Valuation of Commercial Real Estate

Aaron Mesmer – Block Funds

• Block Real Estate Services, Founded in 1940• 350 Partnerships• $2 billion of assets under management• 30 million square feet under management• Annual sales/leasing volume of $900 million• Started Block Funds in 2004• Continued Syndication Model• 2014: $150mm acq. and $100mm dev.

Block Funds Overview

• Office• Industrial• Retail• Multi-Family

Types of Commercial RE

• Range from single-story to sky scrappers• Highest profile “trophy” properties• Fundamentals most impacted by employment• Highest costs upon lease rollover• Trends towards larger floor

plans, open working spaces, mixed-use environments

Office

• Lowest TI costs of all property types• Distribution Warehouse Space

– Trend towards larger spaces, higher clear heights– Driven by demand for storing and distribution

• i.e. BNSF Intermodal – Gardner, KS

– Just-in-time delivery drives demand for location• i.e. UPS Worldport – Louisville, KY

• Manufacturing Space– Diminishing demand – Most functional obsolescence– Potential redevelopment

opportunities (i.e. Paseo)

Industrial

• Most glamorous of the product types• Most quickly evolving– Post WWII strip center development– 1960’s and 1970’s grocery anchored model– 1980’s and 1990’s enclosed mall model– Current trend toward lifestyle centers • Live, work, play

• Highest credit risk

Retail

• New household formation improving apartment demand• Least correlation to performance of other property types• Fundamentals highly linked to job growth• Most subsidized form of real estate– Affordable housing increasing in importance– Section 42, section 8, LIHTC, etc.

• Trend toward sustainable housing

Multifamily

• Individual Ownership• Syndicates or Partnerships – LP or LLC– Based on individual transaction

• Private Equity Funds – LP, “Reg D” structure– $25 to $500 million of equity

• Institutional Advisors – Advise pension funds, large endowments, etc.– $500 million to $1.25 billion– Minimum deal size of $25 million– Mix of domestic and international holdings

Private Equity Buyers

• Real Estate Investment Trusts (REITs)• Similar to institutional advisors• Advantages:– Access to capital (debt and equity)– Broad reach to emerging markets

• Disadvantages:– Public reporting - competition can monitor strategy– Long-term nature of real estate not well understood on

wall street which emphasizes quarterly returns– Decisions made to boost short-term earnings may not

maximize long-term investor returns

Publicly Traded

• Cash Flows• Debt Principal Reduction• Appreciation

3 Ways to Build Wealth

• Net Operating Income– Operating Revenues – Operating Expenses = NOI– Maximizing NOI is most important aspect of asset

management– Market assumptions have big impact on NOI projections

• Impact of debt on cash flows• Key cash flow return criteria:– Capitalization rate– Cash-on-cash return

Cash Flows

KU Corporate Center100 Jayhawk Way

Office Building100,000 SF10 Tenants

Average Rent = $20.00 PSFAverage Expenses = $8.00 PSFBuilt in 1995

Cash Flow Example #1

KU Corporate Center Cash FlowsIncome 2009 Notes

Potential Rental Income $2,000,000 100,000 SF x $20.00 PSFParking Revenue $12,000 10 Reserved Spots x $100 per month x 12 monthsBillboard Revenue $60,000 $5,000 per month x 12 monthsEquals: Gross Potential Revenue $2,072,000 Less: Vacancy Allowance (10%) ($207,200)

Equals: Total Operating Income $1,864,800

ExpensesTaxes $200,000 $2.00 PSF per yearUtilities $300,000 $3.00 PSF per yearInsurance $100,000 $1.00 PSF per yearRepairs & Maintenance $150,000 $1.50 PSF per yearManagement $50,000 $0.50 PSF per year

Equals: Total Operating Expenses $800,000

Net Operating Income $1,064,800 Income less expenses

Capital Repairs $25,000 $0.25 PSF per year

Income Before Debt Service $1,039,800

Wildcat Towers300 Trailer Way

Multi-Family8 UnitsAverage Rent:

$500 per monthAverage Expense:

$250 per monthBuilt in 1965

Cash Flow Example 2

Wildcat Towers Cash FlowsWildcat TowersCash Flow Example

Income 2009 NotesPotential Rental Income $48,000 $500 per month x 8 units x 12 monthsLaundry Revenue $1,500 $125 per monthEquals: Gross Potential Revenue $49,500 Less: Vacancy Allowance (5%) ($2,475)

Equals: Total Operating Income $47,025

ExpensesTaxes $4,700 Utilities $3,600 $300 per month for common areas and vacant unitsInsurance $1,200 $0.15 per square footRepairs & Maintenance $6,500 Includes make-ready expensesPayroll $5,000 For property manager and landscaperManagement $3,000

Equals: Total Operating Expenses $24,000

Net Operating Income $23,025 Income less expenses

Capital Reserves $2,000 $250 per unit per year

Cash Flow Before Debt Service $21,025

• Varies depending on capital structure• Even most institutional buyers use leverage

– Enhance returns by “positive leverage”• Compare loan constant vs. cap rate

– Diversify holdings by increasing purchase capacity• Each month principal balance is reduced

– Lowers risk– “Make money in your sleep”

• Importance of loan terms– Amortization, maturity, perm/short-term, recourse/non-recourse,

prepayment ability, stated vs. effective rate

Debt Principal Reduction

KU Corporate Center Possible Debt

Principal Balance LTV Cash RequiredInterest

Rate Payments Monthly Payment Annual Debt ServiceLoan Balance at End of 5

YearsLoan Balance at End of 10

Years% of Principal

Reduction

$6,500,000 50% $6,500,000 5.75% 240 ($45,635.43) ($547,625.14) ($5,495,529.10) ($4,157,397.49) 36.04%

$6,500,000 50% $6,500,000 5.75% 300 ($40,891.92) ($490,702.99) ($5,824,366.43) ($4,924,303.88) 24.24%

$6,500,000 50% $6,500,000 6.25% 240 ($47,510.33) ($570,124.00) ($5,541,062.06) ($4,231,411.84) 34.90%

$6,500,000 50% $6,500,000 6.25% 300 ($42,878.51) ($514,542.12) ($5,866,309.37) ($5,000,859.12) 23.06%

$6,500,000 50% $6,500,000 7.00% 300 ($45,940.65) ($551,287.77) ($5,925,539.91) ($5,111,170.77) 21.37%

$8,500,000 65% $4,500,000 5.75% 240 ($59,677.10) ($716,125.18) ($7,186,461.14) ($5,436,596.72) 36.04%

$8,500,000 65% $4,500,000 5.75% 300 ($53,474.04) ($641,688.53) ($7,616,479.18) ($6,439,474.31) 24.24%

$8,500,000 65% $4,500,000 6.25% 240 ($62,128.90) ($745,546.77) ($7,246,004.23) ($5,533,384.72) 34.90%

$8,500,000 65% $4,500,000 6.25% 300 ($56,071.90) ($672,862.77) ($7,671,327.63) ($6,539,585.00) 23.06%

$8,500,000 65% $4,500,000 7.00% 300 ($60,076.23) ($720,914.78) ($7,748,782.95) ($6,683,838.69) 21.37%

$9,750,000 75% $3,250,000 5.75% 240 ($68,453.14) ($821,437.70) ($8,243,293.66) ($6,236,096.24) 36.04%

$9,750,000 75% $3,250,000 5.75% 300 ($61,337.87) ($736,054.49) ($8,736,549.65) ($7,386,455.82) 24.24%

$9,750,000 75% $3,250,000 6.25% 240 ($71,265.50) ($855,186.00) ($8,311,593.09) ($6,347,117.76) 34.90%

$9,750,000 75% $3,250,000 6.25% 300 ($64,317.76) ($771,813.17) ($8,799,464.05) ($7,501,288.68) 23.06%

$9,750,000 75% $3,250,000 7.00% 300 ($68,910.97) ($826,931.66) ($8,888,309.86) ($7,666,756.15) 21.37%

Purchase Price $13,000,000

Note: Difference between 20 and 25 year amortization is an additional 11.85% reduction of principal over 10 years

• Driven by demand• Driven by increases in replacement costs– Important as commodity prices increase rapidly

• Appreciation higher in U.S. in costal cities• Depreciation risks– Functional obsolescence– Changing market fundamentals– Unexpected occurrences

• Construction, traffic patterns, natural disasters

Appreciation

KU Corporate Center DispositionYear 6 Projected Income: $1,125,266

Sales Cap Rates Sale Price Cost of Sale (2%)Debt Principal

Retirement Net Proceeds from

Sale6.50% $17,311,787 ($346,236) ($8,799,464.05) $8,166,088 6.75% $16,670,610 ($333,412) ($8,799,464.05) $7,537,734 7.00% $16,075,231 ($321,505) ($8,799,464.05) $6,954,263 7.25% $15,520,913 ($310,418) ($8,799,464.05) $6,411,031 7.50% $15,003,549 ($300,071) ($8,799,464.05) $5,904,014 7.75% $14,519,564 ($290,391) ($8,799,464.05) $5,429,708 8.00% $14,065,827 ($281,317) ($8,799,464.05) $4,985,047 8.25% $13,639,590 ($272,792) ($8,799,464.05) $4,567,334 8.50% $13,238,426 ($264,769) ($8,799,464.05) $4,174,193 8.75% $12,860,185 ($257,204) ($8,799,464.05) $3,803,517 9.00% $12,502,958 ($250,059) ($8,799,464.05) $3,453,434 9.25% $12,165,040 ($243,301) ($8,799,464.05) $3,122,275 9.50% $11,844,907 ($236,898) ($8,799,464.05) $2,808,545 9.75% $11,541,192 ($230,824) ($8,799,464.05) $2,510,904

10.00% $11,252,662 ($225,053) ($8,799,464.05) $2,228,145

• Sales comparables approach– Good for quick benchmark– Hard to get “apples to apples” in commercial RE

• Cost approach– Know “top of market” pricing not to exceed– Good philosophy = buy below replacement cost

• Income capitalization approach– NPV, IRR, Capital Accumulation

• Instinct

Valuation of CRE

• Gross Rent Multiplier• Capitalization rate• Cash-on-cash return• Discounted cash flows– NPV– IRR– Capital accumulation

Income Capitalization

• Price divided by Gross Income• Least used method – more common with MF• Advantages– Very little info required, easy to obtain– Use for quick comparisons of similar properties

• Disadvantages– Does not take into account many important factors,

including appreciation, operating expenses, leverage, taxes or risk level

Gross Rent Multiplier

• NOI/Purchase Price = Cap Rate• NOI/Cap Rate = Purchase Price• Advantages

– Takes into account income/expenses– Most commonly used method– Easy comparison

• Disadvantages– Does not factor appreciation, leverage, taxes, risk– Only considers 1st year projected income– Not appropriate in many situations (near-term rollover, heavy

capital requirements, low occupancy, value-add situations)

Capitalization Rate

• COC = cash flow after debt but before taxes initial equity investment

• If paying cash, COC = Cap Rate• Good way to determine “yield” in early years• Most comparable to dividend yield rate on a stock or the coupon

rate on a bond• Advantages

– Takes into account capital costs and debt structure– Easy to understand for cash oriented buyers

• Disadvantages– Does not account for appreciation/depreciation, taxes or risk level– Hard to get meaningful comparison among potential investments

Cash-on-Cash Return

• Use forecasting model of expected cash flows• Can determine IRR, NPV and capital accumulation• Advantages

– Takes into account all facets of an investment, including cash flow, capital repairs, debt and sale

– Recognized as best method for valuation– Use of Argus Software and other models helps

• Disadvantages– Can be difficult to get all info – relying on estimates– Heavily “back-end” weighted due to impact of exit assumptions

Discounted Cash Flows

• Sum of the present value of all future cash flows minus the initial investment

• Advantages– Allow investors to set return benchmarks and price accordingly– Good for comparing alternatives

• Disadvantages– No compensation for size/time disparities– No consideration of how intermediate cash flows can be

reinvested– Positive and negative cash flows discounted at same rate

Net Present Value (NPV)

• Percentage rate earned on each dollar invested for each period its invested

• IRR is the rate at which NPV = $0• Advantages

– Good method for comparing alternatives– Answers basic questions about expected timing and amount of

+/- cash flows• Disadvantages

– No compensation for size/time disparities– No consideration of how intermediate cash flows can be

reinvested

Internal Rate of Return (IRR)

• In addition to cash flow stream from DCF model, capital accumulation takes intermediate cash flows and reinvests them at a “safe rate”

• Allows comparison of investments with different time periods and sizes

• Impractical, not commonly used

Capital Accumulation

• Don’t let a higher potential returns override your gut instinct

• If it doesn’t feel right, walk away• Only way to factor in all of the intangibles that can’t be

quantified– Who are you buying from?– What city are you buying in?– What market factors are at work?– General sentiment?– Touch/feel of a project

Instinct

• Most analysis is done on a pre-tax basis– Individual taxes vary, some are tax exempt

• However, ability to shield income is one of the most important benefits of real estate

• Writing off interest expense• Cost recovery (aka depreciation)– Commercial = 39 years, apartments = 27.5 years– Tenant improvements = useful life– Cost segregation can advance schedule– Shields only income, not capital gains

Tax Considerations

• “Fourth” way to build wealth in real estate• Allows a seller to defer capital gains and cost recovery

recapture taxes as long as seller purchases “like kind” property of equal or greater value (both debt and equity)

• 45 days after closing to identify; 180 to close• Can “reverse” exchange – buy trade prop 1st • Careful to follow rules so that IRS recognizes• Similar 1033 trades and 721 contributions to “upload”

property into a fund

1031 Exchange

Examples of 1031 BenefitsAssumptions

25%Cost Recovery Recapture Rate

20%Capital Gains Taxes

Cost Recovery Recapture: ($399,306)

Capital Gains Taxes: ($129,274)

Total Taxes Due Upon Sale: ($528,580)

Taxes Saved by Using 1031 Trade: $528,580

Reinvested Tax Proceeds:

5 Years 10 Years 15 Years

5% $674,616 $861,000 $1,098,879

12% $931,538 $1,641,688 $2,893,215

15% $1,063,162 $2,138,399 $4,301,084

16.50% $1,134,331 $2,434,275 $5,223,953

18% $1,209,262 $2,766,498 $6,329,078

Basis adjusts to market value upon death

Use government tax dollars to create wealth

• No investment is worth sleepless nights• Historically real estate seen as higher risk – Return hurdles higher than equities/bonds– Recent thought that more transparency and available

information decreased risk – not true– Still less transparent and less regulated than most– Recent “credit crisis” is partially due to inappropriate

pricing of real estate risk• Never enough potential return to account for a bad

deal

Risks of Real Estate

• Financial Risk– Will NOI cover debt service?– Potential for capital calls even in good deals (i.e. TI’s)

• Inflation Risk– Agreements lock in rates for many years – will they keep pace with

inflation?– Some LL’s use CPI rate increases to hedge– Most have base stops for expenses or NNN structure

• Political Risk– Changes in laws change inability to produce NOI– Zoning, building codes, environmental law, tax law– Examples: 1986 tax law changes, ADA compliance

Types of Risk

• Market Risk– Changes in economic and market conditions– Can be micro or macro

• Projection Risk– Use numerous assumptions when creating DCF– Changes to assumptions has big impact on CF’s– Importance of conservative underwriting– Only thing you can be certain of is that you will not

hit your projections exactly

Types of Risk (2)

• Liquidity Risk– Real estate is a cash business. Cash is always king. Needed for

tenant improvements, operations, debt service, capital repairs, etc.

– Never assume something can be sold, even at a deep discount– Capital markets (both debt and equity) serve as “oil” of the real

estate engine. • Interest Rate Risk

– Floating rate loans typical for construction and short-term notes

– Can hedge with caps, floors, collars, swaps, etc.

Types of Risk (3)

• Due Diligence– Know everything about a property you can before you buy

• Diversification– Buy different product types in different markets– Key advantage of fund structure vs. one-off deals

• Insurance• Credit Enhancements

– Lease guarantees, loan guarantees, letters of credit, corporate backed lease

• Shifting Risk to Tenants– CPI, base stop and/or NNN

• Non-Recourse Debt

Risk Management Strategies

• Less Risky Features:– Lower leverage or no leverage– Diversity of product type/location– Stabilized, income producing properties– Rated credit tenants

• Development is most risky• Buying value-add deals second most risky

Risk Variables

• Building Relationships, Building Wealth• 8.0% cash-on-cash target• 15.0% IRR target• Buying in cities around U.S.• Apartments, Medical Office, Industrial• www.blockfunds.com

Block Income Funds