1.
Financial Analysis of Value-Added Commercial Real Estate Projects

2.
Objectives <ul><li>Develop skills to identify and analyze value-added investment opportunities </li></ul><ul><li>Review key metrics, data points, and structural issues used when evaluating value-added investments from both a debt and equity viewpoint </li></ul><ul><li>Complete a comprehensive case study that evaluates a value-added investment and includes both equity and debt underwriting evaluation. </li></ul>

3.
Value Added Investments: An Overview <ul><li>In a value-added investment, the investor intends to increase the property value by: </li></ul><ul><ul><li>Increasing the property’s economic cash flow (NOI – CAPEX) by </li></ul></ul><ul><ul><ul><li>Increasing revenue </li></ul></ul></ul><ul><ul><ul><li>Decreasing expenses </li></ul></ul></ul><ul><ul><ul><li>Lowering the risk of the cash flow stream </li></ul></ul></ul>

4.
Value Added Investments: How Value is Increased Increasing Revenue and/or Lowering the Risk of the Cash Flow Stream Changing the Tenant Mix of the asset: <ul><li>Generally an upgrade in quality: </li></ul><ul><li>Increasing occupancy </li></ul><ul><li>Increasing the lease rate </li></ul><ul><li>Increasing the lease term </li></ul><ul><li>Increasing tenant credit </li></ul>Rehabilitating the asset, including upgrading the class of the asset: <ul><li>Typically capital improvements. Rehabilitation of the physical asset should result in one or more of the following: </li></ul><ul><li>Increased demand </li></ul><ul><li>Higher occupancy </li></ul><ul><li>Higher lease rate </li></ul><ul><li>Longer lease term </li></ul><ul><li>Better tenant credit </li></ul>Repositioning the asset: <ul><li>Changing the asset’s use: </li></ul><ul><li>Adding on to an existing asset classes and keeping existing use (new construction) </li></ul><ul><li>Changing asset uses (hotel to multifamily) </li></ul>

5.
Value Added Investments: How Value is Increased Increasing Revenue Rolling existing leases: Changing the tenant mix. A situation where current market conditions are better than existing rent roll (“roll tenants to market”). Submarket story: <ul><li>Market area of the asset is being upgraded such as </li></ul><ul><li>New infrastructure – roads </li></ul><ul><li>New employment centers – hospitals, large retail </li></ul><ul><li>Major private project </li></ul>

6.
Value Added Investments: How Value is Increased <ul><li>Operating expenses can be decreased through efficiencies or property upgrades </li></ul><ul><ul><li>Taxes </li></ul></ul><ul><ul><li>Insurance </li></ul></ul><ul><ul><li>Maintenance </li></ul></ul><ul><ul><li>Management </li></ul></ul><ul><ul><li>Reserves </li></ul></ul>

7.
How Value is Added to Commercial Properties <ul><li>Office/Warehouse Properties </li></ul><ul><ul><li>Minor : Renovation of common areas </li></ul></ul><ul><ul><li>Moderate : Increasing efficiency, modernizing HVAC, internet </li></ul></ul><ul><ul><li>Total gut – down to the concrete – turning a “C” into an “A” </li></ul></ul><ul><li>Retail Properties </li></ul><ul><ul><li>Minor : Facelift – fresh sign band, fresh parking lot </li></ul></ul><ul><ul><li>Moderate : New facade, rearranging of physical space </li></ul></ul><ul><ul><li>Major : De-malling centers </li></ul></ul><ul><li>Multifamily Properties </li></ul><ul><ul><li>Minor : Paint, carpet, landscaping </li></ul></ul><ul><ul><li>Moderate : Kitchen, baths </li></ul></ul><ul><ul><li>Major : Total gut – tenants displaced </li></ul></ul>

8.
Underwriting the Value-Added Loan

9.
Underwriting The Value Added Loan <ul><li>General Value Added Characteristics </li></ul><ul><ul><li>The asset is not ready for sale or permanent financing. </li></ul></ul><ul><ul><li>There is a “bet” that value can be increased by increasing the cash flow. </li></ul></ul><ul><li>The Value Added Loan </li></ul><ul><ul><li>Typically higher leveraged than stabilized transactions. </li></ul></ul><ul><ul><li>Typically higher priced than stabilized loans. </li></ul></ul><ul><ul><li>Primary users of bridge financing, mezzanine debt and equity joint ventures. </li></ul></ul>

10.
The Capital Structure Based on Costs 20%-100% Sponsor Equity - Highest Risk - First Loss Piece - Profit Equals Difference in Cost and Value B 65%-80% 1 st Mezzanine - Current Yield/IRR: 8-12% - Typically pays current, but may accrue A 0%-65% Senior Debt - First Trust - Lower Rate/Lower Risk/Pays current - Required Yield: 6-8%

11.
Information Needed to Underwrite the Loan and Analyze the Deal <ul><li>To underwrite a value added real estate transaction, the investor requires basic information prior to making an investment decision. </li></ul><ul><ul><li>Capital Structure </li></ul></ul><ul><ul><ul><li>The investors must know what they need & how the capital structure works. </li></ul></ul></ul><ul><ul><ul><li>You must know the capital structure before analyzing anything else. </li></ul></ul></ul><ul><ul><li>Sources & Uses </li></ul></ul><ul><ul><ul><li>Understand how capital will be used in the project. </li></ul></ul></ul><ul><ul><ul><li>Understand where the capital budget is coming from. </li></ul></ul></ul><ul><ul><li>Capital Improvement Budget </li></ul></ul><ul><ul><ul><li>Understand how much will be spent to rehab or improve the asset. </li></ul></ul></ul><ul><ul><ul><li>Requires a line item budget. </li></ul></ul></ul><ul><ul><ul><li>Understand which improvements add value & which improvements are really deferred maintenance. </li></ul></ul></ul>

12.
Information Needed <ul><ul><li>Current & Historical Operating Statements </li></ul></ul><ul><ul><ul><li>Understand the current NOI and the historical NOI. </li></ul></ul></ul><ul><ul><ul><li>Investor typically wants the last 3 years and the current/analyzed NOI. </li></ul></ul></ul><ul><ul><ul><li>How do the current and historical NOI compare to Pro Forma NOI? How far is there to go? </li></ul></ul></ul><ul><ul><li>Rent Roll </li></ul></ul><ul><ul><ul><li>Basic information : Tenant name, lease start date, lease maturity date, lease rate, and future lease rate increases. </li></ul></ul></ul><ul><ul><ul><li>Tenant roll : Lease expirations should be converted into roll schedule. The investor should analyze a year-by-year review, focusing on how much roll (as a percent of the leases) will occur each year. </li></ul></ul></ul><ul><ul><ul><li>Understand the fine print : Escalators, escape clauses, landlord obligations, percentage rent, etc. </li></ul></ul></ul>

13.
Information Needed <ul><ul><li>Project Pro Forma </li></ul></ul><ul><ul><ul><li>This is the borrower’s projection of revenues and expenses based on an event timeline. </li></ul></ul></ul><ul><ul><ul><li>Should translate into an increased NOI. </li></ul></ul></ul><ul><ul><ul><li>The project Pro Forma should produce the stabilized NOI. </li></ul></ul></ul><ul><ul><ul><li>The project “Stabilized NOI” is the key to future value. </li></ul></ul></ul><ul><ul><li>Exit Value </li></ul></ul><ul><ul><ul><li>This is the key metric every value added investor is trying to determine. </li></ul></ul></ul><ul><ul><ul><li>Formulas: </li></ul></ul></ul><ul><ul><ul><ul><li>Stabilized NOI/Exit Cap Rate = Exit Value </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Exit Value estimated by DCF </li></ul></ul></ul></ul><ul><ul><li>Other Helpful Information </li></ul></ul><ul><ul><ul><li>Site Plan </li></ul></ul></ul><ul><ul><ul><li>Aerial Photos </li></ul></ul></ul><ul><ul><ul><li>Appraisal </li></ul></ul></ul><ul><ul><ul><li>Market sale comps </li></ul></ul></ul><ul><ul><ul><li>Market lease comps </li></ul></ul></ul>

14.
Exit Strategies

15.
Exit Strategies <ul><li>Opportunistic loans and real estate investments are fairly easy to get into, and much more difficult to get out of. </li></ul><ul><li>Anyone can make an investment, but the art of the business is structuring an investment with a defined exit strategy, the appropriate structure and pricing that reflects the risks of the transaction. </li></ul>

16.
Exit Strategies <ul><li>Permanent Loan Refinance </li></ul><ul><ul><li>Most common and most preferred </li></ul></ul><ul><ul><li>Based on sizing the exit or permanent loan, use the following constraints: </li></ul></ul><ul><ul><ul><ul><li>Pro Forma and stabilized NOI (the post-event NOI) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Permanent loan sizing criteria </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>LTV constraint </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Future Interest Rate </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Amortization rate </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Interest rate + amortization = loan constant </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Reserve deductions (the capital reserve and leasing costs) </li></ul></ul></ul></ul></ul>

17.
Exit Strategies <ul><ul><li>Sale Exit </li></ul></ul><ul><ul><ul><li>Based on Pro Forma NOI at stabilization </li></ul></ul></ul><ul><ul><ul><ul><li>Key assumptions: </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Future 10 year fixed rate loans </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Future spreads </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Future cap rates </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><li>Generally assumed: </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Selling costs </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Permanent market underwriting </li></ul></ul></ul></ul></ul>

18.
Value Added Investing: Metrics

19.
Value Added Metrics <ul><li>The Key Metrics </li></ul><ul><li>Increasing the cash on cash return </li></ul><ul><ul><li>A value added deal should see at least a 100-200 bps increase from initial cash on cash return to stabilized pro forma cash on cash return. </li></ul></ul><ul><ul><li>Formula : Beginning NOI / Acquisition Price </li></ul></ul><ul><ul><ul><ul><li> vs. </li></ul></ul></ul></ul><ul><ul><ul><ul><li> Stabilized NOI / Acquisition Price </li></ul></ul></ul></ul><ul><li>Increasing the cash on cash return </li></ul><ul><ul><li>A value added deal should see at least a 100-200 bps decrease in initial cash on cash return on cost to stabilized pro forma cash on cash return on value. </li></ul></ul><ul><ul><li>Formula : Stabilized NOI / Total Cost </li></ul></ul><ul><ul><ul><ul><li> vs. </li></ul></ul></ul></ul><ul><ul><ul><ul><li> Stabilized NOI / Value at Stabilization </li></ul></ul></ul></ul>

20.
Value Added Metrics <ul><li>The Key Metrics </li></ul><ul><li>Increasing the debt service coverage ratio </li></ul><ul><ul><li>The debt service coverage ratio has to increase preferably to a level where the stabilized debt service coverage ratio qualifies for permanent financing. </li></ul></ul><ul><ul><li>Formula: Stabilized NOI / Debt Service (Permanent Loan) </li></ul></ul>

21.
Value Added Metrics <ul><li>The Key Metrics </li></ul><ul><li>The Gross Profit Test: </li></ul><ul><ul><li>Gross Profits must be at a level to account for the risk and time required to complete the value-added process </li></ul></ul><ul><ul><li>Formulas: </li></ul></ul><ul><ul><ul><li>Exit Value (Stabilized NOI / Exit Cap Rate) </li></ul></ul></ul><ul><ul><ul><li>LESS: Total Capital Stack </li></ul></ul></ul><ul><ul><ul><li>EQUALS: Gross Profit </li></ul></ul></ul><ul><ul><ul><li>Gross Profit percentage on cost = </li></ul></ul></ul><ul><ul><ul><li>Gross Profit/ Total Capital Stack </li></ul></ul></ul><ul><ul><ul><li>Gross Profit percentage on Value= </li></ul></ul></ul><ul><ul><ul><li>Gross Profit/ Exit Value </li></ul></ul></ul>

22.
Value Added Key Metrics <ul><li>The Key Metrics for Equity Investors </li></ul><ul><li>Equity IRR Meeting or Exceeding Required Return for both the Pre and Post Value-Added Event </li></ul><ul><ul><li>Compare to the required return </li></ul></ul><ul><ul><li>Levered and Unlevered calculations </li></ul></ul><ul><ul><li>Required return is different in the Pre and Post Value Added Event due to changing risk </li></ul></ul><ul><li>NPV >= 0 on Equity </li></ul><ul><ul><li>Required return is different in the Pre and Post Value Added Event due to different levels of risk </li></ul></ul><ul><ul><li>Levered and Unlevered calculations can be calculated </li></ul></ul>

23.
Sources <ul><li>Ling, D. & Archer, W. (2008). Real estate principles: a value approach (2 nd ed). New York: McGraw-Hill/Irwin. </li></ul><ul><li>Linneman, P. (2008). Real estate finance and investments: risks and opportunities (2 nd ed). Philadelphia: Linneman Associates. </li></ul>