Financial Analysis of Value-Added Commercial Real Estate Projects

ObjectivesObjectives

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.

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Value Added Investments: Value Added Investments: An OverviewAn Overview

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In a value-added investment, the investor intends to increase the property value by:– Increasing the property’s economic cash

flow (NOI – CAPEX) byIncreasing revenue

Decreasing expenses

Lowering the risk of the cash flow stream

Value Added Investments: Value Added Investments: How Value is IncreasedHow Value is Increased

Increasing Revenue and/or Lowering the Risk of the Cash Flow Stream

Changing the Tenant Mix of the asset:

Generally an upgrade in quality:a.Increasing occupancyb.Increasing the lease ratec.Increasing the lease termd.Increasing tenant credit

Rehabilitating the asset, including upgrading the class of the asset:

Typically capital improvements. Rehabilitation of the physical asset should result in one or more of the following:a.Increased demandb.Higher occupancy c.Higher lease rated.Longer lease terme.Better tenant credit

Repositioning the asset:

Changing the asset’s use:a.Adding on to an existing asset classes and keeping existing use (new construction)b.Changing asset uses (hotel to multifamily)

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Value Added Investments: Value Added Investments: How Value is IncreasedHow 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:

Market area of the asset is being upgraded such asa.New infrastructure – roadsb.New employment centers – hospitals, large retailc.Major private project

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Value Added Investments: Value Added Investments: How Value is IncreasedHow Value is Increased

Operating expenses can be decreased through efficiencies or property upgrades• Taxes• Insurance• Maintenance• Management• Reserves

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How Value is Added to How Value is Added to Commercial PropertiesCommercial 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

Underwriting the Value-Added Loan

Underwriting The Value Underwriting The Value Added LoanAdded 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.

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The Capital Structure The Capital Structure Based on CostsBased on Costs

20%-100%

Sponsor Equity

- Highest Risk - First Loss Piece - Profit Equals Difference in Cost and Value

B65%-80%

1st Mezzanine - Current Yield/IRR: 8-12% - Typically pays current, but may accrue

A0%-65%

Senior Debt

- First Trust - Lower Rate/Lower Risk/Pays current - Required Yield: 6-8%

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Information Needed to Underwrite Information Needed to Underwrite the Loan and Analyze the Dealthe Loan and Analyze the Deal

To underwrite a value added real estate transaction, the investor requires basic information prior to making an investment decision.1. Capital Structure

The investors must know what they need & how the capital structure works.

You must know the capital structure before analyzing anything else.

2. Sources & UsesUnderstand how capital will be used in the project.

Understand where the capital budget is coming from.

3. Capital Improvement BudgetUnderstand 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.

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Information NeededInformation Needed

4. Current & Historical Operating StatementsUnderstand 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?

5. Rent RollBasic 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.

Information NeededInformation Needed6. 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.

7. Exit ValueThis 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

8. Other Helpful InformationSite Plan

Aerial Photos

Appraisal

Market sale comps

Market lease comps

Exit Strategies

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Exit StrategiesExit Strategies

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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.

Exit StrategiesExit Strategies

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1. 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)

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Exit StrategiesExit Strategies

2. Sale ExitBased 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

Value Added Investing: Metrics

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Value Added MetricsValue Added MetricsThe 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

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Value Added MetricsValue 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)

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Value Added MetricsValue Added MetricsThe 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 StackEQUALS: Gross Profit

Gross Profit percentage on cost =Gross Profit/ Total Capital Stack

Gross Profit percentage on Value=Gross Profit/ Exit Value

Value Added Key MetricsValue 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

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SourcesSources

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.

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