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Development pro form homework assignment on

Sakai? Please read Linneman chapter 12 Exam answer key available on line; please review and se me if you have questions In 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 evaluation Entitlement (permitting) work Land acquisition Capital sourcing Site work Vertical construction Marketing/leasing Property management Property disposition

Development pro forma process

Putting 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 (postdevelopment) 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 forma

Some 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 Park

N:\Private\Fin 70710\OVERLAND MARKETPLACE 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

Economics
Investment 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 riskier Second, 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 investment If 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 return

Suppose 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 information
Suppose 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 return

Developers tend to use the development cap/market cap

spread as their metric of value Return 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 bps Note: 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 valuation Land 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