Real Estate Financial Modelings

Guide to the Real Estate Business

www.realestatefinancialmodeling.com Photograph by Zoltan Farago. All rights reserved. All Other Contents Copyright 2009 Real Estate Financial Modeling, LLC. All rights reserved.

Table of Contents

Foreword Why Real Estate? A Big-Picture Real Estate Business Framework Types of Real Estate Types of Real Estate Investors Elements of Real Estate Investment Types of Capital Equity Debt 1031 Exchange Uses of Capital Investment Objectives and Methods Income (Maximizing Cash Flow and Yield) Recouping of Investment and Profit Taking Valuation of Real Estate Discounted Cash Flow and Time Value of Money Model NOI, Cap Rates and Comparable Sales Model Replacement Cost Additional Resources

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Foreword. This guide has been kept concise so that it can be read in a single afternoon. It is written on a basic level and is primarily intended to bring up to speed those with little prior exposure to the world of real estate. However, there is likely something of interest in the guide for readers of all levels of expertise. The guide takes a big-picture view of the industry and attempts to show how all of the pieces fit together. It is by no means an exhaustive treatment, and is best read as a companion to Professor Peter Linnemans Real Estate Finance & Investments: Risks and Opportunities textbook, with the Barrons Dictionary of Real Estate Terms at hand. I wish you all the best in your real estate endeavors. Bruce Kirsch Principal Real Estate Financial Modeling, LLC www.realestatefinancialmodeling.com

Why Real Estate? Real estate is a dynamic, high-stakes industry where massive fortunes have been made, lost, and sometimes made again. Real estate is the suburban American dream home with the white picket fence, the tiny overpriced New York studio apartment, the Nike corporate campus, the Empire State Building, the shopping mall, the monstrous Wal-Mart Supercenter, and the Hawaiian vacation resort with the oceanside golf course, to name a few manifestations. The industry is enormous in size (the U.S. commercial market alone is a multi-trillion dollar market) and expansive in scope. Real estate is often the majority of a U.S. familys wealth, and is usually a major portion of a corporations assets. It is home to both low-key moguls such as Walter Shorenstein and Gerald Hines and flamboyant personalities like Sam Zell and Donald Trump. Real estate is about people, properties, deal making and value creation. If all of this interests you, read on!

A Big-Picture Real Estate Business Framework. Below is one framework in which to view the real estate business (it is by no means the only way!). The comprising elements are explored separately on the following pages.
Types of Real Estate Investors Private Individual Family Investment Firm REIT Equity Mortgage Hybrid Non-REIT Pension funds Life/insurance companies Opportunity (private equity) funds Other Investment banks Commercial banks State and city governments

Types of Capital Equity Personal and/or family investment Private equity Tax credits Debt Commercial mortgage loans Government bonds 1031 Exchange

&

Residential Detached single family homes Townhomes

Commercial Office Central Business District (generally highrise and midrise) Class A (e.g., The GM Building in NYC) Class B (increasingly lesser in quality and location) Class C Suburban (generally midrise) Class A Class B Class C Medical Office Multifamily (apartments, condominiums and cooperatives) Small properties Suburban garden apartments Urban midrise Urban highrise Hotels and resorts Limited service Full service (e.g., The Ritz Carlton or Marriott) Extended stay Industrial Heavy industrial (manufacturing) facilities Light assembly Storage and distribution facilities Research and development facilities Retail Shopping centers Super regional centers (e.g., Mall of America) Regional center Community center Neighborhood center Convenience center Specialty center Big box (freestanding) store (e.g., Home Depot) Strip commercial Other Golf courses Assisted living Student housing

Land Health Care Institutions

Valuation Methods Discounted Cash Flow and Time Value of Money Model NOI, Cap Rates and Comparable Sales Replacement Cost

Uses of Capital Acquisition of existing rental property Rehabilitation/Repositioning Land entitlement or rezoning Ground-up new property development

Investment Objectives and Methods Income (Maximizing Cash Flow and Yield) Escalation of rents Achieving operational efficiencies Refinancing of debt at a lower rate Paying down debt Acceleration of depreciation Favorable tax re-assessment Deferring maintenance Lowering debt amortization Offering ancillary property services Recouping of Investment and Profit Taking Condominium (ownership interest) sale Sale and leaseback Refinancing Fee simple disposition

Types of Real Estate. Real estate is generally separated into residential and commercial categories. Detached single family homes and townhomes are usually what fall under residential (some will also include multi-family in this category), while commercial is comprised of multiple sectors as broken out below.
Types of Real Estate Residential Detached single family homes Townhomes Commercial Office Central Business District (generally highrise and midrise) Class A (e.g. The GM Building in NYC) Class B (increasingly lesser in quality and location) Class C Suburban (generally midrise) Class A Class B Class C Medical Office M ultifamily (apartments, condominiums and cooperatives) Small properties Suburban garden apartments Urban midrise Urban highrise Hotels and resorts Limited service Full service (e.g., Ritz Carlton or Marriott) Extended stay Industrial Heavy industrial (manufacturing) facilities Light assembly Storage and distribution facilities Research and development facilities Retail Shopping centers Super regional centers (e.g., Mall of America) Regional center Community center Neighborhood center Convenience center Specialty center Big box (freestanding) store (e.g., Home Depot) Strip commercial Other Golf courses Assisted living Student housing

Land Health Care Institutions

Types of Real Estate Investors. Real estate is a well-established investment vehicle, and unsurprisingly, real estate investors have grown in number, type and sophistication over time. Investors fall into the four main categories that are shown and described below.
Types of Real Estate Investors Private Individual Family Investment Firm REIT Equity Mortgage Hybrid Non-REIT Pension funds Life/insurance companies Opportunity (private equity) funds Other Investment banks Commercial banks State and city governments

Private individuals, families, or investment operations make both small and large investments. Developers, those who transform raw land or an existing property to an improved (and hopefully more valuable) state, often fall in this category. REITs (real estate investment trusts), which own about one third of the commercial investment properties in the U.S., can be either privately or publicly owned. o Equity REITs develop, manage, invest in and own properties. Their revenues come primarily from rents from tenants and capital gains realized upon sales of assets. o Mortgage REITs do not generally own real estate they typically loan money to people or companies that buy real estate. They also purchase existing mortgages or mortgage-backed securities. Their revenues come from the interest paid to them on the capital they loan. o Hybrid REITs combine the two types of investment explained above. Non-REIT equity investors, which can be either privately or publicly owned, include large money managers such as pension funds1, life/insurance companies, and opportunity funds (private equity funds), all of which make equity investments, and the latter of which tends to invest in transactions with higher risk/return profiles. In the other category fall investment banks that raise equity and debt for REITs and other types of real estate firms wishing to access the capital markets, and commercial banks such as Wachovia, which make loans on real estate investments. Lastly are state and city governments, which issue bonds that private investors fund and then sell to developers.
Pension funds are funds managed for large groups of public and private sector employees who hope to be supported through their retirements based on investment returns achieved by their former employers fund managers investments in vehicles such as real estate and the stock market.
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Elements of Real Estate Investment. Below is a basic way to view the components of real estate investment. The pages that follow address each element.
Elements of Real Estate Investment Types of Capital Equity Personal and/or family investment Private equity Tax credits Debt Commercial mortgage loans Government bonds 1031 Exchange Uses of Capital Acquisition of existing rental property Rehabilitation/Repositioning Land entitlement or rezoning Ground-up new property development Investment Objectives and Methods Income (Maximizing Cash Flow and Yield) Escalation of rents Achieving operational efficiencies Refinancing of debt at a lower interest rate Paying down debt Acceleration of depreciation Favorable tax re-assessment Deferring maintenance Lowering debt amortization Offering ancillary property services Recouping of Investment and Profit Taking Condominium (ownership interest) sale Sale and leaseback Refinancing Fee simple disposition

Types of Capital All real estate projects, like other business ventures, require capital to get off the ground and to come to fruition. Whether you are building a highrise office complex in San Diego, a community of detached single family homes in Ohio, or converting a vacant warehouse into loft condominiums in New Yorks SoHo, nothing happens without capital. Real estate investments usually entail a mixture of equity and debt (see diagram on next page). The various types of capital are discussed below. Equity. Equity is generally cash that is invested in return for an ownership share in an investment project2. This stake can be held indefinitely, sold back to the developer or another investor for cash, or traded for other assets. In the first two scenarios, the difference between the cash originally invested in the project and that received when the share is sold by the investor, less transaction costs such as legal fees, is the investors cash on cash return on investment, or ROI. The main sources of equity are shown below: Personal and/or family investment personal or family wealth is often a source of equity in real estate projects, many of which are run by family-based real estate operations. Private equity this is a fancy name for cash that is invested in projects, often by an investment management firm3, on behalf of investor clients such as wealthy individuals and families, endowments and pension funds who entrust these firms to achieve targeted cash on cash investment returns over the life of the fund in which their investments reside. Tax credits tax credits are federal government granted tax breaks that real estate developers are allotted for developing low-income housing or renovating and preserving historical structures for reuse. The developer sells these credits to corporations or middlemen for cash.

Non-cash equity types include land contributions by an investor, sweat equity, whereby a developer will contribute their expertise and man-hours to an investment. Some may also consider pre-sales e.g., of homes or condominiums, to be equity. 3 Private equity can also simply be cash that friends or acquaintances invest in a project.

Debt. Many real estate projects are simply too large for a developer to raise a sufficient amount of cash to pay for the whole project. In Washington, DC, for example, hard construction costs alone for a Class A office building are at least $250 per square foot, meaning an office building of 200,000 square feet in gross area would have a construction contract alone of around $50,000,000. For most, this is a prohibitive amount of cash to raise for an investment. Consequently, debt, or borrowed money that will be repaid to the lender at a certain rate of interest, often enters the picture in funding real estate investment (see diagram below). Additionally, many developers choose to use debt, also known as leverage, as a financing vehicle due to a desire to diversify their investments, the tax shelter associated with making interest payments, and the higher returns on equity that can be achieved with debt as part of the financing structure. Commercial mortgage loans from major financial institutions are a common way real estate projects get financed. Government bonds are another source of debt financing for projects.

Capital structure of a sample $100MM investment with an 80% Loan-to-Cost General Equity breakdown 10% from Principal/Developer Equity 20% Equity $20,000,000 90% from Equity partner e.g., Opportunity (private equity) fund M ezzanine (Junior) Debt $20,000,000

80% Debt

Senior Debt $60,000,000

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1031 Exchange. A special case that can be considered a source of capital is made possible by a federal law that allows the disposition (sale) of one real estate property and the use of the cash received to acquire another real estate property that generates similar real estate taxes without the payment of capital gains taxes. This is known as a 1031, or like kind, Exchange.

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Uses of Capital A real estate investment can be made once financing has been arranged. Projects take many forms, some of which are described below: Acquisition of existing rental property a rental property can be office, multifamily (apartments), hotel, retail, warehouse or industrial. Often the primary object of acquiring an existing property is the income that comes from the tenants renting space at the property, which can be improved over time through rent escalations. Capital appreciation is naturally another motivation for such an acquisition. Rehabilitation/Repositioning rehabilitation of an existing property is another investment option. Some renovations will be undertaken to retain the existing use of the property, while others are intended to convert the property to an alternative use. Conversions of commercial, industrial, and warehouse properties have historically been popular ways of creating differentiated multifamily product. Old industrial and warehouse properties have also been converted into office buildings. Land entitlement or rezoning acquisition of land (i.e., gaining title, or legal ownership) for resale to another investor. This may entail petitioning the city or town government for a rezoning, or a change in the permitted use, of the parcel(s) in question. Ground-up new property development building new real estate product generally takes the form of office, retail, hotel, multifamily, single family detached homes, industrial, warehouse, or a combination thereof (any combination of retail, hotel, multifamily and office is referred to as mixed-use). Ground-up development usually also entails land acquisition if the land is not already owned by the developer. For the second and fourth investment types above, uses of capital will generally include: architectural and engineering fees; construction fees; interior design and decoration fees; and property marketing / leasing brokerage fees.

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Investment Objectives and Methods. Some real estate investments are made for a long-term income stream e.g., purchase of a hotel or office building, while others target near-term recouping of investment and profit taking, such as condominium development. Income (Maximizing Cash Flow and Yield) In the case of investments targeting long-term income, the primary method of maximizing after-tax cash flow and yield (the rate of earnings) on the investment is the escalation of rents. Some additional ways to enhance investment yield are described below.

Achieving operational efficiencies negotiating a better contract with your vendor e.g., your maintenance or cleaning service provider. Scale is an advantage the larger a customer you are for your vendors, the more leverage you have in decreasing your service contract fees. Refinancing of debt at a lower interest rate depending on the amortization structure of the debt and the cash management features in the loan agreement, securing better interest rates on debt may lower interest payments and increase after-tax cash flow. Paying down debt depending on the amortization structure of the debt and the cash management features in the loan agreement, paying off owed principal may also lower interest payments, increasing cash flow. Acceleration of depreciation accelerated depreciation will lower adjusted gross income and increase after tax cash flow in the near term. Favorable tax re-assessment convincing the period assessor that their assessment is too high can marginally cut your property tax (this does not happen that often). Deferring maintenance pushing out capital improvements into future periods will increase cash flow in the near term. Lowering debt amortization by paying off a smaller portion of the principal of debt owed, cash flow will increase. Offering ancillary property services some owners offer Internet access, IT services, and other non-real estate related products to their (captive audience) tenants. Since tenants already have a

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relationship with the owner, they may contract for services to reduce the number of vendors with whom they do business.

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Recouping of Investment and Profit Taking Methods of recouping investment and harvesting of return that allow lumpsum repayment of debt are shown below. Condominium (ownership interest) sale condominiums are part ownerships in office, retail or residential complexes. These are spaces that are sold outright to a third party, who can lease and resell the space if they choose. Sale and leaseback many large companies own their own buildings, especially if they are the only tenant in the building. If they decide that they would like to sell the building so they can make other investments, but do not want to move to another building, they will sell the property and then lease their space back from the new owner. Refinancing leveraging a currently debt-financed property at a value higher than the original value at which it was financed, paying off the original loan and keeping the equity piece, is a way to recoup investment and take profits. Fee simple disposition whether or not the owner of a property is a tenant at the property, they can simply sell the property, repay their lender for debt owed, and invest their return elsewhere.

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Valuation of Real Estate. Determining the worth of a real estate property, whether it is a parcel of land or a 2,000-unit apartment portfolio, is critical to success in real estate investing. Three valuation methods used by investors are described here. Note that more than one method can (and should) be employed when evaluating an investment to allow the multiple valuations to serve as checks on one another. Valuation Method One: Discounted Cash Flow and Time Value of Money Model Real estate finance operates along the same basic principles as finance for any other business: the discounted cash flow (DCF) and time value of money (TVM) model. Discounted cash flow analysis for real estate dictates that a real estate asset is worth the expected value of all future cash flows generated by that asset, with the expected future cash flows adjusted back to their value in present-day dollars. DCF analysis rests on the concept of the time value of money i.e., the assumption that a dollar in hand today is worth more than a dollar received tomorrow, next month, next year, or any time in the future. The reasoning is that if you have one dollar today, you can invest it and get a positive return so that you have an amount more than one dollar by the time you would have received the one dollar in the future. If one thinks of an investment over a multiple-period scenario (see below), and assumes the return earned from the investment in the first period is added to the original investment, and the same percentage return is achieved in the second period, the investment is not growing in just a simple fashion, but is growing at the percentage return of an increasingly larger base. This is known as compounding, and applies in that a rental property is expected to grow its cash flows over multiple periods at a positive rate (which may or may not be assumed to be constant from period to period). Each periods compounded future cash flow is known as the future value of the original investment at that point in time.

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Discounted Cash Flow and Time Value of Money Model Assume a 5.5% constant growth rate
Year 1 Year 2

Today

End of Year 1

End of Year 2

$100 Today $100 ---

$105.50 End of Year 1 $100 $105.50 $100 x (1 + .055)

$111.30 End of Year 2 $100 $111.30 $100 x (1 + .055) x (1 + .055)

Present Value Future Value of $100 Future Value Derivation

When valuing a real estate property, assuming that its value comes only from its expected future cash flows, DCF states that the present value of the property (i.e. the maximum you should pay for it, or the very least that you would accept for it as the seller) is the sum of the present values (the discounted value, or mathematical converse of the future compounded value) of all of the expected future cash flows of the property. If you are evaluating an investment property using this model, you would determine the net present value (NPV) of the investment by subtracting the investment you make (the price you would pay for the property) from the sum of the present value of the propertys future cash flows (which likely will include proceeds from the buildings sale after an assumed number of years). If the difference is a positive number, then the investment could be partially justified on this basis. While this valuation process may seem simple, there are a lot of other factors that go into the determination of the expected cash flows and into making an investment. Both tasks are quite involved and subject to many assumptions, making them a combination of both art and science.

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Valuation Method Two: NOI, Cap Rates and Comparable Sales Model You will likely hear the terms NOI and cap rates thrown around more often that any other real estate terms. An explanation follows so you know when to smile and when to frown when discussing a propertys price. NOI and cap rates are an alternate, quick, and more basic way of valuing real estate, but the valuation estimate produced by this method is reliable only when the earnings of the property are assumed to be stabilized i.e., that next years earnings of the property are expected either to be flat, or to grow relatively smoothly over the current earnings. The earnings of a property are known as net operating income, or NOI. More specifically, NOI is total operating income less total operating expenses for a property. A capitalization rate, or cap rate, can be thought of as the reciprocal of the ratio of a propertys price to its future stabilized earnings, or more precisely, the percentage that results when dividing next years stabilized NOI (earnings) by the price paid today for the building4. An example is below. Next years stabilized NOI: $500,000 Price paid for building: $5,000,000 Cap rate = ($500,000 / $5,000,000) = 10% In other words, Cap rate = Next years stabilized NOI / Price paid today. To do a back of the envelope valuation of a(n assumed) stabilized property, you normally multiply the reciprocal of the cap rate, also known as the multiple, by next years stabilized NOI, as this is the first cash flow you will receive as the owner. Cap rates are discussed so much because they measure how expensive certain properties are for the stabilized income they are expected to generate. The lower a cap rate, the higher the price that was paid for a given level of stabilized NOI (i.e., in the extreme, properties are overvalued). Conversely, the higher a cap rate, the lower the price that was paid for a given level of stabilized NOI (i.e., in the extreme, properties are undervalued). Note that cap rates differ by asset class and location e.g., good central business district offices will have lower cap rate than suburban offices all else equal.
Cap rates quoted by one person are not necessarily calculated off of the same years NOI figure as those quoted by another person (e.g., one person may use next years earnings while another person may use current years earnings), and NOI is not necessarily being defined in the same way by all parties (e.g., some may deduct cap ex, leasing commissions, etc., as operating expenses while others who do not consider them operating expenses do not deduct them to get to NOI). To prevent yourself from grossly miscalculating the price paid for a building, it is important to ask how the person quoting the cap rate calculated it (although they may tell you its none of your business!).
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Cap rate discussion is analogous to stock market investors talking about the forward P/E ratio (current share price-to-the next fiscal years earnings per share) of stocks as a measurement of under- or over-valuation of the shares based on their expected earnings in the upcoming year. Cap rates are used to value properties by looking at the cap rates of recently sold properties with similar characteristics to the one being valued. Applying the multiple of these comparable sales to the estimated next years stabilized NOI will tell the investor the propertys rough market value. See the example below. Cap rate of comparable properties recently sold: 8% Estimate of next years stabilized NOI at property being valued: $3,500,000 Multiple = 100 / 8 = 12.5 Estimated market value = 12.5 x $3,500,000 = $43,750,000 For more on cap rates, including a discussion of the Gordon Model, see Chapter 7 of Professor Linnemans text. Valuation Method Three: Replacement Cost In situations when fair compare properties do not exist, and even when they do, an investor can value a property based on the cost of replacing (reconstructing) it on a per square foot basis. This approach entails estimating replacement of the property, less depreciation, and then adding back the value of the land site (note that land does not depreciate). In general, replacement cost is not used as a strict valuation method, but as more of a sanity check and upper bound on valuation calculations (i.e., if you are buying a building for $500 per square foot and your estimate of replacement cost is only $350, you will likely question the logic of paying such a steep premium).

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Additional Resources Financial Modeling Solutions and Education Real Estate Financial Modeling www.realestatefinancialmodeling.com Glossary Institutional Real Estate Inc. Commercial Real Estate Lingo http://www.irei.com/terms/terms.html Periodicals Knowledge at Wharton http://knowledge.wharton.upenn.edu/index.cfm?fa=viewCat&CID=8 Globe Street www.globest.com Commercial Property News www.cpnonline.com Real Estate Alert www.realert.com Realty Stock Review www.reri.org National Real Estate Investor www.nreionline.com The Real Deal www.trdeal.com Wall Street Journal (Wednesday edition) http://online.wsj.com/public/us New York Times http://nytimes.com/pages/realestate/index.html Crains New York Business http://www.crainsnewyork.com/

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Real Estate Organizations CCIM Institute www.ccim.com Urban Land Institute www.uli.org National Association of Office and Industrial Properties www.naiop.com National Association of Real Estate Investment Trusts www.nareit.com International Council of Shopping Centers http://icsc.org/ Appraisal Foundation www.appraisalfoundation.org National Multi-Housing Council www.nmhc.org The Institute of Real Estate Management www.irem.org

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