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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.
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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 discloses the results of Slater and Lenard’s crude
financial feasibility calculations. The analysis begins with the NOI
that the suggested property would produce, if the property actually
existed. Slater and Lenard calculated that they could spend up to
$1,624,084 for site acquisition and still be financially feasible. The
Feasibility Technique3 They made this calculation based off of
information on the property's NOI and assumptions about the
currently available mortgage finance terms. However, there are
several problems with Slater and Lenard's calculations.
The first problem Slater and Lenard did not take into account
is time. Specifically, their analysis does not consider the time value
of money, or that it could be several years before the first renter
moves in. During the time when there is no one renting the property,
the owner is either spending his own capital or drawing on a
construction loan to complete the project, a cost that is not
adequately calculated in the analysis. Along with that, the income
and expenses of the property will inevitably change over time due to
changes in the real estate market and inflation. Thus, the NOI of the
property may be very different than what it would be if it existed
today.
The second problem they did not consider is the valuation of
completed buildings. Ultimately, the calculations expect that the
value of the building will be equal to the sum of its costs
(construction + site). If this were actually true, though, no one would
risk their capital on development, as development would never
create any value. Ultimately, the completed value of real estate
development, generally needs to be greater than the sum of their
costs.
Also, the rent assumption is considerably aggressive. Although
luxury properties might be able to charge premium rents - and do
well, those rents will be sensitive to location, which has not been
determined in the analysis.
The last problems are vacancy and parking. The vacancy

assumption is low, but does not completely deviate from the market.
However, students could wonder whether high-priced apartments
will have the same vacancy as more moderately priced apartments.
In regards to parking, the question needs to be asked it students will
need or be willing to pay for parking, if they are within walking
distance of the campus.
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 needed calculations for determining an acceptable site
acquisition cost that is consistent with a project being completed
with a 5.2% yield on cost.
There are several comments that can be made about this. First,
why 5.2%? A yield on cost is the ratio of the cash flow upon project
completion divided by the total amount of money spent. Money
spent includes the amount it took for site acquisition, development
costs, and other financing costs. This should approximate the cash
flow yield on the property, which is its cap rate minus capital
expenditures. Data in Exhibit 11 of the case indicates that the
property might be expected to be valued 6.5% cap rate upon
completion. With a 20% CapEx share, this rate would produce a
cash yield of 5.2%.
NOI at completion is calculated by grossing up the NOI given
in Exhibit 16 for 20 months at a 3% annual rate. 20% of this amount
then goes toward CapEx. Therefore, the supportable site acquisition
cost is the amount a developer can spend on the land as long as the

property cash flow is at least 5.2% of the total project cost, including
land, 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 In the yield on cost approach, neither construction
costs nor financing costs are adjusted for the time at which they
occur. The approach embellishes the initial cash flow yield of the
completed property. Also, it does not take the required rate of
return on equity into account. Specifically, it fails to consider the
systematic risks of the project. Although cash flow yield is
measured relative to cost, it would be more appropriate to compare
cash flow to property value. Thus, the analysis 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 probably accept the
revenue and cost figures in Exhibit 16 as a starting point. However,
those figures were calculated in December 2012, and the building is
not scheduled to be completed and occupied until August 2014.
Therefore, students have to determine the necessary growth rates
over the next twenty months and increase the fi...


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