FUNDAMENTALS OF PROJECT FINANCIAL AND INVESTMENT ANALYSIS

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FUNDAMENTALS OF PROJECT FINANCIAL AND INVESTMENT
ANALYSIS

• This presentation will lay the groundwork for the
  remainder of the course, reviewing basic
  principles of finance as they relate to real
  estate project financial-investment analysis and
  evaluation.
• There will be four sessions
• I. Structuring a real estate feasibility
  analysis
• II. Evaluating the risk/return tradeoff for
  real estate projects
• III. Developing techniques of financial
  analysis
• IV. Examining problems and pitfalls of financial
  investment analysis.

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I. STRUCTURING A REAL ESTATEFEASIBILITY ANALYSIS
This introductory session will address the
concept of feasibility and real estate investment
analysis development of the first-year pro
forma and the usefulness of the CAP rate.
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• Yes, Virginia there are only three things that
  matter in real estate...
• LOCATION! LOCATION! LOCATION!

L REGIONAL FACTORS MACROECONOMIC CIRCUMSTANCES
x L
x NEIGHBORHOOD ELEMENTS
L SITE-SPECIFIC FEATURES
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OUTLINE OF A FEASIBILITY STUDY

• 1. Site Analysis
• Survey of site to determine net useable land area
• Zoning of site and related constraints
• Availability of utilities to site
• Subsurface soil conditions
• Preliminary title report, CC Rs
• 2. Initial Concept
• Establish target land development concept in
  terms of developers goals, permitted zoning, and
  developers financial resources

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OUTLINE OF A FEASIBILITY STUDY

• 3. Demand Analysis
• Evaluate the economic base that supports the
  community in which project is located
• Population projections
• Employment projections
• Income Projections
• Study the demand forces that pertain to your
  specific project type
• Analyze the competitive market within which you
  must operate
• 4. Supply Analysis
• Determine market area related to project
• Analyze the present and future inventory of
  product that you will be competing with in
  relation to your delivery date
• Determine product mix in relation to competitive
  rents, pricing, and amenities

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OUTLINE OF A FEASIBILITY STUDY

• 5. Specific Development Scheme
• With architects and engineers, developer relates
  concept to market conditions, with a specific
  development scheme, land use plan
• 6. Cost Estimates
• Based on a specific plan, developer then estimate
  all hard and soft costs based on the bid date
  of the project

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OUTLINE OF A FEASIBILITY STUDY

• 7. Financial Structure
• Reviews profitability for go/no go decisions
• Review mortgage loan ratios, terms of borrowing,
  equity position, tax considerations
• Determine phasing, if any, and absorption rates
• 8. Rate of Return Analysis
• Review risk factors related to project
• Review length of investment period
• Determine rate of return on and of the
  investment

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WILSHIRE BOULEVARD OFFICE BUILDING

• Building Synopsis
• Gross building area 205,000 sq. ft.
• Net leasable area 176,000 sq. ft. (86)
• Parking structure 427 cars

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WILSHIRE BOULEVARD OFFICE BUILDING

• Direct Costs
• Office building 205,000 sq. ft. at 43/sq. ft.
• Parking structure
• Above grade 22,420 sq. ft. at 24/sq. ft.
• Below grade 125,000 sq. ft. at 28/sq. ft.
• Tenant improvements 176,000 sq. ft. at 11/sq.
  ft.
• Site development
• Architectural Engineering
• 6 of hard costs (14,984,000)
• Contingency
• 5 of 15,883,040
• TOTAL

• 8,815,000
• 538,000
• 3,511,000
• 1,936,000
• 84,000
• 889,040
• 794,152
• 16,667,192

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WILSHIRE BOULEVARD OFFICE BUILDING

• Indirect Costs
• Real estate taxes
• 1 of direct cost plus land 15 mos./2
• Permits, legal fees, title, escrow, insurance
• Development fee 3 of hard costs
• Leasing commission 3 on 22 x 176,000 x 5
  years
• Lease-up expense 4/sq. ft. x 176,000 sq. ft.
  for 6 mos.
• Consulting fee
• TOTAL

• 123,000
• 150,000
• 500,015
• 580,800
• 352,000
• 150,000
• 1,855,815

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WILSHIRE BOULEVARD OFFICE BUILDING

• TOTAL DIRECT AND INDIRECT COSTS
• Financing cost 16 for 15 mos./2 on total costs
  
• financing cost (20,581,119)
• Land
• TOTAL COST INCLUDING FINANCING

• 18,523,007
• 2,058,112
• 3,000,000
• 23,581,119

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WILSHIRE BOULEVARD OFFICE BUILDINGFULL-YEAR
OPERATING PRO FORMA
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BASIC ACCOUNTING FOR INCOME PROPERTIES

• GROSS POSSIBLE INCOME (GPI)
• - VACANCY AND BAD DEBT FACTOR
• EFFECTIVE GROSS INCOME (EGI)
• - OPERATING EXPENSES
• NET OPERATING INCOME (NOI) OR NET EFFECTIVE
  INCOME
• - DEBT SERVICE
• CASH FLOW BEFORE TAXES (CFBT)
• - NET TAXES
• NET SPENDABLE INCOME (NSI)
• CFBT Principal Paydowns - Depreciation
  TAXABLE INCOME

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THE CAP RATE CONCEPT
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GRAPHIC INTERPRETATION OF CAP RATE
MV(1/k)NOI
MV
NOI
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WHAT THE CAP RATE MUST TAKE INTO ACCOUNT

• 1. Riskless Rate of Return
• real return
• inflationary adjustment
• 2. Liquidity
• 3. Management Return
• 4. Parcel Specificity Risk

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HOW TO CHOOSE THE CORRECT CAP RATE

• How do you know what the correct capitalization
  rate is? Only by knowing intimately every
  feature of the property you are considering,
  along with the basic factors touched upon above
• Investor demand for and the existing supply of
  the particular type of property
• Stability and security of future income
• Capitalization rates of price earning ratios of
  alternate, non-real estate investments with
  comparable risk.

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DETERMINING RISK AND DEMAND

• The investor can determine risk and demand as it
  affects the CAP rate by carefully examining the
  propertys features
• 1. Exact Location
• In the main business district, for example, even
  a few feet may make one location better than
  another. Access to mass transportation becomes
  increasingly important as the costs of private
  transportation and/or regulations become
  increasingly higher.
• 2. Age of the Building
• The older the building, the less future income
  can be derived from it in its present state.
• 3. Size of the Land Parcel

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DETERMINING RISK AND DEMAND

• 4. Quality of the Tenancies
• For example, other things being equal, a
  long-term lease represents more stable value than
  a short-term lease (e.g., hotel/motel room
  rentals are far less secure than apartment
  building leases).
• 5. Existing Financing on the Property Even
  between properties of otherwise equal investment
  value, better financing on one may give it an
  apparently lower CAP rate.
• 6. Operating Costs
• Pay particular attention to higher energy costs
  for heating and air conditioning. In any
  comparison of buildings for investment purposes,
  the type of construction (glass walls, for
  example) can have an important bearing on those
  costs. Labor costs and the likelihood of
  continued increases also need to be considered.

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EXCEL SPREAD SHEET AND CHART INSERTS

• PP 16 - 22

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II. EVALUATING THE RISK-RETURN TRADEOFF FOR A
REAL ESTATE PROJECT

• Now we will address the generation of the
  discounted cash flow, and take a first cut at
  financial ratio analysis.

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DISCOUNTED CASH FLOW MODELS

• I. DCF Model-Basic Data Requirements
• A. Investment outlays
• land costs
• building costs
• depreciation method
• useful life
• B. Operational characteristics
• rental income
• vacancy and collection factors
• operating expenses
• changes over time

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DISCOUNTED CASH FLOW MODELS

• I. DCF Model-Basic Data Requirements
• C. Financing
• amount of equity
• amount of debt
• amortization schedules
• interest rates
• required rate of return
• D. Reversion
• holding period
• terminal value
• debt retirement plans
• reversion period expenses

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DISCOUNTED CASH FLOW MODELS

• I. DCF Model-Basic Data Requirements
• E. Taxation elements
• ordinary income
• capital gains
• recapture provisions
• minimum tax, preference items

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II. DCF MODEL INPUTS AND OUTPUTS
Basic Data Requirements of Model
CASH FLOW ANALYSIS
Annual Cash Flows during Holding Period
Reversion Cash Flow at End of Holding Period
Implicit Assumptions - CAP Rates - Price/Rent
Ratios - Expense Ratios
Riskiness - Leverage - Coverage -
Break-even Points
Rate of Return - IRR/NPV
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RISK DICHOTOMY FOR REAL ESTATE
Risk
Debt/Equity
Assets
Business Risk
Financial Risk
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III. PROBLEMS INHERENT IN REAL ESTATE INVESTMENT
ANALYSIS FOR INCOME PROPERTIES UNDERLYING RISK
ANALYSIS

• A. Stabilized pro forma net operating income
• B. Projected changes in operating expenses and
  revenue base
• C. Projected selling price or refinancing value
• D. Estimated holding period
• E. Reinvestment opportunities
• F. Tax effects and financing effects

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A HIDDEN ISSUE IN MANY ANALYSISEXPECTED
DISTRIBUTION OF RETURNS FOR INVESTMENTS
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SPREAD SHEET ANALYSIS - 1986 TAX LAWS

• EXCEL SPREAD SHEET AND CHART INSERTS

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OFFICE BUILDING MARKET ANALYSIS

• 1. KEY ELEMENT Non manufacturing employment
  growth is the underlying demand generation for
  office space.
• 2. Analysis of the office buildings, though
  related more or less to all sub-markets, must
  stratify the market into appropriate subsections
  (see Figure 1).

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EXPLAINING OFFICE MARKET INSTABILITY

• 1. High financial leverage typical of office
  building finance makes new construction highly
  sensitive to changes in mortgage money rates and
  terms.
• 2. Tax shelter resulting from depreciation and
  interest deduction from taxable income provides a
  strong inducement to builders and investors to
  construct office buildings during periods of
  prosperity.
• 3. Office building construction often reflects
  non-market considerations, such as corporate
  prestige and image.

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EXPLAINING OFFICE MARKET INSTABILITY

• 4. The elasticity of supplies of existing office
  space facilitates the postponement of new demand
  under conditions of uncertainty, high money
  rates, or recession.
• 5. The eternal optimism of developers, the
  naivete of lenders, and the lack of sophisticated
  market analysis techniques prolong periods of
  over- and under-construction.
• 6. The long planning and construction period
  required often results in continued high
  construction volume long after weakness becomes
  apparent in the demand for office space.

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OFFICE SPACE MARKET ANALYSIS
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OFFICE SPACE MARKET ANALYSIS

• Demand for office space results from
• Expansion of space requirements by existing
  tenants
• New tenants moving from other cities
• New business firms in the community
• Increases in supply of office space may result
  from
• Existing tenants going out of business, reducing
  space, or moving to other cities
• Addition of new office space being added
  (including remodeling)
• Vacant office space available from previous years

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OFFICE SPACE MARKET ANALYSIS

• Example 1 Consider a community with following
  characteristics
• 5 percent office-space vacancy target, Vn
• Net real growth G of 1 million square feet of
  space
• Upgrade demand U for 760,000 square feet
• No space removed Or from inventory
• 200,000 square feet of space added Ou to the
  market
• 250,000 square feet of over hang Ov

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OFFICE SPACE MARKET ANALYSIS

• Example 2 Using the above data and not knowing
  the amount of space added Ou to the market, the
  absorption rate can be determined by first
  setting the market in equilibrium

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ANALYZING OFFICE BUILDING INVESTMENTSSPECIFIC
BUILDINGS

• 1. Building-site specific
• Street identity and prestige
• Efficiency ratio for net rentable space
• Percent of full floor users
• Tenant improvements
• Tenant mix
• Tenant turnover and leasing conditions
• Parking
• 2. Locational features
• Downtown
• Airport
• Regional shopping centers
• Freeways/heavily traveled main roads

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ANALYZING OFFICE BUILDING INVESTMENTSSPECIFIC
BUILDINGS

• 3. Market elements
• Amount and quality of competing space (correct
  strata)
• Current rentals
• Vacancies (and reasons for vacancies)
• Absorption rates
• Market capture potential
• 4. Key to office building investment analysis
• Purchase price of the property
• Financing terms
• Lease terms
• Present and future levels of operating income and
  expenses
• Future selling price
• Applicable depreciation rules
• Income and capital gains tax rates

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PROFITABILITY RATIOS(Calculated for each year of
project)
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RISK RATIOS
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ASSUMPTION RATIOS
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PROFITABILITY RATIOS
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RISK RATIOS
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ASSUMPTION RATIOS
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III. DEVELOPNG THE TECHNIQUES OF FINANCIAL
ANALYSIS

• This session will focus on two of the most widely
  used analytic tools
• Net present value (NPV)
• Internal rate of return (IRR)

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FUNDAMENTALS OF INVESTMENT ANALYSIS MESURING
RETURNS

• I. Time Value of Money Time and Risk
• A certain dollar today is worth more than a
  certain dollar tomorrow
• A risky dollar tomorrow is worth less than a more
  certain dollar tomorrow

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I. TIME VALUE OF MONEY TIME AND RISK

• A. Timing Present Value and Future Value
• If 1.00 now could be invested at 10percent for
  one year, it would produce 1.10 as the total
  return. In this context, it is said that
• The present value (PV) of 1.10 next year is
  1.00
• The future value (FV) of 1.00 today is 1.10
• The interest rate is the opportunity cost of funds

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I. TIME VALUE OF MONEY TIME AND RISK

• B. NPV (net present value) and IRR (internal rate
  of return)
• NPV Discounted cash flow of benefit stream -
  Discounted cash flow of cost stream

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II. SIMPLE INVESTMENT DECISION RULES
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• Definition IRR is a discount rate that takes the
  NPV 0. Hence 10 percent is IRR of our example.

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• Reinvestment Assumption
• For Option A, if 1.10 at the end of year 1
  reinvested at 10 will yield 1.10(1.1)1.21.
  Hence, if one can reinvest at the IRR10, Option
  As Benefit Stream FV1.211.21-2.42. This is
  identical to FV of Benefit Stream for Option B.
• Conclusion
• If IRR, reinvestment, and discount rate are
  identical, IRR rate and NPV will yield proper and
  consistent investment decisions.

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III. IRR and NPV Conflicts

• A. Multiple IRR solutions
• B. Mutually exclusive investments with different
  timing of cash flows
• C. Mutually exclusive investments with scale
  differences
• D. Reinvestment rate substantially different from
  IRR

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Class Problem
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SUGGESTED SOLUTION TO CLASS PROBLEM
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• 1. Choose investment with greatest NPV which
  differs with interest rate used for discounting
  PX.
• 2. NTVA 5000(1i)2 5000(1 i)5000
• Terminal Value of Cash Flows, excluding initial
  cost of 10,000.
• NTVB 16,500
• NTV and NPV rules yield same answers! Why?
• 3. At i 20 NTVA 18,000 gt 16,500 NTVB if A
  is preferred to B does NPV rule yield same
  result?

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IV. EXAMINING THE PROBLEMS AND PITFALLS OF
FINANCIAL ANALYSIS

• The day concludes with a presentation on duration
  and reinvestment issues, how to take uncertainty
  into account, and a summary of analytic
  techniques.
• Approaches to risk analysis
• Most likely outcome versus best/worst scenarios
• Sensitivity analysis for key parameters
• Probabilistic approaches
• Problems with the use of IRR
• Uniqueness
• Assumed reinvestment rate IRR
• Borrowing/lending rate market rate IRR

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• Three apparently different problems with the
  discount rate
• Cash flow disparity
• Project scale
• Time horizon difference

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• Reinvestment rate assumption and typical problems
• Time disparity of cash flows

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• Scale size differences

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• Time horizon issue

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• Other issues related to the use of IRR include
• Are the IRR and interest rates independent of one
  another for most investment decisions?
• How does the optimal holding period affect cash
  flows?
• How does the analysis change if there are capital
  budgeting/rationing constraints?

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DURATION AN INTRODUCTION
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