Real Estate DCF

Wally Boudry

Spring 2014

Admin Case is due 5/5 and is up on Blackboard

Final Exam Due 5/15 I will post it on Blackboard after class 5/7

Warning This is a huge topic and covers everything

you have learned so far You will eventually value a property

If you get the basics down you can then think about more complicated examples (mezz foreclosures etc.)

Try to break it down into little piece (leases, taxes etc) that you understand instead of getting overwhelmed If nothing makes sense, try a simple BOE calc to

start Always benchmark numbers as you go

Do the cap ex numbers make sense? Do those rent numbers makes sense? etc.

Warning Mechanically this topic ranges from very

simple to quite complex Complexity is usually a function of how

complex the leases are and also if you have a complicated partnership waterfall to deal with More on waterfalls in the final topic

Regardless of how complicated the modeling is, that isn’t where the value add in the process is Give me enough time and I can train a monkey to

do it Where you add value is in your analysis, not

in your numbers

Overview So far we have priced properties using BOE

techniques These models, while still widely used in practice,

are flawed from a theoretical stand point. From a theoretical perspective, all BOE

techniques are not necessarily value maximizing That is, accept or reject decisions are not guaranteed in

expectation to maximize value. It may turn out that they are consistent with value

maximization, but this is due to chance rather than design

What we need is a method that will maximize value.

NPV From corporate finance you will remember

that the net present value NPV rule is designed to maximize the value of the firm.

The same principle applies in real estate Accept positive NPV projects. Reject negative NPV projects.

DCF

The approach we will take to calculate the NPV of a property is the discounted cash flow DCF technique.

We will forecast out cash flows and then discount them back at the opportunity cost of capital.

As in regular corporate finance, the difficult part of DCF in real estate lies in the inputs to the DCF model not the model itself!

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You will never calculate NPVs, but this is the pricing framework. In reality we base everything on IRRs and equity multiples

Discounting Obviously the timing of discounting matters at

least theoretically In most cases cash flows will be calculated

monthly, then aggregated up to annual numbers and then discounted The correct thing to do would be to discount monthly, but

very few people do unless specified in a partnership waterfall

Some problems will naturally set up just to do annual cash flows

We care about monthly cash flows because annual cash flows can average out monthly problems (e.g. 6 months of being short on debt service followed by 6 months of covering debt service 2x will give an annual DSCR greater than 1) I can easily overcome this issue, but I need to know it

exists In most cases, monthly v annual discounting

won’t matter mathematically (that is, it won’t change your accept/reject decision.)

Stub Years You will some times see DCF done with a “stub year” Typically we will assume a whole year holding period

5 year hold or a 10 year hold etc. If we don’t purchase the property on 1/1/20xx then fiscal

and calendar years don’t overlap A way to deal with this is a stub year model

The stub year is the short year (if we buy in September, it is September thru Dec)

Then every year after is a full calendar year, so the total hold will be “Holding period + stub year”

The end result is: You can build both models into a spreadsheet, but a lot of IF

statements are required You will need to use XIRR when discounting (this is just IRR

with specified dates)

Taxes You will see DCF done on a before tax basis

and on an after tax basis Remember we are talking about income taxes

here not property taxes Many RE investors are tax exempt, which is

why they don’t worry about taxes Debt underwriters don’t care about income taxes

Taxes also change which is why it makes sense for a taxed investor to start by examining a before tax analysis

We will introduce “basic” income taxes into our analysis You could spend a whole course just on real

estate taxation because the rules are quite complicated

After Tax Pro Forma In BOE analysis we ignored all taxes apart

from property taxes For many investors, taxes are an important

factor in determining the return on a project Investors receive after tax cash flows not before

tax cash flows In order to examine a property on an after tax

basis we will have to create an After Tax Pro Forma This is simply the after tax equivalent of the pro

forma we have already examined.

Before Tax Pro Forma

Potential Gross Income PGI (rentable sqft * effective rent $/sqft)- Vacancy (Vacancy rate * PGI)+ Other Income (laundry, parking etc.)- Operating Expenses+ Expense Reimbursements= Net Operating Income (NOI)- Capital Expenditure= Cash Flow from Operations (CFO)- Financing Costs=Cash Flow after Financing (CFAF)

Cash Flow versus Accrual From an investment analysis perspective,

cash is king. You pay out cash flows not accrued earnings

From a tax perspective, what you worry about is when obligations or revenues were generated You don’t actually have to have paid something

for it to be a liability – you just have to have created the obligation.

To get from our before tax pro forma (before tax cash flow based) to our after tax pro forma (after tax cash flow based) we will have to back out the effects of taxes and non-cash flow items.

Depreciation Depreciation is a non-cash flow item

You don’t actually pay depreciation to anyone! This is why you never saw it in the before tax pro

forma Depreciation is important on an after tax

basis because the IRS views depreciation as an allowable deduction That is you can deduct depreciation from revenue

to reduce your taxable income and hence your tax paid. [Good]

As with all things involving tax, there are rules governing how much depreciation you can deduct. [Bad] These rules also change through time…

Depreciation The logic behind allowing a depreciation

deduction is that fixed assets wear out through time from use.

This is eminently sensible for a factory Each car that Ford produces reduces the effective

life of the machine that made it. For real estate it is not as obvious

Does land wear out? How about buildings?

Is the price tag of many historic buildings purely a reflection of land value?

Why does the depreciable life reset when the building is sold?

Depreciation For residential buildings depreciation is taken

on a straight line basis over 27.5 years DO NOT depreciate land! For non-residential buildings the useful life is

39 years. Kind of unintuitive since many buildings will be

economically obsolete before the 39 year limit is up and some will have value long after 39 years.

Historically the useful life was also shorter: pre-1986 it could be as low as 15 years.

What does this tell you about a property whose value is derived from depreciation deductions? In the 80s a lot of investments were set up essentially as tax shelters

Capital Improvements Capital improvements are a cash item (you pay

them out of cash) but from a tax perspective they are an investment.

The tax view is that while you might have to pay now to put in a new system in your building, that system will give you benefits for many periods into the future. Compare this to say electricity which only gave you a

benefit in the current period. So although capital improvements are a cash

outflow, from a tax perspective what we have to do is capitalize and depreciate them. Since we capitalize and depreciate, CAPEX has a big

impact on cash flow, but only minor tax effects.

This holds true for tenant improvements and leasing commissions as well

Debt Debt service is a cash flow item

You pay debt holders cash From a tax perspective, however, not all debt

service is an expense Debt Service = Principal + Interest The IRS views interest payments as an allowable

deduction, but principal payments are simply a reduction in the liability you owe and therefore not deductible.

So although we pay “loan amount * MC” in debt service, we can only deduct “outstanding balance * interest rate” This is why we need those pesky amortization tables.

After Tax Pro Forma

Potential Gross Income PGI - Vacancy (Vacancy rate * PGI)+ Other Income (laundry, parking etc.)- Operating Expenses+ Expense Reimbursements= Net Operating Income (NOI)- Capital Improvement Expenditure= Cash Flow from Operations (CFO)- Financing Costs=Cash Flow after Financing (CFAF)- Income Tax- Equity After Tax Cash Flow

(EATCF)

TaxNOI- Interest Expense- Depreciation=Taxable Income* Investor’s tax rate=Income Tax

This is what a more complicated after tax pro forma might look like

Rents

Reimbursements

Other income

Operating Expenses

NOI

Capital items

Cash flow before debt service

Debt serviceCash flow after debt service but before taxes

Cash flow after taxes

Tax calculation

Capital Gains

Our after tax pro forma takes care of taxes for general operations

At some point however we will sell the property and at this stage we may have a capital gain or loss to deal with.

That is, we don’t receive all of the sale price when we sell the property.

Working out our tax obligation has two parts1) Gain on sale (the difference between the sale price and

the gross book value [original cost + CI])2) Depreciation Recapture (the amount of accumulated

depreciation)

Capital Gains Tax The depreciation recapture may appear a little

strange, but the logic behind what it is doing is quite simple.

The IRS allows you to take a depreciation deduction from ordinary income because your asset is wearing out through time.

If, after some period of time, you sell your asset for more than you bought it for plus improvements, then: You have made a gain on your asset’s original value (and

the IRS wants a piece of it) Your asset hasn’t actually worn out (and the IRS wants

its money back!) The place where things get a little strange is that

capital gains are taxed at 20% (it was 15 previously), while depreciation recapture is at 25% (your depreciation deduction shielded income at the personal tax rate.)

Accelerated Depreciation Currently the IRS allows you to deduct

straight line depreciation on buildings over 27.5 or 39 years

This wasn’t always the case Prior rules allowed for accelerated

depreciation or depreciation faster than straight-line

For properties that have accelerated depreciation the gain on sale has one added twist Depreciation that is in excess of straight line is

recaptured as ordinary income NOTE: if you want to model the tax aspects of

a real estate transaction fully, go and talk to a RE Tax expert!

Capital Gains Tax

Net Selling Proceeds- original cost (or gross book value)= capital gain* capital gains rate= Capital Gains Tax

Accumulated Depreciation* Recapture Tax Rate= Recapture Tax

Total Tax on Sale

Adjusted Base When we do capital improvements on a property

these improvements add to the property’s value, so we can capitalize them into the property

We can sometimes depreciate these improvements at a faster rate than the property itself (MACRS splits assets by useful life) This is often called “cost segregation”

Cost segregation is pretty complicated and there are companies that specialize in it You need to know tax laws inside and out…

For this course we will ignore this and just add capital improvements to original cost to get the gross book value. Essentially we are assuming that capital improvements

happen just before we sell the property

Put It All Together And Stir We now have all the tools we need to work

out the cash flow side of our DCF. What we have to do now is put them all

together… Remember, putting them together is the easy

part, making sure that the numbers you use aren’t garbage is the hard part. You are buying the assumptions that make the

yield, not buying the yield itself! After each line of the pro forma always remember

to do a GIGO check: “Does that number make sense?”

Information Spectrum The amount of information you have on a

property will vary greatly depending on your situation

Ideally you would have the complete rent roll, past operating expenses etc. This would allow you to do a very accurate in

place valuation for a stabilized asset In other cases you won’t have complete

information, the building may be unstabilized, or might be a development deal This is where the “art” part of valuation comes

into it Always be aware of the assumptions you are

making and your own potential biases e.g. I know I am conservative when I underwrite

Where do we start? The first place to start is figuring out what

our rents are so we can work out PGI. There are a couple of ways of going about

doing this and each is suited to a given situation.

1) Actual Rents: if you are lucky enough to have the rent roll of the building then you can forecast out actual rents as far as they are stated.

2) Market Rents: if you don’t have the rent roll, then you have to make your best guess of what the rent roll looks like.

You will still need market rents even if you have a rent roll because you will need to assume something for the space after the lease ends

Rent RollSpace Breakdown SqFeetGround Floor 14,626Mezzanine through 34th Floor 643,408Below Grade 3,494Total 661,528

Floor TenantSquare

Feet Expiration

Total Sqft Per

FloorRent psf per Year (2005)

Rent psf per Year

(2006)34 Available 4,500 Available 4,50033 Available 5,500 Available 5,50032 Delathree.com 7,271 Jul-2010 7,271 $42.67 $43.7431 Delathree.com 9,660 Jul-2010 9,660 $42.68 $43.7530 Goodman & Jacobs 5,850 May-2009 $26.07 $26.6630 Available 4,150 Available29 ESRI 4,500 Apr-2012 $22.98 $23.4429 Eagle Ocean 5,500 Jan-2009 $26.01 $26.5328 Access Integrated Technologies 10,000 Jul-2010 10,000 $51.78 $53.33

10,000

10,000

This is the actual rent roll for a Class B 34 story 661,000 sqft mixed use office building in Lower Manhattan.

Rent Roll27 Corecom 3,900 Feb-2010 $29.56 $30.3727 Transaction Auditing Group 6,100 May-2014 $25.73 $26.1426 Sharretts, Paley, Carter, & Blauvelt 9,276 Jun-2009 9,276 $22.48 $23.0425 New Global Telecom 9,660 Aug-2009 9,660 $41.30 $42.5424 State of New York 6,485 Dec-2014 $26.50 $27.0324 Available 3,950 Available23 Hextalls & Co. 5,850 May-2015 $25.88 $26.5323 Available 4,150 Available22 Infonet Services 3,134 Aug-2007 $25.63 $26.2722 Lava Trading 6,899 May-2011 $45.50 $48.5622 Metromedia 1,697 Oct-2009 $41.79 $43.0522 Met-Tel Corp 4,532 Aug-2010 $44.82 $46.1721 ROM Reinsurance 8,865 Mar-2014 $24.19 $24.6821 Available 1,552 Available21 Available 7,700 Available20 Arbinet the Exchange 21,286 Jul-2015 21,286 $40.89 $42.1219 Fusion Telecommunications 13,686 Mar-2010 $47.39 $48.8119 Access Integrated Technologies 8,606 Jul-2010 $47.10 $48.4618 Fusion Telecommunications 1,319 Mar-2010 $47.39 $48.8118 Access Integrated Technologies 500 Jul-2010 $43.46 $44.6618 Internap Network Services 4,620 Jul-2015 $45.86 $47.1318 New Global Telecom 1,319 Aug-2009 $41.30 $42.5418 US LEC Communications 1,610 Jan-2016 $53.22 $57.3718 AT&T 3,220 Feb-2014 $40.14 $40.9418 Telco Group 1,610 Sep-2009 $34.69 $35.73

10,000

10,435

10,000

16,262

18,117

22,292

14,198

Rent Roll17 Access Integrated Technologies 1,610 Jul-2010 $47.10 $48.4617 Neutral Tandem 1,610 Sep-2014 $23.97 $24.4517 XO New York 1,319 Aug-2015 $47.43 $48.8517 Arbinet the Exchange 1,610 Jul-2015 $40.89 $42.1217 Available 1,319 Available16 Paetec Communications 11,430 Dec-2012 $39.31 $40.3016 State of New York 12,200 Dec-2014 $26.50 $27.0316 Available 4,837 Available15 Internap Network Services 26,072 Jul-2015 26,072 $51.78 $53.3314 Internap Network Services 29,958 Jul-2015 29,958 $45.86 $47.1313 Board of Education 25,200 Sep-2018 25,200 $27.16 $27.4612 Board of Education 25,200 Sep-2018 25,200 $27.16 $27.4611 Board of Education 25,200 Sep-2018 25,200 $27.16 $27.4610 Available 30,000 Available 30,0009 AT&T 25,886 Feb-2014 25,886 $40.14 $40.948 Available 30,000 Available 30,0007 Telco Group 15,000 Sep-2009 $34.69 $35.737 XO New York 15,000 Aug-2015 $47.43 $48.856 Available 30,000 Available 30,0005 RVM 12,000 Jan-2009 $23.41 $23.885 Available 14,700 Available5 Available 3,300 Available4 US LEC Communications 9,331 Jan-2016 $53.22 $57.374 Available 20,669 Available3 Available 4,416 Available3 Neutral Tandem 13,062 Sep-2014 $23.97 $24.453 IP-Only 5,580 Mar-2017 $49.17 $50.653 Royal Blue Financial 6,942 Jan-2009 $30.38 $31.14

7,468

28,467

30,000

30,000

30,000

30,000

Rent Roll2 Peer One Network 10,755 Apr-2009 $42.54 $43.812 ITC 1,609 Jul-2009 $40.26 $41.272 RNI Communications 1,850 Jun-2009 $31.84 $32.472 US LEC Communications 669 Jan-2016 $53.22 $57.372 Peer One Network 3,000 May-2012 $42.54 $43.812 Document Technologies 4,310 Nov-2009 $26.07 $26.662 Available 7,807 Available

Mez Internap Network Services 11,500 Jul-2015 11,500 $51.78 $53.33Ground Duane Reade 8,038 Oct-2014 $80.50 $80.50Ground Board of Education 4,000 Sep-2018 $27.16 $27.46Ground VVVJ Tobacco Group 1,683 Oct-2014 $102.85 $102.85Ground Available 385 AvailableGround Available 520 AvailableB-Grade Qwest Communications 100 Sep-2010 NA NAB-Grade Con Edison 100 Oct-2007 NA NAB-Grade Global Crossing 150 Nov-2010 $417.00 $430.00B-Grade Cogent 150 Sep-2006 $360.16B-Grade Looking Glass 150 Oct-2011 $360.16 $370.97B-Grade XO New York 255 Aug-2015 NA NAB-Grade New Global Telecom 300 Aug-2009 NA NAB-Grade MCI Metro Access 340 Apr-2008 $61.76 $61.76B-Grade Cablevision Lightpath 540 Jun-2011 $225.10 $231.85B-Grade Level 3 Communications LLC 289 Apr-2009 $35.82 $36.90B-Grade Time Warner Telecom 262 MTM $30.00 $30.00B-Grade Metropolitan Fiber NA Apr-2008 $21,000.00 $21,000.00

14,626

3,494

30,000

Rent Roll The rent roll above gives 2005 and 2006 rents

per sqft for each tenant. Notice that rents differ by amount of space,

location in building (basement v ground v mezzanine v office), length of lease etc.

Also notice the ground floor retail is paying higher rents ($50-100 per sqft is market.)

Given this information we can forecast out these leases using what we know about the lease rather than using a market rate.

The rows in yellow indicate vacant space. The expiration column tells you when the leases

expire. In most deals you will be given lease abstracts

and estopells which will spell out the exact details of the lease (rents, escalations, reimbursements etc.)

Rents So we can take our actual rents as a starting

point For a mixed use building like this one (with retail

and office) and very different quality floors (below grade, ground, mezzanine through 34) you would normally split the space up when thinking about rents

With this rent roll I would go lease by lease; with no rent roll I would break the building up by space class (retail; below grade etc.)

How do we grow the rents? If you know the escalation clauses then use them If you don’t know the escalation clauses then you

have to make an educated guess (this is all brokerage reports are…)

Rents How do you make an educated guess about rent

growth? NCREIF properties have rents that have increased

roughly level with inflation for long periods of time. This suggests somewhere around 2-3% is a good place to

start. The economic intuition behind this goes

something like follows Each year your property depreciates from an economic

perspective (it loses functionality and wears out) This suggests that all things equal your real rents should

decline through time. If you maintain your property well and keep it up to

scratch then you shouldn’t be losing value, or a lot of value, in real terms.

Hence growing rents at the rate of inflation isn’t implausible.

Rents In Chapel Hill Class A office rents grow at

around 5% Is this plausible over the long term? That is, 5% > 3%. What needs to be happening

for this to be true? Be very skeptical if someone shows you a pro

forma with 10% growth in rents over a long period of time It may happen over short periods of time, but it is

very unlikely to be a long term trend. Remember the rule of 72 (72/growth rate = years

to double) Juicing your rents is probably the easiest way

of justifying the price of an overvalued property.

Below Market Leases A very common “value” story for a property is

under market leases This only works if you have long term leases

Story: tenants were signed many years ago before the market got hot and rents went up. Now the building is full of tenants who are paying rents substantially below the current market rates because escalation clauses didn’t keep up with rent inflation. When these rents roll to market, the property will get a huge boost to NOI.

What do you think?

Outs Also be careful of lease exit clauses Some leases have exit clauses or “outs” Typically there will be

Triggering date: e.g. in the 5th year of the lease Notice: e.g. at least 12 months A penalty: e.g. $1,000,000

The exit clause is designed to hopefully give the landlord enough time to re-tenant the space and cover the costs of re-tenanting

Just because you have a full building with long leases doesn’t mean you don’t have cash flow volatility if you have a lot of outs that will likely be exercised

RolloverYear SQFT Expiring Percentnow 179455 0.269452006 150 0.000232007 3234 0.004862008 340 0.000512009 87967 0.132082010 61334 0.092092011 7589 0.011392012 18930 0.028422013 0 0.000002014 87149 0.130852015 118328 0.177672016 11610 0.017432017 5580 0.008382018 79600 0.11952

Key Tenants

Tenant SQFT Exp DateNYC Board of Education 79600 Sep-18Internap Network Services Corp 73008 Jul-15AT&T Corp 29106 Feb-14Arbinet tHEXCHANGE, Inc 22896 Jul-15Access Intergated Technologies 20716 Jul-10State of New York 18685 Dec-14XO New York Inc 16574 Aug-15

When do our key tenants roll over?Why do we care?

Rollover The previous slide shows when our leases roll

over. The yellow rows indicate years when greater

than 10% of our space rolls over This is a typical benchmark most people use as an

indicator of serious rollover Why would you care about this?

Think about trying to put debt on this property Currently we have 26% vacancy in our

building Is this good? Is it bad? How can we tell?

Vacancy Since this property is in Manhattan we can get

pretty good data on what market vacancy rates are!

In 2005 the office vacancy rate in lower Manhattan (where this building is) was approximately 12-13% This market got hit very badly by 9-11 and many Class A

Office tenants moved to midtown or Jersey This was good for the midtown market, but bad for the

lower Manhattan. It had however started to rebound in recent years before

the credit crunch. This rate had tightened to around 6-7%. What do you make of our 26% vacancy rate?

Vacancy The building actually just underwent a huge

redevelopment converting it into a high tech infrastructure building Basically the whole building was rewired to allow tech

and communications firms to run generators and other electrical systems.

There is actually a “silicon alley” sprouting up in lower Manhattan as tech firms move in.

Given the massive redevelopment the high vacancy rate is somewhat expected (think of 340 Madison Ave)

The concerning part is that the current vacancy is located in many of our prime floors. When might this be advantageous rather than

concerning?

What do we do about leases rolling over? Obviously we need to make an assumption about what will

happen to the leases that roll over What are the options?

The tenant could renew the space The tenant could leave and we could lease the space The tenant could leave and the space may remain vacant

A pretty reasonable assumption is that for the leases that expire you will re-lease the space to market vacancy levels and at market rates. Notice that for a 10 year analysis this rate could trend through

time Under what circumstance would this “reasonable

assumption” be unreasonable? (i.e. when would you really want to talk to the tenant if possible?)

Source: PWC/Korpacz

“General Vacancy” General Vacancy is a pro forma line item

created by Argus You will often time see people employ it in excel

spreadsheets (mine does) The logic goes like this:

To be conservative I want to include a General Vacancy Loss that overrides actual Absorption and Vacancy Turnover if actual vacancy is less than my assumption

So a 5% vacancy assumption is: max (actual vacancy, 5%)

The idea is I’m being conservative

The Calculation If a lease starts after space is available (we

have vacant space) we need to calculate the lost PGR I did this using the “market leasing” base rent in

the lease spreadsheet: usually you will just use a market rate

For each year calculate: (1) Potential Total Revenue = Total Potential

Gross Revenue + Absorption and Vacancy Turnover

(2) General Vacancy = x%*PTR General Vacancy Loss = IF(AVTO>GV,0,GV-AVTO)

For monthly just convert the annual number to a monthly number

Operating Expenses Typically operating costs are split into fixed and

variable costs (variable refers to variable with respect to occupancy) Fixed costs – property taxes and insurance are a good

example Variable – pretty much everything else

Once again there are a couple of ways of looking at this If you have the financial statements for the property you

can work out operating expenses as a percentage of PGI or EGI or on a sqft basis

Taking a stable historic rate and using that isn’t a bad option.

If you don’t know the building’s financials, then you can make an educated guess by talking to local property operators or companies like REIS or BOMA B/C apartments in Raleigh has operating costs of ~35% of

PGI.

Be careful assuming massive property price appreciation, but only moderate property tax increases.

Tenant Improvements Tenant improvements are by their nature a

“lumpy” variable A fairly conservative way of going about modeling

TIs is to assume that you will have to pay them every time leases roll over This isn’t necessarily true since if an existing tenant re-

leases space any TIs are likely to be smaller than for a new tenant, but this can be modeled.

You will typically have an idea of what TIs in your market are running at and this will vary by property type, quality, location and market conditions $50 per sqft in Chapel Hill for Class A office etc

Remember to make sure that you don’t add TIs for vacant space Be consistent in your assumptions – the space can’t be

vacant and having TIs done on it!

Regular TIs

Renewal TIs (rule of thumb is ~50% of regular)

Capital Improvements Like TIs, capital improvements are a “lumpy”

variable as well. Unlike TIs, capital improvements are difficult to

forecast You don’t know when you are going to need that new roof

or when the HVAC system will fail. Once again you have options in how to deal with

this “lumpiness” If you know a particular system will need to be replaced

then specifically budget for it. This will be typical for newly purchased properties where

you know the problem exists The other alternative is to create a general reserve for it

each year

Capital Expenditure A simple reality check for capital expenditure is

to divide total capital expenditure by total NOI over your investment horizon Class A NCREIF properties average around 30% of NOI

in capital expense (CAPEX, TI, LC) annually Multi-family can be quite small due to low TIs & LCs

Remember capital expenditure is a trade off If you scrimp on capital expenditure expect a lower re-

sale price (either the new owner will need to fill reserves or they will need to do improvements.)

It is inconsistent to assume no capital expenditure and an average market sale price when you sell the property

Terminal Value As with all DCF methods we will need a

terminal value 10 years is a fairly typical forecast period for

DCF analysis if you don’t have an idea of your actual hold time Actual holds tend to be around 5-7 years. Notice that your hold and strategy may be related

(3 year lease up strategy on a 4 year hold) It is pretty standard practice to calculate the

terminal value by capping out the Year 11 NOI.

This requires a “going out” cap rate. You buy at a “going in” cap rate and sell at a

“going out” cap rate Economically, which should be higher?

“Going Out” Cap Rate Cap rates move around through time and

whether your going in cap rate or going out cap rate is larger will be a function of when you bought and sold.

Cap Rate = Total Return – Growth Cap Rate = real risk free return + risk premium

+ inflation - inflation (the inflations cancel each other)

Real risk free returns and risk premia aren’t very volatile, they do however trend with the business cycle.

Over short holding periods they should be roughly constant.

Also be very careful if someone uses a going out cap rate that is a lot lower than their going in cap rate. This implies that while your building has been

economically depreciating its value has been increasing greatly!

Source: RCAA lot of capital chasing fixed assets

Source: RCA

Source: RCA

One of these property types is not like the others.…

Unlevered IRR

Going in Cap Going Out Cap

Cap Rates and Interest Rates You can think of cap rates as just being a

spread to treasuries What we have seen since the start of the

financial crisis is a rapid decrease in treasury rates The 10 year now sits around 2%

We have also seen cap rates at first increase and then compress (especially in gateway markets)

This leads to the question – am I stupid buying Manhattan office at a 4 cap? I am buying today at a 200 b.p. spread What does my exit cap look like?

DH’s Raleigh Apartment Example Raleigh apartment building with 25, 1125 sqft

apartments. Rents are $900 per month and are expected to

rise by 5% per year. 1 apartment is vacant in any given year Operating expenses are $120,000 for the first

year and are also expected to rise by 5% per year. The property also generates other income from

laundry operations equal to 5% of EGI. You have negotiated a 30 year FRM at 6% with a

75% LTV ratio

Example ctd… Your marginal tax rate is 35% federally and

7% state. Capital gains are 15% Federal, 7% state.

Depreciation recapture is 25%. Your required return is 15% You plan to sell after 5 years and sales

expenses are 8% The ask price is $2,000,000 80% of property value is in the building.

Year 1 2 3 4 5 6PGI 270000 283500 297675 312559 328187 344596vacancy 10800 11340 11907 12502 13127 13784EGI 259200 272160 285768 300056 315059 330812other inc 12960 13608 14288 15003 15753 16541Total Rev 272160 285768 300056 315059 330812 347353Operating Expense 120000 126000 132300 138915 145861 153154NOI 152160 159768 167756 176144 184951 194199Debt Service 107919 107919 107919 107919 107919 107919BTCF 44241 51849 59837 68225 77032 86280Taxes 1881.3 5553.7 9415.4 13476 17747ATCF 42360 46295 50422 54749 59286

NOI 152160 159768 167756 176144 184951DEPR 58182 58182 58182 58182 58182INT 89499 88363 87157 85876 84516Tax Inc 4479.2 13223 22418 32086 42254MTR 0.42 0.42 0.42 0.42 0.42Tax 1881.3 5553.7 9415.4 13476 17747

After Tax Pro Forma

From an Amortizationtable

Where did this come from?

25*$900*12Growing at 5% after

4%

Is this reasonable?

Disposition Cash Flow

Assume our cap rate remains constant at 7.608%

Sale Proceeds 2552563sale exp 204205Net Sale Proceeds 2348358 2348358 Acc Dep 290909Mortgage 1395815 Original Cost 2000000 rate 0.25BTER 952543 Gain 348358 72727Tax 149366 rate 0.22ATER 803177 76638.8

Yr 6 NOI/ Cap Rate = 194199/0.07608

From amortization table

Where did I get this?

After Tax Cash Flows

Year 0 1 2 3 4 5ATCF 0 42360 46295 50422 54749 59285.9Price -500000 0 0 0 0 0ATER 0 0 0 0 0 803177Cash Flows -500000 42361 46297 50425 54753 862468

IRR 18.275%

Do we invest?Remember this is equity not total capital

Partitioning the IRR You will often see people partition the IRR of

a real estate project into the IRR from operations and the IRR from disposition

Calculate the present value of cash flows at the IRR Operations $152,987 (30.6%) Disposition $347,013 (69.4%) Total $500,000

Multiplying the percentages by the IRR gives the partitioned IRRs of [0.306*18.275 = 5.59%] and [0.694*18.275=12.68%]

Where would you rather the IRR came from – operations or disposition?

Partitioning the IRR Be very skeptical when the majority of the

IRR is coming from disposition This implies you are making all your money in the

deal by betting on the price of the asset 5 or 10 years from now!

In fact I can set up a deal that has negative carry (I’m not covering my debt service) that will beat an IRR benchmark. All I have to do is assume a huge disposition cash

flow This was the fallacy that got people to invest

in commercial real estate at 4% cap rates The cap rate was the lowest they had ever seen,

but if you assume they will go even lower then the disposition cash flow will get you over your IRR benchmark.

Also notice that a 4 cap rate by definition means your CF yield is low

Places People Screw Up Debt Service: for some strange reason people

mix up monthly and annual payments Depreciation: people forget to net land out of

the property price – you can’t depreciate land Mortgage Value: people often forget to

subtract the mortgage value from the sale price in working out your terminal cash flow

Equity Cash Flow: people will often try and IRR the total investment not the equity investment

Capital Expenses: people forget to include them

Cost of Capital Up until now we took the required return as

given That is, we said the investor required an IRR of

15% We will now try and estimate the cost of

equity for a real estate project The way we estimate the cost of equity in real

estate is the same as you learned in finance except for some unique features of real estate.

Cost of Equity There are two ways you can estimate the cost

of equity: Asset Pricing Model – this could be the capital

asset pricing model (CAPM) or it could be the Fama and French three factor model.

Survey – institutions such as PWC-Korpacz survey investors to find out their required returns for given property types in given locations.

You are probably familiar with the first of these two methods.

The reason that the second method is very common will become obvious when we cover the first method.

Asset Pricing Models Any asset pricing model relates expected returns

to a set of risk factors In the case of the CAPM the required return is a function

of the market risk premium In the case of FF the required return is a function of the

market risk premium and size and book to market factors When these models were originally developed

(60’s for the CAPM; 90’s for FF) the assets that were used to test whether the models were “good” or not were almost exclusively stocks

It turns out that these models do a reasonable job of pricing stocks, but tend to do poorly on pricing anything that wasn’t a test asset.

Asset Pricing Models It turns out that when you try and price real

estate using these models they give you results that don’t make a great deal of sense That is, real estate does not load on the risk factors in

these models At the same time we know that real estate returns are

heavily macro-economy dependent! That is, real estate is risky

CAPM

Rf)E(Rm βrfE(Ri)

The CAPM says the expected return on asset i is equal to the risk free rate plus beta times the expected market risk premium.

Intuitively it says that high beta stocks, those that co-vary a lot with the market, are risky and should have high expected returns

The sense in which these stocks are “risky” is that they pay off when all your other assets are paying off and do poorly when all your other assets do poorly – they magnify the good and bad times.

What we want is an asset that does poorly when the other assets do well and vice versa

CAPM Since returns for individual properties are not

readily available in real estate, people tend to try and estimate the cost of equity using indices

The two most commonly used are: NCREIF (National Council of Real Estate Investment

Fiduciaries) NAREIT (National Association of Real Estate Investment

Trusts) These series are very different!

NCREIF returns are un-levered (all equity) appraisal based returns for institutional grade properties (although I can get transaction based indexes now.)

NAREIT returns are the REIT index – this means the value weighted index of levered stock exchange traded REIT returns

You will often see people use one index when it has absolutely no relationship to the property they are trying to value.

Is either series really “real estate”? The obvious limitation of the NCREIF data is that

it is appraisal based It is only as accurate as the appraiser and it is available

only on a quarterly basis. It also has some nasty statistical properties due to

appraisal smoothing (the newer transaction based indexes are statistically better)

The limitation of NAREIT data is not so obvious Market returns, daily frequency if you want it

The problem with NAREIT returns is that they are securitized returns Academic studies (I’ve written a couple of them) typically

find very little, if any, relationship between NAREIT returns and underlying property returns!

CAPM Theoretically speaking, the market return, Rm, in

the CAPM is the value weighted return on all wealth This would include stocks, bonds, real estate, human

capital… In practice people tend to use some broad based

equity index like the S&P 500 (academics will tend to use the value weighted return on the NYSE, AMEX and NASDAQ.)

The risk free rate used will tend to be a long term government bond like the 10 year bond This is especially true for real estate where you have long

holding periods.

NCREIF v NAREIT

NAREIT v NCREIF

-0.200000

-0.150000

-0.100000

-0.050000

0.000000

0.050000

0.100000

0.150000

0.200000

0.250000

1978

1979

1981

1983

1985

1986

1988

1990

1992

1993

1995

1997

1999

2000

2002

2004

Time

Retu

rn

NCREIF

NAREIT

What do you notice about the two series?

CAPM Beta NAREIT

This is the CAPM regression for the NAREIT equity index on the NYSE, AMEX and NASDAQ value weighted index.

The Beta is 0.469 Does a beta this low

make sense for real estate?

Regression StatisticsMultiple R 0.576R Square 0.332Adjusted R Square 0.326Standard Error 0.056Observations 112

ANOVAdf SS MS F Significance F

Regression 1 0.169621 0.1696 54.63 3.02638E-11Residual 110 0.34154 0.0031Total 111 0.511161

CoefficientsStandard Error t Stat P-valueIntercept 0.019 0.005704 3.3402 0.0011Beta 0.469 0.063518 7.3912 3E-11

CAPM Beta NCREIFSUMMARY OUTPUT

Regression StatisticsMultiple R 0.038904875R Square 0.001513589Adjusted R Square -0.00756356Standard Error 0.01710349Observations 112

ANOVAdf SS MS F Significance F

Regression 1 4.8778E-05 5E-05 0.1667 0.683812798Residual 110 0.03217823 0.0003Total 111 0.03222701

Coefficients Standard Error t Stat P-value Lower 95%Intercept 0.024270407 0.00175071 13.863 7E-26 0.020800916BETA -0.0079614 0.01949666 -0.408 0.6838 -0.046599199

CAPM beta with NCREIF returns.

The beta is -0.007! Does this make

sense?

Cost of Equity We can use our estimated betas to calculate

the cost of equity for real estate. The yield on the 10 year treasury is 3.83%

(2007) Assuming a market risk premium of around

6% (this implies a 10% return on the S&P 500) 3.83+0.469*6=6.6% NAREIT 3.83+-0.007*6=3.3% NCREIF

Does a cost of equity between 3.3 and 6.6% seem reasonable? Either real estate is not very risky or our pricing

model is bad When do most real estate developers go

bankrupt?

Limitation As you can see, using asset pricing models

doesn’t give us an economically appealing answer to the equity cost of capital for real estate We know real estate is risky – the times it does well and

the times it does very poorly are very much related to business cycles!

This suggests that it should have a reasonably high cost of capital

Our models just don’t seem to support this People tend to just stick with their intuition and

reject the model as bad, rather than conclude real estate is safe.

Korpacz IRR

2Q944Q94

2Q954Q95

2Q964Q96

2Q974Q97

2Q984Q98

2Q994Q99

2Q004Q00

2Q014Q01

2Q024Q02

2Q034Q03

2Q044Q04

2Q054Q05

2Q064Q06

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

Office IRRApartment IRRSuburban Office IRRRetail IRRStrip Center IRR

Korpacz Cap Rates

2Q944Q94

2Q954Q95

2Q964Q96

2Q974Q97

2Q984Q98

2Q994Q99

2Q004Q00

2Q014Q01

2Q024Q02

2Q034Q03

2Q044Q04

2Q054Q05

2Q064Q06

0.00

0.02

0.04

0.06

0.08

0.10

0.12

Office Cap RateApartment Cap RateSuburban Office Cap RateRetail Cap RateStrip Center Cap Rate

Surveys Notice that institutional quality IRRs are

lower than non-institutional quality IRRs by around 2% Institutional quality real estate is less risky than

non-institutional quality real estate IRRs tend to be 2-3% higher than cap rates

Total Return = Cap Rate + Growth IRR = Cap Rate + Inflation

So it appears that although they are only survey numbers, they do conform to our basic intuition about real estate returns.

Surveys Notice that the IRRs reported are property

level returns They are not the expected return on equity, they

are the expected return on assets As such we would expect the required return

on equity to be higher

IRR Benchmarks Class A Core NYC/DC you are looking at

single digit levered returns These markets just aren’t driven by economics at

the moment Core outside of NYC/DC, but in good major

metros you are high single digit/low double digit levered

Core-plus / value add (these are core properties but with some stink – either vacancy [core plus] or capital expenditure issues [value add] or both) Unlevered IRRs in low double digits, levered IRRs

in the high teens. This varies a lot by asset quality.

If you go non-core or to tertiary markets it is anyone’s guess…

Conclusion This is a really big topic Here is my approach Step 1: Big Picture

What don’t you like? What do you like? What issues are there?

Step 2: Break it down Break it into small parts (rents, rollovers,

expenses etc.) and deal with each individually Step 3: DCF it

Put what you know from 1 and 2 into the after tax pro forma. Remember the usual mistakes (depreciation, equity cash flow etc.)

Step 4: Check it Mathematically and economically

Where did value come from? What cap rate did you buy at? What cap rate

did you sell at? Buy high, sell low = high price appreciation

In and out caps are similar, then look at NOI growth Buy low NOI, sell high NOI at same cap = high

price appreciation Where did that rent growth come from? In place

leases? Assumed lease rolls? In and out caps are the same, NOI growth is

normal Check your capital items are reasonable

In and out caps are the same, NOI growth is normal, capital items are good Check for mechanical errors…

1290 Avenue of the Americas

The Deal Vornado (70%) and Trump (30%) just refinanced

1290 Avenue of the Americas Lending syndicate was: UBS, Goldman, BoC &

German American Capital Corp. ~2.1m sqft office building (43 stories) Class A

between 51st & 52st Undergoing lobby and façade improvements

950m loan @ 3.344%, 10 year full term IO U/W: LTV 47.5%, 9.9 DY, 2.93x cover ($2b) CRA: LTV 70.8%, 9.3 DY, 2.77x cover ($1.34b) The delta between the U/W and the CRA is small on cash

flow (mainly rent bumps), but large on value. CRA @ 6.5 cap, U/W @ 4.7 cap. Comp caps were 3.8%.

U/W revenue 152.3MM; expenses 54MM; NOI 97.66MM

478M of this loan is cash out. VNO still has an equity basis in the deal, but it is significantly lower than it was.

CMBS The loan will be securitized as the single

asset CMBS deal “VNDO 2012-6AVE”

A, X-A and X-B are senior in coupon rights. X-A is stripped off A; X-B is stripped off B.

Economics The weighted average cost on the CMBS bonds is going to be close

to S+165ish Pricing wasn’t public, but that would be an educated guess based on

recent issues: 10 yr AAA is 90ish; AA is 190ish; A is 260ish; BBB is 420ish.

A lot would depend on how bullish people are on the AAA tranche (36% subordination on low leverage is a lot of protection v single asset exposure)

10 year swaps was at 165, so S+165 = 330 This is at the money territory On a standalone basis this loan would be somewhere between AAA

and AA. That is about as solid a loan as you can get

The 3.3 rate also shows how competitive CMBS lending is against the life lenders at present This type of loan is firmly in life lender territory (low leverage, top

quality asset, top market…) and would be considered of good quality by life lender standards (they shoot for around an A)

How did people think about the credit risk of this deal? The borrower? Tenant Quality? Lease rolls? Roll probabilities? Market v in place rents?

VNO isn’t credit constrained. If it makes sense to use more capital, they have access to it.

Tenants

45% of base rent comes from IG tenants. Nice mix of tenants – national law firms, financials, media, education/medical

Of 6.95m in future rent bumps, the CRAs only gave them 1.35m (this is the main cash flow wedge)

Lease rolls

2014 roll is dominated by 2 tenants (MoFo 155,934 and Microsoft 173,817.) MoFo is leaving and Microsoft is negotiating at present. MoFo is leaving because they want more space.

How did they mitigate these risks? They have a lot of notice on MoFo leaving and will hopefully have the same for Microsoft. Each space has a $10m reserve against it for re-tenanting ($~60 PSF). MoFo is also below market.

Roll Probabilities

So we have some serious roll around refi, but…AXA has signage rights. Bryan Cave is a long term tenant and has just expanded its space (no law firm can take signage rights if they are in place.)

It is CW’s world headquarters (they are also the leasing agent for the building)

In place v Market

The MoFo space is in the 30 to 43 bucket. So the fact they are rolling is a plus from a cash flow perspective

The lower floors are above market, which is problematic. Microsoft is in the 2-10 bucket, which might explain the slow lease renegotiation.

Overall, the over market leases on 2-16 are just outweighed by the under market leases 17-43

What happened? Well not much on the bond front simply

because the loan is 16 months old, but Equitable (the anchor) is subleasing its space and

looking to move Microsoft is leaving

So there is some potential for some issues around refi because AXA is unlikely to renew But once again the basis on the loan is quite low,

so it is very unlikely any of the bonds would suffer losses.