LBD3300 Advanced Real Estate
003 Real Estate Cost Benefit Analysis
Prepared for: LearnByDoing.ca
By: @ProfBruce
Date: September 2012
Create the Future
Professor Bruce Murray Firestone
B. Eng. (Civil), M. Eng.-Sci., Ph.D.
Founder Ottawa Senators, Ottawa Senators
Foundation and Scotiabank Place
Entrepreneurship Ambassador, Telfer School of
Management, University of Ottawa
Executive Director, Exploriem.org
Novelist, Quantum Entity Trilogy
Writer, Entrepreneurs Handbook II
Columnist, Ottawa Business Journal
Broker, Century 21 Explorer Realty
•Follow him on Twitter at @ProfBruce
•Read his blogs at www.EQJournal.org and
www.DramatisPersonae.org
•Current motto: “Making Each Day Count”
Lecture 3—
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Cost/Benefit Analysis: Internal Rate of Return
Cap Rates
Business Models for Real Estate
Differentiated Value
Highest and Best Use
How to Buy—you make money in r.e. when you buy
not when you sell
When to Sell
Why Vacant Land is Worth More than Land with a
Building
IRR—
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Probably truest measure of project’s rate
of return
IRR = interest rate that exactly balances
discounted value of future net cashflows
with investment required to develop
project or enterprise
higher interest rate (discount rate) needs
to be in order that future net cashflows
exactly offset upfront investment, higher
IRR is/ better project is, at least in terms of
return on investment
IRR—
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IRR found by solving following equation by
trial and error
Computers do it using iterative process
IRR—
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In simplest model, if student loans Professor
$1,000 and Professor pays it back in three
years with interest of, say, $150 per year, we
have:
Year Investment/Cashflow (from the
Student’s POV)
0
-$1,000
1
$150
2
$150
3
$1,150
IRR—
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IRR can be found by solving the following
equation by trial and error (not much trial or
error here):
$1,000 – $150/(1+irr)^1 – $150/(1+irr)^2 –
$1,150/(1+irr)^3 = 0
or IRR = 15% p.a.
IRR—
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Survey after survey (not scientifically) of
students
No students willing to lend (poor) Professor
$1,000 in return for $150 per year of
interest
Usually aren’t interested until money gets to
be around $200/year and most of them
looking for $300 or $400 in interest per year
Implies Internal Rates of Return in 20 to 40%
p.a. range
IRR—
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Rates of return for students pursuing
architecture degree suggest IRRs are in
range of just 14%
http://www.eqjournal.org/?p=1061
Possibly
architects
somewhat
‘other
directed’
IRR is not whole story
Ignores alternative investment returns on
equity invested elsewhere
IRR—
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Personal discount rates tend to fall as
people age because:
a. Usually have more CASH as they get older
and greater supply of money implies price
will fall
b. their willingness to take risks drops so
that would rather have it in T-bills than
startups by time most people are in 60s, 70s
or 80s
IRR—
IRR—
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Mega
corporations
have
minimum
expectations for IRRs (on equity) around 20
to 22% p.a.
Entrepreneurs and startups require much
higher IRRs because so many things can go
wrong
Land dev target rate for IRR = 100% p.a.!
IRR—
IRR
IRR
On Equity
Investors
Principal
0
($81,500)
($75,000)
($6,500)
1
$7,458.29
$5,593.72
$3,520.57
2
$7,458.29
$5,593.72
$3,520.57
3
$7,458.29
$5,593.72
$3,520.57
4
$7,458.29
$5,593.72
$3,520.57
5
$164,030.72
$123,023.04
$42,663.68
abd%
p.a.
mno%
p.a.
xyz%
Incl Mgt Fee
p.a.
IRR—
Solve:
-81,500 + 7,458/(1+r)^1 +
7,458/(1+r)^2 + 7,458/(1+r)^3 +
7,458/(1+r)^4 + 164,030/(1+r)^5 = 0
IRR—
Solve:
-75,000 + 5,594/(1+r)^1 +
5,594/(1+r)^2 + 5,594/(1+r)^3 +
5,594/(1+r)^4 + 123,023/(1+r)^5 = 0
IRR—
Solve:
-6,500 + 3,521/(1+r)^1 + 3,521/(1+r)^2
+ 3,521/(1+r)^3 + 3,521/(1+r)^4 +
42,664/(1+r)^5 = 0
IRR—
IRR
IRR
On Equity
Investors
Principal
0
($81,500)
($75,000)
($6,500)
1
$7,458.29
$5,593.72
$3,520.57
2
$7,458.29
$5,593.72
$3,520.57
3
$7,458.29
$5,593.72
$3,520.57
4
$7,458.29
$5,593.72
$3,520.57
5
$164,030.72
$123,023.04
$42,663.68
21.2%
p.a.
15.7%
p.a.
78%
Incl Mgt Fee
p.a.
IRR—
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Mega
corporations
have
minimum
expectations for IRRs (on equity) around 20
to 22% p.a.
Entrepreneurs and startups require much
higher IRRs because so many things can go
wrong
Land dev target rate for IRR = 100% p.a.!
IRR—
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Banks lend money at 3% but mega corps
want minimum IRRs of 20 to 22% p.a.?
How much interest on savings account
Less than 1% (in fact, after all the fees,
probably negative)
Banks use OPM (Other People’s Money)
mixed in with a little of own capital so their
IRRs on equity among best on planet
IRR—
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Reverse IRR Model
Establish monthly goals for new enterprise
http://www.old.dramatispersonae.org/IRR/R
everseIRRAcmePromotions.xls
Ski racers want to race > when they know
other times
Set goal, break it down into intervals and
WIN
IRR—
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Same thing for any business
No good to say, ‘I want $150k in revenues
first year’
Need $12,500/month or $625 /day, every
day for 20 working days in each month
Visualization is key
Put up sign “N = ?” and drive N up
N can be leasing, sales, number of clients…
IRR—
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Don’t think that, ‘oh well, I didn’t make
$625 in sales today, I’ll make it up at
month’s end’
Doesn’t work
Miss today’s target, means sell $1,300
tomorrow or $1,925 day after
Pretty soon, you and your business toast
IRR—
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Reverse IRR Model based on assumption
that, going in, you are likely to know costs
more accurately that what revenues likely
to be
Revenue estimates, whether based on
marketing surveys are guesstimates/can
be highly unreliable
Goal setting based on expected costs plus
allowance for profitability probably
reasonable mechanism to establish future
revenue streams
IRR—
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Using OPM (Other People’s Money) or
leverage (aka debt)
Normally increases IRR on your equity
Can cause risk to go down not up!
E.g., use your equity to build five units
instead of one
One tenant leaves, have 20% vacancy rate
instead of 100%
Free cashflow from other four (still occupied)
units helps biz stay afloat
IRR—
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If average vacancy rate for each unit over a
ten year period, say, 10%,
Probability all five units vacant at same time
low
0.1 to power of five or just .001%
Entrepreneurs can argue with Bank for more
leverage not less
IRR—
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Bank will say:
1. Put down more equity, better debt to equity
ratio/means if asset values tumble, their loans
protected by your equity since in Bankruptcy,
Foreclosure or Power of Sale proceeding, secured
creditor (the Bank) gets paid first
2. If only had one unit instead of five and becomes
vacant, your income from other sources may be
enough to cover loan payments but if coping with all
five units becoming vacant, under water
IRR—
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Known as cashflow coverage for loan
Your free cashflow as calculated by Lender
must be significantly greater than monthly
mortgage obligations or won’t make the
loan
Lenders usually only include half rental
income and will deduct from your
employment and other income, other
monthly obligations like home mortgage,
car payments and student loans
Cap Rate—
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Most real estate professionals do not use IRR
however
Use Cap Rates to compare one project with
another
Cap Rate (‘Capitalization Rate’) approximate
measure, as all financial measures are
Cap rate, r = (NOI + Mortgage PMT)/S.P.
Cap Rate—
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One way to look at inverse of Cap Rate,
approximation for number of years it takes
to earn back your capital
Widely used in commercial real estate sector
Higher Cap Rate, better for Buyer and worse
for Seller
Cap Rate—
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Total ROE = ROE (Cash-on-Cash Portion) +
ROE (General Real Property Inflation) + ROE
(Average Principal Repaid) + ROE (Tax
Advantage on Unearned Rents)
Cap Rates only measure first variable
IRR first three
Maple Leaf Design and Construction (An Example of
Bootstrapping)
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Bootstrapped their way to success
Source of capital (essentially supplier credit)
Friendly landowner provides options on land, basically at no
cost
Owner gets paid by home buyer not Maple Leaf
Self Capitalize
-why?
-VC-funding is hard to get and takes a lot of time
-also, you may end up losing control of your business
-VC funded biz are just large biz w/ 0 revenues
-power comes from having real clients/real cashflow
-if you do go for financing and you do it at the mezzanine
stage, you’ll have more leverage
-Maple Leaf Design and Construction
Brain Saumure, B. Arch (CU and SOA)
Fred Carmosino, B. Com (Sprott)
-No serfdom for Brian: wanted to be his own boss
because he could create more interesting work for
himself than others could create for him
-Started with $0
Maple Leaf Design and Construction
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Option on lots
Sweat equity: summer in a trailer with plans, signs and
Agreements of Purchase and Sale
Pre-sell
Collected deposits
Now have $$$ in their bank account– impressed with a trust
Used homeowners credit scores to get construction financing
What is cheaper? Debt or Equity?
Debt.
What is cheaper than debt?
Bootstrap Capital (e.g.: Trade Credit,
Deposits,…)
They’re FREE!
Reverse out the work
-the Internet is the most important new invention of the last 50 years
-it is where electrification was at same stage, 20 yrs in
-create custom outputs from standard inputs (e.g. new age virtual
home builder)
-reverse out the work to customers and suppliers
-match making
-mass communicate at ~ no cost (Twitter, FB, blog, Skype, email, IM,
messaging,…)
-Crowd sourcing (voting on designs)
-user generated content by customers (and suppliers) e.g.:
YouTube, Twitter, FB, Reddit, Digg & Threadless (suppliers:
artist community submit t-shirt designs voted on by
customers)
Virtual home builder:
-tried in 2000 to get home builders to do this
-very conservative industry
-put lots available and designs online in a
physics engine together w/ all
options/finishes
-allow everyone to use physics engine
-go online: choose lot, design, fit-up, finishes
(carpet, tile, kitchen cabinets, lighting
package, plumbing fixtures, etc.)
-put cash register online too
-consumer can see what granite or concrete
counter tops add to cost
-can fool around for 30+ hours
-then hit “submit” button
Homebuilders fear putting prices online – their
competitors might find out!
Ever heard of “Secret Shoppers?”
-Put CPM (schedules) online: let customers see
where their home is at and let suppliers see
too when they’re needed for Footing and
Foundation, framing, roofing, windows,
electrical, plumbing, insulation, dry wall,
paint, carpet, cabinets,…
-As more options are available, more users will visit the site, as
more users visit the site, more suppliers come onboard and
you have a virtuous cycle
-Now “Best Homes 4 U” is enjoying network effects
-Suddenly, the flow of cash could reverse direction w/ suppliers
becoming advertisers and sponsors
More about Best Homes 4 U:
-Allow lawyers access for e-closings
-Allow lenders access for e-funding
-Now if your WS attracts 10,000s of visitors,
you can get your suppliers and your
suppliers’ suppliers to pay for ads so more
people will buy higher-end products
(chandeliers, beveled mirrors, granite,
counter tops, home theatre,…)
-more options => more people => more
options => more people…
-In a virtuous, self-reinforcing cycle (Google is
also an example of Network Effects)
-30+ hours in Design Centre with clients can
become just 60 minutes
-Imagine the productivity increase for
homebuilder sales staff, lawyers, mortgage
lenders, the GC, the foreman (Worst problem?
Homebuyer questions about when this or that
happens..), suppliers, trades, subs, …
Also, customer satisfaction increases since:
a)
b)
they get EXACTLY what they want,
they feel they had a hand-in its creation
(like Aunt Jemima Pancake Mix: just add
eggs and milk).
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The folks who bring you this pancake mix famously
had an erroneous insight years ago—they thought
that by adding powdered eggs and milk to their mix
and eliminating the instructions “Just add eggs and
milk”, they could save the busy consumer time and
sell more product
It turned out that homemakers liked adding ‘real’
eggs and milk: first, they thought it was healthier
that powdered eggs and milk and, second, they
wanted to be involved in ‘making’ their kids’
breakfasts
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For most kids, you are what you do for them
By taking this away, sales went down not up
Best Homes 4 U, by involving the consumer in the
design of their own home are catering to a deep
seated need in humans to ‘buy-in’
This is a powerful lesson for tech—giving
consumers the power to customize products and
services is big business. For example, Dell is
currently using Threadless.com’s platform to allow
artists to submit and prospective customers to
select winning designs for laptop covers
Highest and Best Use—
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Many models developed as organizing
principles for villages, towns and cities
First villages probably founded by handful
of families joining together for mutual
protection
Division of labour increases well being of
village
Those better skilled at farming, hunting,
gathering, flint knife carving or producing
textiles would specialize in those tasks
Highest and Best Use—
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Improvement in wealth of village from intravillage trading
Over time, surplus develops in one village
led to trade with other nearby villages which
had own specializations
As cities, towns and villages grew, problem
of how to efficiently organize became more
pronounced
Highest and Best Use—
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Spatial organization of city, at various times,
been based on: a) religious or other forms
of hierarchical systems, b) defense
principles, c) royal edict, d) class or race
based systems, e) guild based separation, f)
fiat based systems (a master planned
community with its zoning codes is an
example of this), g) FOB (Friends of the Boss
– Mayor, Fire Chief, Chief of Police and so
forth), or combinations of above
Highest and Best Use—
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Structuring cities based on principle that
each individual parcel should be put to
highest and best use prominence over the
last century
highest and best use is use or combination
of uses that produces highest land rents
Comparative analysis of costs and benefits
of alternative projects; project that produces
highest IRR (Internal Rate of Return) is
arguably right use for subject property
presumably also produces highest land
rents
Highest and Best Use—
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Rule is also ‘DAD rule’– Dollars are
Democrats rule
DAD rule, persons or organizations that
have the where-with-all to develop parcel to
highest and best use will also be those
willing to pay highest price for lands or
highest land rent
Implies: a) land supply rationed using price
mechanism, b) anyone can participate
irrespective of race, creed, gender or
religion and c) lands used efficiently at
greatest intensity and density
Highest and Best Use—
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Land limited resource and should be used
efficiently
Seems self-evident
Remarkable how often neo-urbanists run
into the NIMBY mentality, not-in-my-backyard syndrome
Highest and Best Use—
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Dunrobin Village Plaza OMB Hearing (I
am opposed because I don’t want it)
Robertson Mews OMB Hearing (walking
the dog, golf playing)
Dunrobin Lake (You got any evidence?)
Palladium OMB Hearing (10th anniversary,
I was never an opponent)
Highest and Best Use—
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Modern’ alternative seems to be to place all
our faith in all-seeing, all-knowing master
planners and zoners to dictate how cities
grow, change and develop
This is just another form of FOB, Friends of
the Boss
Zoning actually keeps entrepreneurs out
Best friend of large developers
Same as Rent Control (Minto experience)
Highest and Best Use—
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Nimbys are Wrong to Oppose Mixed Use and Higher
Densities
Nimbys fear growth and sprawl
Also oppose densification and intensification
Highest and best use rules imply an increase in city density
over time as urbanization increases and population grows
Rent curves, measured cross-sectionally at any point in
time, tend to peak in the city centre and fall towards the
urban/rural boundary, all else being equal
As city expands outward over time, overall demand for all
types of land uses and demands on the public room,
increase
Rent curves tend to secularly increase as demand for land,
apartments, commercial and institutional space increases
Highest and Best Use—
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If this were not true, the rent curve (and density
gradient) of a place like Manhattan would not look
significantly different from, say, a town like Ottawa
To meet such demand, landowners are inclined to
increase the density of built form
Rents for existing housing stock and commercial
property are secularly increased from this
combination of greater demand, intensification and
densification
Creeping commercialization of residential areas, the
addition of commercial uses to homes and more
mixing together of various uses will, prima
facie, also contribute to rising rents
Highest and Best Use—
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As long as public order and safety are maintained,
home owners should not fear densification or
mixed use coming to their neighborhood
Land rents will go up and property values will go up
not down
If a new office tower is constructed nearby, more
would-be potential homeowners or renters have
just moved into your community
Demand for housing in the area goes up and so do
prices
Highest and Best Use—
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Densification and increased mixing together
of different land uses (aka, intensification)
make for more interesting communities;
ones that better support public
transportation and can be safer too
It makes no sense to construct single
purpose suburbs made up exclusively of
single family homes where no employment
uses are permitted