Real Estate DCF

1. Real Estate DCF Wally Boudry Spring 2014

2. Admin • Case is due 5/5 and is up on Blackboard • Final Exam • Due 5/15 • I will post it on Blackboard after class 5/7

3. Warning • This is a huge topic and covers everything you have learned so far • You will eventually value a property • If you get the basics down you can then think about more complicated examples (mezz foreclosures etc.) • Try to break it down into little piece (leases, taxes etc) that you understand instead of getting overwhelmed • If nothing makes sense, try a simple BOE calc to start • Always benchmark numbers as you go • Do the cap ex numbers make sense? Do those rent numbers makes sense? etc.

4. Warning • Mechanically this topic ranges from very simple to quite complex • Complexity is usually a function of how complex the leases are and also if you have a complicated partnership waterfall to deal with • More on waterfalls in the final topic • Regardless of how complicated the modeling is, that isn’t where the value add in the process is • Give me enough time and I can train a monkey to do it • Where you add value is in your analysis, not in your numbers

5. Overview • So far we have priced properties using BOE techniques • These models, while still widely used in practice, are flawed from a theoretical stand point. • From a theoretical perspective, all BOE techniques are not necessarily value maximizing • That is, accept or reject decisions are not guaranteed in expectation to maximize value. • It may turn out that they are consistent with value maximization, but this is due to chance rather than design • What we need is a method that will maximize value.

6. NPV • From corporate finance you will remember that the net present value NPV rule is designed to maximize the value of the firm. • The same principle applies in real estate • Accept positive NPV projects. • Reject negative NPV projects.

7. DCF • The approach we will take to calculate the NPV of a property is the discounted cash flow DCF technique. • We will forecast out cash flows and then discount them back at the opportunity cost of capital. • As in regular corporate finance, the difficult part of DCF in real estate lies in the inputs to the DCF model not the model itself! You will never calculate NPVs, but this is the pricing framework. In reality we base everything on IRRs and equity multiples

8. Discounting • Obviously the timing of discounting matters at least theoretically • In most cases cash flows will be calculated monthly, then aggregated up to annual numbers and then discounted • The correct thing to do would be to discount monthly, but very few people do unless specified in a partnership waterfall • Some problems will naturally set up just to do annual cash flows • We care about monthly cash flows because annual cash flows can average out monthly problems (e.g. 6 months of being short on debt service followed by 6 months of covering debt service 2x will give an annual DSCR greater than 1) • I can easily overcome this issue, but I need to know it exists • In most cases, monthly v annual discounting won’t matter mathematically (that is, it won’t change your accept/reject decision.)

9. Stub Years • You will some times see DCF done with a “stub year” • Typically we will assume a whole year holding period • 5 year hold or a 10 year hold etc. • If we don’t purchase the property on 1/1/20xx then fiscal and calendar years don’t overlap • A way to deal with this is a stub year model • The stub year is the short year (if we buy in September, it is September thru Dec) • Then every year after is a full calendar year, so the total hold will be “Holding period + stub year” • The end result is: • You can build both models into a spreadsheet, but a lot of IF statements are required • You will need to use XIRR when discounting (this is just IRR with specified dates)

10. Taxes • You will see DCF done on a before tax basis and on an after tax basis • Remember we are talking about income taxes here not property taxes • Many RE investors are tax exempt, which is why they don’t worry about taxes • Debt underwriters don’t care about income taxes • Taxes also change which is why it makes sense for a taxed investor to start by examining a before tax analysis • We will introduce “basic” income taxes into our analysis • You could spend a whole course just on real estate taxation because the rules are quite complicated

11. After Tax Pro Forma • In BOE analysis we ignored all taxes apart from property taxes • For many investors, taxes are an important factor in determining the return on a project • Investors receive after tax cash flows not before tax cash flows • In order to examine a property on an after tax basis we will have to create an After Tax Pro Forma • This is simply the after tax equivalent of the pro forma we have already examined.

12. Before Tax Pro Forma • Potential Gross Income PGI (rentable sqft * effective rent $/sqft) • - Vacancy (Vacancy rate * PGI) • + Other Income (laundry, parking etc.) • - Operating Expenses • + Expense Reimbursements • = Net Operating Income (NOI) • - Capital Expenditure • = Cash Flow from Operations (CFO) • Financing Costs • =Cash Flow after Financing (CFAF)

13. Cash Flow versus Accrual • From an investment analysis perspective, cash is king. • You pay out cash flows not accrued earnings • From a tax perspective, what you worry about is when obligations or revenues were generated • You don’t actually have to have paid something for it to be a liability – you just have to have created the obligation. • To get from our before tax pro forma (before tax cash flow based) to our after tax pro forma (after tax cash flow based) we will have to back out the effects of taxes and non-cash flow items.

14. Depreciation • Depreciation is a non-cash flow item • You don’t actually pay depreciation to anyone! • This is why you never saw it in the before tax pro forma • Depreciation is important on an after tax basis because the IRS views depreciation as an allowable deduction • That is you can deduct depreciation from revenue to reduce your taxable income and hence your tax paid. [Good] • As with all things involving tax, there are rules governing how much depreciation you can deduct. [Bad] These rules also change through time…

15. Depreciation • The logic behind allowing a depreciation deduction is that fixed assets wear out through time from use. • This is eminently sensible for a factory • Each car that Ford produces reduces the effective life of the machine that made it. • For real estate it is not as obvious • Does land wear out? • How about buildings? • Is the price tag of many historic buildings purely a reflection of land value? • Why does the depreciable life reset when the building is sold?

16. Depreciation • For residential buildings depreciation is taken on a straight line basis over 27.5 years • DO NOT depreciate land! • For non-residential buildings the useful life is 39 years. • Kind of unintuitive since many buildings will be economically obsolete before the 39 year limit is up and some will have value long after 39 years. • Historically the useful life was also shorter: pre-1986 it could be as low as 15 years. • What does this tell you about a property whose value is derived from depreciation deductions? In the 80s a lot of investments were set up essentially as tax shelters

17. Capital Improvements • Capital improvements are a cash item (you pay them out of cash) but from a tax perspective they are an investment. • The tax view is that while you might have to pay now to put in a new system in your building, that system will give you benefits for many periods into the future. • Compare this to say electricity which only gave you a benefit in the current period. • So although capital improvements are a cash outflow, from a tax perspective what we have to do is capitalize and depreciate them. • Since we capitalize and depreciate, CAPEX has a big impact on cash flow, but only minor tax effects. • This holds true for tenant improvements and leasing commissions as well

18. Debt • Debt service is a cash flow item • You pay debt holders cash • From a tax perspective, however, not all debt service is an expense • Debt Service = Principal + Interest • The IRS views interest payments as an allowable deduction, but principal payments are simply a reduction in the liability you owe and therefore not deductible. • So although we pay “loan amount * MC” in debt service, we can only deduct “outstanding balance * interest rate” • This is why we need those pesky amortization tables.

19. After Tax Pro Forma • Potential Gross Income PGI • - Vacancy (Vacancy rate * PGI) • + Other Income (laundry, parking etc.) • - Operating Expenses • + Expense Reimbursements • = Net Operating Income (NOI) • - Capital Improvement Expenditure • = Cash Flow from Operations (CFO) • Financing Costs • =Cash Flow after Financing (CFAF) • Income Tax • Equity After Tax Cash Flow (EATCF) • Tax • NOI • Interest Expense • Depreciation • =Taxable Income • * Investor’s tax rate • =Income Tax

20. This is what a more complicated after tax pro forma might look like Rents Reimbursements Other income Operating Expenses NOI Capital items Cash flow before debt service Debt service Cash flow after debt service but before taxes Cash flow after taxes Tax calculation

21. Capital Gains • Our after tax pro forma takes care of taxes for general operations • At some point however we will sell the property and at this stage we may have a capital gain or loss to deal with. • That is, we don’t receive all of the sale price when we sell the property. • Working out our tax obligation has two parts • Gain on sale (the difference between the sale price and the gross book value [original cost + CI]) • Depreciation Recapture (the amount of accumulated depreciation)

22. Capital Gains Tax • The depreciation recapture may appear a little strange, but the logic behind what it is doing is quite simple. • The IRS allows you to take a depreciation deduction from ordinary income because your asset is wearing out through time. • If, after some period of time, you sell your asset for more than you bought it for plus improvements, then: • You have made a gain on your asset’s original value (and the IRS wants a piece of it) • Your asset hasn’t actually worn out (and the IRS wants its money back!) • The place where things get a little strange is that capital gains are taxed at 20% (it was 15 previously), while depreciation recapture is at 25% (your depreciation deduction shielded income at the personal tax rate.)

23. Accelerated Depreciation • Currently the IRS allows you to deduct straight line depreciation on buildings over 27.5 or 39 years • This wasn’t always the case • Prior rules allowed for accelerated depreciation or depreciation faster than straight-line • For properties that have accelerated depreciation the gain on sale has one added twist • Depreciation that is in excess of straight line is recaptured as ordinary income • NOTE: if you want to model the tax aspects of a real estate transaction fully, go and talk to a RE Tax expert!

24. Capital Gains Tax • Net Selling Proceeds • original cost (or gross book value) • = capital gain • * capital gains rate • = Capital Gains Tax Accumulated Depreciation * Recapture Tax Rate = Recapture Tax Total Tax on Sale

25. Adjusted Base • When we do capital improvements on a property these improvements add to the property’s value, so we can capitalize them into the property • We can sometimes depreciate these improvements at a faster rate than the property itself (MACRS splits assets by useful life) • This is often called “cost segregation” • Cost segregation is pretty complicated and there are companies that specialize in it • You need to know tax laws inside and out… • For this course we will ignore this and just add capital improvements to original cost to get the gross book value. • Essentially we are assuming that capital improvements happen just before we sell the property

26. Put It All Together And Stir • We now have all the tools we need to work out the cash flow side of our DCF. • What we have to do now is put them all together… • Remember, putting them together is the easy part, making sure that the numbers you use aren’t garbage is the hard part. • You are buying the assumptions that make the yield, not buying the yield itself! • After each line of the pro forma always remember to do a GIGO check: “Does that number make sense?”

27. Information Spectrum • The amount of information you have on a property will vary greatly depending on your situation • Ideally you would have the complete rent roll, past operating expenses etc. • This would allow you to do a very accurate in place valuation for a stabilized asset • In other cases you won’t have complete information, the building may be unstabilized, or might be a development deal • This is where the “art” part of valuation comes into it • Always be aware of the assumptions you are making and your own potential biases • e.g. I know I am conservative when I underwrite

28. Where do we start? • The first place to start is figuring out what our rents are so we can work out PGI. • There are a couple of ways of going about doing this and each is suited to a given situation. • Actual Rents: if you are lucky enough to have the rent roll of the building then you can forecast out actual rents as far as they are stated. • Market Rents: if you don’t have the rent roll, then you have to make your best guess of what the rent roll looks like. • You will still need market rents even if you have a rent roll because you will need to assume something for the space after the lease ends

29. Rent Roll This is the actual rent roll for a Class B 34 story 661,000 sqft mixed use office building in Lower Manhattan.

30. Rent Roll

31. Rent Roll

32. Rent Roll

33. Rent Roll • The rent roll above gives 2005 and 2006 rents per sqft for each tenant. • Notice that rents differ by amount of space, location in building (basement v ground v mezzanine v office), length of lease etc. • Also notice the ground floor retail is paying higher rents ($50-100 per sqft is market.) • Given this information we can forecast out these leases using what we know about the lease rather than using a market rate. • The rows in yellow indicate vacant space. • The expiration column tells you when the leases expire. • In most deals you will be given lease abstracts and estopells which will spell out the exact details of the lease (rents, escalations, reimbursements etc.)

34. Rents • So we can take our actual rents as a starting point • For a mixed use building like this one (with retail and office) and very different quality floors (below grade, ground, mezzanine through 34) you would normally split the space up when thinking about rents • With this rent roll I would go lease by lease; with no rent roll I would break the building up by space class (retail; below grade etc.) • How do we grow the rents? • If you know the escalation clauses then use them • If you don’t know the escalation clauses then you have to make an educated guess (this is all brokerage reports are…)

35. Rents • How do you make an educated guess about rent growth? • NCREIF properties have rents that have increased roughly level with inflation for long periods of time. • This suggests somewhere around 2-3% is a good place to start. • The economic intuition behind this goes something like follows • Each year your property depreciates from an economic perspective (it loses functionality and wears out) • This suggests that all things equal your real rents should decline through time. • If you maintain your property well and keep it up to scratch then you shouldn’t be losing value, or a lot of value, in real terms. • Hence growing rents at the rate of inflation isn’t implausible.

36. Rents • In Chapel Hill Class A office rents grow at around 5% • Is this plausible over the long term? • That is, 5% > 3%. What needs to be happening for this to be true? • Be very skeptical if someone shows you a pro forma with 10% growth in rents over a long period of time • It may happen over short periods of time, but it is very unlikely to be a long term trend. • Remember the rule of 72 (72/growth rate = years to double) • Juicing your rents is probably the easiest way of justifying the price of an overvalued property.

37. Below Market Leases • A very common “value” story for a property is under market leases • This only works if you have long term leases • Story: tenants were signed many years ago before the market got hot and rents went up. Now the building is full of tenants who are paying rents substantially below the current market rates because escalation clauses didn’t keep up with rent inflation. When these rents roll to market, the property will get a huge boost to NOI. • What do you think?

38. Outs • Also be careful of lease exit clauses • Some leases have exit clauses or “outs” • Typically there will be • Triggering date: e.g. in the 5th year of the lease • Notice: e.g. at least 12 months • A penalty: e.g. $1,000,000 • The exit clause is designed to hopefully give the landlord enough time to re-tenant the space and cover the costs of re-tenanting • Just because you have a full building with long leases doesn’t mean you don’t have cash flow volatility if you have a lot of outs that will likely be exercised

39. Rollover

40. Key Tenants When do our key tenants roll over? Why do we care?

41. Rollover • The previous slide shows when our leases roll over. • The yellow rows indicate years when greater than 10% of our space rolls over • This is a typical benchmark most people use as an indicator of serious rollover • Why would you care about this? • Think about trying to put debt on this property • Currently we have 26% vacancy in our building • Is this good? • Is it bad? • How can we tell?

42. Vacancy • Since this property is in Manhattan we can get pretty good data on what market vacancy rates are! • In 2005 the office vacancy rate in lower Manhattan (where this building is) was approximately 12-13% • This market got hit very badly by 9-11 and many Class A Office tenants moved to midtown or Jersey • This was good for the midtown market, but bad for the lower Manhattan. • It had however started to rebound in recent years before the credit crunch. • This rate had tightened to around 6-7%. • What do you make of our 26% vacancy rate?

43. Vacancy • The building actually just underwent a huge redevelopment converting it into a high tech infrastructure building • Basically the whole building was rewired to allow tech and communications firms to run generators and other electrical systems. • There is actually a “silicon alley” sprouting up in lower Manhattan as tech firms move in. • Given the massive redevelopment the high vacancy rate is somewhat expected (think of 340 Madison Ave) • The concerning part is that the current vacancy is located in many of our prime floors. • When might this be advantageous rather than concerning?

44. What do we do about leases rolling over? • Obviously we need to make an assumption about what will happen to the leases that roll over • What are the options? • The tenant could renew the space • The tenant could leave and we could lease the space • The tenant could leave and the space may remain vacant • A pretty reasonable assumption is that for the leases that expire you will re-lease the space to market vacancy levels and at market rates. • Notice that for a 10 year analysis this rate could trend through time • Under what circumstance would this “reasonable assumption” be unreasonable? (i.e. when would you really want to talk to the tenant if possible?)

45. Source: PWC/Korpacz

46. “General Vacancy” • General Vacancy is a pro forma line item created by Argus • You will often time see people employ it in excel spreadsheets (mine does) • The logic goes like this: • To be conservative I want to include a General Vacancy Loss that overrides actual Absorption and Vacancy Turnover if actual vacancy is less than my assumption • So a 5% vacancy assumption is: max (actual vacancy, 5%) • The idea is I’m being conservative

47. The Calculation • If a lease starts after space is available (we have vacant space) we need to calculate the lost PGR • I did this using the “market leasing” base rent in the lease spreadsheet: usually you will just use a market rate • For each year calculate: • (1) Potential Total Revenue = Total Potential Gross Revenue + Absorption and Vacancy Turnover • (2) General Vacancy = x%*PTR • General Vacancy Loss = IF(AVTO>GV,0,GV-AVTO) • For monthly just convert the annual number to a monthly number

48. Operating Expenses • Typically operating costs are split into fixed and variable costs (variable refers to variable with respect to occupancy) • Fixed costs – property taxes and insurance are a good example • Variable – pretty much everything else • Once again there are a couple of ways of looking at this • If you have the financial statements for the property you can work out operating expenses as a percentage of PGI or EGI or on a sqft basis • Taking a stable historic rate and using that isn’t a bad option. • If you don’t know the building’s financials, then you can make an educated guess by talking to local property operators or companies like REIS or BOMA • B/C apartments in Raleigh has operating costs of ~35% of PGI. • Be careful assuming massive property price appreciation, but only moderate property tax increases.

49. Tenant Improvements • Tenant improvements are by their nature a “lumpy” variable • A fairly conservative way of going about modeling TIs is to assume that you will have to pay them every time leases roll over • This isn’t necessarily true since if an existing tenant re-leases space any TIs are likely to be smaller than for a new tenant, but this can be modeled. • You will typically have an idea of what TIs in your market are running at and this will vary by property type, quality, location and market conditions • $50 per sqft in Chapel Hill for Class A office etc • Remember to make sure that you don’t add TIs for vacant space • Be consistent in your assumptions – the space can’t be vacant and having TIs done on it!

50. Renewal TIs (rule of thumb is ~50% of regular) Regular TIs