Debt Capital
what you owe; what you borrowed to buy the investment
Equity Capital
what you own; what you have in the investment (down payment)
Investment
The pursuit of a future return by delaying consumption and taking risk.
Real Estate Investment
The use of debt and/or equity to purchase an income producing property. (Exception: REIT stocks)
Holding Period
the time you hold onto the investment
Discount Rate
required rate of return on the investment
Capitalization Rate
annual rate of return on the investment
Periodic Cash Flow
expect to make rent each month
Price Appreciation
expect the price of real estate to go up
Diversification
real estate is a good diversifier; it does not correlate with other investments
Increase equity through mortgage reduction
people increase ownership as they pay down their debt; you're making money with the banks money
Tax Shelter
you can save on your income taxes
Leverage
increases your returns by using the banks money; to make higher returns
Hedge against inflation
real estate tends to go up with inflation; doesn't devalue us like it devalues the dollar
Estate building
build a large amount of real estate and give it to your heirs
Pride of ownership
having your name on a billboard
Cash-Flow from Operations
On-going rent collection and payment of operating and other expenses.
Cash-Flow from Reversion
Cash received when investment property is sold.
What is PGI?
the maximum income you can make on the property; making the money from rent
Building Area for collecting rents
NLA - Net Leasable Area
Vacancy
typically expressed as a % of PGI
What are the differing types of Vacancy?
Unrented space
Natural Vacancy (Turnover)
Collection Loss
Effective Gross Income - EGI
Anticipated income from the operation of a property after adjusting for vacancy and collection losses.
Fixed Expenses
an expense that does not change with occupancy
Variable Expenses
an expense that does change with occupancy
Replacement Reserves
money you save to pay for short-lived items
Net Operating Income - NOI
Anticipated income from the operation of a property after adjusting for operating expenses.
Before-tax cash flow
income after debt service
After-tax cash flow
income after income taxes
Reversion
the cash you make on the sale of real estate
Real estate investors are active and passive
Decide if you want to do it full time or just a side investor
Nonfinancial assets can generally be broken down into 3 categories
Real Assets (Durable Goods)
Human-related Assets - inheritance, pensions
Other Assets - collectibles, jewelry
What is a capital expenditure?
purchase for the replacement of short lived items
We should consider these our "outlays" for real assets and human-related assets.
How do we evaluate capital expenditures?
We use the "CF" key similar to our calculation of IRR in the financial assets chapter except now we look at NPV
What does NPV mean?
Discounted value of future cash flows; both cash inflows and outflows
What is the decision rule on evaluating investments?
You want NPV to be greater than zero
What is a discount rate?
Required rate of return
How do we decide on our discount rate when evaluating assets?
A typical return for that type of real estate
What does IRR mean?
Rate when your NPV is zero
The rate you make when your cash inflows equal your cash outflows
What is the decision rule for IRR?
Compare it to the discount rate
Profitability Index (PI)
To compare two investments
Important b/c two different real estate investments can require two different amounts of cash
No two investments are typically the same amount of money
Leasing vs. Owning the Home
Little short term liquidity
Maintenance/Taxes/Insurance/Loan Costs
Price Volatility
Tax Savings
Pride of Ownership
Inflation
Operating Expense Ratio (OER)
TOEs/EGI - total operating expense/ effective gross income (income after vacancy)
How much you're spending on operating expenses as opposed to your income - make sure you're making money - shows you home much those mandatory costs are costing you
Not good
Is this better if OER is low or high?
lower
Debt Service Coverage Ratio (DCR)
NOI/DS - income after operating expenses/debt service - can we cover our debt annually
A typical DCR guideline
DCR > 1.25
Why not just greater than 1? - we need that cushion; what if you lose some tenants, income will go down, need cushion to make sure you can cover that debt; if renters tear up rental house
Breakeven or Default Ratio (BE/D)
[TOEs + DS] / EGI - shows you if you're making money at all
BE/D < 0.9 is a typical guideline
Total Return on Investment
NOI / Price or Value -
What does this represent? - cap rate, ROI
What should we compare it to in our analysis? - discount rate, required rate of return
Equity Dividend or Equity Capitalization Ratio (EDR or ECR) (like ROE)
BTCF/ Initial Equity (Eq0) - what you're making on your down payment; the cash you're taking home vs. the cash you put in the project; should be higher than cap rate
This is sometimes called the "Cash on Cash" return.
Real Estate Development
The construction of new buildings and/or the renovation of existing buildings
What is the Personality of a Developer?
Risky
Large Debt
Constant Changes
Creative
Design - building green, sustainable
Financing - get money from different places
(private equity, bank loans, go public/get
stock)
Marketing - know your product
Flexible
Be ready to negotiate - price
Be ready to
Conserve capital
hold your money back until the very end, until you finish; use the bank's money or your client's money first; you can overcome cost overruns with your own money; appliances are expensive at the end
Mitigate risk
put the risk on everyone else that is involved instead of on you the builder; put the contractor's name on the loan; take bids for jobs
Maximize profit
looking for 10-15%
Land Developers
buys lands and develops it to sell lots or a commercial development; buys a lot and develops it into a site (utilities, access, roads, clearing); banks don't want to loan on it; people are more apt to buy the finished product than a patch of dirt
Speculative Developers
builds w/o a buyer
Fee Developers
builds with a contract for a buyer; customer builders
Renovators and Converters
refurbishes an existing building
Real Estate Development Process
Conceive a Development Project
Feasibility Analysis
Planning and Contract Negotiation
Financing/Formal Commitment
Project Construction
Manage the Asset
Use in Search of a Site
you know what you're going to build you just need to find the right site (happens 95% of the time)
Site in Search of a Use
you have the site and you're looking for the best use for it - highest and best use analysis
Elements of Feasibility Analysis
will it work, is the process feasible
Site Analysis
analyzing the lot to see if our development is possible
Market Analysis
analyzing the market to see if the development can be supported by the market
Financial Analysis
can we afford it and make money
Zoning
see if you can change
Title
make sure it's a clear title
Environmental issues - Phase Assessments (3 steps)
1. History - any spills etc.
2. Soil Borings - bore and test soil
3. Remediation - clean soil
Subsoil conditions
can it hold what you're going to build
Easements / Utilities
parking, retention pond, where utilities can go
Existing Stock
makes sense to join the competition in that area
Building Permits
any new competition coming in at same time, more important b/c new is better
Vacancy Rates
you're likely going to have the same as everybody else
Traffic Counts (Retail)
see how many possible customers
Market Rents
need to be in line with the market rent
Step 3 - Planning and Contract Negotiation
This is the last chance to back out before a big financial commitment is made.
Negotiate the Sales Contract on the Land
Finish or Refine the design and obtain approvals
Architects, Landscape Architects, Engineers: finalize the design
Government: make sure you get the permits and pass the zoning
General Public: sometimes have to satisfy the neighbors so they don't complain and stop you
Construction Loan
pay to build the building; short-term loan (6 months-2 years)
Permanent Mortgage
either the developer or the buyer; long-term loan; ex. mortgage, bank note
Mezzanine Financing
private equity money that is hybrid debt; if the builder needs more cash than what they're getting from the bank
Site preparation
make sure the sites have utilities, access, etc.
Actual "improvement" construction
build house or warehouse etc.
Tenant improvements
finishing touches of the construction; won't finish it out all the way until they do this; build to suit - commercial
Certificate of Occupancy
government approval to move in
Sell or Lease?
Selling happens more often
Sell more often during hot markets, lease more often during a cold market/ recession
Some develop just to rent; more investors than developers
Real Estate Development pro/con
Generally, one of the most profitable of the real estate professions.
Generally, one of the most risky with a large chance of bankruptcy.
Zoning
see if you can change
Type I Construction
-Fire resistant: What materials? - concrete or steal, maybe brick
-Designed to contain fire to a single floor
-These are typically multi-storied buildings with multiple exits.
Type II Construction
-Noncombustible: What materials? - concrete and steal, maybe brick; roof could catch on fire
-So what makes it different than Type 1?
Roof deck or covering is combustible.
-These are typically warehouses, arenas, newer churches, etc.
Type III Construction
-Ordinary construction: What materials? - wood, bricks, stucco, maybe some concrete, typical wood frame w/ maybe brick or concrete on outside
-What do I mean by: A lumberyard enclosed by four block walls. - inside is wood and outside isn't going to burn
-
Type IV Construction
-Heavy timber: What materials? - wood
-What makes them different from type 3? - does not have enclosed spaces, no insulation, heavy timber like lodges, exposed beams on the inside
-Typical buildings are mills, warehouses and older churches. Why would thes
Type V Construction
-Wood frame: What materials? - wood interior walls, any kind of outside
-Why are most modern buildings built this way if possible? - cheaper
-Typical buildings are residential homes, multi-family apartments, hotels, etc.
Foundation
This is probably the most important part of construction as it is holds up the rest of the structure.
Slab
formed by concrete and footings sunk in the earth (soil bed)
Crawlspace
also known as pier and beam as it is made with concrete footings, post and piers and an exterior wall. - easier to work on utilities
Basement
combination; crawl space below the slab
Foundation - Purposes
-Anchors the building down where it can't fall over
-Holds the weight of the building up; provides stability
-Keeps infestation out (termites)
Framing
This is the walls of the structure (from top to bottom) that is used to provide stability and for the design of the building. This framing is generally made with steel or concrete in commercial buildings and mostly wood in residential buildings.
Girder
weight bearing framing
Joist
horizontal framing
Rafter
roof framing
Sill
framing that separates openings; windows and doors
Stud
vertical wood framing, 16 inches apart
Framing - Purpose
-Insulation
-Room design and layout
-Holds and transfers the weight from the roof to the floor; stability
Exterior Walls
The outer wall exposed to the weather. (Has 2 components); sliding and sheathing
Siding
Brick veneer
Concrete
Vinyl siding
Stucco
Wood siding
Prefabricated Metal
Sheathing
Nailed to the studs to support the siding. (i.e. plywood, foam) (Also provides a moisture barrier and insulation)
Roofing
Top cover of the building consisting of rafters or trusses, sheathing and exterior covering and trim.
Typical roofing designs
Gable
Hip
Flat
Typical Roofing materials often include
asphalt shingles
metal
cedar shakes
tar and gravel
slate
Roofing - Purpose
-Keeps out elements; rain and snow
-Place to provide insulation for your home; keep the heat in
-Design and color
Ventilation
-A building must breathe. It needs moisture to be taken outside.
-Typical methods include attic fans and vents, hood in the kitchens, ridge vents, weepholes in the exterior walls, crawl space vents, etc.
-This is done to prevent mold growth, paint peeling
Insulation
-This maintains temperatures inside the building. It cannot stop heat flow, but can slow it down. Insulation is generally rolled or blown.
Plans
blueprints showing the design of a house
Specifications
list of materials needed to build the house
General Contractor
builder of the home
Subcontractor
help build individual parts of the building
Gross Living Area (GLA)
heated and cooled area above grade (land); does not include basements
Gross Building Area (GBA)
square footage under roof; adds the basement, attic, garage, porches
Gross Leasable Area (GLA)
area that is leasable or rentable; tells you what you are using not necessarily the whole building (not hallways, elevators, public entries)