2) Explain the feasibility analysis provided in the case and critique it as a basis for
decision-making. Your critique should include both a discussion of what is wrong
with the technique, as well as what may be wrong with the assumptions within the
specific application of the technique.
Exhibit 17 presents the results of Slater and Lenard’s back-of-theenvelope financial feasibility calculations. As described in the
case, this analysis begins with the NOI that the proposed
property would generate were it in existence today. With
information on the property’s NOI, along with assumptions
regarding currently available mortgage finance terms, Slater
and Lenard calculated that they could spend up to $1,624,084
for site acquisition and the project would be financially
feasible. The Feasibility Technique3 There are several
problems with the simple feasibility analysis conducted by
Slater and Lenard.
1)Time. The feasibility analysis does not consider the time value of
money, even though it could be several years before the first tenant
moves in. During this time, the developer is spending either his own
capital or drawing on a construction loan to complete the project, a
cost that is not captured in the analysis. Additionally, the income and
expenses of the completed building will change over time due to
inflation and changes in the real estate market. The NOI of the
completed building may be quite different than what it would be if it
existed today.
2)Valuation of completed building. The feasibility analysis assumes
that the value of the completed building will be equal to the sum of
its costs (construction + site). If this were true, development would
never create any value, meaning that no one would risk their capital
to do it. On average, the completed value of real estate developments
must be greater than the sum of their costs.
3)Rent. The rent assumption is reasonably aggressive. While it is
true that a luxury property might be able to command premium
rents, it is also true that those rents will be particularly sensitive to
location, which has not yet been determined.
Vacancy/credit. The vacancy assumption is low, but not entirely out
of line with the market. However, students may wonder whether
high-priced apartments will have the same vacancy as those priced
more moderately. Parking. Will students need and/or be willing to
pay for parking in a walk-to-campus location?
3) Suppose instead you were considering developing to a yield on cost. In other
words, you would be willing to make an investment into the development project
as long as the annual cash flow of the property was at least 5.2% of the total
development cost, where cash flow is measured at project completion and the time
of development cost is ignored (except for when calculating construction loan
interest). Development costs include both hard and soft costs, as well as interest
on any construction loan. Assume that Lenard can finance hard development costs
with a construction loan that charges 6% interest to repaid upon project
completion. The first draw on the construction loan is made to pay for the
demolition, with twelve subsequent draws evenly spread to cover the remaining
hard costs. You may assume that the property’s net operating income (NOI) is
growing at 3% per year and that property CapEx (capital expenditures) is 20% of
NOI. Discuss the merits and deficiencies of using this approach to determine the
appropriateness of a real estate development project. Justify any additional
assumptions you must make to complete your analysis.
The “Yield on Cost” tab in the Instructor Spreadsheet contains the
required calculations for determining a supportable site acquisition
cost that is consistent with the project being completed with a 5.2%
yield on cost.
The calculations deserve a few comments:
Why 5.2%? A yield on cost is the ratio of the
property cash flow upon project completion divided by the
total number of dollars it took to develop, including site
acquisition, hard and soft development costs, and any
financing costs. This should approximate the cash flow yield
on the completed property, which is its cap rate less capital
expenditures. Data in Exhibit 11 of the case indicate that the
property might be expected to be valued upon completion at a
6.5% cap rate. With a 20% CapEx share, this rate would
deliver a 5.2% cash yield.
NOI at completion is calculated by grossing up the
NOI given in Exhibit 16 for 20 months at a 3% annual rate. Of
this amount, 20% is then assumed to go toward CapEx.
The supportable site acquisition cost is therefore the
amount a developer can spend on the land such that the
property cash flow is at least 5.2% of the total project cost,
including land, hard and soft development costs, and
construction financing. This is calculated to be $1,653,258.23.
Merits of the Yield on Cost Approach
There is a partial adjustment for the time value of
money. In the yield on cost approach, property income and
cash flow are projected to the level they will reach upon
project completion, which accounts for the time to build.
The approach incorporates financing costs into the
analysis.
It is simple. Deficiencies of the Yield on Cost
Approach
There is only a partial adjustment for the time value
of money. In the yield on cost approach, construction costs
and financing costs are not adjusted for the time at which they
occur.
The approach overemphasizes the initial cash flow
yield of the completed property.
It does not consider the required rate of return on
equity. In particular, it fails to consider the systematic risks
of the project.
Cash flow yield is measured relative to cost, but it
would be more appropriate to compare cash flow to property
value. Thus, the analysis implicitly assumes that the project
value at completion will equal the cost of the project.
4) Develop a pro forma for the completed apartment complex and estimate its
value at completion. Justify any additional assumptions you must make to
complete your analysis.
In creating a pro forma, students will likely accept the revenue and
cost figures in Exhibit 16 as a good starting point. However,
those figures were calculated as of December 2012, and the
building is not scheduled to be completed and occupied until August
2014. Therefore, students must determine the relevant growth rates
over the next twenty months and increase the figures in Exhibit 16
accordingly. Students then must make assumptions regarding the
growth rate of both income and expenses over the subsequent ten
years. The pro forma also requires assumptions regarding vacancy
and credit loss. Perhaps most important to the building valuation
calculation are assumptions regarding the exit cap rate and the
property-level discount rate. The assumptions necessary to complete
a pro forma valuation of the property are highlighted in blue on the
“Pro forma” tab of the Instructor Spreadsheet. Note that with an exit
cap assumption of 6.5%, a long- run growth assumption of 3%, and
a CapEx share of NOI of 20%, the long-run discount rate must be
8.2%. With these assumptions, the value of the property upon
completion is estimated to be $4,385,686.
In practice, each of these assumptions should be supported by
analysis of the given line item. How much does it cost to heat the
common areas in a fifteen-unit building in Madison? What is the
likely growth of property taxes? The case mentions that Lenard has
analyzed each line item, so for the purposes of the teaching note, the
only adjustment being made in the pro forma is to apply a growth
rate. However, instructors should seek out opinions from their
students regarding the assumptions made in the case and whether or
not they might have thought through the given assumptions
differently.
5) Estimate the net present value (NPV) of the development project as a function
of the cost of land. Assume that you will always pay the soft costs and that you
will definitely make the draws on the construction load that you calculated in
Question 3. Further assume that the construction loan itself was zero NPV to the
lender and that the risk-free rate is 3%. How much can pay for the land so that the
development is zero NPV? What internal rate of return (IRR) will a developer
achieve with a zero NPV investment into this development project? Justify any
additional assumptions you must make to complete your analysis.
Hard Costs
To complete an NPV analysis of the development project, students
have to discount the costs of construction. The timing of these cash
flows were already used in the yield on cost analysis above and are
calculated on the “Construction loan table” tab of the Instructor
Spreadsheet. For the construction loan to be zero NPV to the lender,
the lender must receive a risk-free rate of return on the draws it
knows the developer will make. Thus, the present value of these
costs can be calculated by discounting the loan draws at the risk-free
rate of 3%.4
Soft Costs
Exhibit 14 indicates that soft costs are assumed to be paid in equal
amounts over the twenty months of the development process. With
soft costs assumed to be 3.25% of total hard costs, this can be
calculated as $4,065.02 each month, beginning in January 2013 and
continuing through
August 2014. The question assumes that you always pay these costs.
Therefore, they are risk-free and must be discounted at the risk free
rate of 3%.
Sales Proceeds
As described in the pro forma, the building is to be sold in August
2014 for an estimated price of $4,385,686. Students may also make
an assumption regarding sales commissions, which would reduce
sales proceeds and thus, the present value of the building. The
appropriate discount rate for the property sale is the discount rate on
property-level cash flows. As was done in the pro forma, the
teaching note assumes that this discount rate is 8.2%.
As shown in the “NPV” tab of the Instructor Spreadsheet, the NPV
of the development process is $1,261,828.32. This implies that a
developer can pay up to this amount for the land and the project will
still have positive NPV.
Note that the spreadsheet also calculates that at a zero NPV purchase
price for the land, the developer earns a 17.12% IRR. This is much
higher than the 8.2% return on the property because of the
operational leverage in the project. The purchase of land implicitly
allows you to borrow against the future value of the building.
6) Now consider the problem as a real option. Assume that a plot of land in
Madison gives you the right, but not the obligation, to build this particular luxury
fifteen-unit apartment building at any time during the next ten years. The strike
price is the present value of the construction cost, which you calculated in
Question 5. You should further assume that these costs are growing at 3% per
year. The underlying asset value is currently the price of a property valued in
Question 4 if it existed today. Using the binomial option pricing model, estimate
the maximum price you should be willing to pay for the necessary land. At this
price, is the NPV you calculated in Question 5 positive or negative? Qualitatively
explain the relationship between the price of land that delivers a zero NPV in
Question 5 and the price of land you calculate in Question 6. Assume a risk-free
rate of 3%.
Students are expected to be familiar with the binomial option pricing
model before completing this section. As mentioned earlier,
instructors wishing to teach a module on real options in a real estate
context are invited to consider the “Right of Acquisition” case. The
teaching note for that case provides a detailed description of the
binomial model and how to implement it.
Three tabs in the Instructor Spreadsheet are devoted to this problem.
The assumptions are in the “Options assumptions” tab; the potential
evolution of the built property price is shown in the “Property price
tree” tab; and the option (land) valuation is completed in the “Option
price tree” tab. Note that many of the assumptions are derived from
calculations made in earlier sections.
The problem instructs students regarding some of the specific
assumptions. For instance, students are told to use a 3% risk-free
rate and a 3% growth rate in construction costs. The strike price is
given as the present value of construction costs, which had been
calculated with the project’s NPV. The dividend yield is calculated
by dividing the property cash flow during its first year of property
operation by its price. The only assumption for which the case and
problem provides no guidance is the volatility to the return on a
luxury apartment building in Madison, WI. Much more discussion
on property volatility is given in the teaching note for “The Right of
Acquisition.” Here, it is important for instructors to notice that at
20% volatility, the option price is calculated as $1,261,828.32. This
is exactly the same as the land price calculated in the NPV analysis.
Why? The simple answer is that this option (the right to build a
property worth over $3.8 million for around $2.5 million, both in
present-value terms) is deeply in the money. With these parameter
values, it is optimal to exercise the option and develop the land
immediately. Thus, the “option” value of the land is zero. Note that
delaying development, which would only be optimal if the land
value was greater than its value with immediate development,
becomes optimal with sufficiently higher volatility or sufficiently
lower growth in construction costs. This is illustrated with a simple
data table at the bottom of the “Option assumptions” tab. Students
who have calculated that the value of the land is greater under the
real options approach must conclude from the model that delaying
development is optimal. Under those circumstances, simply doing an
NPV analysis would be incorrect, because it neglects the value
associated with the option to wait to develop in future periods.
7) In light of your previous calculations (and any additional qualitative reasoning),
describe whether or not you believe that Slater and Lenard will be able to earn an
appropriate rate of return (or more) by pursuing the project.
Both the NPV and options analyses indicate that the price of the land
that would give Lenard and Slater an appropriate risk-adjusted rate
of return is $1,261,828.32. Given that the developers want to
purchase three parcels in order to develop their apartment building,
it seems unlikely that this low land acquisition cost can be achieved
with the prevailing prices for existing single-parcel buildings.
This conclusion, however, rests on the assumptions that led to the
given value of the land. It could be that students have made other
assumptions regarding discount rates and other factors that led them
to derive a sufficiently high land price, so that it exceeds the cost of
three parcels of land. One strategy for an instructor is to review these
assumptions and potentially challenge those that seem to have
generated the higher land valuation. In the discussion of this final
question, however, it is recommended that the instructor spend time
discussing potential factors that are not captured well by the specific
analysis completed. These include the following:
Holdup problem. The case acknowledges that Lenard and Slater
require three adjoining parcels for their proposed apartment
development. In practice, how would they make such an acquisition?
Is it ever likely that in such a “hot” market three adjoining properties
would simultaneously be for sale? If not, one can imagine the
developers approaching current owners with an offer to buy their
property. To the extent that neighbors talk to one another, they will
probably learn that the viability of the project rests on the ability of
the developers to secure three properties. What incentives does this
create for the owner of the crucial third parcel? Such an owner may
realize the significance of his property and hold out for a greater
price than he would accept on a single transaction. While there may
be contracting ways around the holdup problem, such approaches
may be more costly and more time- consuming than what the
developers have budgeted for.
Seasonal student housing. The discussion of risks mentioned that
idiosyncratic factors (e.g., weather) may delay the project. Although
it is true that such risks would not influence the discount rate, they
may conceivably have an important influence on expected cash
flows. In a standard commercial development, a delay of one month
is likely to do little more than stall the receipt of cash flows by one
month. However, student housing is very much tied to the academic
calendar. Students need housing in the fall. If the project is not
completed before the start of the academic year, the developers may
have to wait another entire year before receiving significant cash
flow.
Purchase answer to see full
attachment