financial analysis of value-added commercial real estate projects

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

2. Objectives Develop skills to identify and analyze value-added investment opportunities Review key metrics, data points, and structural issues used when evaluating value-added investments from both a debt and equity viewpoint Complete a comprehensive case study that evaluates a value-added investment and includes both equity and debt underwriting evaluation. 2 Introduce the module by first discussing the learning objectives.Introduce the module by first discussing the learning objectives.

3. Value Added Investments: An Overview 3 In a value-added investment, the investor intends to increase the property value by: Increasing the property�s economic cash flow (NOI � CAPEX) by Increasing revenue Decreasing expenses Lowering the risk of the cash flow stream Discussion Question: Ask students to identify ways in which an investor can (1) increase the property�s net cash flow, (2) increase revenue, (3) decrease expenses, (4) and/or lower the risk of the cash flow stream. Discussion Question: Ask students to identify ways in which an investor can (1) increase the property�s net cash flow, (2) increase revenue, (3) decrease expenses, (4) and/or lower the risk of the cash flow stream.

4. Value Added Investments: How Value is Increased 4 Discuss how each of the following increase revenue and/or lower the risk of the cash flow stream: Changing the Tenant Mix Generally, changing the tenant mix can increase value. By increasing the occupancy, rental income increases and the risk of losing existing tenants decreases. Increasing the lease rate to market levels may also increase rental income. Strengthening or lengthening lease terms provide the investor with a more certain stream of cash flow for a longer period of time. Rehabilitating the Asset Maintaining the asset and investing in capital improvements can increase the asset�s life and can attract new and better tenants, which can lead to higher occupancy, higher lease rate, longer lease term, and better tenant credit. Repositioning the Asset Additions to the asset or completely changing the asset�s use can reposition the asset in the market, and increase revenue or lower the risk of cash flows Discuss how each of the following increase revenue and/or lower the risk of the cash flow stream: Changing the Tenant Mix Generally, changing the tenant mix can increase value. By increasing the occupancy, rental income increases and the risk of losing existing tenants decreases. Increasing the lease rate to market levels may also increase rental income. Strengthening or lengthening lease terms provide the investor with a more certain stream of cash flow for a longer period of time. Rehabilitating the Asset Maintaining the asset and investing in capital improvements can increase the asset�s life and can attract new and better tenants, which can lead to higher occupancy, higher lease rate, longer lease term, and better tenant credit. Repositioning the Asset Additions to the asset or completely changing the asset�s use can reposition the asset in the market, and increase revenue or lower the risk of cash flows

5. Value Added Investments: How Value is Increased 5 Discuss how each of the following increase revenue: Rolling Existing Leases � Changing the tenant mix can allow the investor to bring in new tenants at higher rents, thereby increasing rental income. Submarket Story � Activity in the area around the asset, such as new infrastructure, employment centers, etc., can increase demand for space in the asset. This increased demand will also drive rents higher, thus increasing rental income. Discuss how each of the following increase revenue: Rolling Existing Leases � Changing the tenant mix can allow the investor to bring in new tenants at higher rents, thereby increasing rental income. Submarket Story � Activity in the area around the asset, such as new infrastructure, employment centers, etc., can increase demand for space in the asset. This increased demand will also drive rents higher, thus increasing rental income.

6. Value Added Investments: How Value is Increased Operating expenses can be decreased through efficiencies or property upgrades Taxes Insurance Maintenance Management Reserves 6 Decreasing operating expenses can increase the revenue of an asset, and can be accomplished in several ways: Insurance � Maintenance � Routine property maintenance can reduce the risk of a much more costly improvement. Management � Reserves � Often difficult to achieve much of a decrease unless the property has been mismanaged.Decreasing operating expenses can increase the revenue of an asset, and can be accomplished in several ways: Insurance � Maintenance � Routine property maintenance can reduce the risk of a much more costly improvement. Management � Reserves � Often difficult to achieve much of a decrease unless the property has been mismanaged.

7. 7 How Value is Added to Commercial Properties Office/Warehouse Properties Minor: Renovation of common areas Moderate: Increasing efficiency, modernizing HVAC, internet Total gut � down to the concrete � turning a �C� into an �A� Retail Properties Minor: Facelift � fresh sign band, fresh parking lot Moderate: New facade, rearranging of physical space Major: De-malling centers Multifamily Properties Minor: Paint, carpet, landscaping Moderate: Kitchen, baths Major: Total gut � tenants displaced Discuss the examples of how value is added to each of the different types of commercial property.Discuss the examples of how value is added to each of the different types of commercial property.

9. Underwriting The Value Added Loan General Value Added Characteristics The asset is not ready for sale or permanent financing. There is a �bet� that value can be increased by increasing the cash flow. The Value Added Loan Typically higher leveraged than stabilized transactions. Typically higher priced than stabilized loans. Primary users of bridge financing, mezzanine debt and equity joint ventures. 9 General Value Added Characteristics Value added assets assume that value can be increased by increasing the cash flow the asset generates. The Value Added Loan Because there is only a �bet� that value will be increased, the Value Added Loan is riskier and thus leveraged and priced higher than stabilized transactions and loans. Additionally, bridge financing, mezzanine debt, and equity joint ventures are more commonly used for these deals because of the added risk. General Value Added Characteristics Value added assets assume that value can be increased by increasing the cash flow the asset generates. The Value Added Loan Because there is only a �bet� that value will be increased, the Value Added Loan is riskier and thus leveraged and priced higher than stabilized transactions and loans. Additionally, bridge financing, mezzanine debt, and equity joint ventures are more commonly used for these deals because of the added risk.

10. The Capital Structure Based on Costs 10 Here is an example of a capital stack for an value-added investment. Notice each level of financing increases in risk, as seen in their increasing rate of returns, as we work our way up the stack.Here is an example of a capital stack for an value-added investment. Notice each level of financing increases in risk, as seen in their increasing rate of returns, as we work our way up the stack.

11. Information Needed to Underwrite the Loan and Analyze the Deal To underwrite a value added real estate transaction, the investor requires basic information prior to making an investment decision. Capital Structure The investors must know what they need & how the capital structure works. You must know the capital structure before analyzing anything else. Sources & Uses Understand how capital will be used in the project. Understand where the capital budget is coming from. Capital Improvement Budget Understand how much will be spent to rehab or improve the asset. Requires a line item budget. Understand which improvements add value & which improvements are really deferred maintenance. 11 Explain why each piece of basic information is important to making an investment decision. Capital Structure � It is important for investors to know what they need and how the capital structure works to understand their stake in the investment, where he or she stands for recovery in line in the event of default or foreclosure, etc. Sources & Uses � Knowing where the capital is coming from and what it is going towards is also important. The capital should be coming from a reliable source and the borrower should be using the capital in such a way that it will add value to the asset. Capital Improvement Budget � Provides a framework for what improvements are planned to be made and how much will be spent on each improvement. Explain why each piece of basic information is important to making an investment decision. Capital Structure � It is important for investors to know what they need and how the capital structure works to understand their stake in the investment, where he or she stands for recovery in line in the event of default or foreclosure, etc. Sources & Uses � Knowing where the capital is coming from and what it is going towards is also important. The capital should be coming from a reliable source and the borrower should be using the capital in such a way that it will add value to the asset. Capital Improvement Budget � Provides a framework for what improvements are planned to be made and how much will be spent on each improvement.

12. Information Needed Current & Historical Operating Statements Understand the current NOI and the historical NOI. Investor typically wants the last 3 years and the current/analyzed NOI. How do the current and historical NOI compare to Pro Forma NOI? How far is there to go? Rent Roll Basic information: Tenant name, lease start date, lease maturity date, lease rate, and future lease rate increases. 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. Understand the fine print: Escalators, escape clauses, landlord obligations, percentage rent, etc. Continue to explain why each piece of basic information is important to making an investment decision. Current & Historical Operating Statements � These statements provide a good reference point for the estimated value of the asset. Comparing the historical NOI and the Pro forma NOI can show the investor how accurate the estimated asset value is. Rent Roll � Knowing who the tenants are and the terms of their leases is also important because it can provide a better estimate of the rental income the property generates. Can allow for the analysis of leasing risk due to tenant lease expirations, estimated capex (TI and LC)Continue to explain why each piece of basic information is important to making an investment decision. Current & Historical Operating Statements � These statements provide a good reference point for the estimated value of the asset. Comparing the historical NOI and the Pro forma NOI can show the investor how accurate the estimated asset value is. Rent Roll � Knowing who the tenants are and the terms of their leases is also important because it can provide a better estimate of the rental income the property generates. Can allow for the analysis of leasing risk due to tenant lease expirations, estimated capex (TI and LC)

13. Information Needed Project Pro Forma This is the borrower�s projection of revenues and expenses based on an event timeline. Should translate into an increased NOI. The project Pro Forma should produce the stabilized NOI. The project �Stabilized NOI� is the key to future value. Exit Value This is the key metric every value added investor is trying to determine. Formulas: Stabilized NOI/Exit Cap Rate = Exit Value Exit Value estimated by DCF Other Helpful Information Site Plan Aerial Photos Appraisal Market sale comps Market lease comps Continue to explain why each piece of basic information is important to making an investment decision. Project Pro Forma � Viewing a project�s Pro Forma can provide an investor with a better idea of the potential cash inflows and thus the value of the asset. Exit Value � The exit value determines the value when the property is stabilized and sold or held by the equity investor. Other Helpful Information � Other information that might be helpful in making the underwriting decision include a site plan, aerial photos, an appraisal, market sale comps, and market lease comps. Continue to explain why each piece of basic information is important to making an investment decision. Project Pro Forma � Viewing a project�s Pro Forma can provide an investor with a better idea of the potential cash inflows and thus the value of the asset. Exit Value � The exit value determines the value when the property is stabilized and sold or held by the equity investor. Other Helpful Information � Other information that might be helpful in making the underwriting decision include a site plan, aerial photos, an appraisal, market sale comps, and market lease comps.

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15. Exit Strategies 15 Opportunistic loans and real estate investments are fairly easy to get into, and much more difficult to get out of. 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.

16. Exit Strategies 16 Permanent Loan Refinance Most common and most preferred Based on sizing the exit or permanent loan, use the following constraints: Pro Forma and stabilized NOI (the post-event NOI) Permanent loan sizing criteria LTV constraint Future Interest Rate Amortization rate Interest rate + amortization = loan constant Reserve deductions (the capital reserve and leasing costs) Refinancing is usually much cheaper than the sales process because you do not have to pay transfer taxes and you defer paying capital gains taxes; however, loan fees, lawyers� fees, and accounting fees are likely to be realized. Source: Linneman, 2008 Refinancing is usually much cheaper than the sales process because you do not have to pay transfer taxes and you defer paying capital gains taxes; however, loan fees, lawyers� fees, and accounting fees are likely to be realized. Source: Linneman, 2008

17. 17 Exit Strategies Sale Exit Based on Pro Forma NOI at stabilization Key assumptions: Future 10 year fixed rate loans Future spreads Future cap rates Generally assumed: Selling costs Permanent market underwriting The Sale Exit strategy is more profitable than refinancing, but it is not without its taxes and fees. Finding a buyer can be difficult for which a broker�s services are solicited. Once a buyer has been found, the investor receives what is left after debt, fees, capital gains taxes, and depreciation taxes have all been repaid. Source: Linneman, 2008.The Sale Exit strategy is more profitable than refinancing, but it is not without its taxes and fees. Finding a buyer can be difficult for which a broker�s services are solicited. Once a buyer has been found, the investor receives what is left after debt, fees, capital gains taxes, and depreciation taxes have all been repaid. Source: Linneman, 2008.

18. Value Added Investing: Metrics 18

19. 19 Value Added Metrics The Key Metrics Increasing the cash on cash return 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. Formula: Beginning NOI / Acquisition Price vs. Stabilized NOI / Acquisition Price Increasing the cash on cash return 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. Formula: Stabilized NOI / Total Cost vs. Stabilized NOI / Value at Stabilization These calculations will be covered in the case study These calculations will be covered in the case study

20. 20 Value Added Metrics The Key Metrics Increasing the debt service coverage ratio The debt service coverage ratio has to increase preferably to a level where the stabilized debt service coverage ratio qualifies for permanent financing. Formula: Stabilized NOI / Debt Service (Permanent Loan) These calculations will be covered in the case study These calculations will be covered in the case study

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

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

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