Fin 4071010/30/2013

AdminDevelopment pro form homework assignment

– on Sakai? Please read Linneman chapter 12Exam answer key – available on line; please

review and se me if you have questionsIn the news? Overland Park

..\Data\OVERLAND MARKETPLACE P-1 101405 P-3.pdf ; Google Earth 159th and Metcalf, Overland Park, KS

Development pro forma (from pervious slides)

Real estate development is a process:Site evaluationEntitlement (permitting) workLand acquisitionCapital sourcingSite work“Vertical” constructionMarketing/leasingProperty managementProperty disposition

Development pro forma processPutting together a development pro forma:

Start with a site plan – layout out leasable spaces Estimate rent rates for space uses/tenant types (first pass –

commercial broker) and lease type (gross versus NNN) Estimate operating expenses – RE taxes, insurance, CAM

expenses (general rules of thumb) and expense recoveries (if net lease)

Estimate capital costs - since focus is on first year stabilized (post-development) NOI, usually include initial lease commissions, initial TI (part of construction budget), and possibly a cap ex reserve

Compute year 1 stabilized NOI Use forecasted end-of-development period cap rate to value

development project on comletion

Cost side – estimate hard/soft development costs – Layout detailed construction plan w/time line – use to

compute construction loan “draw down” (explain?) to determine how much interest accrues (recall that interest is “paid” by rolling it into the loan balance outstanding)

Compute total development project costs including construction loan interest accruals

Compute cash yield on development costs = NOI/total cost; compare to the market cap rate forecasted on project completion

If development yield (also called the development cap rate) minus market cap rate (the spread) is big enough, proceed

Notes on pro formaSome project costs incurred prior to land

acquisition/construction are called “pre-development” and may be paid by the developer (rather than from a joint venture formed by the developer and capital partners (investors))

Thus, the purpose of the pro forma must be specified

Construction plans are usually quite detailed, but not in our Overland Park example (see pro forma)

Back to Overland ParkN:\Private\Fin 70710\OVERLAND MARKETPL

ACE P-1 101405 P-3.pdf ; N:\Private\Fin 70710\Overland Park Master Proforma 21407 B.xls

Google earth – 159th Street and Metcalf Avenue, Overland Park, KS

EconomicsInvestment analysis for stabilized properties is relatively

straightforward DCF analysis –

Usually you forecast cash flow based on leases and lease turnover Based on end of investment period income (NOI), estimate sale

price of property with simple method (direct capitalization) Discount cash flow to find present value

Cap rate = NOI/(property price); cap rate is similar to interest rate or rate of return (income over cost of investment) Basic idea – cap rates should be similar for similar properties;

observe prices, NOI for similar, recently traded properties and compute cap rate

Use cap rate from “comparables” and NOI from target property to estimate target property value

Development is somewhat different; First, it is much riskierSecond, there is less value in forecasting NOI

out multiple periods because of the lack of lease encumbrances

In development, you have forecasts of stabilized (post development) NOI and total project cost:Compute something like cap ratio: (unlevered)

yield = development cap rate = NOI/project cost;Like market cap, development cap is something of a

rate of return on investmentIf the development cap (think return on project) is

higher than the market cap (think market return on stabilized real estate investment), then the project is a money maker

Development is risky – how much higher does dev. cap have to be?

Good question –it depends on the perceived risks of the project; generally, for a retail development, development cap (yield) is expected to be at least 250-300 bps. higher than the market cap rate

The math – the implied % capital gain (value-added) on the development investment:

Market cap = NOI/price; Dev cap = NOI/cost(Dev cap)/(Market cap) = price/cost = 1 + (price – cost)/cost = 1 +% capital gain

If the yield is 9% and the cap rate is 6%:% capital gain = 9%/6% - 1 = 50%

How does this relate to standard economic

analysis?First, it is just a rule of thumb – we have no

objective measure of the cost of capital, nor do we have a time value of money analysis

Note that debt costs are considered part of the project cost (they are capitalized and included), but that equity capital costs are not included as project costs

The implied investment horizon is the construction and stabilization period (i.e., we are assuming asset sale upon stabilization); will this be in the interests of your capital partner?

Computing rate of returnSuppose that the forecasted development cap is 9% and that

the market cap is 7%; Value/cost is 9%/7% = 128.6%; thus each $1 of cost generates $1.286 in market value; 9%/7% - 1 = 28.6% is the capital gain (value-added);

What is the return on the equity investment in the development project? We need some additional informationSuppose the development is financed with 25% equity capital and

the remainder construction debt; Also suppose that the equity “comes in first” (it is invested before

you receive construction debt funding) and the equity is invested at the start of the project (land take down)

Assume that project takes 3 years from land acquisition (financed with equity) to stabilization and that revenues and operating costs are negligible until stabilization, what is the return on equity (IRR)?

At the end of the 3 year development period, assume we sell the development for $1.286/per dollar of cost,

Debt financing is $.75; leaving $.536 for the equity holders

Solve for IRR: $.25 = $.536/(1+IRR)3; IRR = 29% - what do you think?

Required development returnDevelopers tend to use the development cap/market

cap spread as their metric of valueReturn requirements are often defined in terms of the

spread –Office building spreads are usually at least 200 bps; Retail spreads are usually 250 bps -300 bpsNote: equity IRR is sensitive to the development time

horizon; thus there is usually an implied development period in these spreads (24-36 months)

Question – suppose you were doing a “build-to-suit” in which the building in custom built for a tenant and leases prior to construction; what should the spread be?

Residual land valuationLand is often valued as a residual - essentially

total value of project net of other development costs (including a fair return on costs)

In this spirit, a common way of setting up development pro forma – find the maximum land value consistent with the required dev. cap/market cap spread

Overland Park illustration