LECTURER

BERNEL HALL

Real Estate Finance Course – Rutgers Business School

Outline

The American Dream, The American NightmarePeople, Process, Product, Timing, and

ExecutionCharacteristics of Property TypesThe Napkin AnalysisSteps in the Real Estate Acquisition ProcessBusiness Cases:

Slam Dunk: 614-640 South Broad Street, Elizabeth, N.J. “sUe S. A.: 152 East 7th Street, Roselle, N.J. Roles and “Response” ability: 58 Cypress, Newark, N.J.

Questions and Answers

The American Dream

Homeownership has been promoted as government policy using several means involving mortgage debt and the government sponsored entities Freddie Mac, Fannie Mae, and the Federal Home Loan Banks, which fund or guarantee $6.5 trillion of assets with the purpose of directly or indirectly promoting homeownership

Homeownership has been further promoted through tax policy which allows a tax deduction for mortgage interest payments on a primary residence.

The Community Reinvestment Act also encourages homeownership for low-income earners

The promotion of homeownership by the government through encouraging mortgage borrowing and lending has given rise to debates regarding government policies and the subprime mortgage crisis

According to the 2012 U.S. Census Bureau, the homeownership rate is 65% among Americans

The American Nightmare (Zillow is Right!)

Buying isn’t for everyone…neither is being a landlord

Price-to-Rent RatioBuy-Rent Breakeven

HorizonUrbanites Rule…Better neighborhood,

better investment?

People, Process, Product, Timing, and Execution

Identify your personal strengths and interest as well as your weaknesses and irritants

You’re only as good as your team…there is no such thing as a self-made real estate millionaire

It’s not about who you know, it’s about who knows you…

Every deal is different but your commitment to due diligence and details must remain the same

There is always money for a good deal

Make tenants come to you…then screen for the best tenants

The time is always right to buy, sale, refinance, or raise rents…depending on where you are in the real estate cycle

Follow up then follow through...

•GC•3rd-party Prop. Mgr.

•Asset Mgr.•Bookkeeper

•Investors•End User•Partners

•Banks•Friends•Family•Gov’t•Seller

•Owners•Brokers•Banks•Politicians

Sourcing Financing

Managing

Harvesting

Office Retail Residential Industrial Hotel

Location CBD, government,

access to labor, support services,

highways, and other public

transportation

Highway, population

density, visibility

Proximity to jobs, NEW schools,

amenities, physical image

Proximity to consumer truck access, access to

labor

Proximity to tourist

attractions and other travel generators

including airports and CBDs

Demand Factors

Job growth (chamber of commerce)

Demographics, effective buying income and high

median household income in trade

area

Household formation job

growth, interest rates, product-

market mix

Cheap, skilled labor force

Occupancy rates, Travel statistics

Supply Factors Vacancy rates,

absorption rates, planned, pipeline

and potential competition

Location, age and performance of

competition, capture or

catchement rate analysis

Vacancy rates, Absorption rates, planned, pipeline

and potential competition

Vacancy rates, absorption rates, planned, pipeline

and potential competition

Location, age, and performance of

competition

Barriers to Entry

Financing, tenants, zoning,

approvals

Anchor tenants, zoning,

approvals, traffic concerns,

antigrowth, sprawl issues

Single family: Few multifamily:

zoning, approvals, land

costs

Land costs, environmental

easements

Management contract

Key Design Issues

Efficiency, flexibility,

parking, build-to-suit versus multi-tenant spec., open

v. perimeter offices

Visibility, circulation,

parking, image, mall v. big box v. community center,

etc.

Image, unit size, fixtures and

details, amenities

Cross-docking, Costs, flexibility, reuse possibilities,

load-bearing capacity, turning rations, ceiling heights, trailer

storage

Image, amenities

Key Pro Forma Assumptions

Tenant improvements,

lease commisssions,

operating expenses

Sales per square foot, percent rent,

CAM reimbursement

Market pricing Lease term, triple

net leases Fixed operating

expenses

The Napkin Analysis: Cost-to-Rent

Start with total development cost and end with the minimum rent required for feasibility

Site Acquisition Costs + Construction Costs = Total Expected Development Cost X Loan to Value Ratio = Permanent Mortgage X Annualized Mortgage Constant = Cash Required for Debt Service X Lender Required Debt Service Coverage Ratio = Required Net Operating Income or NOI + Estimated Operating Expenses (Not passed through to tenants) = Required Effective Gross Income ÷ Expected Occupancy Rate = Required Gross Revenue ÷ Leasable Square Feet = Rent Required Per Square Foot

Question: Is this average required rent per square foot achievable? Typical approach for “Site looking for a Use”

The Napkin Analysis: Cost-to-Rent

Cost-to-Rent Example:o Class B office building rehab project: 30,000 SF (of which 27,200 NRSF).o Acquisition cost = $660,000; o Rehab construction budget: $400,000 hard costs + $180,000 soft costs.o Estimated operating costs (to landlord) = $113,000/yr.o Projected stabilized occupancy = 95%.o Permanent loan available on completion @ 11.5% (20-yr amort) with 120% DSCR.o Estimated feasible rents on completion = $10/SF.Site and shell costs: $ 660,000

+ Rehab costs: 580,000= Total costs:$1,240,000X Lender required LTV x 80%= Permanent mortgage amount: $ 992,000X Annualized mortgage constant: x 0.127972= Cash required for debt svc: $ 126,948X Lender required DCR: x 1.20= Required NOI: $ 152,338+ Estd. Oper. Exp. (Landlord): 113,000= Required EGI: $ 265,338 Projected occupancy (1-vac): 0.95= Required PGI: $ 279,303 Rentable area: 27,200 SF= Required rent/SF: $10.27 /SF

The Napkin Analysis: Rent-to-Cost

Start with rents & building, and end with supportable development costs Total Leaseable Square Feet (based on the building efficiency ratio times the

gross area) X Expected Average Rent Per Square Foot = Projected Potential Gross Income (PGI) - Vacancy Allowance = Expected Effective Gross Income - Projected Operating Expenses = Expected Net Operating Income ÷ Debt Service Coverage Ratio ÷ Annualized Mortgage Constant ÷ Maximum Loan to Value Ratio = Maximum Supportable Total Project Costs (Question: Can it be built for this including all costs?) - Expected Construction Costs (Other than Site) = Maximum Supportable Site Acquisition Cost

Question: Can the site be acquired for this or less? Typical approach for “Use looking for a Site”.

The Napkin Analysis: Rent-to-Cost

Rent-to-Cost Example:o Office building 35,000 SF (GLA), 29,750 SF (NRA) (85% “Efficiency Ratio”).o $12/SF (/yr) realistic rent (based on market analysis, pre-existing tenant wants space).o Assume 8% vacancy (typical in market, due to extra space not pre-leased).o Preliminary design construction cost budget (hard + soft) = $2,140,000.o Projected operating expenses (not passed through) = $63,000.o Permanent mortgage on completion available at 9% (20-yr amort), 120% DCR.o Site has been found for $500,000: Is it feasible?Potential Gross Revenue = 29,750 x $12 = $ 357,000

Less Vacancy at 8% = - 28,560= Effective Gross Income $ 328,440Less Operating Expenses - 63,000= Net Operating Income $ 265,000 1.20 = Required Debt Svc: $ 221,200 12 = Monthly debt svc: $ 18,433 Supportable mortgage amount = $ 2,048,735 0.75 LTV = Min. Req. Value: $ 2,731,647Less Construction Cost - 2,140,000 Supportable site acquisition cost: $ 591,647

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So, the project seems feasible. But then again, something seems left out. The project may be feasible but…

The Napkin Analysis: Limitations

Just because a project is financially feasible, does not necessarily mean that it is desirable.

Just because a project is not feasible using debt financing, does not necessarily mean that it is undesirable: A project may appear unfeasible with debt financing, yet it might be a

desirable project from a total return to investment perspective (and might obtain equity financing).

Do not confuse the Napkin feasibility analysis with a full assessment of the desirability of a development project from a financial and core competency perspective.

The Napkin Analysis does not compute the value of the completed property.

Hence, does not compute the NPV of the development investment decision: NPV = Value – Cost .

The Napkin Analysis merely computes whether it is possible to take out a permanent loan to finance (most of) the development costs.

Steps in the Acquisition Process

1. Determine the Investment Criteria A. Cash and/Credit Available (F&F, Banks, Etc.) B. Investment Objectives: I.) Future Cash Flow; II.)

Asset Appreciation; III.) Tax ShelterC. Hurdle ReturnD. Liquidity RequirementE. Investor’s Capacity to Source/Develop/RenovateF. Time Availability G. Tax Position

Steps in the Acquisition Process

2. Determine the Investor’s Property Criteria A. Proximity to Jobs and Infrastructure/Prestige FactorB. Raw Land, Improved Land, Land Plus BuildingC. Type of Project (Property Type/Ground-up Development

or Rehabilitation)D. Size,# of Units, Age & Condition, Required Amenities

3. Locate PropertiesA. Municipal Planning/Development OfficeB. Large Not-for-ProfitsC. Real Estate BrokersD. General ContractorsE. Divorce/Bankruptcy Court

Steps in the Acquisition Process

4. Qualitative AnalysisA. Personal Inspection – Age & Condition (Mechanical,

Electrical, Structural, Appearance, Engineer, General Contractor, Architect)

B. Evaluation of Location and MarketC. Amenities (Existing/Desirable) – Project, Natural, Local D. StabilityE. Legal Status (Zoning, Attorney, Municipal Authority)F. Trends and/or Discontinuities

5. Gather Basic Financial DataA. Verify via the examination of existing leases, contracts,

financial statements, operating statements, tax returns (3 yrs. Minimum)

Steps in the Acquisition Process

6. Quantitative Analysis and Asset Business PlanA. The Napkin AnalysisB. Discounted Cash Flow Analysis-(Establish Projected IRR, Cash-

on-cash Return, Profit Margin, Time Horizon)

7. Detailed Personal Financial AnalysisA. Property Tax Implications/DepreciationB. Corporate/Partnership Tax Implications

8. Obtain Comparables (Appraiser, Management Company, Leasing Broker, Accountant, Local Owners, and Realtors)

A. Recent SalesB. Replacement CostsC. Return (Income & Expense)D. Evaluate Operating Efficiency and Realized Returns against

Asset Business Plan and the Market

Steps in the Acquisition Process

9. Study RisksA. Market Conditions – Competition (Existing & Future)B. General Economic Conditions, Trends,

DiscontinuitiesC. Policy Changes: Tax Law, Zoning, Density, Historic

Designations D. Are your initial assumptions still reliable?

10. Study RewardsA. How much so far? Keep an on-going track recordB. Where are your profits coming from? More of this…

Less of that…?C. What are you betting on?

Case Study#1: “The Slam Dunk”

• Structured $50,000 hard money loan against one of the first condos to be completed and sold within new, state-of-the-art building

• Utilized unique understanding of construction process to objectively gauge the risk and timing associated with removing mechanic’s lien and obtaining TCOs

• Executed “no money down” partnership agreement with investor while retaining 50% of the interest income from the transaction

• Made $50,000 hard money loan to a general contractor that needed to remove a mechanic lien on a pre-sold condominium

– 2,200 SF, 2 bedroom, 2 bath condominium built within an 18 unit condominium building

– Stainless steel appliances, granite countertop, dishwasher, refrigerator, bamboo floors

– Security system, Intercom• One mile from Downtown Elizabeth /NJT Train Stop

• $12 mm Total Development Cost• $50,000 hard money loan against single unit• Completed 2013• 12-month Loan Term• Realized IRR: 18%• Profit Margin: 1.2x

Investment Overview

Structure Key Transaction Metrics

Case Study #2: “sUe” S. A.

• Structured $25,000 hard money collaterized by 75% renovated house and a personal guaranty from long-term, municipal employee

• Loan included a default provision, default interest rate, due-on-sale clause, and lien against borrower’s personal residence

• Made $25,000 hard money loan to a real estate investor who needed the funds to complete a renovation project

– 1,000 SF, 2 bedroom, 2 bath single-family home originally built in 1923

– 3 bedrooms, 2 baths– Renovations included kitchen and bathroom

upgrades• Investor was a repeat customer with credible full-time

job as city policeman

• $150,000 Total Development Cost• $25,000 hard money loan • Default Date: Winter 2011• Lawsuit Filed: Summer 2012• Wage Garnishment Start Date: Fall 2013• Projected Gross IRR: 37%• Profit Margin: 1.44x

Investment Overview

Structure Key Transaction Metrics

Case Study #3: Roles and “Response” ability

• Acquired off-market “fix-up” property via a joint venture with a development partner specializing in asset repositioning transactions

• Retained control of the assets throughout renovation and holding period via title and managing member designation

• Included partnership roles, performance penalties, and buyout clauses in operating agreement

• Partnered with a renowned general contractor/investor to invest in the acquisition, renovation, and leasing of a multi-family house

– 2,444 SF, 9-bedroom, 3 bath two-family home– Originally built in 1920– Renovations included kitchen and bathroom

upgrades– Partner was a licensed general contractor and

residential property manager• One mile from Interstate 78 and 10 minutes away from

Newark Liberty International Airport

• $150,000 Total Development Cost• $150,000 Equity Investment• Initial Investment Date: Spring 2011• Projected Investment Recapture/Harvest Date: Fall

2012 • Actual Investment Recapture/Harvest Date: Fall 2014 • Projected Gross IRR: 17%• Profit Margin: 1.7x

Investment Overview

Structure Key Transaction Metrics

Case Studies Summary

You miss 100% of the shots you don’t take…So take a shot… Your business, your brand Forecast vs. actual: Make your money going into the deal If you don’t measure it, you can’t manage it… Risk-adjust every investment: You should always retain “Response”

ability. Profit margins are fluid…Never lose track of the numbers because…

Compound interest is like the wind…whether you see it or not, it is working for you or against you…

Tracking and Branding go hand and hand Surprises are rarely welcomed in business. Be the first to know! Over-achieve…and brag about it to the right people Be honest and share your experiences with like-minded people that

you can trust

Questions and Answers