Real Estate Finance & Investments I Lecture Notes Fall 2006 PDF

11.431/15.426J Real Estate Finance & Investments I: Fundamentals & Micro-Level Analysis Fall 2006 Introductory Lecture Slides (Selections from Chs.1, 2, 7 of text.) 1  Overview: 1. Magnitude of Real Es...

11.431/15.426J Real Estate Finance & Investments I: Fundamentals & Micro-Level Analysis Fall 2006 Introductory Lecture Slides (Selections from Chs.1, 2, 7 of text.) 1  Overview: 1. Magnitude of Real Estate Investment 2. Performance of R.E. Investment 3. The “Real Estate System” (role of capital mkts) 4. The space market 5. The asset market & investment industry 6. Example real world R.E. development investment 2 Magnitude Figure 1a: Net Asset Value of U.S. Structures ($ billions, 2003, source BEA) Total = $ 23,747 Govt. R.E., $5,751 Houses, $11,917 Commercial R.E., $6,079 3 Magnitude Figure 1b: Net Asset Value of U.S. Commercial Real Estate Structures ($ billions, 2003, source BEA) Total = $ 6,079 Billion Institutional, $955 Office, $1,131 Hotel & Recreational, $554 Retail, $1,313 Residential (apts), $1,168 Industrial*, $958 4 Magnitude U.S. Institutional Commercial Real Estate Physical Stock: 44B SF Capital Value: $3.3 Trillion U.S. Commercial R.E. Physical Space (SF) U.S.Commercial R.E. Capital Value ($) Retail Apartment 25% 25% Retail Apartment 34% 41% Warehouse 9% Office 18% Warehouse Office 16% 32% Source: PPR, 2003 5 Asset Mkt Exhibit 1-5: Major Types of Capital Asset Markets and Investment Products Public Private Markets: Markets: Equity Stocks Real Property REITs Private firms Assets: Mutual funds Oil & Gas Partnerships Debt Bonds Bank loans MBS Whole Assets: Mortgages Money instruments Venture Debt 6 Magnitude 1.2.4 The Magnitude of Real Estate in the overall Capital Market… Exhibit 1-7 US Capital Market Sectors, a $70 Trillion Pie… U.S. Capital Market Sectors, a $70 Trillion Pie Private Debt (49% RE), 16% Public Debt (22% RE), 30% Private Equity (78% RE), 30% Public Equity (17% RE*), *Corporate real estate owned by publicly traded firms, plus 24% REIT s. Source: Authors' estimates based on Miles & T olleson (1997) updated with FRB statistics. * Corporate real estate owned by publicly-traded firms, plus REITs. Source: Authors’ estimates based on Miles & Tolleson (1997). 7 Magnitude Exhibit 1-8: US Investable Capital Market with Real Estate Components Broken Out U.S. Investable Capital Market with Real Estate Components Broken Out. (Source: Based on Miles & Tolleson 1997) Private Debt 9% Stocks 26% Bonds 24% REIT Equity 0% Agricultural/Timberl ands Private Commercial 2% MortgagesCMBS 2% 1% Commercial Real RMBS Estate Equity 6% House Equity Private Residential 7% Mortgages 17% 6% 8 Performance Investment Total Return Performance (per annum avg) as of June 30, 2006 20.00% 1yr. 3yr. 15.00% 5yr. 10yr. 10.00% 5.00% 0.00% Real Estate Stocks Bonds T-Bills CPI (NCREIF) (SP500) (Lehman G/C) -5.00% Total Investment Return asReal EstateStocks (SP Bonds (Leh T-Bills CPI 1yr. 18.68% 8.63% -1.52% 3.95% 4.01% 3yr. 15.79% 11.21% 1.60% 2.31% 3.27% 5yr. 12.01% 2.50% 5.13% 2.16% 2.59% 10yr. 12.42% 8.35% 6.25% 3.68% 2.59% 20yr. 8.17% 11.02% 7.32% 4.68% 3.12% 9 Exhibit 2- 2-2: The “Real Estate System” System”: Interaction of the Space Market, Asset Market, & Development Industry Industry SPACE MARKET LOCAL SUPPLY DEMAND & ADDS (Landlords) (Tenants) NATIONAL NEW ECONOMY RENTS & OCCUPANCY FORECAST FUTURE DEVELOPMENT INDUSTRY ASSET MARKET IF IS SUPPLY YES DEVELPT CASH (Owners PROFITABLE FLOW Selling) CAPI ? TAL PROPERTY MKT MKTS CONSTR MARKET REQ’D DEMAND COST VALUE CAP (Investors INCLU RATE Buying) LAND = Causal flows. = Information gathering & use. 10 1.1.1 The Space Market… Supply: Demand: Property Owners MARKET Property Users (Landlords) (Tenants) Rents (e.g.$/SF) Occupancy 11 Space Mkt Exhibit 1-3: Change in Supply & Demand & Rent over Time REAL RENT $25 $20 D2 D1 LRMC 16 $15 D0 13 $10 S1 S2 $5 3.5 4 4.5 5 5.5 6 6.5 QUANTITY OF SPACE (Mil 12 1.2 The Real Estate Asset Market (Property Market)… Supply: Demand: Investors MARKET Investors Wanting to Sell Wanting to Buy Property Prices: “Cap Rates” 1/($Asset/$Income) 13 Asset Mkt WHY DO PEOPLE INVEST?... Individuals: – THE 25-YR-OLD "YUPPY" ?... – THE 25-YR-OLD "DINC" COUPLE ?... – THE 35-YR-OLD "YOUNG FAMILY" ?... – THE 45-YR-OLD "MID-LIFE CRISIS" ?... – THE 65-YR-OLD "RETIREE" ?... Î DIFFERENT LIFE STYLES, LIFE CYCLES, PERSONAL GOALS, LEVELS OF WEALTH 14 Asset Mkt WHY DO PEOPLE INVEST?... Institutions: – LIFE INSURANCE COMPANIES – PENSION FUNDS – MUTUAL FUNDS – BANKS – FOUNDATIONS ÎDIFFERENT CONSTITUENCIES, EXPERTISE, LIABILITIES, REGULATIONS, SIZES 15 Asset Mkt WHY DO PEOPLE INVEST?... ===> DIFFERENT TIME HORIZONS, RISK TOLERANCES, NEEDS FOR INCOME vs GROWTH Therefore,... (opportunities for new product development in the investment industry) 16 Asset Mkt TWO MAJOR INVESTMENT OBJECTIVES: 1) GROWTH (SAVINGS) - RELATIVELY LONG-TERM HORIZON (NO IMMEDIATE NEED); 2) INCOME (CURRENT CASH FLOW) -- SHORT-TERM & ON-GOING NEED FOR CASH. 17 Asset Mkt MAJOR CONSTRAINTS & CONCERNS: - RISK - LIQUIDITY - TIME HORIZON - MANAGEMENT BURDEN, EXPERTISE - AMOUNT OF FUNDS AVAILABLE FOR INVESTMENT (SIZE) - CAPITAL CONSTRAINT Therefore (again),... What? 18 Example Montague Court Development Cost Budget: Hard Costs Total Cost Cost/Sq.Ft. 1. Land $15,124,000 $ 66.33 2. Base Shell & Sitework 9,111,000 39.96 3. Tenant Improvements 7,399,000 32.45 Total Hard Costs: $ 31,634,000 $ 138.75 Soft Costs 4. Architect/Engineers $ 262,000 $ 1.15 5. Permits/Fees 768,000 3.37 6. Legal/Title/Taxes 171,000 0.75 7. Marketing 46,000 0.20 8. Leasing Commissions 1,790,000 7.85 9. Developer Fee 228,000 1.00 10. Contingency 556,000 2.00 11. Construction Interest 1,074,000 4.71 Total Soft Costs: $ 4,895,000 21.46 Total Project Cost: $ 36,529,000 $ 160.21 19 Montague Court Development Project Cash Flow Projection: Year 0 Year 1 Year 2 Year 3 For the Years Ending 2000 2001 2002 POTENTIAL GROSS REVENUE Base Rental Revenue $222,735 $3,410,017 $4,349,783 Absorption & Turnover Vacancy $0 $0 $0 Schoduled Base Rental Revenue $222,735 $3,410,017 $4,349,763 Expense Reimbursement Revenue Oper. Expenses $36,196 $565,778 $725,706 Total Reimbursement Revenue $36,196 $565,778 $725,706 TOTAL POTENTIAL GROSS REVENUE $268,931 $3,975,795 $5,075,489 General Vacancy -$10,357 -$159,032 -$203,020 Collection Loss -$5,179 -$79,516 -$101,510 EFFECTIVE GROSS REVENUE $243,395 $3,737,247 $4,770,959 OPERATING EXPENSES Oper Expenses $243,395 $704,520 $725,656 TOTAL OPERATING EXPENSES $243,395 $704,520 $725,656 NET OPERATING INCOME $0 $3,032,727 $4,045,303 LEASING & CAPITAL COSTS Tenant Improvements $0 $0 $0 Leasing Commissions $0 $0 $0 Cap Reserves $0 $35,226 $36,283 Construction Costs (Payoff constr loan) $0 $21,405,000 $0 TOTAL LEASING & CAPITAL COSTS $0 $0 $21,440,226 $36,283 LAND $15,124,000 CASH FLOW BEFORE DEBT SERVICE & INCOME TAX -$15,124,000 $0 -$18,407,499 $4,009,020 20 Example Evaluating the development project… Cap rates for R&D/Office properties in Milpitas, CA. = 9.35%. Stabilized NOI (Yr.3) = $4,045,303. What is expected value of the finished project at end of development phase (end of Yr.2)?… 21 Example Evaluating the development project… Cap rates for R&D/Office properties in Milpitas, CA. = 9.35%. Stabilized NOI (Yr.3) = $4,045,303. What is expected value of the finished project at end of development phase (end of Yr.2)?… NOI $4,045,303 Value = = = $43,265,273 CapRate 0.0935 22 Example Evaluating the development project… Cap rates for R&D/Office properties in Milpitas, CA. = 9.35%. Stabilized NOI (Yr.3) = $4,045,303. What is expected value of the finished project at end of development phase (end of Yr.2)?… $43,265,273 What is expected return (IRR) on the development project?… 23 Compute return as discount rate to equate future expected cash flows to present land cost (opportunity value)… CF1 CF2 CFT Land Cost = + + K + 1 + IRR (1 + IRR )2 (1 + IRR )T In the present example… 0 − $18,407,499 + ($4,045,303 / 0.0935) $15,124,000 = + 1 + IRR (1 + IRR )2 0 − $18,407,499 + $43,265,273 $15,124,000 = + 1 + IRR (1 + IRR )2 $24,857,774 $15,124,000 = 0 + (1 + IRR )2 ⇒ IRR = 28.2% 24 Compute return as discount rate to equate future expected cash flows to present land cost (opportunity value)… CF1 CF2 CFT Land Cost = + + K + 1 + IRR (1 + IRR )2 (1 + IRR )T In the present example… 0 − $18,407,499 + ($4,045,303 / 0.0935) $15,124,000 = + 1 + IRR (1 + IRR )2 0 − $18,407,499 + $43,265,273 $15,124,000 = + 1 + IRR (1 + IRR )2 $24,857,774 $15,124,000 = 0 + (1 + IRR )2 ⇒ IRR = 28.2% Should we do the development?… 25 Compute return as discount rate to equate future expected cash flows to present land cost (opportunity value)… CF1 CF2 CFT Land Cost = + + K + 1 + IRR (1 + IRR )2 (1 + IRR )T In the present example… 0 − $18,407,499 + ($4,045,303 / 0.0935) $15,124,000 = + 1 + IRR (1 + IRR )2 0 − $18,407,499 + $43,265,273 $15,124,000 = + 1 + IRR (1 + IRR )2 $24,857,774 $15,124,000 = 0 + (1 + IRR )2 ⇒ IRR = 28.2% Should we do the development?… Is 28.2% a sufficient expected return, given the risk?… 26 What actually happened with this investment... Leased the entire project in late 2000, lease through 2010 to Cisco, at more than double the pro-forma rent! 0 − $18,407,499 + ($9,380,960 / 0.14) $15,124,000 = + 1 + IRR (1 + IRR )2 0 − $18,407,499 + $67,006,857 $15,124,000 = + 1 + IRR (1 + IRR )2 $48,599,358 $15,124,000 = 0 + (1 + IRR )2 ⇒ IRR = 79.3% Actual Ex Post Devlpt IRR: 79.3%! 27 What could very easily have happened with this 1999 investment... The tech bubble burst in 2001, driving market rents on new leases down to $0.90/SF by 2002 (vs $1.59 in pro-forma), and that’s if you could find a tenant at all! 0 − $18,407,499 + ($2,157,920 / 0.095) $15,124,000 = + 1 + IRR (1 + IRR )2 0 − $18,407,499 + $22,714,947 $15,124,000 = + 1 + IRR (1 + IRR )2 $4,307,448 $15,124,000 = 0 + (1 + IRR )2 ⇒ IRR = −46.6% Result would have been an Ex Post Devlpt IRR: -46.6%! 28