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Real Estate Division

BUSI 331 Real Estate Investment Analysis and Advanced Income Appraisal

Len Sherwood

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REAL ESTATE DIVISION

UNIVERSITY OF BRITISH COLUMBIA

Topics:

• Introduction • Overview of Real Estate Assets and Markets• Analysis of Income and Expenses• Introduction to Leasing• Lease Analysis• Taxation of Real Estate Investments• Questions

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•The lesson will take about 1.5 hours and will be followed by a free-for-all question and answer session. During the presentation please do not hesitate to ask questions and/or provide your opinion.

Introduction

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This webinar is intended primarily to help you to understand concepts and proper procedures. Only the major points of the text will be addressed.

Goal

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Investment Analysis vs. Appraisal

Investment Analysis: Value to the Owner based on a set ofowner-defined criteria and circumstances:

• Required Rate of Return (RRR)• Risk tolerance• Cash flows (income) versus appreciation (capital gain)• Financing• Tax status

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Investment Analysis vs. Appraisal

Appraisal: Market Value

• Uses an analytical framework to determine the value of property in the eyes of the market as opposed to an individual• Concerned with cash flows from the property on a before financing, before tax basis• Net Operating Income (NOI) measures the cash return from the property

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Point to Ponder

“Much learning does not teach a person to have intelligence”..Heraclitus-5th Century BC

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What is intelligence? It is the capacity to reason, to ask questions, and that is what we must do as appraisers and consultants. Learn these BUSI 331 procedures, by all means, but do not apply them blindly.

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CHAPTER ONEOVERVIEW

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Two types of students for this course:•Appraisers•Consultants

This course is of interest to both types.

Of interest to

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Investment Consulting

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Appraisal

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Basic formula is NI/OAR = MVNI from supply and demand;OAR = measure of risk

All valuations reflect risk-return

Overview

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Advantages of RE Investments

•High returns•Inflation hedge•Financial leverage•Tax sheltering

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•Financial risk (increases with leverage)•Interest rate risk (as per financial)•Illiquidity•Management

Disadvantages of RE Investments

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Pay attention to fundamentals:•Net rent obtainable•Quality of tenants•Quality of real estate

Tax benefit is secondary due to impact of tax law changes at any time (MURBs)

Fundamentals

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Ref. P 1.12. Log1.05 2=n (use Excel “log” function) to find that at 5% mv will double in 14 years.

Rule of thumb: 70/i = years for mv to double.e.g. 70/.05 = 14 years.

Rule of Thumb

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CHAPTER TWOANALYSIS OF

INCOME AND EXPENSES

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The whole point of this chapter is to demonstrate how to properly estimate net operating income of the subject property

GOAL

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Process

•Analyze operating history•Find and analyze market rents and expenses•If s.p. operation is similar to market use s.p. NOI for valuation•If not, investigate why not and adjust as required.

The following slides illustrate this process.

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Operating History-Apartment

RECONSTRUCTED INCOME STATEMENT

ITEM PROJECTED2006 2007 2008 2009

REVENUE

Apartment rent 129,391 129,754 129,049 147,300Laundry 3,100 3,351 4,120 4,100Parking 900Potential Gross Income 152,300 100.0%LESS: Vac./bad debt 3,046 2.0%EFFEC. GROSS INC. 132,491 133,105 133,169 149,254

EXPENSES

Property Taxes 10,489 11,082 11,121 11,121 7.3%Insurance 1,722 2,113 2,302 2,302 1.5%Utilities 17,599 12,534 15,122 15,085 9.9%Repairs and Maintenance 1,980 3,029 5,430 3,480 2.3%Garbage 2,050 2,050 2,050 2,050 1.3%Caretaker 5,173 6,000 6,000 9,918 6.5%Licence & ROMA 518 470 677 677 0.4%Advertising 1,807 3,409 1,195 1,200 0.8%Management 2,650 2,662 2,663 2,985 2.0%Sub-total 43,988 43,349 46,560 48,818 32.1%

Appliance Reserve 1,480 1,480 1,480 1,480 1.0%Structural Reserve 1,987 1,997 1,998 2,239 1.5%Total Expenses + Res. 47,455 46,826 50,038 52,537 34.5%

NET REVENUE 85,036 86,279 83,131 96,717 63.5%

ACTUAL

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Rental spreadsheet-Retail

Lease Term Area Rate Mcon RateStreet Date Yrs SF $Net Adj CAM $Gr Remarks

Douglas Apr-08 5 2,329 14.80 15.24 8.83 24.07Renovated. HVAC. Rent averaged $14/$15/$15/$15/$15. 2 months fixturing with commencement June 2008.

Bay Aug-08 5 1,447 17.60 17.70 9.59 27.29 Plaza location. Finished main floor office.

Blanshard Jul-08 5 17,000 20.00 20.24 8.00 28.24 Renewal. Jordan's furniture. Interior unit Blanshard Square plaza. Good.

Gorge E. Mar-07 5 1,368 22.00 24.38 7.00 31.38Built 1951. Garden store. Rent averaged $18/20/22/24/26. Good condition. Finished space. No TIs. CAM estimated.

Pandora Sep-08 5 1,100 20.00 20.00 9.00 29.00 Good finished office space leased to mortgage broker. Good parking at $100 per stall. No Tis.

RETAIL LEASES

Rental Rate Trend with Building Class

0.00

10.00

20.00

30.00

0.00

Building Class

Renta

l Rate

Per

Squ

are F

oot

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When comparing market rents of retail, office and industrial properties ensure all (including s.p.) are based on rentable area as per BOMA standard.

BOMA

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In Victoria, expenses/EGI are typically 30% to 35%. S.P. For 2008 is 38%.Why? Rents are below market because owner has not been diligent, but expenses are at market, so use market rents for valuation.

Ratio Analysis

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Basic Accounting Statements

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Income StatementAccounting vs for tax

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Appraisal: NOI is before tax and financing because this creates common denominator for comparison of investments.

Forecasting: Appraisal vs Investing

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GRM-direct comparison method

OCR-typical return on investment for a particular income-property type.

Ratio Analysis

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P. 2.20. This applies in situations where landlord pays expenses such as for apartments, but does not normally affect retail/office/industrial properties that are usually rented on an absolute net basis.

Operating Leverage

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After Tax Cash Flows

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PARAMETERS:•Investment horizon•Cash flow forecasts (lease and market)•Reversion estimate

These statements must be discounted to NPV

Pro Forma Statements

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We all use DCF, but do we understand it?If an investor requires a return on investment (ROI) of 10% he will invest $100 today to receive $110 a year from now. This is the foundational concept of DCF.

Discounted Cash Flow Concept

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What do we mean by present value?$110 received one year from now, at an investor's required rate (discount rate) of 10% has a value today of $110/(1+10%) = $100. $100 plus 10% = $110.

Present Value

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Let's see how well you can apply DCF. Here is a multiple-choice question. You have three minutes to tackle it.

TEST

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Ref p.2.33. FV of property is increased at a 6% rate. Does not account for differing income and expense rate changes. Better to base reversion on projected NOI and projected cap rate.

Reversionary Value

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DCF example-In Advance

Year 1 Year 2 Year 3 Year 4 Year 5 ReversionTiming of cash flow B.O.P. B.O.P. B.O.P. B.O.P. B.O.P. Begin Yr 6Base Rent 1,080,000 1,125,000 1,170,000 1,215,000 1,260,000 1,305,000Recoveries 877,500 903,825 930,940 958,868 987,634 1,017,263Vacancy -58,725 -60,865 -63,028 -65,216 -67,429 -69,668Effective Gross Income 1,898,775 1,967,960 2,037,912 2,108,652 2,180,205 2,252,595

Expenses -877,500 -903,825 -930,940 -958,868 -987,634 -1,017,263Structural Reserve -37,976 -38,735 -39,510 -40,300 -41,106 -41,928

Net Cash Flow 983,300 1,025,400 1,067,462 1,109,484 1,151,465 14,917,551Present Value 983,300 953,861 923,710 893,091 862,218 10,390,949Net Present Value 15,010,000

Rentable area 90,000 square feetNet Rent 12.00 per sfExpenses 9.75 per sfStructural reserve 2.00% of Effective Gross IncomeBase rent increases at 0.50 per sf per yearRecoveries increase at 3.00% per yearVacancy is 3.00%Expenses increase at 3.00% per yearStructural reserve increases @ 2.00% per yearDiscount rate is 7.50%5 year reversionary cap rate is 8.00%

Ref year 2. If investor can get $1,025,400 at start of year 2 he will invest $953,861 now (7.5%)Difference in mv between paid in advance and in arrears is $690,000 PV

Before Tax Discounted Cashflow-Rent Paid In Advance5 Year Lease

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Rent paid in arrears

Year 1 Year 2 Year 3 Year 4 Year 5 ReversionTiming of cash flow E.O.P. E.O.P. E.O.P. E.O.P. E.O.P. End Yr 5Base Rent 1,080,000 1,125,000 1,170,000 1,215,000 1,260,000Recoveries 877,500 903,825 930,940 958,868 987,634Vacancy -58,725 -60,865 -63,028 -65,216 -67,429Effective Gross Income 1,898,775 1,967,960 2,037,912 2,108,652 2,180,205

Expenses -877,500 -903,825 -930,940 -958,868 -987,634Structural Reserve -37,976 -38,735 -39,510 -40,300 -41,106

Net Cash Flow 983,300 1,025,400 1,067,462 1,109,484 1,151,465 14,393,313Present Value 914,697 887,312 859,265 830,782 802,063 10,025,787Net Present Value 14,320,000

Before Tax Discounted Cashflow-Rent Paid In Arrears5 Year Lease

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Be careful when timing cashflows. As you can see from the foregoing it can have a marked impact on market value. In advance, reversion is based on income at beginning of year 6, in arrears it is based on end of year 5 income.

Note about DCF

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REAL ESTATE DIVISIONRefer to page 4.5 Typical lease-paid in advanceMarket value of site via DSC 600,000

PV PV annuityreversion 1 per

of 1 period

0.15 11.53Rate 8.00%Years 25Income 30,000 345,863Reversion 600,000 87,611

PV 433,473

10.71Rate 9.00%Years 25Income 15,000 PV 160,599


643,996Sum of Combined Interests

ANNUAL COMPOUND INTEREST TABLE

Leased Fee

Leasehold

Subleasehold

Lease Analysis

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INTRODUCTION TO LEASING

CHAPTER THREE

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A lease is the lifeblood of an income-property. A property with a vacant building is difficult to sell unless, of course, its value is all in its site; and it will sell for less than a fully leased property.

THE LEASE

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•Names•Estate being created•Premises description•Commencement date•Term•Rent and payment method•Signatures•Covenants and conditions

MAIN ELEMENTS OF A LEASE

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•Net lease-tenant pays base rent plus all expenses•Gross lease-tenant only pays base rent

LEASE TYPES

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For retail/office and industrial properties gross leases are becoming rare. Check the lease and back-out any expenses paid by landlord to find net rent that actually goes into the landlord's pocket.

GROSS LEASE

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Face rates shown in net leases are often stated as net rates but do not reflect tenant inducements provided by the landlord or repayment of fixturing paid for by the landlord.

BE CAREFUL-NET LEASE

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Read the lease carefully and interview the landlord. Adjust the face rate for any landlord TIs such as free parking, free rent for fixturing time, and payments made by landlord towards tenant improvements. The result is net effective rent that goes to the landlord

Net Income-Net Lease

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Try this test.

TEST (mc2)

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•Cumbersome to remove when lease terminates•Information available for competition•Requires greater management including registrable plan by a surveyor.

Lease registration

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Have a go at this question.

TEST (mc3)

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•Inflation hedge•Minimum management (mainly net leases)•Tax benefits (lease to avoid cap gains tax)•Security•Marketability (good tenant=lower risk)•Mortgageability (good tenant=lower risk)•Simpler default procedure (easier to evict than foreclose)

LEASE BENEFITS TO LESSOR

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•Financing technique (no need to purchase, equivalent to 100% mortgage)•Tax benefits (rent is deductible)•Security (provides firm rental term)•Sale leaseback (cash and tax benefits)

LEASE BENEFITS TO LESSEE

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•Bradford-Bank of Montreal•Quadra and McKenzie-Telus•Toronto-4-unit industrial building•Victoria-waterfront site

IMPACT OF LEASES ON MV

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Try this question

TEST (mc4)

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Methods of establishing lease rate:•% of upland mv adjusted for zones of value•Comparison with similar waterlot rates

WATERLOT LEASE

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LEASE ANALYSIS

CHAPTER FOUR

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Small differences in net operating income create large value differences when capitalized, particularly when the market is strong and cap rates are low. A $1 psf rental error at 6.0% cap for a 30,000 sf building is an mv error of $500,000

BE CAREFUL OUT THERE

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•Estimate MV with market rents then adjust for pv of leasehold interests (use this)•Estimate mv and allocate value between leased fee and leasehold interests (seldom used)

INCOME VALUATION METHODS

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REAL ESTATE DIVISIONRefer to page 4.5 Typical lease-paid in advanceMarket value of site via DSC 600,000

PV PV annuityreversion 1 per

of 1 period


PV 433,473





Leased Fee

Leasehold

Subleasehold

Example of Allocation-25 Year Term

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Same except 5-year term


PV 537,714




5-year termLeased Fee

Leasehold

Subleasehold

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Very difficult to estimate remaining economic life of a building for reversionary adjustment and unrealistic to include in discounted cashflow. Cap rate normally adjusts for quality and condition of building. Older building with low reversion value=higher cap

Improved Property Lease-p 4.9

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The valuation problem illustrated on page 4.12 is so unusual that we won't spend much time on it. Just remember that this type of problem is handled by drawing timelines, estimating NPV of each of the interests, and summing them.

COMPLICATED LEASE PROBLEM

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Convert p 4.17 to Excel

Payment E.O.P. B.O.P. Payment E.O.P. B.O.P.PV PV annuity PV PV annuity

reversion 1 per Years reversion 1 per Yearsof 1 period of 1 period

0.83 1.91 0.08 10.16Rate 10.00% Rate 10.00%Years 2 Years 27Amount 8,000 6,612 15,273 1-12 Amount 20,000 1,526 203,219

0.01 10.920.83 1.91 Rate 10.00%

Rate 10.00% Years 52Years 2 Amount 20,000 141 218,451Amount 14,000 11,570 26,727 15,232 38-62

0.08 10.16 0.01 10.92Rate 10.00% Rate 10.00%Years 27 Years 52Amount 14,000 1,068 142,253 Amount 200,000 1,408 reversion

115,526 13-37Present Value 147,439


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Shopping centres and food stores tend to have percentage leases, but lenders rely on base rates. Most percentage leases I've valued did not reach percentage rent trigger levels and stayed at base rates.

PERCENTAGE RENT

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Doctored documents in Newmarket

Due diligence-verify, verify, verify

Do not assume

PRACTITIONER BEWARE

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If valuing an improved property and a ground lease is in place with no renewal options, beware. MV of lessee's interest only extends to the end of the ground lease. Always check title. Know the interest you are analyzing.

GROUND LEASE IMPACT

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TAXATION OFREAL ESTATE INVESTMENTS

CHAPTER FIVE

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Unless you are an accountant, don't act like one.

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