Financial Analysis of Value-Added Commercial

Real Estate Projects

Objectives
Develop skills to identify and analyze valueadded 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:

An Overview
In a value-added investment, the investor
intends to increase the property value by:
Increasing the propertys economic cash flow
(NOI CAPEX) by
Increasing revenue
Decreasing expenses
Lowering the risk of the cash flow stream

Value Added Investments:

How Value is Increased
Increasing Revenue and/or Lowering the Risk of the Cash Flow Stream
Generally an upgrade in quality:
Changing the Tenant Mix of
the asset:

Rehabilitating the asset,

including upgrading the class
of the asset:

a.Increasing occupancy
b.Increasing the lease rate
c.Increasing the lease term
d.Increasing tenant credit

Typically capital improvements. Rehabilitation of the physical

asset should result in one or more of the following:
a.Increased demand
b.Higher occupancy
c.Higher lease rate
d.Longer lease term
e.Better tenant credit

Changing the assets use:

Repositioning the asset:

a.Adding on to an existing asset classes and keeping existing use (new

construction)
b.Changing asset uses (hotel to multifamily)

Value Added Investments:

How 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 as

a.New infrastructure roads
b.New employment centers hospitals, large retail
c.Major private project

Value Added Investments:

How Value is Increased
Operating expenses can be decreased
through efficiencies or property upgrades

Taxes
Insurance
Maintenance
Management
Reserves

How Value is Added to

Commercial 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

Added 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

Based on Costs
20%-100%
Sponsor Equity

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65%-80%
1 Mezzanine

0%-65%
Senior Debt

st

- Highest Risk
- First Loss Piece
- Profit Equals Difference in Cost and Value
- Current Yield/IRR: 8-12%
- Typically pays current, but may accrue
- First Trust
- Lower Rate/Lower Risk/Pays current
- Required Yield: 6-8%

Information Needed to Underwrite

the 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 & Uses

Understand how capital will be used in the project.
Understand where the capital budget is coming from.

3.

Capital Improvement Budget

Understand 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 Needed
4.

Current &

Historical Operating Statements

Understand 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 Roll
Basic 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 Needed
6.

Project Pro Forma

This is the borrowers 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 Value
This 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 Information

Site Plan
Aerial Photos
Appraisal
Market sale comps
Market lease comps

Exit Strategies

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Exit Strategies
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.
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Exit Strategies
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 Strategies
2. Sale Exit
Based 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

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Value Added Investing: Metrics

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Value Added Metrics

The 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 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 Metrics

The Key Metrics
The Gross Profit Test:

Gross Profits must be at a level to account for the

risk and time required to complete the valueadded process
Formulas:
Exit Value (Stabilized NOI / Exit Cap Rate)
LESS:
EQUALS:

Total Capital Stack

Gross Profit

Gross Profit percentage on cost =

Gross Profit/ Total Capital Stack
Gross Profit percentage on Value=
Gross Profit/ Exit Value
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Value 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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Sources
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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