants
        • Management
    • 8. 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)
    • 9. 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
    • 10. Cash Flow Adequacy
      • Debt Coverage Ratio – DCR
      • Expressed 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
    • 11. 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.
    • 12. 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.
    • 13. 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
    • 14. A Second Equity Return Ratio
      • Equity Build Up (EBU):
        • Expressed as
        • EBU = (Debt Service – Interest) / Equity
        • Alternatively:
        • EBU = Principal Paid / Equity
        • Measures the periodic principal paid down of a loan attributable amortization
    • 15. An Apartment Income Proforma
    • 16. Determining the Maximum Loan Amount
    • 17. Determining the Return to the Equity Investor
    • 18. Property Cap Rates and Premium over U.S. Treasury Securities Sources: St. Louis Federal Reserve, Mortgage Bankers Association, and Marquette University.
    • 19. 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
    • 20. Limitations of “Single Number” Value Calculations
      • Cash-on-Cash and Income Capitalization Approaches have significant limitations.
        • Don’t consider income/expense fluctuations
          • Variable cash flows vs. a fixed number
          • Differential rates of income and expense growth
        • Adjustment for risk is a blunt instrument
        • Don’t fully consider effects of leverage
        • Don’t explicitly consider value appreciation
        • Don’t consider tax shelter benefits
    • 21. So Let’s Look at Total Investment Return Total Investment Return
    • 22. 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%
    • 23. Total Rate of Return on Real Estate
      • Total Return = IRR RE = Cap Rate + growth rate
      • Total Return = IRR RE = NOI / Property Price + growth rate
      • 9.0% = 7.0% + 2.0%
    • 24. Discounted Cash Flow Analysis
      • Measures the present value of the income stream to be generated by the property over the life of the investment
      2020 2019 2018 2017 2016 2015 2014 2013 2012 2011
    • 25. 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
    • 26. 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.
    • 27. 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%
    • 28. 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 11 POTENTIAL 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%                      
    • 29. We can Analyze the Property with and without Debt Gateway Business Center Investment Analysis using Different Investment Cash Flow and Sale Return Splits I. IRR -- Unleveraged Investment                       0 1 2 3 4 5 6 7 8 9 10 Property Purchase 6,600,000                     Cash Flow   415,725 511,770 456,104 499,901 516,486 493,554 520,369 565,930 274,357 558,337 Property Sale                     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 Return 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 10 Loan 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 7,969,514 Debt Service   -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 -325,000 Mortgage Balance                     -5,000,000 Property Cash Flows -1,600,000 90,725 186,770 131,104 174,901 191,486 168,554 195,369 240,930 -50,643 2,644,514 Return 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%                    
    • 30. Sponsors can Provide Investor Preferred Cash Flow Returns III. IRR -- Leveraged Investment and Equity Investor     Required Investment   -6,600,000     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 10 Cash 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 -325,000 Cash 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 96,000 Arrears Cash Flow Preferred Return     5,275 0 0 0 0 0 0 0 96,000 Cash Flow Split   0 32,097 1,862 28,141 38,092 24,332 40,421 67,758 0 3,171 Return of Investment                     1,200,000 Reversion 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 1,775,438 Return 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 36,051 Cash Flow Split   0 21,398 1,242 18,760 25,394 16,222 26,948 45,172 0 2,114 Return of Investment                     450,643 Reversion Split                     380,267 Developer 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%                    
    • 31. 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 10 Cash Flow Preferred Return   90,725 101,275 96,000 96,000 96,000 96,000 96,000 96,000 0 192,000 Cash Flow Split   0 32,097 1,862 28,141 38,092 24,332 40,421 67,758 0 3,171 Return of Investment   0 0 0 0 0 0 0 0 0 1,200,000 Reversion Split   0 0 0 0 0 0 0 0 0 465,000 Equity 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 1,933,938 Equity 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 36,051 Cash Flow Split   0 21,398 1,242 18,760 25,394 16,222 26,948 45,172 0 2,114 Return of Investment   0 0 0 0 0 0 0 0 0 450,643 Reversion Split   0 0 0 0 0 0 0 0 0 148,000 Developer Proceeds -400,000 0 53,398 33,242 50,760 57,394 48,222 58,948 77,172 -50,643 636,809 Developer IRR 12.00%                     Reversion Split after 12% IRR lookback                   73,767 Developer Proceeds -400,000 0 53,398 33,242 50,760 57,394 48,222 58,948 77,172 -50,643 710,576 Developer IRR 12.88%                    
    • 32. 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.
    • 33. The Equity Property Sale Waterfall
      • After debt, cash flow pays
          • Return of principal to investors then sponsors
          • A preferred return of 8% to 12% to investors
          • A promotional return to achieve target, with some return to developer.
          • After target is reached, higher return to developer.
    • 34. Investor Target Returns: Each use is different *Unleveraged Internal Rate of Return. Higher leverage increases return on equity. Anchor Tenant Timing of sale or lease Target IRR* Sector Occasional Lease up after construction 7-12% Industrial Desirable Pre-leasing usually req’d 7-12% Retail Desirable Pre-leasing desirable 7-12% Office None Lease-up after construction 7.5-11% Multi-family None Pre-sales for each phase 8-20% For-sale residential Depends on phase With phasing 20-30% Land Development
    • 35. So…
      • How much debt should we use?
    • 36. What is Our Incremental Cost of Debt? Incremental Cost of Funds Assumptions Loan Amortization Term 30 30 30 Prepayment Year 10 10 10 Property Value $30,000 $30,000 $30,000 LTVR 70.00% 75.00% 80.00% Loan Fees 0.50% 0.75% 1.25% Incremental Closing Costs 0 100 250 UST 10 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 Information Loan Amount 21,000 22,500 24,000 Points and Increment Costs 105 269 550 Funds Disbursed 20,895 22,231 23,450 Debt Service 101 113 127 Outstanding Loan Balance 16,573 17,991 19,433 Borrower Cost of Funds 4.12% 4.61% 5.17% Incremental Cost of Funds Incremental New Funds 1,336 1,219 Incremental Debt Service 12 13 Incremental Outstanding Loan Balance 1,419 1,442 Incremental Cost of Funds   11.53% 13.96%
    • 37. 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
    • 38.
      • Fundamental Skills for Real Estate Development Professionals I
      • Financial Analysis
      • Wednesday, October 26
      • 9:00 a.m. - 10:15 a.m.