final 210 notes.docx

Topic 6 Equity and capital Structure In the Investment process, this is section: 4. Apply decision making criteria 5. Make an investment decision The two main financial decision-making metrics that are used: Net Present Value (NPV) Internal Rate Of Return (IRR) Both metrics use cash flow models of p...

Topic 6 Equity and capital Structure In the Investment process, this is section: 4. Apply decision making criteria 5. Make an investment decision The two main financial decision-making metrics that are used: Net Present Value (NPV) Internal Rate Of Return (IRR) Both metrics use cash flow models of properties or real estate investment, developed as par of the financial analysis. Equity holder: is anyone who has a stake in the ownership of a property. The own the residual rights to all cash flows and liquidation proceeds after ‘’ the creditors have been paid.’’ Unlimited upside Possibility to limit downside risk though the form of equity. No set maturity date No set cash flow stream Ultimate decision makers Real estate equity investment: Direct Proprietorship Co-ownership Property is owned directly by one or more individuals. Unlimited liability which extends to the owners’ other assets The income of the property is taxed in the hands of the owners. Indirect Partnership Formal agreement among a group of people or companies to share ownership. General Partners (GP) Unlimited liability which extends to the partners’ other assets The income of the property is taxed in the hands of the partners. Limited partners (LP) Only at risk for their investments Income of the property is taxed in the hands of the partners. Generally, financial partners are not involved in the day-to-day management of the property. Partner’s share may be disproportionate to the capital invested. Corporation Legat entities, owned by shareholders but separate form their owners. Shareholders elect the BOD who selects management. Pay corporate taxes. Income is distributed through dividends, if declared, which are taxed in the Shareholders’ hands. Shareholders are only at risk for their investment. Private or publicly traded. Corporations whose primary business is investing in or operating real estate projects are called Real Estate Operating Companies (REOC), the pay regular corporate taxes. REIT (Real Estate Investment Trusts) Legal entities whose primary business is real estate investment. To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment. At least 90% of trust’s revenue must come from rent or mortgage interest and capital gains from real or immovable properties in Canada. At least 75% of the total faire market value of all trust properties that the REIT holds must be in Canada. Must be publicly traded (can be private in the US) High levels of distribution (about 90% of its taxable income). Net Present value The NPV is the sum of the PV of the cash flow generated by the investment MINUS the initial investment: NPV = SUM (PV of cahs flows) − initial investment The discount rate is the rate of return required by the investor AKA hurdle rate. The Hurdle rate is also used to discount a project’s future cash flows to its net present value. If the NPV returns a value greater than zero, the investment generates a rate of return greater than the hurdle rate. The greater the NPV the more attractive the investment The NPV can be calculated using cash flows before interest (unlevered) or after interest (levered) The hurdle rate will be different under both scenarios. An unlevered NPV will generally us Risk adjusted weighted average cost of capital (WACC) A Levered NPV will generally use risk adjusted required cost of equity return. IIR The IRR is the rate of return of the investment. IRR tells the investor what the annual growth rate is. It is the discount rate which will give an NPV of zero The IRR is compared to the hurdle rate of the investor. If IRR > Hurdle rate: investment is made. The greater the IRR the more attractive the investment The IRR can be calculated on an unlevered or levered basis. It would then be compared to the appropriate hurdle rate (UL or L) Most widely used investment metric in real estate Allocation of profit Preferred returns: When an investor (LP) has first claim on profits until he has achieved a certain IRR. Often given as an incentive for a financial partner to invest. Promote: When an investor earns a disproportionate share of the profits Often given to the investment manager of operating partner (GP) as a form of bonus for achieving a higher IRR Generally, applies to profits after the financial partner (LP) has achieved his targeted IRR. Claw back: when an investor gives up a portion of their return to another investor if a certain IRR is not met. Applies most often to the operating partner or investment manager. Exits Not all investors in a project may want to exit (sell) at the same time. For example, a managing partner earning management fees may want to retain the asset while a financial partner may want to sell their investment. There are strategies that can be used to make the exit of one or more investors easier and less contentious. Right of First Offer Right of First Refusal Shotgun Clause Sale by Appraisal Right of first offer: the departing investor (i.e. the departing co-owner) sets their selling price but “MUST FIRST OFFER” the existing remaining investors (i.e. the remaining co-owner) the chance to purchase the asset at that selling price “before offering it in the market”. Right of first refusal: the departing investor (i.e. the departing co-owner) “MUST OFFER” the existing remaining investor (i.e. the remaining co-owner) the chance to purchase the asset at the specific price already agreed upon with a third party. Shotgun Clause: a co-owner offers to buy the share of the “other co-owner at a price he/she determines”. The “other co-owner” must EITHER sell his/her share at the offered price OR decide to buy the offering co-owner’s share at the offered price. Sale by Appraisal: when investors agree to transact, the value will often be set by one or more independent appraisers. Capital Structure Secured debt: guaranteed by a specific asset (mortgage) Wrap-around: 2nd rank on a mortgaged asset. When the first mortgage reaches maturity, the new lender will advance additional funds to repay it and becomes the 1st ranked lender on the asset. Mezzanine debt: subordinated to the first and second mortgage, it offers a higher LTV for a higher rate. Unsecured debt: Secured only by the corporate credit and not one specific asset. Preferred Equity: receives dividends and liquidation proceeds before the funds are paid to common equity holders. Additional Sources of Funds Sale Leaseback: Property owner sells their asset and then leases it back from the buyer. Ground Lease: Landowner provides a long-term lease on the land and permits the lessee to build on the land. Pad Sale: The segregation and sale of a small portion of a property (Pad). Sale of rights: the selling of air, mineral, water, oil, and gas rights Topic 7 Development Development The creation of a new property, from concept, through construction, to tenant occupancy Can be driven by: Requirements for a specific user Speculation The cost of bringing new commercial space to the market includes both development and construction costs. Development costs are often referred to as Soft Costs and will start before construction begins. They include: professional services (legal, architecture, engineering, surveyors) environmental studies and land remediation land acquisition (sometimes included as a hard cost) permits and zoning. project management costs lease-up and operating costs to bring a property to a stabilized level. financing costs The construction costs or hard cost consist of: Site preparation (leveling, demolition, clearing) Actual building costs Construction companies will often give a fixed price contract based on the approved building plans. Any changes, which are called Change Orders, will result in additional changes. Construction costs can include building access roads and ramps, landscaping Average construction costs can be obtained from third party sources in the market Development process Site Selection: Finding a property that satisfies the requirements for the project or that has potential use. Predevelopment: Market analysis Detailed Planning Design Architecture Infrastructure requirements Pro-forma financial analysis Start of discussions with potential investors Due diligence on site selected. Different scenarios can be considered during predevelopment. Entitlements: A property owner’s right to use the land can be constrained by local governments. Zoning: specifies the uses that are allowed within certain areas: Residential Commercial Industrial Infrastructure to be built by developer vs city. Water, power, sewage Roadway access Social and community requirements (schools, parks, etc.) A city may require certain studies. Environmental impact Traffic Noise The developer enters into a construction contract with a construction company to build the structure and related infrastructure according to the plans. Fixed Price (Lump Sum) Contract Guaranteed Maximum Price Contract Any savings go to the developer. Cost Plus (Time and Materials) Contract Typically used when construction costs are difficult to determine in advance. Developer pays the costs plus a predetermined profit margin to the construction company. Fixed Priced and Guaranteed Maximum Price contracts protect the developer Cost Plus contracts protect the construction company. Site work: preparing the site for the construction work to begin. Soil studies Surveying Setback Easements Clearing, leveling, digging, and removing earth Creation of infrastructure needed in the building process Power, water, sewage Access roads, parking, fencing Trailer, telephone, internet It is often during this stage that unanticipated risks occur Environment Endangered species Soil problem Cultural issues (burial grounds) Construction work according to the specified plans Pouring of foundation Shell construction Outer construction Floor plates Major mechanical HVAC Change orders due to “scope creep” must be well managed and are often a source of cost overruns. Interior Finishing and Tenant Fit-out prepare the interior for the ultimate purpose of the building. Tenant specified: designed by the tenant to meet his needs Often partially or completely funded by the developer through Tenant Allowances Developer specified. Multifamily Hotels Senior residences Not all properties open fully leased. In some cases, it takes additional time to bring a property to a stabilized NOI position. This can represent significant additional costs for the developer. Interest (carrying) cost. Operational costs Leasing and sales costs Pre-leasing or pre-sales (condos) can reduce this risk. Delays in construction can negatively impact pre-leasing and pre-sales. Development risk Entitlement delays: Government works at its own pace. Carrying cost of land Loss of pre-sale or pre-leasing Construction cost overruns and bad estimates Unexpected conditions Soil condition Environmental issues Material/Labor shortages Scope creep Changes in tenant requirements or developer demands Delayed Lease-up Can delay or hamper take-out financing. Development financing Capital will be required for the different phases of development. Predevelopment Land acquisition Construction Stabilization Take-out Predevelopment Generally speaking, there is no project specific financing available for the predevelopment stage. Considered too high a risk by most lenders as there is no certainty the project will be executed. The developer must use his own capital or, in some instances, corporate credit. Investors can enter a project at this stage, but some developers will want to delay this in order to earn a higher promotion. Land Acquisition Some lenders are willing to lend for the acquisition of land. Typically, low LTV (around 60% or less) Land acquisition loans must usually be repaid at the start of the construction loan. Typically, variable rate loans based on Prime or Bankers’ Acceptance rate Some land banking loans are also available at lower LTVs (50% or less) Construction Loans The amount will be based on total expected cost and anticipated value at stabilization. LTC of 65% or less LTV of 75% or less Can include or exclude land values depending on project. Typically, variable rate loans are based on Prime or Bankers’ Acceptance rate. Interest is capitalized and increases the principal amount outstanding. The amounts are advanced (called draws) as the project advances. Often include developer soft costs Stabilization Funding for carrying (interest) and operational costs during the stabilization period are sometimes included in the construction loan. Multifamily Condos Bridge financing called a mini perm can be arranged if property has not reached its stabilized NOI. Typically, floating interest rate loan. Take-Out Once the property has reached its stabilized NOI, or has been delivered to the tenants, take-out financing is arranged. Typically, a mortgage loan The amount of the loan is based on the value of the property. The take-out financing is used to reimburse the construction loan. Any excess funds can be distributed to the equity investors. Topic 8 REITs and housing finance Real Estate Investment Trusts (REIT’s): Are Special purpose legal entities (SPEs) whose primary business is real estate investment. Equity REIT: Purchase, own and manage “income producing properties” Mortgage REIT: focus their investment in “real estate debt” Hybrid REIT: Combination of equity and mortgage REITs REIT Qualification “Qualified REIT properties” must account for at least 90%. At least 90% of the trust’s revenue must come from rent or mortgage interest and capital gains from real or immovable properties in Canada. At least 75% of the total fair market value of all trust properties that the REIT holds must be in Canada. Must be publicly traded (can be private in the U.S.) High level of distributions (approximately 90%) REIT Structure REIT Taxation and Distributions Income is “not taxed within the Trust” as long as the income is distributed to the unitholders. Flow through to the Unitholders Represents a huge advantage to non-taxable institutional investors. Typical distribution in Canada is 85% to 95% of income. 90% income distribution rule in the U.S. Metrics See notes for formulas. Others: LTV Interest coverage DSCR Property statistics Occupancy Rent levels and growth Lease rollovers Expense recovery ratio Same store sales Housing finance The system of housing finance in Canada is composed of three sets of institutions: Mortgage Originators Financial Institutions Non-regulated Finance Companies Mortgage origination often goes through the broker market. Mortgage Insurers CMHC Genworth Financial Canada Canada Guaranty Suppliers of funding. Mortgage Origination The Canadian residential mortgage market is dominated by banks. About 80 per cent of mortgages are originated by lenders that are federally regulated by the Office of the Superintendent of Financial Institutions (OSFI). The minimum down payments to qualify for a residential mortgage are: Mortgage Insurance Mortgage loan insurance protects the mortgage lender in case the borrower is unable to make their payments. It is required if the down payment is less than 20% of the purchase price. Mortgage loan insurance isn't available, if: the purchase price is $1 million or more. the loan does not meet the mortgage insurance company’s standards. Mortgage loan insurance premiums range from 0.6% to 4.50% of the amount of the mortgage “depending” on the amount of the down payment. Premiums based on the amount of your mortgage loan can be obtained from: Canada Mortgage and Housing Corporation (CMHC) Genworth Canada Guarantee Mortgage Insurance Company Premiums are either added to the mortgage loan or paid upfront. Adding premiums to the mortgage increases debt servicing costs Mortgage Funding Topic 9 Capital markets. Why Invest in Real Estate Diversification of investment portfolio assets Low covariance with other assets Lowers the volatility of returns within the investment portfolio. Availability of large size investments Important for investors that must deploy large sums of capital. Caisse de dépôt et placement du Québec Canada Pension Plan OMERS Low volatility of returns for larger assets Depends on the holding period. May no longer be true for Shopping Centers Debt Market A Debt Security is an obligation of a borrower to repay borrowed funds to the lender under a specified set of conditions known as the terms of the debt. The terms and conditions of debt are governed by the Indenture. Administered by the Trustee Terms include: Interest rate Amortization Maturity date Security Recourse Non-recourse Seniority Covenants Private One Lender: Whole Loan Syndicate: a group of lenders is formed to make the loan. Usually when the size of the loan is beyond the financial capability or risk tolerance of a single lender. Public Issue Offered directly to the public through investment bankers. Can include: Bonds Notes Commercial paper Credit and Risk Assessment Although all terms and conditions will be evaluated by the lender/investor credit and risk assessment will include: Credit Metrics Leverage Coverage Security Recourse Non-recourse Seniority Covenants Leverage Metrics looks at the value of a borrower’s assets against the total amount of funds borrowed. The lower the ratio of funds borrowed to asset value, the greater the amount of “equity cushion” exists. Protects the lender in case property values decrease. Examples of leverage metrics include: Debt/Equity Debt/Asset Value Coverage Metrics looks at the funds being generated by the business as a going concern against the amounts required to service all of its outstanding debt. The higher the ratio of cash flow available to the amount required to service its debt, the lower the chance that a borrower will default on its loans. Protects the lender in case property values decrease. The most used coverage metric is DSCR. Security Assets pledged as collateral (Ex: building mortgaged) Recourse loans are not only guaranteed by the security but also by a claim over the entity’s other assets. Depending on the financial strength of the borrower this can greatly reduce the risk of a loan. Non-recourse loans are solely guaranteed by the security. If the borrower defaults and the value of the security is insufficient to recover the loan amount it is the lender which suffers the additional loss. Unsecured or corporate loans are secured only by the corporate credit and not one specific asset. Seniority refers to the hierarchy of all the lenders’ claims against the cash flow or liquidation proceeds of the borrower. Claims are paid to the most senior positions first. Claims of equal seniority are paid on a pro-rata basis. Covenants are certain financial metrics the borrower must maintain. DSCR, minimum equity, unencumbered assets, etc. Investors – Real Estate Commercial Banks Investment Banks Insurance Companies Pension Funds Private Equity Funds Sovereign Funds Individuals/Families Conduits CMBS RMBS MBS Mortgage-backed Securities Mortgage-backed Securities are a type of bond or note that is secured by a pool of mortgage loans. Individual mortgages are pooled together and used as collateral to issue mortgage-backed securities sold to investors. CMBS or Commercial Mortgaged-backed Securities are secured by mortgages on commercial real estate. NHA MBS or National Housing Act Mortgaged-backed Securities are secured by CMHC (Canada Mortgage and Housing Corporation) insured mortgages on residential properties. RMBS or Residential Mortgaged-backed Securities are secured by non-insured mortgages on residential properties. Mortgage-backed Securities are structured as tranches. Each tranche participates in the cash flows derived from the underlying mortgages based on its level of seniority. This sequential distribution of cash is known as the Waterfall. Each tranche is given a credit rating by a Rating Agency CBRS Standard & Poors More senior tranches, with a better credit rating, are considered a safer investment and earn a smaller interest rate. Mortgage-backed Securities are usually issued by Conduits, often backed by financial institutions. Conduits are special purpose corporations. They acquire the pool of mortgages. Create the mortgage-backed securities (referred to as securitization) Sell the securities to investors. Conduits make a profit if they can sell the securities for a price greater than the cost of acquiring the mortgages and by charging fees for the management of the securitization programs. Corporate Real Estate Real estate, including leases, can be a major asset and contributor to the success of a company. Location must be aligned with intended use. Quality must be aligned to the image the company wishes to project. Leases can often be sold and represent an asset for a company. Zellers’ leases sold to Target. Considerations for corporate real estate include: Zoning Visibility and customer access Parking Access to factors of production Labor pool/skilled labor Proximity to raw materials and the cost of transporting these materials. Transportation Shipping of goods (rail, trucks, ports) Employee movement Energy, water, waste disposal Telecommunication and internet bandwidth Corporate image Targeted clients/customers Interior and exterior design Sustainability LEED (Leadership in Energy and Environmental Design) Based on conservation of energy, water, reduction of waste, etc. Own or Lease Considerations include: Flexibility vs certainty Ability to adjust space (size, location, etc.) through leasing vs certainty of availability through ownership. Ability to modify and adjust the space to meet the needs of the company. Availability of capital Alternate use of capital Can “redeployment of the capital generates a higher return for the company?” Redeployment of capital can be achieved through: Sale Leaseback strategy Financing Spinoff Creation of a REIT International Real Estate Investing in real estate in other countries has its own particular rewards and risks. Success in international real estate investment is greatly dependent on a thorough knowledge of the local market. Investing in partnership with local players can ensure expertise in the targeted location. Requires an alignment of interests. Rewards of investing in international real estate can include: Exposure to higher growth markets Generates higher FMV growth for real estate. First mover advantage First to bring new property types to market New construction methodologies New ownership or financing structures Market diversification of risk Limited by globalization of markets Risks of investing in international real estate can include: Geopolitical risks Change in governments, policies, laws. Changes in taxation Culture and customs View towards foreign ownership Design considerations Asset risk Availability of insurance Building codes and methodologies Legal risks Maturity of legal system Power of the courts Property titles and recording Local property laws Financial risks Availability of financing Currency risk and ability to hedge. Maturity of banking system. Ability to repatriate funds. Topic 2 Cash flow modeling Exclusions from NOI Debt Service – Financing costs are specific to the owner/investor and as such are not included in calculating NOI. Depreciation – Depreciation is not an actual cash outflow, but rather an accounting entry and is, therefore, not included in the NOI calculation. Income Taxes – Since income taxes are specific to the owner/investor they are also excluded from the net operating income calculation. Tenant Improvements – Tenant improvements include construction within a tenant’s usable space to make the space viable for the tenant’s specific use. Leasing Commissions – Commissions are the fees paid to real estate agents/brokers involved in leasing the space. Capital Expenditures – Capital expenditures are expenses that occur irregularly for major repairs and replacements, which are usually funded by a reserve for replacement. This does not include minor repairs and maintenance, which are considered an operating expense. Rent Rent is the periodic payment received from tenants for the use of real property. In commercial leases rent is usually expressed as a dollar amount per square foot per year Example: a 5,000 square foot space has a rent of $30/sq. ft. The tenant will pay rent of $12,500 per month $\frac{5,000\ *\$ 30}{12\ months} = \$ 12,500$ Rent will generally increase during the term of the lease by a set amount or some other adjustment factor like inflation (CPI) Total rent is generally made up of one or more of these elements: Base rent Percentage rent Expense recovery Rent free period. All the elements of rent will be documented in the lease. Percentage Rent Percentage rent is a rental payment that is based on the sales or income earned by the tenant. There is often a breakpoint (certain level of sales or income) over which percentage rent will begin The most common formula for percentage rent is: Percentage rent = (actual sales−breakpoint) * percentage factor Expense Recovery Expense participation is when a tenant pays their proportionate share of certain operating expenses of the property. The proportionate share is calculated as leased area/total leasable area. The expenses they are responsible for is contained in the expense participation clause of the lease. The more common expense participation clauses can be categorized as: Gross Lease the rent is all-inclusive. The landlord pays all or most expenses associated with the property, including taxes, insurance, and maintenance out of the rents received from tenants. Single Net Lease the tenant pays base rent plus a pro-rata share of the building's property taxes. Double Net Lease the tenant is responsible for base rent plus a pro-rata share of property taxes and property insurance. Triple Net Lease the tenant is responsible for base rent plus a pro-rata share of property taxes, property insurance and all other property operating expenses. This is the most popular type of net lease for retail space. A triple net lease favors the landlord as it protects him against rising expenses. Expenses are estimated at the start of the year and adjusted to actuals at the end of the year. Referred to as a True-up or CAM Adjustment Rent Free Period a A landlord will often offer a rent-free period at the beginning of the lease as an incentive to the tenant. At the beginning of a lease the tenant often has expenses related to moving or starting up his business. The rent-free period will help offset these costs. Rent-free periods are accounted for on a straight-line basis and must be adjusted for when calculating cash flows. Operating property Model each leasable space separately. Consider any rent adjustments or escalations under the lease. This may necessitate estimating CPI over a number of years. Percentage rent will entail looking at historical sales figures and growth and applying certain assumptions for their future growth (economic outlook, CPI, etc.) In order to estimate expense recoveries a forecast of expenses must be established and any changes to the leasable areas must be taken into consideration Consider any leases expiring during the forecasted period. Consider any renewal options the tenant has, the likelihood of them renewing and the new rent. If a lease termination is expected, several factors must be forecasted: Period of vacancy New rent levels considering current market rents. Any rent-free periods that are likely to be offered Leasing commissions on the new lease Tenant allowances to prepare the space for the new tenant. Forecast expenses for the period under consideration. Look at historical costs in order to identify all relevant expenses. Consider and adjust for any non-recurring items. Increase historical costs by applying an escalation factor (CPI is the most widely used basis) Consider any new costs that are likely to arise. Estimate any non-revenue-generating capital expenditures. Historical trends may indicate a certain level of capital expenditure is required to replace and adjust the structure and its mechanical systems. Estimate any financing costs. Consider in place financing or any future financing. May require forecasting of interest rates. Estimate income taxes to be paid. Prepare different scenarios by varying certain key assumptions: tenant retention, market rates, CPI, interest rate, economic conditions, etc. Scenario analysis often includes 3 scenarios. Most likely Optimistic Pessimistic Property Development The cost of bringing new commercial space to the market includes both development and construction costs. Development costs are often referred to as Soft Costs and will start before construction begins. They include: professional services (legal, architecture, engineering, surveyors) environmental studies and land remediation land acquisition (sometimes included as a hard cost) permits and zoning. project management costs lease-up and operating costs to bring a property to a stabilized level financing costs The construction costs or hard cost consist of: Site preparation (leveling, demolition, clearing) Actual building costs Construction companies will often give a fixed price contract based on the approved building plans. Any changes, which are called Change Orders, will result in additional changes. Construction costs can include building access roads and ramps, landscaping. Average construction costs can be obtained from third party sources in the market. Topic 4 Real Estate Valuation The most widely used method to estimate the value of a commercial property is the Capitalized NOI approach. $Value\ of\ property = \frac{\text{Stabilized~NOI}}{\text{cap~rate}}$ This valuation method presumes that a property will generate its stabilized NOI in perpetuity. The value and cap rate are an inverse relationship. The higher the cap rate the lower the value. Stabilized NOI Potential Rental Income – Potential Rental Income is the sum of all rents (including expense participation) under the terms of each lease, assuming the property is 100% occupied. If the property is not 100% occupied, then a market-based rent is used based on lease rates and terms of comparable properties. Vacancy and Credit Losses – Vacancy and credit losses consist of income lost due to tenants vacating the property and/or tenants defaulting (not paying) their lease payments. A historical average or a specific analysis can be used to determine the vacancy and credit losses. Other Income – A property may collect income other than rent derived from the space tenants occupy. This is classified as Other Income, and could include billboard/signage, parking, vending, etc. Operating Expenses – Operating expenses include all expenditures required to operate the property and command market rents. A property might have operating expenses of insurance, property management fees, utility expenses, property taxes, janitorial fees, snow removal and other outdoor maintenance costs, and supplies. Exclusion from NOI Debt Service – Financing costs are specific to the owner/investor and as such are not included in calculating NOI. Depreciation – Depreciation is “not” an actual cash outflow, but rather an accounting entry and is, therefore, not included in the NOI calculation. Income Taxes – Since income taxes are specific to the owner/investor they are also excluded from the net operating income calculation. Tenant Improvements – Tenant improvements include construction within a tenant’s usable space to make the space viable for the tenant’s specific use. Leasing Commissions – Commissions are the fees paid to real estate agents/brokers involved in leasing the space. Capital Expenditures – Capital expenditures are expenses that occur irregularly for major repairs and replacements, which are usually funded by a reserve for replacement. This does not include minor repairs and maintenance, which are considered an operating expense. NOI Adjustments NOI usually includes management fees. If no fees are reported because the landlord manages the property himself, a market management fee will be estimated and included in operating expenses. In some circumstances NOI will be adjusted for recurring non-revenue generating capital expenditures and leasing commission Institutional investors usually treat these items as “below the NOI” line. Cap Rates Some of the determinants of the Capitalization Rate include the following: Other investment yields (especially GOC rate) Real estate competes for investment dollars with other forms of investments. Perceived risk of asset class Usually seen as a lower risk asset class it is still susceptible to overvaluation. Less liquid investment The market High growth metropolitan market vs stagnant market Property characteristics Type (retail, office, hotel, etc) Quality Size Quality of the rent roll In determining the cap rate for a particular property, cap rates on similar properties sold will be examined and adjusted for the factors just listed. Cap rates for recent transactions can be obtained from third party service firms. See Cushman Wakefield Canadian Cap Rate Report Discounted Cash Flow (DCF) The Discounted Cash Flow (DCF) method values a property by adding together the present value of its future cash flows including its Terminal Value. The Terminal Value (TV) is the value of the property at the end of the investment period and is calculated based on the NOI at that time. $Value\ of\ property = \left( \sum_{}^{}{\text{PV}\left( \text{Cash~flows} \right)} \right) + PV\left( \text{TV} \right)$ This method requires an estimate of the cash flows (as seen in the previous lecture), an estimate of the terminal value and one or more discount rates. The discount rate used should reflect the rate of return required by an investor for an investment with this level of risk. This can be the same as the capitalization rate but if cash flows are uneven a different rate of return may be required by an investor. The discount rate for the terminal value can be different than the rate used for the cash flows if the condition of the property is expected to change. Start-up of operations Age of property when sold. Repositioning of the property (competitive position) Business plan to address vacancy issues. Comparable Sales Approach The Comparable Sales Approach estimates the value of a property by comparing it with the recent selling price of properties that have similar characteristics. Often used for single family houses Sales data for commercial properties are available through third party service companies such as CBRE and Altus. Comparable sales should be for properties of the same or similar. Type Location Age Condition The data from the comparable sales is converted to some common factor such as doors, square feet or units in order to take into account properties of different sizes. The appraiser must then use judgement to determine the value after considering the different characteristics (condition, age, location, etc.) of the properties. Cost Approach The Cost or Replacement Cost Approach estimates the current cost of replacing the subject property using industry sourced construction cost data. Comparing the replacement cost to the market value informs the investor of the likelihood of new properties being developed. The replacement cost is artificially depreciated to consider the age of the property. Topic 5 Real Estate Debt Financing Leverage Leverage Effect Apart from gaining access to funds, many investors add financing to their real estate assets to obtain a higher return. Adding leverage (financing) to an asset or company will act as a multiplier to the return generated by the asset or company. The greater the amount of leverage the greater the multiplicative effect. Terminology Nominal or Loan Amount: principal balance due on the loan, i.e. the amount owed. Maturity date: the date at which the loan is repaid in full. Term: The “period of time” for “which the loan is made” (5 years, 10 years) Interest Rate: percentage rate applied to the outstanding principal balance charged by the lender. Fixed rate: set at the start of the loan. Variable or Floating Rate: rate is reset periodically. Variable rates are “lower than fixed rates at the start” of the loan but could increase beyond the initial fixed rate offered. Amortization Period: Period of time over which the scheduled capital repayments will reduce the loan to zero. If the loan does not have regular periodic payments of capital, the borrower will be required to make a “Balloon payment” for the remaining principle balance at maturity! Amortization of the loan reduces the risk of the lender over time by reducing the amount of principle owed while maintaining the guarantee (mortgage asset). Generally no more than 25 years in Canada Debt Service: the required periodic payments over a year Includes both interest and required capital payments Not all loans require principal repayment prior to maturity. These are called Interest Only/I.O. or non-amortizing loans. Types of Real Estate Loans Term Loans Mortgage loans Guaranteed by the asset Recourse loans are not only guaranteed by the mortgage on the property but also by a claim over the entity’s other assets. Depending on the financial strength of the borrower this can greatly reduce the risk of a loan. Non-recourse loans are solely guaranteed by the property. If the borrower defaults and the value of the property is insufficient to recover the loan amount it is the lender which suffers the additional loss. Unsecured or corporate loans Secured only by the corporate credit and not one specific asset. Construction Loans Lender advances funds to pay for the construction costs as they are incurred, typically 6 months to three years, as opposed to one lump-sum These advances are known as construction draws or draw-downs At the end of each month the interest is not paid by the borrower but added to the outstanding principal balance. This is referred to as Interest Capitalization. Construction loans can extend to the period of time it takes to lease-up a property and stabilize its cash flows. Construction loans are generally repaid from the proceeds of sale of the property or from the proceeds of a term loan. Construction loans are “variable interest rate” loans Bridge Loans Used to finance a property being repositioned in the market Typically short-term: 1 or 2 years Usually with a “variable interest rate” Higher risk nature of the loan commands a higher interest rate. Underwriting The amount a lender will be willing to lend is dependent on two important metrics: Loan to Value (LTV) The Loan To Value Ratio (LTV) measures the value of a loan against the value of the property. It is used to ensure that the liquidation of the asset, if necessary, will generate enough cash to repay the loan. LTV is calculated by dividing the amount of the loan by the property value. Commercial real estate loan LTVs generally fall into the 65% to 80% range depending on the asset category and perceived risk. Debt Service Coverage Ratio (DSCR) The Debt Service Coverage Ration (DSCR) measures the property’s ability to generate enough cash (NOI) to make the required debt payments. DSCR is calculated by dividing the NOI by the loan payment amount (capital and interest) for the year. A DSCR of less than 1 indicates a negative cash flow. For example, a DSCR of .92 means that there is only enough NOI to cover 92% of annual debt service. In general, commercial lenders look for DSCRs of at least “1.25” to ensure adequate cash flow. Lenders will also consider “non-financial” risks such as: Operational risks Ability to lease at market rents Security Maintenance HVAC Services offered Tenant risk Quality of rent roll Rollover risk Environmental risk Legal risk Physical asset risk Liquidity risk Market risk Geographic risk Other risks Interest rates and Fees Corporate or unsecured loans are generally quoted on an Annual Percentage Rate (APR) basis. Monthly rate is the APR/12 For example: a loan with an APR of 12% would require monthly payments of interest of 1% (12%/12 months) Mortgage rates are expressed as “annualized semi-annually compounded rates.” To obtain the monthly rate: Calculate the annual effective rate based on two compounding periods Calculate the nominal rate of the annual effective rate based on 12 compounding period Divide the nominal rate by 12 Interest rates reflect both the market and the project risk The higher the perceived risk, the higher the rate Interest rates for mortgages are often expressed as the amount of basis points (.0001) above the Government of Canada Bond rate (GOC) for a given term. For example: 5-year term might be GOC 5yr + 250 bp GOCs are viewed as riskless investments Variable rates are usually expressed as the amount of basis points above the bankers’ acceptance rate which is tied to the bank’s credit worthiness. Lenders may also charge fees that increase the overall cost of the loan Application fees Origination fees Standby fees The lender’s expenses in underwriting or documenting the loan may also be charged Appraisal fees Legal fees Early repayment of a loan will also typically engender fees and penalties Prepayment penalty Yield maintenance Defeasance