1. Real Estate Investments AM0000_000_000000 Direct Investments Techniques Basic Corporate Finance Applications Dirk Brounen April 23 rd, 2001

2. Real Estate Investments AM0000_000_000000 About Last Week The virtues of indirect investments are all true, but: Is indirect real estate really real estate? Correlation direct real estate - stocks/bonds is lower! Direct real estate returns are less volatile Institutional Investors have long horizons, less need for liquidity Investing indirectly is simple Direct investing requires specific tools and skills

3. Real Estate Investments AM0000_000_000000 Today’s Program A Crash Course in Commercial Brokerage Introduction Theoretical standards - Cash-flow estimation - Ratio-Analysis - Cap-rate - NPV - IRR Practical Applications - Buying the Rembrandt Tower - The effect of leverage

4. Real Estate Investments AM0000_000_000000 Introduction Owning  Investing buying acquiring occupying leasing enjoying selling movingearning Well-beingWealth

5. Real Estate Investments AM0000_000_000000 Real Estate Investment Analysis = Risk Management An Investor will face several types of uncertainties – Paying the right price – Finding suitable lessors at the right time – Facing financing costs that can fluctuate (interest risk) – Facing fluctuating maintenance costs – Being exposed to the real estate cycle – Receiving the right price

6. Real Estate Investments AM0000_000_000000 Sector Differences Cash-flow uncertainties along sector types: Apartments; steady rent flow, low cycle-sensitivity Office; long-term contracts, quiet cycle sensitive Retail; short-term overage contracts, very cycle sensitive Hotels; very short term rent contracts, very cycle sensitive Hotel Apartment Office Risk  Exp.Return 

7. Real Estate Investments AM0000_000_000000 Types of Risks – Business Risk; economic fluctuations – Inflation Risk; can increase cost more than income – Financial Risk; by leveraging – Liquidity Risk; little selling possibilities – Management Risk; bad marketing policy – Legislative Risk; tax law changes – Environment Risk; ABN-AMRO/Schiphol

8. Real Estate Investments AM0000_000_000000 Old School: Three things that matter in Real Estate Investment Decision Making LOCATION  Macro Environment Should you buy/build megastore, or office Should you locate in Amsterdam or Texel? LOCATION  Sub-region Should you locate in Center or Suburb? LOCATION  Property Specific How Large, High and Modern should the building be?

9. Real Estate Investments AM0000_000_000000 New School: Numerous things matter ECONOMICS  Macro, Region and Property Specific FINANCIALS  Crunching the Numbers Applying Modern, Objective Analytics INTUITION  Old fashioned Common Sense

10. Real Estate Investments AM0000_000_000000 Some economics to consider – GDP growth – Consumer Confidence Index – Personal Consumption Growth – Retail Sales – Unemployment Rates for each sector – Interest Rates – Regional Economics ( infrastructure ) – Vacancy Rates (Central Business District, Suburb) – Square Meter Rents (apartments, retail, office, warehouse)

11. Real Estate Investments AM0000_000_000000 GDP Growth Source: CBS

12. Real Estate Investments AM0000_000_000000 Financial number crunching The Cap-rate Cap-rate = “Bruto Aanvangs Rendement (BAR)” = Net Operating Income 1 / Fair Market Value NOI = net rental income FMV =  CFO/(1+r) t + CFS/(1+r) n CFO = Cash flow from operations CFS = Cash flow from sale If Cap-rate of object exceeds the alternatives, the object is superior Average Cap-rates in Netherlands ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 Office 7.00-8.25 7.00-8.00 6.75-7.25 6.40-7.00 6.75-7.25 6.90-7.30 Retail 7.75-8.50 7.50-8.50 6.75-7.75 6.75-7.75 6.75-7.25 6.75-7.25 Industrial 9.00-10.0 9.00-10.0 8.00-9.00 7.75-8.50 7.75-8.50 8.00-8.50 Source: DTZ Zadelhoff

13. Real Estate Investments AM0000_000_000000 Financial number crunching The Cap-rate Cap-rate = NOI 1 /FMV In equilibrium market the cap-rate tracks the interest-rate. R   discount-rate (r)   FMV   Cap-rate  R   discount-rate (r)   FMV   Cap-rate  At this moment R , but Cap-rate is constant: Because of lower future expectations there exists excess supply in the market, which means that FMV is not rising. Suppose R   development cost   new supply   excess demand  FMV   Cap-rate  Cap-rate is poor market indicator, and can only signal “cheapness” of deal compared to alternatives

14. Real Estate Investments AM0000_000_000000 Financial number crunching Widely Used Rules of thumb: Discounted Pay-back Period = Time at which initial investment is repaid. Indicates liquidity-intensity of the project. Does not include profitability differences, risk profiles. Return On Investment (ROI) = Gross profit / total cost This is an accounting number, that does not say anything about profitability. Time value absence can bias the outcome.

15. Real Estate Investments AM0000_000_000000 Financial number crunching Corporate Finance tools: Net Present Value = -Initial Investment + present value of future inflows If NPV exceeds 0, the project is profitable and exceeds the implicit cost of capital (that is included in the discount rate) Profitability Index = PV of cash inflows / initial investment If PI exceeds 1, the project is profitable Internal Rate of Return = Discount rate that equates the PV of future inflows to initial investment If IRR exceeds the return the investor can earn on alternative investments, the project is optimal.

16. Real Estate Investments AM0000_000_000000 Discounting graphically: NPV €  Discount Rate r  -Investment + Σ CF t IRR NPV = -Investment +  CF t /(1+r) t

17. Real Estate Investments AM0000_000_000000 Buying The Rembrandt Tower To Invest or not to invest That’s the question What cash flows should we consider? How should we measure? How should we decide? How should we structure the deal?

18. Real Estate Investments AM0000_000_000000 The Rembrandt Tower Purchase Price = € 42.500.000 Building Synopsis Gross Building Area28,000 sqm Net Leasable Area26,000 sqm Rent Estimations 2002 2003 2004 2005 2006 Philips 2,388,750 2,436,525 2,485,256 2,781,926 2,869,986 Newconony 1,023,750 1,044,225 1,065,110 1,192,254 1,229,994 ABP 1,706,250 1,740,375 1,775,183 1,987,090 2,049,990 Cap Gemini 1,706,250 1,740,375 1,775,183 1,987,090 2,049,990 Base rent 6,825,000 6,961,500 7,100,730 7,948,360 8,199,960 Vacancy (5%) 0 0 0 397,420 410,000 EGI 6,825,000 6,961,500 7,100,730 7,550,940 7,789,960 EGI = Effective Gross Income + -

19. Real Estate Investments AM0000_000_000000 Including Expenses 2002 2003 2004 2005 2006 EGI 6,825,000 6,961,500 7,100,730 7,550,940 7,789,960 Operating Expenses 1,968,500 1,968,500 1,968,500 2,304,450 2,346,355 Managem. Expenses 341,250 348,075 355,035 377,545 389,500 NOI 4,515,250 4,644,925 4,777,195 4,868,945 5,054,105 Taxes* 1,282,838 1,328,224 1,374,518 1,406,631 1,471,437 ATCF o 3,232,413 3,316,701 3,402,677 3,462,314 3,582,668 Operating Expenses : NOI = Net Operating Income – Property TaxesNOI = EGI - Expenses – Insurance – Utilities Corporate Taxes: – Janitorial 35% of (NOI - Interest - Depreciation) – Maintenance Annual Depreciation = 2% of Purchase price - -

20. Real Estate Investments AM0000_000_000000 Including the Sale in 2006 Assume the office price will increase each year with 2%. Expected Sales price in 2006: Sales Price = € 42.500.000 * (1.02) 5 = € 46,923,434 Taxes = 28% of (sale price - purchase price + depreciation) = € 2,428,562 ATCF sale = € 44,494,873 2002 2003 2004 2005 2006 NOI 4,515,250 4,644,925 4,777,195 4,868,945 5,054,105 BTCF sale 46,923,434 BTCF 4,515,250 4,644,925 4,777,195 4,868,945 51,977,539 2002 2003 2004 2005 2006 ATCF o 3,232,413 3,316,701 3,402,677 3,462,314 3,582,668 ATCF sale 44,494,873 ATCF 3,232,413 3,316,701 3,402,677 3,462,314 48,077,541 - - -

21. Real Estate Investments AM0000_000_000000 After Tax Cash Flows 3,232,413 3,316,701 3,402,677 3,462,314 48,077,541 NPV 8% = -42,500,000 + (1+0.08) 1 + (1+0.08) 2 + (1+0.08) 3 + (1+0.08) 4 + (1+0.08) 5 NPV 8% = 1,303,337 12345 3,232,4133,316,701 3,402,6773,462,314 48,077,541 -42,500,000

22. Real Estate Investments AM0000_000_000000 Profitability Ratio Analysis Cap-Rate = BTNOI 1 /Market Value = 4,515,250/42.500.000 =0.1013  10.13% NPV = -Equity Investment + Σ [CF t /(1+r) -t ] BTNPV 8% = € 8,409,213ATNPV 8% = € 1,303,337 BTNPV 11% = € 2,884,226ATNPV 11% = € -3,595,586 BTNPV 14% = € -1,862,353ATNPV 14% = € -7,795,810 PI = Profitability Index = PV/Equity Investment BTPI 8% = 1.20ATPI 8% = 1.03 BTPI 11% = 1.07ATPI 11% = 0.91 BTPI 14% = 0.96ATPI 14% = 0.82 IRR = Σ [CF t /(1 + IRR) -t ] = Equity Investment BTIRR = 12.77%ATIRR = 8.75%

23. Real Estate Investments AM0000_000_000000 Discounting graphically: € 1,303,337 8% NPV €  Discount Rate r  Σ BTCF t ATIRR = 8.75%

24. Real Estate Investments AM0000_000_000000 Leveraging the investment: Finance 70% of the investment with interest-only loan @ 9% Annual Debt Services: 0.09 * 0.70 * 42.500.000 = 2,677,500 2002 2003 2004 2005 2006 NOI 4,515,250 4,644,925 4,777,195 4,868,945 5,054,105 Debt Inter. 2,677,500 2,677,500 2,677,500 2,677,500 2,677,500 Taxes 345,713 391,099 437,393 469,506 534,312 ATCF o 1,492,038 1,576,326 1,662,302 1,721,939 1,842,293 ATCF sale 44,494,873 Loan Repayment 29,750,000 14,744,873 ATCF 1,492,038 1,576,326 1,662,302 1,721,939 16,587,166 Tax Advantage 2002: Taxes = 0.35 * (NOI - Depreciation - Debt Interest) Taxes no loan:0.35*( 4,515,250 - 850,000 - 0) = 1,282,838 Taxes with loan0.35*( 4,515,250 - 850.000 - 2.677.500) = 345,713 - - +

25. Real Estate Investments AM0000_000_000000 After Tax Levered Cash Flows 1,492,038 1,576,326 1,662,302 1,721,939 16,587,166 NPV 13% = -42,500,000 + (1+0.13) 1 + (1+0.13) 2 + (1+0.13) 3 + (1+0.13) 4 + (1+0.13) 5 NPV 13% = 1,015,887 12345 1,492,0381,576,326 1,662,3021,721,939 16,587,166 -12,750,000

26. Real Estate Investments AM0000_000_000000 Ratio Analysis Cap-Rate = BTNOI 1 /Market Value = 4,515,250/42.500.000 =0.1013  10.13% NPV = -Equity Investment + Σ [CF t /(1+r) -t ] BTNPV 13% = € 3,827,336ATNPV 13% = € 1,015,887 BTNPV 17% = € 1,655,400ATNPV 17% = € -800,830 BTNPV 21% = € -142,486ATNPV 21% = € -2,303,565 PI = PV/Equity Investment BTPI 13% = 1.30ATPI 13% = 1.08 BTPI 17% = 1.13ATPI 17% = 0.94 BTPI 21% = 0.99ATPI 21% = 0.82 IRR = Σ [CF t /(1 + IRR) -t ] = Equity Investment BTIRR = 20.50%ATIRR = 15.10%

27. Real Estate Investments AM0000_000_000000 The leverage effect on profitability: In this case leveraging the investment increases profitability because: - You decrease your equity burden - You lower you Tax expenses (deduction) - You finance a 12.77% (initial BTIRR) deal using a 9% loan The last reason can be used as general rule: Positive Leverage: BTIRR > Interest rate on Loan Negative Leverage: BTIRR < Interest rate on Loan No Leverage70% Leverage BTIRR = 12.77% BTIRR = 20.50% ATIRR = 8.75% ATIRR = 15.10%

28. Real Estate Investments AM0000_000_000000 The leverage effect on risk: In every case leveraging the investment increases the risk because: - You take on a fixed burden - In case of disappointing earnings or unexpected expenses, income might be too little to service the debt  The End - In case of a variable rate loan financing cost might increase suddenly Ratio to use to analyze the risk: NOI 4,515,250 DCR = Debt Coverage Ratio = Mortgage Payment = 2,677,500 = 1.69 Mortgage Principal 29,750,000 LTV = Loan To Value Ratio = Property Value = 42,500,000 = 0.70