Further Developing NPV Analysis to Evaluate Real Estate Investment Opportunities
By
C. Walker Collier III
Bachelor of Science in Business Administration, 1998
University of North Carolina at Chapel Hill
Submitted to the Department of Urban Studies and Planning in Partial Fulfillment of the
Requirements for the Degree of
MASTER OF SCIENCE
In Real Estate Development
At the
Massachusetts Institute of Technology
September 2003
©2003 C. Walker Collier III.
All rights reserved
The author hereby grants MIT permission to reproduce and to distribute publicly paper and electronic copies of this
thesis document in whole or in part.
Signature of the Author
C. Walker Collier III
Department of Urban Studies and Planning
August 4, 2003
Certified by
-.-
David M. Geltner
Professor of Real Es ate Finance
Advisor
Accepted by
avid M. Geltn%:
Chairman, Interdepartmental Degree Program in
Real Estate Development
MASSACHUSETTS INSTITUTE
OF TECHNOLOGY
ROTCH
AUG 2 9 2003
LIBRARIES
Further Developing NPV Analysis to Evaluate Real Estate Investment Opportunities
By
C. Walker Collier III
Submitted to the Department of Urban Studies and Planning on August 4, 200 in Partial
Fulfillment of the Requirements for the Degree of Master of Science in Real Estate Development
Abstract
The primary objective of this thesis is to link the theoretical concepts of the broad
academic community to the practice of the real estate industry. The most fundamental focus of
this work is to build upon widely used net present value methodology in an effort to analyze real
estate acquisition and development investments in a more rigorous manner. The main premise
on which this paper is based is using risk-adjusted opportunity costs of capital to discount cash
flows of varying levels of risk.
The cases presented in this paper are included to illustrate the usefulness of the
methodologies to evaluate real estate investments; thus, more attention should be given to the
methodology than the results of the analysis.
The methodologies presented in this paper seem to hold up quite well when apply to realworld cases. To understand the true usefulness of these methodologies it would be helpful to
apply these methodologies to a wide sample of real-world deals.
Thesis Superviser: David M. Geltner
Title: Professor of Real Estate Finance
Acknowledgements
A special thanks to Professor David Geltner for allowing me to piggy-back on all of his
cutting edge research and for continuously redirecting my thoughts and research in an effort to
link the theory of the academic community to the practice of the real estate industry.
Thank you to my family for their endless support and patience throughout all of my years
especially the last one.
Thank you to all of my classmates for sharing their knowledge and insight - I am
certainly a more well-rounded real estate professional because of the time I spent with each of
them.
And finally, a special thanks to Boston Properties for their advice and contribution of
material relevant to case the formulation in this thesis. However, all of the cases in this thesis are
fictitious, designed for educational and illustrative purposes only, and not representative of any
specific real case either at Boston Properties or elsewhere.
Table of Contents
L ist of E xhibits..............................................................................................
5
Relationship of Risk and Return.............................................................................8
Real Estate Investment Application.................................................................10
............ 13
M ethodology ...................................................................................
13
R ental Grow th.........................................................................................
Opportunity Cost of Capital for Institutional Assets............................................17
OCC for Non-Institutional or Non-Stable Assets.................................................19
20
R ollover Risk .........................................................................................
D evelopm ent Projects...................................................................................21
. ..2 4
C ases......................................................................................................
.... 25
Project A ........................................................................................
. 28
Project B .............................................................................................
.......... 31
P roject C ....................................................................................
34
P roject D ..................................................................................................
36
Project E ..................................................................................................
C onclu sion ...................................................................................................
39
B ibliography.............................................................................................
41
List of Exhibits
Exhibit 1 - Risk and Reward Relationship Graph
Exhibit 2 - Boston Office Market Rental History Graph
Exhibit 3 - Asset Class Returns, Risk and Risk Premiums
Exhibit 4 - Project A
Exhibit 5 - Project B
Exhibit 6 - Project C
Exhibit 7- Project D
Exhibit 8 - Project E
Chapter ]
Introduction
The most fundamental theory of financial economics is the principle that investments
with greater risk should have greater expected returns. In order to determine if an investor is
compensated for the risk incurred with a given investment, the investor must first develop a keen
understanding of the relative risks and returns of the broad asset classes. This can most
effectively be done by comparing the average risk premiums of each asset class (i.e. stocks,
bonds, and real estate) with the risk inherent in each of those asset classes. From an historical
perspective, investments with greater risk have, on average, been rewarded with higher returns in an almost directly proportional amount.
When considering the variety of investments within each broad asset class, determining
the appropriate risk premium of a subject investment over the average investment in that asset
class is far more difficult in the case of real estate than the other asset classes. The NCREIF
index is the most widely used benchmark for real estate investment performance. The average
NCREIF asset is large, of institutional quality, stable, fully operational, at least nearly fully
occupied, of high-quality construction and is located at an attractive location within a primary
market. Any real estate asset that is notably different than the average NCREIF asset faces
different (less or more) risk and should therefore have a different risk premium. Determining the
appropriate risk premium (or discount) over and above the average real estate risk premium is
commonly viewed by the real estate industry as more of an art than a science.
This paper attempts to make the analysis described above more of a science than an art by
further developing and linking theoretical methodologies of the academic community to realworld projects. These methodologies can be utilized to more rigorously evaluate acquisitions of
assets with significant rollover risk and development projects. Both methodologies are based on
the idea of using net present value analysis to discount future cash flows with risk-adjusted
opportunity costs of capital. The main contribution of this paper is illustrating a methodology to
derive and apply the appropriate opportunity cost of capital to evaluate various real estate
investment opportunities.
Chapter 2
Relationship of Risk and Return
The two most fundamental considerations for investors when evaluating investment
opportunities are risk and reward. Investors in all asset classes are as equally concerned with the
amount of risk that they are incurring for an expected return as they are with the expected return.
This chapter will discuss the risk and return applications to real estate investment.
Investors seek maximum return with minimum risk. For example, imagine two buildings
that are identical in every way (especially in that they have the same expected return), except that
building A is less risky than building B. No investor would choose to acquire building B instead
of building A, at least not at its current pricing. Eventually, the price of building A would
increase, and the price of building B would decrease, increasing the return for building B and
decreasing the return for building A.
In liquid markets, the riskier asset offers a high expected
return than the less risky asset (Geltner & Miller, 2001).
This concept is quite possibly the most basic point in the economic theory of capital
markets: expected returns are greaterformore risky assets. This theory is illustrated below in
Exhibit 1:
Exhibit 1
Relationship of Risk & Return
C:
C)
a)
III
Risk
Source: Geltner & Miller, 2001.
The expected return can be described by the following formula: E[r] = rf+ E[RP],
where:
E[r] = expected return
rf = risk-free rate
E[RP] = expected riskpremium that investors requirefor investing in a
given asset
The risk-free rate is the return that an investor could earn by investing in a riskless asset,
a US Government treasury note for example. Exhibit 1 illustrates that investors can receive a
return by investing in an asset with no risk; hence, the investor is compensated without incurring
any risk - the investor is being compensated for the time value of money. Essentially, the
investor is allowing someone else to use his money without incurring any risk, and is
compensated for doing so. However, when an investor allows someone to use his or her money
and incurs risk in doing so, the investor is paid a risk premium for incurring the risk. The risk
premium is the difference between expected return and the risk-free rate.
Real Estate Investment Application
Except for the most standard institutional core assets, different real estate investments
have varying levels of risk and therefore have unique risk premiums. Even within the acquisition
of stabilized assets there can be varying levels of risk among different product types, geographic
areas and lease rollover schedules. However, the greatest disparity in risk among real estate
investments is between the acquisition of stabilized assets and the development of new assets.
The dramatic difference in the level of risk between acquisition projects and development
projects is due to the operational leverage inherent in development, regardless of whether or not
a construction loan is used to finance the project. The leverage lies in the difference between the
fixed construction costs and the dynamic market value of the stabilized asset. Operational
leverage consists of two primary components that can act independently or collectively: lease-up
risk and asset-value volatility. At the time of the investment decision, it is impossible to know
what condition the leasing market and real estate asset markets are going to be in at the end of
the construction period. And since the asset value is partly dependent on the leases in-place, the
stabilized-asset value at the end of the construction period is quite uncertain from an ex ante
perspective, and therefore requires a substantially greater risk premium than an investment in a
stabilized asset.
For example, imagine the development of an office building. The current asset value of
similar buildings as the to-be-built asset is $12,000,000, the construction period is one year, the
construction cost is $9,650,000 and the land and up-front fees are $2,000,000. Assuming there is
no appreciation or depreciation in the value of similar assets during the year of construction, the
expected return of the development project is 17.5%:
17.50
=($12,000,000- $9,650,000)- $2,000,000
$2,000,000
Now imagine that the leasing market, the real estate asset market or both change during
the construction period causing the stabilized asset value to be $11,250,000, a decrease of only
6.25%. This decrease in asset value for an unlevered investor in a stabilized asset would only
cause a loss of 6.25% of the investment. However, due to the operational leverage in the
development project, the story for the development investor is much different:
-
20.00
($11,250,000
- $9,650,000)- $2,000,000
$2,000,000
The development investor would lose 20.0%, or $400,000, of his initial investment. The
development investor's loss is magnified because the construction cost of $9,650,000 did not
change with the change in the stabilized asset value (from $12,000,000 to $11,250,000). Due to
the effective leverage ratio being 6 (LR = $12,000,000/$2,000,000), the development investor's
loss is magnified 6 times (6 * 6.25% = 37.5%) which is the difference between the positive
17.5% return and the negative 20.0% return.
Clearly, the operational leverage would not be so large if the development investor is
required to fund equity during the construction period. A decrease in operational leverage means
a decrease in risk (volatility) and usually a concomitant decrease in expected return.
It is evident from the example above that different real estate investments have different
levels of risk and should therefore have different expected returns. The following chapters will
present and discuss methodologies that can be used to determine the appropriate risk-adjusted
returns that investors should expect from various real estate investment opportunities.
Chapter 3
Methodology
Chapter 2 explained the basic risk and return relationship as it pertains to real estate
investment opportunities. This chapter will serve to explain, and build upon, the conventional
methods used in evaluating the risk and expected return in real estate acquisition and
development investments from an ex ante perspective.
Two of the most fundamental considerations when evaluating an investment in an
institutional-quality asset are the rental growth rate and the opportunity cost of capital. The asset
is clearly worth more today and in the future, the higher the rental growth rate and the lower the
opportunity cost of capital; therefore, it is crucial to apply a rigorous methodology in deriving
both. It is important to remember that the price paid for an asset determines, at least in part, the
returns going forward because the future cash flows of the property are independent of the price
paid.
Rental Growth
Many real estate investors assume that rent will grow at the same rate as inflation. Some
analysts are often tempted to use the average of the consumer price index over the last 25 years,
which is 4.91%. This includes the high-inflation period of the 1970's and is clearly not a prudent
assumption to make about rental rates going forward. Others roughly estimate inflation to grow
at 3.0%. There are three problems with assuming that rental rates will grow with inflation: (i)
analysts use off-the-cuff projections of inflation, (ii) ignore the historical real rental growth rate,
and (iii) ignore the economic and functional depreciation of assets.
Since the US Treasury made its first issuance of inflation-indexed bonds in 1997 the
investment market has had a dynamic indicator of the market's expected inflation - rarely,
however, do real estate analysts use this market-driven projection of inflation. The market's
expected inflation rate can roughly be determined by subtracting the yield of inflation-indexed
bonds from the nominal bond yield of US Treasuries (Bridgewater Associates, 2003). For
example, on July 8, 2003 the yield on the 10 year US Treasury was (3 5/8% 5/13), or 3.716%,
and the yield on the US Treasury Inflation Index was 1.996%. From this we can compute that
the implied inflation rate for the next 10 years is 1.720%. Thus, we now have a more rigorous
determinant for the market's expected rate of inflation.
Next, we need to account for the average real rental growth rate. This can most
effectively be derived by graphing the historical Class-A and Class-B rents (assuming that the
acquisition is a relatively new Class-A building) in the subject market against the Consumer
Price Index (CPI). The first step is to identify the peaks, troughs and general cycle over the
historical period by eyeballing the chart. Then compute the average annual growth rate between
peaks and between troughs for the Class-A rental rates. Finally, subtract the average inflation
rate over the same period to arrive at the average real growth rate, which is often negative.
For example, if the annual growth rate between troughs is 2.5% and the average inflation
rate for the same period is 3.25%, then average real growth rate between troughs is -0.75%. The
average real growth rate between peaks is calculated by subtracting the inflation rate between
peaks of 3.5% from the nominal growth rate from the same period which is 2.5%, this yields an
average real growth rate between peaks of -1.0%. In this case, the average real growth rate for
the market is -0.88%.
Now we need to account for the economic and functional depreciation of real estate
assets. First, calculate the ratio of the average Class-B rents to average Class-A rents of the 25
year period. For example, if the Class-B rental rate is $17.50 and the Class-A rental rate is
$25.00, the ratio is 0.70. This ratio can be converted into a annual economic and functional
depreciation rate of -0.71% by computing 0.70^(1/50)-l.1
In order to more clearly understand the methodology presented above, let's take a look at
the Boston CBD office market between 1975 and 1999.
It is important to note here that this methodology assumes that Class-A buildings turn into Class-B buildings after
approximately 50 years.
Exhibit 2
Boston CBD Office Market Rent History ($/SF/yr)
$70 -
2yr bef pki to 2yr bef pk
-0.58%/yr Real
$60 -
A to B,,**
$50
Avg Rent Decline
$50
36%,,*
Over 50 yrs =>,s*
-0.88% /yr
$40
$30
$20
Trough-to-Trough
-0.65%//yr Real
$0
$0
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-CPI
It is evident from the chart above that the Boston Class-A office rents hit a low of
approximately $12.00 per square foot (PSF) in 1977 and another low of $25.00 PSF in 1992.
The nominal average annual growth in that period was 5.01%, computed as (25/12)A(1/15)-1.
But after subtracting the inflation rate of 5.66% from the nominal growth rate the real growth per
year is -0.65%. Identifying the peaks in this case is a little trickier due to the fact that rental rates
were increasing at the end of 1999. Market indicators suggested that rents were expected to
increase for another two years before declining due to additional inventory coming on line. So
rather than measuring the increase in rental rates from the peak in 1989 to the new peak in 1999,
it is best to measure the growth between 1987, two years before the previous peak, and 1997, two
years before the next expected peak. The nominal average annual growth in that period was
2.62%, but after adjusting for the inflation rate of 3.19% the real growth rate per year is -0.58%.
To calculate the economic and functional depreciation for buildings in the Boston office
market you first average the Class-A and Class-B rental rates over the 25 year period. These
averages are $31.64 and $20.32, respectively. Next, compute the ratio of the average Class-B
rental rates to the average Class-A rental rates, which is 0.64. Finally, this ratio is converted into
an annual depreciation rate by the following computation: 0.64^(1/50)-1. The resulting annual
depreciation rate is -0.88%.
Based on the market's expected inflation rate of 1.720%, the real rental rate growth for
the Boston CBD office market is 0.23%, computed as 1.72% - 0.58% - 0.88% = 0.23%. (Geltner,
2002 & 2003).
Opportunity Cost of Capitalfor Institutional Assets
Recall the relationship between the expected return, the risk free rate and the expected
risk premium from Chapter 2, E[r] = rf+ E[RP]. The risk free rate accounts for the time value of
money and the risk premium accounts for the risk inherent in the expected return. Thus, there
should be a higher risk premium for riskier cash flows.
Evaluating real estate investment opportunities using the appropriate opportunity cost of
capital ("OCC") is crucial to long term profitability, however, empirically determining what
OCC to use can be a bit of a challenge. Do you base the OCC off of historical returns? Do you
use ex ante returns? Numerous methodologies exist and several seem to be quite intuitive.
While there is no certainty that history is going to repeat itself with respect to broad asset
class returns, returns are more likely to be similar to historical returns than dramatically different.
Thus, we can use the average historical (1970 - 1998) risk premiums for various asset classes
from the chart below and use them as a fairly reliable proxy for returns going forward.
Exhibit 3
Volatility
Risk Premium
6.80%
2.66%
NA
G Bonds
10.20%
11.80%
3.40%
Real Estate
10.22%
9.92%
3.42%
Stock
14.68%
16.21%
7.88%
Geltner & Miller, 2001.
Asset Class
T-Bills
Total Return
Here we calculate the historical risk premiums for each asset class by subtracting the
average 30-day T-Bill rate from the historical total returns of each asset class for the period
between 1970 and 1998. From Exhibit 3 you can see that the risk premium for institutionalquality real estate, benchmarked by the NCREIF index, had an average risk premium of 342
basis points for the period between 1970 and 1998. You can also see that the risk premium on
long-term bonds was in line with that of institutional-quality real estate while the premium for
stocks (benchmarked by the S&P 500) was much greater, more than twice as much. Based on
the premise that historical returns are a good indication of returns going forward, we can add the
historical average real estate risk premium to the current risk-free rate to determine the expected
return for real estate going forward. For example, if the yield on the 30-day T-bill was 4.0%,
then you would simply add the 3.42% historical average real estate risk premium and get an ex
ante return of 7.42% for institutional-quality real estate.
An alternative approach, surveying, can act as a sound check to this methodology.
Professional investors generally respond to survey questions regarding relative risk between real
estate and stocks by saying that real estate is approximately half as risky as stocks. This roughly
agrees with Exhibit 3 which shows that real estate has a volatility of 9.92% and stocks have a
volatility of 16.21%. However, results from surveys regarding the risk of real estate vary in
different economic conditions. For example, during the early 1990's real estate risk premiums
were viewed as two-thirds of stock risk premiums.
Basing real estate return expectations off of historical performance can be a reliable guide
to quantify the relative risk of real estate when compared to other assets classes. However,
because real estate risk premiums vary over time, the methodology cannot be used as a fail-safe
method.
Thus far, we have focused on determining the appropriate opportunity cost of capital for
institutional-quality real estate, those that are similar to the average property in the NCREIF
index. The average asset in the NCREIF index is large, fully operational, well located, of highquality construction and has a smooth lease rollover schedule. The following section will
discuss the appropriate opportunity cost of capital for real estate assets that are different than the
average NCREIF asset and therefore should have different discount rates. These assets vary by
size, lease rollover (amount of market risk) and operational or life-cycle phase (i.e. stabilized
asset versus a development project).
OCC for Non-Institutional or Non- Stable Assets
The properties that make up the NCREIF index, the most widely used benchmark for
institutional real estate assets, are on average worth close to $30 million. These properties are
primarily owned by large institutions and are traditionally regarded as fairly safe, stable assets.
Smaller, older assets with lumpy rollover schedules and less credit worthy tenants, as well as
redevelopment and development projects, have considerable more risk than stabilized
institutional-quality assets. Higher opportunity costs of capital, reflecting greater risk, should be
used when valuing such investment opportunities. Even the most stable non-institutional assets
demand a minimum risk premium of between 100 and 200 basis points over institutional-asset
returns due to the lack of liquidity in the market for these types of assets.
Rollover Risk
The average NCREIF asset has a staggered lease rollover schedule which moderates the
amount of market exposure, or lease-up risk, in any one year. However, normal
operating/leasing issues can create lumpy rollover schedules which cause assets to have
abnormally high levels of market risk during a short period of time. This creates an elevated
level of risk and investors in such assets demand higher risk premiums than the risk premiums of
that average institutional-quality assets.
This elevated risk can be accounted for by separating the contractual and non-contractual
expected cash flows and discounting them by risk-adjusted discount rates, rather than using a
blended opportunity cost of capital for all of the cash flows as is customary in the industry. For
example, cash flows that are contractually obligated by an executed lease from a tenant should be
discounted at a rate commensurate with the credit of that tenant. This discount rate is called the
intralease discount rate. If the credit of a tenant is unknown, or if the luxury of breaking out the
cash flows on a tenant-by-tenant basis is not an option, then some benchmark which roughly
mirrors the average corporate bond yield of the tenant base in the subject property can be used as
a proxy. For institutional-quality buildings, the average Baa corporate bond yield will generally
serve as an appropriate discount rate. The projected cash flows that are not contractually
obligated, those based on releasing space where leases will expire, are clearly less certain (more
risky) and should therefore be discounted at a higher OCC - a premium over the stabilized
property opportunity cost of capital. The size of this premium is based on the vacancy in the
market, the absorption of vacant space, the amount of new space coming on line and the
marketability of the subject property. This discount rate is called the interlease discount rate. It
should be noted that once leases are signed they become contractually obligated cash flows and
are not subject to the market risk. So only the future value of the future leases should be
discounted back to time zero at the interlease discount rate. Due to the uncertainty of the
projected disposition value of the building it is appropriate to also discount it back to time zero at
the interlease discount rate as well.
As mentioned above, it is customary for buyers to use a blended opportunity cost of
capital for all cash flows whether or not they are contractually obligated or a projection of cash
flow from new leases. This blended rate, the stabilized-property opportunity cost of capital, is
the return that investors could earn from investing in another asset with the same level of risk.
The stabilized OCC generally falls between the appropriate interlease and intralease discount
rates. Subsequently, the pure intralease discount rate is generally going to be lower than the
stabilized property OCC because the intralease discount rate does not have to compensate for the
interlease risk.
Development Projects
Recall that cash flows should be discounted by a risk-adjusted opportunity cost of capital
in order to account for different levels of risk. Not only should different cash flow streams be
treated differently but cash flows in phases with varying levels of risk should also be treated
differently. In the case of development projects, risk is very different in each of the three phases:
the construction/development phase, the lease-up phase and the stabilized-operational phase.
Thus, cash flows in these three phases should be discounted by using risk-adjusted opportunity
costs of capital for each phase.
The cash flows upon stabilization are relatively safe and should be discounted at the
stabilized-property opportunity cost of capital, as discussed in the previous section. These cash
flows should be discounted back to the period before the asset becomes stabilized, or the last
period of the lease-up phase.
The cash flows in the lease-up phase, including the present value of cash flows from the
stabilized-operational phase, should be discounted back at an opportunity cost of capital 50 - 300
basis points higher than the opportunity cost of capital from the stabilized phase to reflect the
lease-up risk discussed in the previous section. These cash flows should be discounted back to
the last period of the construction/development phase in order to determine the asset value at the
end of the construction phase, VT.
The construction/development phase of the development process is by far the most risky
due to the operational leverage inherent in development. Therefore cash flows during the
construction/development phase should be accounted for by using a higher discount rate.
Assuming the fundamental risk and return relationship holds true for real estate development
projects, as it should, the following equation defines development project's risk and return
relationship:
VT -LT
(1+ E[rc ])T
VT
LT
(1+E[rv])" (1+E[rD]
Where:
VT = Expected value of asset at time T;
LT =
Expected balance due on construction loan at time T (all construction costs
includingfinancing costs);
E[rv] = Market expected total rate of return (going-inIRR) on investments in
completedproperties of the type to be built;
E[rD] = Market expected return on construction loans.
The resulting opportunity cost of capital for the construction/development phase, or E[rc], should
be used to discount all of the cash flows during the construction phase, as well as the present
value of the cash flows from the subsequent phases that were discounted back to time T. The
present value of all of the project cash flows is the benefit, BO, from undertaking the development
project. Alternatively and maybe more simply, the net difference of the asset value at time T,
VT,
and the construction costs at time T, LT, can be discounted back at E[rc] to time zero
resulting in Bo. The market value of the land and other up-front expenditures necessary to begin
the project, Co, should be subtracted from Bo in order to determine the net present value of the
development project (Geltner, 2002 and 2003):
NPV = BO - Co
As is the case with all NPV analysis, only zero and positive NPV deals should be
undertaken. In theory, an investor can maintain long-term profitability only if he/she invests in
non-negative NPV deals.
Chapter 4
Cases
The previous section discussed theoretical methodologies to evaluate real estate
investment opportunities. This section will serve to apply the previously discussed
methodologies to real world real estate investment deals in order to help the reader develop a
deeper understanding of both the underlying concepts of the analysis as well as the real-world
application. Projects A and B are acquisition deals and Projects C, D and E are development
deals.
Note that the following cases are designed as illustrative examples and do not represent
actual projects. The analyses presented herein are performed from an ex ante perspective so as
to illustrate a real-world investment decision.
Project A
The analysis presented on the previous page illustrates the acquisition of a stabilized
institutional-quality asset in the Midtown Manhattan submarket of New York City. The two
main highlights from Project A are: (i) the flat rollover schedule of in-place leases, and (ii) the
large amount of capital expenditures in the first two years of the projections.
Since Project A's lease rollover schedule is fairly typical when compared to the average
NCREIF asset, there is no need to unbundle the cash flows and use different risk-adjusted
opportunity costs of capital to discount back different cash flows. Instead, the stabilized asset
opportunity cost of capital should be used to discount all cash flows as it factors in the typical
rollover risk found in NCREIF assets.
Another aspect of Project A that merits some discussion is the large amount of capital
expenditures in the first two years of the projections. The large amount of capital expenditures
commands an abnormally high going-in capitalization rate (based off net operating income).
This throws the normal relationship of the going-in capitalization rate and the projected total
return off a bit. Normally, the going-in capitalization rate is lower than the project's expected
total return - this is not the case in Project A. This can be concluded from comparing the goingin capitalization rate of 11.05% to the NPV (based off an OCC of 8.28%) of -$5,391,199. Since
the NPV is negative, it is clear that the total return from Project A is lower than 8.28%.
The most notable aspect of Project A is that fact that it represents an average NCREIF
asset with respect to lease rollover and therefore does not necessitate the unbundling of cash
flows. Since Project A is a normal institutional-quality asset it should trade at competitive
pricing levels due to the competition and liquidity in the institutional market. The competition
and liquidity in this asset market normally cause transactions to be near zero NPV deals. The
largely negative result of the analysis suggests that either the acquisition price is much too high
or, more likely, that there is some pertinent information that was not factored into the analysis.
In normal circumstances, the investor has access to all of the pertinent information.
Exhibit 4
PROJECT A SUMMARY
Type of project: Acquisition of asset similar to average NCREIFasset
Rental Growth:
10 year TIPS Yield
Real Rent Growth
Net Rental Growth
Acquisition Price:
Stabilized Asset Phase OCC:
30-day T-Bill
Real Estate Risk Premium
Stabilized Asset Going-in IRR
1.72%
-1.49%
0.23%
4.86%
3.42%
8.28% :discount
Sincethis project is similar to the average NCREIFasset witha staggered
rollover schedule thereis no need to unbundle the cash flowsand useseparate
rates.
$120,490,232
Acquisition CapRate:
11.05%
Disposition CapRate:
9.50%
Intralease Discount Rate:
Average Corporate Yleld on Baa Credit
N/A
interleaase Discount Rate:
Stabilized Asset Going-in IRR
Lease-up Risk Premlum
Interlease Discount Rate
8.28%
NIA
N/A
2005
2009
2007
2003
2004
Revenue
Expenses
19,400,000
(6,089,984)
19,370,000
(7,777,765)
19,270,000
(7,743,481)
19,470,000
(7,993,188)
21,900,000
(9,144,931)
19,882,000
(7,735,729)
19,927,788
(7,753,544)
19,973,682
(7,771,401)
20,019,681
(7.789,298)
20,065,787
(7,807,237)
NOI
13,310,016
11,592,235
11,526,519
11,476,812
12,755,069
12,146,271
12,174,244
12,202,281
12,230,383
12,258,550
Capex
(8,115,505)
(8,235,231)
(3,094,610)
(2,653,958)
(1,208,063)
(1,390,899)
(1,797,013)
(1,550,818)
(1,612,238)
Cash Flow After Capex
Acquisition/Disposition
Project Cash Flow
5,194,511
3,357,004
8,431,909
8,822,854
11,547,005
10,532,963
10,783,345
10,405,268
10,679,565
5,194,511
3,357,004
8,431,909
8,822,854
11,547,005
10,532,963
10,783,345
10,405,268
10,679,565
10,646,312
129,334,540
139,980,851
Time 0
Years
(120,490,232)
(120,490,232)
OCC
8.28%
Non-contractual CF(future leases)
8.28%
Future Values of Future Leases
8.28%
Present Value of Disposition
8.28%
$58,375,693
Acquisition
8.28%
(S1_20490232)
Profitability
1999
2000
2001
2002
(1,613,308)
PV
Contractual CF
NPVof Project
1998
$15,853,142
$40,870,198
5,884,615
4,452,438
2,397,860
4,818,234
3,781,223
3,299,144
1,504,709
0
0
0
742,073
959,144
3,613,675
5,041,631
8,247,861
9,028,254
10,783,345
10,405,268
10,679,565
6,481,548
7,412,863
7,070,202
6,006,043
3,872,043
2,706,181
1,404,601
4,998,634
0
129,334,540
($5,391,199)
-4.47%
7,693,581
0
10,646,312
Profitability = NPV/Acquisition Cost
Project B
Project B is the acquisition of another Midtown Manhattan institutional-quality office
building. As opposed to Project A, Project B has an extremely lumpy rollover schedule - 100%
of the in-place leases expire between 1999 and 2003. This causes the asset to face increased
market risk. As discussed previously, it is useful to unbundle the interlease and intralease cash
flows and utilize the respective discount rates when evaluating such assets.
Since the credit quality of the tenant base is unknown, the average corporate yield on Baa
credit was used as a proxy for the intralease opportunity cost of capital. In 1998, the average
corporate yield on Baa credit was 7.22%. This OCC is used to discount the contractually
obligated cash flows that are either bound by existing leases or will be bound by future leases.
The point is that once the lease is contractually obligated, either today or in the future, its cash
flows should be discounted using the intralease discount rate which reflects the tenant's ability to
pay rent.
After evaluating the vacancy in the market, the absorption of vacant space, the amount of
new space coming on line and the marketability of the subject property the appropriate lease-up
risk premium for Project B is estimated to be 100 basis points. This lease-up risk premium is
added to the stabilized asset going-in IRR, of 8.28%, to arrive at the interlease discount rate of
9.28%. This interlease discount rate is used to discount back the future value of the future leases.
The spread between the interlease and intralease discount rates reflect the elevated risk in noncontractual cash flows.
The future values of future leases beginning in 2000 and 2001 of $15,066,030 and
$15,516,266 respectively were computed by discounting the projected lease payments
(contractual lease payments in the future) by the intralease discount rate. However, in
discounting these values to time zero the interlease discount rate is used to account for the
uncertainty in the projection of the future lease value.
This project illustrates a methodology which is rarely used in the marketplace, if used at
all; however, it extremely useful in that it more rigorously evaluates real estate acquisitions
based on a risk-adjusted opportunity costs of capital. If we assume that all pertinent information
is included in the cash flow projections, the resulting negative NPV suggests that the investor is
not adequately compensated for the risk incurred in the acquisition of the asset.
Exhibit 5
PROJECT B SUMMARY
Typeof project: Acquisition of stabilized asset w! significant rollover
Rental Growth:
10 year TIPS Yield
RealRent Growth
Net Rental Growth
Acquisition Price:
1.72%
-1.49%
0.23%
$160,328,634
Acquisition Cap Rate:
9.84%
Disposition Cap Rate:
9.50%
Stabilized Asset Phase OCC:
30-day T-Bill
RealEstate Risk Premium
Stabilized Asset Going-in IRR
4.86%
3.42%
8.28%
intralease Discount Rate:
Average Corporate Yield on Baa Credit
7.22%
Interleaase Discount Rate:
Stabilized Asset Going-in IRR
Lease-up Phase Risk Premium
Interlease Discount Rate
8.28%
1.00%
9.28%
2007
1998
1999
2000
2001
2002
2003
2004
2005
2006
Revenue
Expenses
23,300,000
(7,528,958)
22,925,000
(6,903.750)
23,420,000
(7,381,940)
22,650,000
(5,815,887)
25,550,000
(11,423,574)
25,608,842
(8,672,977)
25,667,819
(8,692,951)
25,726,932
(8,712,971)
25,786,181
(8,733,037)
25,845,566
(8.753,149)
NOI
15,771,042
16,021,250
16,038,060
16,834,113
14,126,426
16,935,865
16,974,868
17,013,961
17,053,144
17,092,418
Capex
(8,115,505)
(8,235,231)
(3,094,610)
(2,653,958)
(1,208,063)
(3,092,871)
(3,194,002)
(1,016,897)
(1,227,662)
(1,199,876)
7,655,537
7,786,019
12,943,450
14,180,155
12,918,362
13,842,994
13,780,866
15,997,064
15,825,483
7,655,537
7,786,019
12,943,450
14,180,155
12,918,362
13,842,994
__13,780,866
15,997,064
15,825,483
15,892,542
180,334,543
196,227,085
7,655,537
7,786,019
10,354,760
8,508,093
5,167,345
2,768,599
0
0
0
0
0
0
2,588,690
5,672,062
7,751,017
11,074,395
13,780,866
15,997,064
15,825,483
15,892,542
13,800,510
12,213,234
0
0
2,964,473
0
Years
Time 0
Cash Flow After Capex
AcquisitionlDisposition
Flow
Project Cash
Cash Flow
(160,328,634)
(160,328,634)
Prnlect
OCC
Contractual CF
7.22%
PV
$34,219,920
Non-contractual CF (future leases)
Future Values of Future Leases
9.28%
$49,415,857
Present Value of Disposition
9.28G
$74,245,829
Acquisition
0
0
15,066,030
15,516,266
10,326,431
180,334,543
($160,328,634
($2,447',028)
NPV of Project
Profitability= NPV/Acquisition Cost
Profitability
Intralease OCC: Average
corporate yield of Baa credit.
Interlease OCC:
Stabilized Asset Going-inIRR
Lease-up Risk Premium
Interlease OCC
8.28%
1.00%
9.28%
PVof new leases that replace the leases
that expired In 1999-discounted at
intralease rateof 7.22%
PVof new leases that replace the leases that
expired in 2000 - discounted at intralease rate of
7.22%.This continues going forward.
Project C
Project C is the development of a 37% preleased Class-A suburban office building within
a fairly tight submarket. This case is representative of a typical development deal illustrating
two of the most fundamental characteristics inherent in development projects: lease-up risk and
operational leverage.
It is easiest to analyze development projects in reverse chronological order. Beginning
with the terminal value, a disposition capitalization rate 20 basis points higher than the going-in
capitalization rate was assumed to account for depreciation of the building. Moving from project
disposition to project stabilization, the stabilized-asset going-in IRR, or stabilized-asset phase
OCC, from the previous section was utilized to discount all of the cash flows from disposition
(month 152) to stabilization (month 32). The present value of those cash flows, the stabilizedasset value, is $68,395,866.
After considering the amount of preleased space in Project C and evaluating the overall
condition of the submarket, as well as where the building would fit into the market and the
amount of space coming online, the appropriate lease-up phase risk premium was estimated to be
145 basis points. Generally a project with only 37% of the space preleased would command a
lease-up phase risk premium closer to 200 basis points but the subject market appears to be quite
strong with healthy absorption. Thus, the cash flows (including the stabilized-asset value) in the
lease-up phase, months 14 through 33, were discounted at the lease-up phase OCC of 9.73%,
resulting in an asset value at the end of the construction phase, LT, of $46,205,326.
Finally, the cash flows during the construction/development phase, most of which are
outflows with the exception of the lease-up asset value, were discounted at the E[rc] which is
derived by the equation:
V
-L
(1+E[rc])
_
VT
LT
(1+E[r])
(1+E[rD]
As shown in Exhibit 6, the resulting E[rc] is 14.42%. The present value from discounting
the cash flows during the construction phase result in a benefit, BO, from undertaking the
development of Project C of $17,064,497. The costs of undertaking the development, Co, were
$8,438,521 and result in a highly positive NPV of $8,624,976.
Such a highly positive resulting NPV in a market presumed to be competitive and
efficient suggests that the value of the land used to compute Co may not have been the current
market value, and instead may have been the cost of the land. Significant value can be created in
the entitlement process; the methodology presented in this paper assumes that the land is fully
entitled at the time of the investment analysis. However, if the correct land value was used to
compute Co, then the analysis represents that Project C is an extremely attractive investment
opportunity where the investor is more than adequately compensated for the risk incurred.
Exhibit 6
PROJECT C SUMMARY
Type of project: Development project 37% pre-leased
Rental Growth:
10 year TIPS Yield
Real Rent Growth
Net Rental Growth
-1.49%
0.23%
Going-in Cap. Rate
Disposition Cap. Rate
9.7%
9.9%
Development Phase OCC E[rc):
Opportunity Cost of Capital:
Construction Phase Costs E[rD]
Construction Cost L r
1.72%
6.75%
$25,521,554
VT
T
(1 + E[r,
(1+ E[rc])'
Stabilized-Asset Phase OCC:
30-day T-Bill
Real Estate Risk Premium
Stabilized-Asset Phase OCC E[ry]
4.86%
3.42%
8.28%
Lease-up Phase OCC:
Lease-up Phase Risk Premium
Lease-up Phase OCC
1.45%
9.73%
T
-
_
]) T
L
(I+ E[r
25,522
46,205
46,205 - 25,522
(I+ E[r
(1.098)
)T
08
(1.068).08
14.42%
E[r c] =
Project Phases
Construction/Development
Lease-up
Stabilized
Total
Months
Note: While this analysis was performed on a monthly basis, the development phase OCC
is shown on a monthly basis and should be adjusted accordingly
Months
13
19
120
152
0
13
$68,395,866
Stabilized Asset Value
33
34
35
36
37
($8,438,521)
NPV of Project
$8,625,976
38
All cash flows after month 31 were discounted at the stabilized-asset OCC of 8.28%.
$17,064,497
Land and Fees
Profitability
32
$46,205,326
Lease-up Asset Value V r
PV of Asset (including constr. costs)
31
Vr - L 7 discounted at the development phase OCC of 14.42%.
26.36%
Profitability = NPV/(construction costs + land and fees)
39
40
Project D
Project D is a speculative development project in a strong suburban office market. This
case highlights a deal where the development opportunity cost of capital is significantly higher
than normal due to the narrow margin between the value of the asset at the end of construction,
VT,
and the total cost of construction at the same time, L1 .
As shown in Exhibit 7, VT is $19,469,540 and LT is $15,070,780. The margin between
VT
and LT is narrower than investors like to see in speculative development deals. The increased
risk resulting from the narrow margin is reflected by the relatively high development phase
opportunity cost of capital of 23.37%. This NPV analysis tells the investor that Project D does
not compensate the development investor for the risk that he/she incurs and should not be
pursued.
Exhibit 7
PROJECT 0 SUMMARY
Type of project: Speculative office development in a tight submarket
Rental Growth:
10 year TIPS Yield
Real Rent Growth
Net Rental Growth
Going-in Cap. Rate
Disposition Cap. Rate
Development Phase OCC E[rc):
Opportunity Cost of Capital:
Construction Phase Costs E[roJ
1.72%
6.75%
Construction Cost L r
-1.49%
0.23%
9.9%
9.3%
VT - Lr
$15,070,780
Stabilized-Asset Phase OCC:
30-day T-Bill
Real Estate Risk Premium
Stabilized-Asset OCC E[ry)
(1+
4.86%
VT
LT
(1 + E[r,.])'
(1 + E[rD
_
T
E[rc])
3.42%
25
23.37%
E[r] =
Prolect Phases
(1.068)
(1.098)1"25
(1+-E[r ])
1.50%
9.78%
15,070
19,470
19,470 -15,070
8.28%
Lease-up Phase OCC:
Lease-up Phase Risk Premium
Lease-up Phase OCC
Months
Note: While this analysis was performed on a monthly basis, the development phase OCC
Construction/Development
Lease-up
Stabilized
Total
Months
is shown on a monthly basis and should be adjusted accordingly.
0
15
Lease-up Asset Value V r
36
37
$19,469,540
PV of Asset (including constr. costs)
$2,560,500
Land and Fees
($4,848,949)
NPV of Project
($2,288,450)
Profitability
35
cash flows after month 32 were discounted at the
$stabilized asset OCC of 8.28%.
$21,781,799 4All
Stabilized Asset Value
34
33
32
asset value) were discounted at the lease-up OCC of 9.78%.
VT
-
LT discounted
at the development phase OCC of 23.37%.
-18.60%
Profitability = NPV/(construction costs + land and fees)
38
3
40
41
Project E
Project E is a build-to-suit development project in a strong primary US market with an
executed 20-year lease for a Baa credit tenant. This case illustrates the amount of risk that is
mitigated by having an executed lease prior to construction. First, the rental projection goes
from being based on projections of the rental market to be a forecast of contractually obligated
cash flows. More importantly, most of the operational leverage and all of the lease-up risk is
mitigated by having an executed lease prior to commencing construction. There is, however,
still some asset market risk but it is de minimus in this case due to the term of the lease.
As briefly highlighted in the discussion of the interlease and intralease opportunity costs
of capital, the yield on a certain corporate bond should approximately equal the going-in IRR of
a real estate asset with a tenant base of the same credit 2. Single-tenant assets are near perfect
examples of this - the only difference being that the reversion payment of real estate assets is less
certain than the reversion payment of bonds. With bonds, investors receive the principal that
they originally invested at maturity while real estate investors receive whatever the market will
bear upon disposition. Thus, there is more risk in the reversion of real estate assets than in the
reversion payment of bonds.
In Project E, rather than pricing the real estate off of the historical average real estate risk
premium of the last 28 years it is more appropriate to price it based on the credit of the tenant
since it will only be occupied by one tenant. The stabilized OCC for Project E is based off the
average corporate yield on Baa credit in 1998, which was 7.22%, plus a reversion risk premium
of 50 basis points. Thus, the stabilized opportunity cost of capital for Project E was 7.72%. Due
to the build-to-suit nature of this project there is no lease-up risk premium.
2
Assuming that the duration of the lease and the bond are similar.
The relatively lower construction/development phase opportunity cost of capital, or E[rc],
of Project E is a result of the mitigated lease-up risk and the diminished operational leverage
characteristic of build-to-suit deals.
Similar to Project C, the highly positive NPV of Project E may be a result of using cost of
the land to compute Co rather than using the true market value. Assuming, however, that the
market value of the land was used to compute Co and that all information pertinent to Project E
was considered in this analysis, the investor is more than adequately compensated for the risk
incurred in this development project.
Exhibit 8
PROJECT E SUMMARY
Type of project: Build-to-suit for Baa credit rated tenant
Rental Growth:
Contractual Rental Growth
Going-in Cap
Disposition Cap. Rate
Development Phase OCC E[rcl:
Opportunity Cost of Capital:
Construction Phase Costs E[r 0
Construction Cost L T
2.55%
7.2%
8.0%
6.75%
Vr
$19,631,172
Stabilized-Asset Phase OCC:
Average Corporate Yield on Baa Credit
Reversion Risk Premium
Stabilized-Asset OCC E[rv]
Vr
(1+
T
])
E[r,])T
LT
(1+ E[r])T
41,105
41,105
19,631
(1 + E[rc])"_
(1.075 )"5
(1.068 )1.5
E[re] =
Months
18
120
138
8.45%
Note: While this analysis was performed on a monthly basis, the development phase OCC
is shown on a monthly basis and should be adjusted accordingly.
19
18
Months
Stabilized Asset Value V T
$41,104,705
PV of Asset (including constr. costs)
$15,768,947
Land and Fees
($2,987,289)
NPV of Project
$12,781,658
Profitability
L_
(1+ E[rc
7.22%
0.25%
7.47%
Proiect Phases
Construction/Development
Stabilized
Total
-
91.88%
4
20
21
JAllcash flows after month 18 were discounted at the stabilizedasset OCC of 7.47%.
VTr- L-r discounted at the development phase 0CC at 9.00%.
Profitability = NPV/(construction costs + land and fees)
24
25
26
Chapter 5
Conclusion
The primary mission of this paper is to further develop rigorous methodologies to
evaluate real estate acquisition and development investment opportunities. These methodologies
implement net present value analysis from an ex ante perspective. A major part of this
methodology is deriving the appropriate opportunity costs of capital for different cash flows
based on the varying levels of risk. Overall, the methodologies presented herein seem to hold up
quite well in real-world application.
In theory, assuming that the real estate asset markets are competitive and efficient, and
that all of the market players have all of the information pertinent to the investment decision, the
resulting NPV's from the analyses should be nearly zero on an ex ante basis. Clearly, that is not
consistent with some the cases in this paper. This is likely due to the numerous assumptions that
were made in order to have the level of detail necessary to perform the analysis, the true market
value of the land not being used to compute Co, or one of the market players having more or less
information than the other market players. However, it should be pointed out that these cases
were used as illustrative examples of how to apply the methodology so nothing is lost by the
dispersion of the NPV results. Under normal circumstances real estate investors considering
investments will have access to almost all of the pertinent information necessary to apply this
methodology and make a well-informed investment decision.
As stated previously, this paper focuses on further developing NPV analysis in an effort
to more rigorously evaluate various real estate investment opportunities. Additional application
of the methodologies presented in this paper would be helpful in determining how the results of
these methodologies compare with the results of the methodologies more commonly used in the
industry.
Bibliography
Bridgewater Associates. Inflation Linked Bonds. 2003.
http://www.bwater.con/pdf/USII.pdf
Geltner D. & Miller N.G. Commercial Real Estate Analysis and Investments. Upper Saddle
River, New Jersey: Prentice Hall. 2001.
Geltner D. Real Estate Finance & Investment I and II Class Notes. Fall 2002 and Spring 2003.