1. Chapter 11 Lecture: Real Estate Cash Flow Pro Formas

2. "PROFORMA" = a multi-year cash flow forecast (Typically 10 years.) Show to: Lenders, Investors

3. 2 types of CFs: Operating Reversion (Sale of Property)

4. 2 ways of defining "bottom line"...

5. 1)Property level (PBTCF, most common in practice):  Net CF produced by property, before subtracting debt svc pmts (DS) and inc. taxes.  CFs to Govt, Debt investors (mortgagees), equity owners.  CFs due purely to underlying productive physical asset, not based on financing or income tax effects.  Relatively easy to observe empirically.

6. 2) Equity ownership after-tax level (EATCF):  Net CF avail. to equity owner after DS & taxes.  Determines value of equity only (not value to lenders).  Sensitive to financing and income tax effects.  Usually difficult to observe empirically (differs across investors).

7. Either way: Useful for applying DCF (it’s the numerators). Software like ARGUS is used in real world practice.

8. Typical proforma line items... At Property, Before-tax Level:

9. Operating (all years): Potential Gross Income = (Rent*SF)=PGI - Vacancy Allowance = -(vac.rate)*(PGI)= -v + Other Income = (eg, parking, laundry) = +OI - Operating Expenses = - OE _____________________ _______ Net Operating Income = NOI - Capital Improvement Expenditures = - CI _____________________ _______ Property Before-tax Cash Flow = PBTCF

10. Reversion (last year & yrs of partial sales only): Property Value at time of sale = V - Selling Expenses = -(eg, broker) = - SE __________________ ______ Property Before-tax Cash Flow = PBTCF

11. Questions… How forecast vacancy (v)? – Vac = (vac months)/(vac months + rented months) in typical cycle; – Look at typical vac rate in rental mkt, or history in subject bldg. – Project for each space/lease: Probability of renewal & Expected vacant period if not renewed.

12. Questions… How forecast resale value (“reversion”, V at end)? – Divide Yr.11 NOI by “going-out” (terminal) cap rate.

13. Questions… What should be the typical relationship between the going-in cap rate and the going-out cap rate?... – Usually going-out  going-in (older bldgs have less growth & more risk), esp. if little capital imprvmt expdtrs have been projected – Why?... Opportunity cost, “apples-to-apples” comparison with alternative investments that you don’t have to manage yourself.

14. Operating Expenses include: Fixed:  Property Taxes  Property Insurance  Security  Management Variable:  Maintenance & Repairs  Utilities (not paid by tenants)

15. Operating Expenses NOTE: OE do not include: income taxes, or depreciation expense. Must include mgt expense even if self-managed. Why?... Opportunity cost, “apples-to-apples” comparison with alternative investments that you don’t have to manage yourself.

16. Capital Expenditures include: Leasing costs:  Tenant build-outs or improvement expenditures (“TIs”)  Leasing commissions to brokers Property Improvements:  Major repairs  Replacement of major equipment  Major remodeling of building, ground & fixtures  Expansion of rentable area

17. Simple numerical example... (in book, p.125) Exhibit 11-2: The Noname Building: Cash Flow Projection Yea r: 1234567891011 Item: Market Rent/SF: $10.00$10.10$10.20$10.30$10.41$10.51$10.62$10.72$10.83$10.94$11.05 Potential Revenue: Gross Rent Space 1 (10000SF) $105,0 00 $103,0 30 $108,2 86 Gross Rent Space 2 (10000SF) $100,0 00 $105,1 01 $110,4 62 Gross Rent Space 3 (10000SF) $100,0 00 $101,0 00 $106,1 52 Total PGI $305,0 00 $306,0 00 $304,0 30 $309,1 31 $314,2 83 $319,5 39 $324,9 00 Vacancy allowance: Space 1 $0 $51,51 5 $0 $54,14 3 $0 Space 2 $0 $52,55 1 $0 $55,23 1 Space 3 $100,0 00 $0 $53,07 6 $0 Total vacancy allowance $100,0 00 $0 $51,51 5 $0$52,55 1 $53,07 6 $0$54,14 3 $0$55,23 1 Total EGI $205,0 00 $306,0 00 $252,5 15 $304,0 30 $256,5 81 $261,2 07 $314,2 83 $265,3 96 $319,5 39 $269,6 69 Other Income $30,00 0 $30,30 0 $30,60 3 $30,90 9 $31,21 8 $31,53 0 $31,84 6 $32,16 4 $32,48 6 $32,81 1 $33,13 9 Expense Reimbursements Space 1 $0$1,833$2,003$0$1,651$964$1,118$2,870$0$1,823$329 Space 2 $0$2,944$3,114$1,814$3,465$0$153$1,905$469$2,292$0 Space 3 $0 $170$0$260$0 $1,752$316$2,139$645 Total Revenue $235,0 00 $341,0 78 $341,8 91 $285,2 38 $340,6 24 $289,0 75 $294,3 24 $352,9 74 $298,6 67 $358,6 02 $303,7 81 Reimbursable Operating Expenses Property Taxes $35,00 0 $36,75 0 Insurance $5,000 $5,250 Utilities $16,66 7 $25,50 0 $26,01 0 $22,10 9 $27,06 1 $23,00 2 $23,46 2 $28,71 7 $24,41 0 $29,87 7 $25,39 6 Total Reimbursable Expenses $56,66 7 $65,50 0 $66,01 0 $62,10 9 $67,06 1 $65,00 2 $65,46 2 $70,71 7 $66,41 0 $71,87 7 $67,39 6 Management Expense $6,150$9,180 $7,575$9,121$7,697$7,836$9,428$7,962$9,586$8,090 Total Operating Expenses $62,81 7 $74,68 0 $75,19 0 $69,68 4 $76,18 2 $72,69 9 $73,29 8 $80,14 6 $74,37 1 $81,46 3 $75,48 6 NOI $172,1 83 $266,3 98 $266,7 01 $215,5 54 $264,4 42 $216,3 76 $221,0 26 $272,8 28 $224,2 95 $277,1 39 $228,2 95 Capital Expenditures TI $50,00 0 $55,00 0 Leasing Commissions $15,15 0 $15,45 5 $15,76 5 $15,92 3 $16,24 3 $16,56 9 Common physical improvements $100,0 00 Net Cash Flow (operations) $172,1 83 $201,2 48 $266,7 01 $150,1 00 $164,4 42 $145,6 11 $150,1 03 $272,8 28 $153,0 53 $277,1 39 Net Cash Flow (reversion) $2,282, 951 IRR @ $2,000,000 price: 10.51%

18. Real world example... The R.R. Donnelly Bldg, Chicago $280 million, 945000 SF, 50-story Office Tower

19. Location: In “The Loop” (CBD) at W.Wacker Dr & N.Clark St, On the Chicago River...

20. Donnelley Bldg Pro Forma... RR Donnelley Bldg Annual Cash Flow Projection Year:20002001200220032004200520062007200820092010 POTENTIAL GROSS REVENUE Base Rental Revenue2403381 1 2499105 4 2563535 0 2638381 1 2792293 9 2865413 1 2937366 3 3005749 6 2952544 8 2985025 2 3074274 9 Absorptn & Turnover Vac.0-122098-45383-284864-538960-64691-280794-98390- 3542566 -468748-133817 Scheduled Base Rent Rev.2403381 1 2486895 6 2558996 7 2609894 7 2738397 9 2858944 0 2909286 9 2995910 6 2598288 2 2938150 4 3060893 2 CPI & Other Adjustmt Rev. 1295978148969616882581891784210039723142272533401275805646594200 Expense Reimbursmt Rev.1383078 0 1435973 5 1488694 2 1521537 8 1558817 2 1666517 0 1702862 9 1762648 9 1620340 9 1885704 7 1966110 9 Miscellaneous Income270931279059287430296054304935314082323505333212343207353504364108 TOTAL PGR3943150 0 4099744 6 4245259 7 4350216 3 4537748 3 4788291 9 4897840 4 5067686 3 4299544 0 4859205 5 5063414 9 Collection Loss-561044-592080-625946-638690-681665-759463-770676-811778-827703-867105-921832 EFFECTIVE GROSS REVENUE3887045 6 4040536 6 4182665 1 4286347 3 4469581 8 4712345 6 4820772 8 4986508 5 4216773 7 4772495 0 4971231 7 OPERATING EXPENSES Repairs & Maintenance17239001775613182918818832201938829199874920579472120365217171722482042316872 Contract Cleaning10334591064415110018911226051145141120152612279821273344115761413346811390062 Security738946761114783949807466831690856640882340908811936075964158993081 Utilities10765971108856114531911708631196712125095512805001326010123764113932691447839 General & Administrative741398763639786549810146834450859483885267911825939179967355996376 Insurance144503148838153303157902162639167518172544177720183052188543194200 Real Estate Taxes794383481821498427614868044289408559209081948597699141006301 2 1036490 2 1067584 9 Management Fee9717611010134104566610715871117395117808612051931246627105419311931241242808 Non-Reimbursable118890122456126131129915133812137826141961146220150607155124159778 TOTAL OPERATING EXPENSES1449328 8 149371539790 8 1583414 6 1630152 3 1685986 4 1733908 8 1788083 6 1789309 0 1880936 0 1941686 5 NET OPERATING INCOME2437716 8 2546815 2 2642874 3 2702932 7 2839429 5 3026359 2 3086864 0 3198424 9 2427464 7 2891559 0 3029545 2 LEASING & CAPITAL COSTS Tenant Improvements27292039050713818287071312390576219368644112339471094909 3 1439521 Leasing Commissions8361512103644684456082396166289709371606741896473182461531 Structural Reserves9528198139101084104116134759220920227548234374241405248648 RR Donnelley TI000100000000000 TOTAL CAPITAL COSTS45181660968228395015309111769982113256514635655425101766368 0 2149700 OPERATING NET CASH FLOW2392535 2 2485847 0 2614479 3 2549841 6 2662431 3 2913102 7 2940507 5 3144173 9 66109672676589 0 Reversion @8.75%, 1%Cost 3427714 00 TOTAL NET CASH FLOW2392535 2 2485847 0 2614479 3 2549841 6 2662431 3 2913102 7 2940507 5 3144173 9 66109673695372 90

21. Section 11.2: “Opportunity Cost of Capital” (OCC) at the Property Level or: WHERE DO DISCOUNT RATES COME FROM?...

22. Broad Answer: THE CAPITAL MARKETS That is, competing investment opportunities. (This is so, whether we are talking about IV or MV.)

23. IN DCF APPLICATIONS, KEEP IN MIND WHAT THE DISCOUNT RATE IS... Disc. Rate= Required Return = Oppty. Cost of Capital = Expected total return = r = r f + RP = y + g, among investors in the market today for assets similar in risk to the property in question.

24. NOTE: Risk is in the object not in the beholder. Property "X" has the same risk for Investor "A" as for Investor "B". Therefore, oppty cost of cap (r) is same for “A” & “B” for purposes of evaluating NPV of investment in “X” (same discount rate). Unless, say, “A” has some unique ability to alter the risk of X’s future CFs. (This is rare: be skeptical of such claims!)

25. Example... REIT A has expected total return to equity = 12%, Avg.debt int.rate = 7%, Debt/Total Asset Value Ratio = 20% What is REIT A’s (firm-level) Cost of Capital (WACC)? Ans: (0.2)7% + (1-0.2)12% = 1.4% + 9.6% = 11%.

26. Example... REIT B has no debt, curr.div.yield = 6%, pays out all its earnings in dividends (share price/earnings multiple = 16.667), avg.div. growth rate = 4%/yr. What is REIT B’s (firm-level) Cost of Capital (WACC)? [Hint: Use “Gordon Growth Model”.] Ans: 6% + 4% = 10%.

27. Example (cont.)... Property X is a Cincinnati Office Bldg, in a market where such bldgs sell at 8% cap rates (CF / V), with 0.5% expected LR annual growth (in V & CF). It has initial CF = $1,000,000/yr. How much can REIT A afford to pay for Prop.X (without suffering loss in share value)?

28. Ans: Prop.X OCC = 8% + 0.5% = 8.5%. Prop.X Val= $1,000,000 / (8.5% - 0.5%) = $1,000,000 / 0.08 = $12,500,000. Note: This is not equal to: $1,000,000 / (11% - 0.5%) = $9,524,000

29. How much can REIT B afford to pay for Prop.X (without suffering loss in share value)? Ans: Same as REIT A: Prop.X Val= $1,000,000 / (8.5% - 0.5%) = $12,500,000. Note: This is not equal to: $1,000,000 / (10%-4%) = $1,000,000 / 6% = $16,667,000.

30. HOW DO YOU DETERMINE THE DISCOUNT RATE?... Usually a single ("blended") multi-year rate is OK for valuation and investment analysis ("going-in IRR"). One source of info is direct surveys of market participants. Another source is historical evidence...

31. Survey avg  200 bps > Hist.avg.

32. Typical per annum OCC (“going-in IRR”) rates (late 1990s)... For high quality ("class A", "institutional quality") income property:  10% - 12%, stated.  8% - 10%, realistic. Lower quality or more risky income property (e.g., hotels, class B commercial, turnarounds, "mom & pops"):  12% - 15% Raw land (speculation):  15% - 30%

33. How to "back out" implied discount rates from "cap rates" (OAR) observed from transaction prices in the property market... Cap rate= NOI / V  CF / V = y. Therefore, from market transaction data... 1) Observe prices (V) 2) Observe NOI of sold properties. 3) Therefore, observe "cap rates" = NOI / V. 4) Compute: r = y + g  cap rate + g.

34. So we can get an idea what the market's expected total return (discount rate) is for different types of properties by: 1. observing the cap rates at which they are sold, 2. and then making reasonable assumptions about growth expectations (g).

35. But, watch out for capital expenditures: y = CF / V cap rate = NOI / V CF = NOI - CI, (unless NOI is already net of a "reserve" for CI) CI / V  1% - 2% on avg in long run (usually). Therefore: r= y + g = (cap rate) + g - (CI/V), unless cap rate already net of CI.

36. Watch out for terminology: In Brealey-Myers “capitalization rate” is often used to refer to “r”, the total cost of capital (especially in corporate finance). “r” is also sometimes called the “total yield” (especially in the appraisal profession).