Table of Contents

Table of Contents

L1-L2: Macro & Micro Environment of PDI ...2

The 4 Quadrant Model ... 2

1. Space Market (Rental)... 2

2. Asset Market ... 2

3. Construction Market ... 2

4. Stock Adjustment ... 2

Links ... 3

Additional Notes ... 3

Property Development Process ... 3

Financial Analysis of “For Sale” vs Income Properties ... 4

Market Analysis ... 4

Land Budgeting Problem ... 5

L3-L4: Developers & Outside Equity Investors ...7

Cash Flow Valuation Methods ... 7

Risk-Adjusted Discount Rate (RADR) ... 7

Certainty-Equivalent Cash Flow (CEQ) ... 8

Equity Allocation ... 9

2-Asset Portfolio Example ... 9

Construction Loans ... 11

Loan Features ... 12

L5-L6: Mortgages & Residential Properties ... 12

Lender Considerations ... 12

Amortization Schedules & Loan Structures ... 13

Underwriting ... 13

Grand Ratios ... 14

Loan-to-Value (LTV) ... 14

Debt Coverage Ratio (DCR) ... 14

Break-even Ratio (BER) ... 14

Mortgage Constant (k) ... 14

ROI & ROE ... 15

L7-L8: Income-producing properties & Valuations ... 15

Commercial Debt ... 15

Incremental Investments (Gradients)... 16

Income Property Analysis & Reversion Value ... 16

Income Projections ... 16

Reversion Value ... 18

Debt Pro-Forma Adjustment... 19

Tax Adjustment on Sale and Gain ... 19

Note on Vacancy ... 20

Valuation Methods & Fundamentals ... 20

1. Sales Comparison Approach (Multiples) ... 20

2. Income Capitalization Approach ... 20

3. Cost Approach ... 21

Highest & Best Use Analysis ... 22

L9-L10: Reposition, disposition & organizational forms ... 22

Repositioning ... 22

Renovation ... 23

Disposition ... 23

Lease Vs. Own... 24

Sale-Leaseback ... 24

L11: Real estate portfolio modelling & REITs ... 24

Single-Asset Real Estate Pro-Forma ... 24

Real Estate Asset Summary ... 25

REITS ... 25

Valuation Measurements ... 25

Investment Performance Measurements ... 25

Modern Portfolio Theory... 26

Excel: Matrix Algebra ... 26

L1-L2: Macro & Micro Environment of PDI

The 4 Quadrant Model

• Links the market for space (rent), the market for assets (property), construction market and stock adjustment.

1. Space Market (Rental)

• The market for space as a factor of production. Can be either rented or owner-occupied.

• Supply – fixed in short run (changes in supply are slow to respond and a small portion of total stock of space i.e. we cannot materialize new land and buildings out of thin air)

• Demand – determined by rent, output per worker and technology of space use

o Outward Shift – economic expansions (e.g. increase in output/worker, population growth) o Inward Shift – economic contractions

2. Asset Market

• Slope = Rent/Cap Rate

• Lower capitalization rates higher property value pivot

3. Construction Market

• Positive to asset prices (due to more projects crossing threshold).

• Heterogenous development opportunities smooths curve

• Slope = difficulty of procuring resources (labour, materials land). Will be flatter when there are more bottlenecks

4. Stock Adjustment

• When market is in equilibrium, new completions = depreciation of current stock

 - deprecation rate

𝑆𝑡𝑜𝑐𝑘 (𝑡) = 𝑆𝑡𝑜𝑐𝑘 (𝑡 − 1) + 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑠 (𝑡) − 𝐷𝑒𝑙𝑒𝑡𝑖𝑜𝑛𝑠 (𝑡) 𝑆(𝑡) = (1 − 𝛿)𝑆_(𝑡−1)+ 𝐶_𝑡

Links

• Space Asset Prices – linked through the cap rate, slope of asset price line: P=R/cap o Cap rate – relationship between asset prices and rental income (as a %)

𝐶𝑎𝑝 𝑅𝑎𝑡𝑒(𝑟) =𝑁𝑒𝑡 𝑅𝑒𝑛𝑡𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 (𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 1) 𝐴𝑠𝑠𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 (𝑡𝑜𝑑𝑎𝑦) = 𝑅₁

𝑃₀

• Asset Prices Construction Activity – as property prices increase, more projects cross the

feasibility threshold for development (NPV > 0). This makes real estate development activity highly volatile as projects are only undertaken when they pass the NPV threshold.

𝑉𝑎𝑙𝑢𝑒 − 𝐶𝑜𝑛𝑠𝑡𝑟𝑢𝑐𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡 = 𝑁𝑃𝑉 > 0

• Construction Activity Stock Adjustment – completed buildings are added to stock of real estate space.

Additional Notes

• Short Run vs. Long Run Adjustments – short run adjustments will be larger before reverting slightly when supply of space adjusts in long run (see below – for LR effect of population growth)

Property Development Process

Process to take a property from one use and transform it into a property for alternate use. Some investors complete the full process however, the average tenure represents the stage at which each player enters and exits the process.

Stage Participants

Site Selection (Inception) – involves selecting and doing due diligence on the current land owner.

Ensures the legitimate title can be ascertained upon purchase and lawyers to create ESCROW accounts to facilitate the transaction.

• Brokers/agents

• Title company

• Market consultants

• Lawyers (conveyance) Feasibility Study – resolving diversity of visions for

what the project should be

• Economic consultants

• Market consultants

• Bankers

• Mortgage brokers

• Engineers

• Lawyers Design – architects are charged with solving the

design problem

• Surveyors

• Soil engineers

• Architects

• General contractors

• Structural engineers

• HVAC engineers

• Environmental abatement consultants

• Land planners

• Landscape architects

• Parking consultants

• Historical preservation

• Lawyers

Financing • Mortgage brokers and bankers

• Syndicators (multiple investors)

• Construction lenders

• Permanent lenders (mortgage/long term financing)

• Stand-by lenders

• Surety companies (prevention against counterparty risk)

• Appraisers (valuation of property)

• Lawyers (contracts) Construction – ensure the development is carried

out at the appropriate speed and with high quality for an efficient cost.

• Architects

• General contractors

• Landscape architects

• Engineers

• Trades (common in residential and smaller projects)

• Lawyers (construction liability) Marketing Sales Operations – after construction is

complete, market risk is the primary risk

• Marketing – brokers, PR firms, advertising agencies

• Sales – brokers, appraisers, lawyers

• Operations – property managers, lawyers

Financial Analysis of “For Sale” vs Income Properties

• If a property developer’s expertise is in bringing the product to market, they may choose to exit their position early.

• Value at risk (VAR) decreases over time with development risk as units are sold and turned into income properties.

• When it is sold, the developer gives up a legal claim to the unit

Market Analysis

Market analysis aims to solve two joint problems 1. The present-future problem

2. Macro-micro problem Features of a good market analysis:

• Delineation of market area and segment

• Delineation of competing products (do not ignore substitutes)

• Justifiable capture rate – the total demand for the product and all competing suppliers into account

• Justifiable absorption rate – the market capacity should be comparable to competitors

• Take into account alternate scenarios – interest rate, work stoppage, entitlements

Valuers Comparable Model – estimates property value based on recent selling price of comparable properties.

Limitations: Assumes the current micro situation will continue into the future disregarding broader market forecasts.

Ideal Conditions Model – assumption that a property will operate with a given vacancy level and rent increase.

Limitation: simple belief about future micro conditions is a pro-forma analysis with no substantiating evidence

Current Conditions Model – market wide conditions are assumed to apply to the property in the future

Limitations: macro evidence today are used to predict micro conditions tomorrow (no forecasting)

Average Forecast Model – market-wide forecasts are assumed to apply to the property.

Limitations: no segmentation of the macro market.

4 Square Design – 6 step model that analyses macro and micro information and forecasts future.

1. Identify property and similar properties to proposed construction (identify current micro market based on target use)

2. Collect available forecast information for the broader market

3. Return to subject property and incorporate terms compatible with forecast data

4. Relate subject property to market segment in present (segment capture rates in present) 5. Use the forecast information from 2 to predict

future macro market trends for each segment 6. Derive implications for specific segment related

to subject property

e.g. capture rates in context of new competitors, and changing market demand, implications for vacancies and tenant profiles

Land Budgeting Problem

Land can be developed for different uses. For a small site, the key question is what do develop from:

• Residential

• Office

• Retail

• Industrial

For larger sites, there can be mixed use developments which involves deciding how much of each to develop. The subsequent analysis should cover:

• Opportunities – accessibility, location/neighbourhood

• Constraints – Size and shape, Contamination, utilities, legal