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3/27/23

Real Estate Finance and Investment

FIN549

Product Types Investment Cycles Investment Strategies Risks Investment Analysis Commercial Leases CRE Cash Flow Components Investment Decision Making (IRR/Multiple/ROE) Cap Rates Leverage Loan Docs Structuring

Agenda C O U R S E O B J E C T I V E

Class #2

Readings: Chapter 4,5 Prerequisite #2

Product Types

Single Family Detached Cluster developments Zero lot line developments

Multifamily High rise Low rise Garden apartments

Residential P R O D U C T T Y P E S

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Non-Residential

Retail Regional shopping centers/malls

Neighborhood centers

Community centers

Strip centers

Specialty /lifestyle centers

Discount/outlet centers

Warehouse/ Industrial Heavy industrial

Light industrial warehouse Office/warehouse

Warehouse: Distribution Research & development (R&D)

Flex space

Office Major multitenant (central business district)

Single or multitenant- suburban

Single tenant - build to suit

Combination office/showroom

Professional- Medical specialized use

Hotel/Motel Business/convention

Full service

Tourist/resort:

Limited service

Extended stay

All suites

Recreational Country clubs Marinas/resorts

Sports complexes

Institutional (special purpose)

Hospital/convalescent Universities Other

Mixed Use Developments Combinations of the above uses

P R O D U C T T Y P E S

Strip Center: Ranges from 10,000 to 200,000 square feet and may be dependent on a single anchor tenant. Strip centers often have out parcels detached from the main building.

Community Retail Centers: Generally 150,000-350,000sqft and have more than one anchor tenant.

Power Center: Several big-box retailers, such as Walmart or Staples, and is most commonly located outside a city or in the outskirts of a major urban area, where land is cheap.

Retail Properties P R O D U C T T Y P E S

Regional Malls: largest type of retail property, ranging from 400,000 to 2,000,000 square feet. Regional malls do well when they successfully maximize a customer’s shopping experience by offering a complementary tenant mix (with both anchor tenants and inline stores), good design, shared amenities, and well maintained common areas.

Retail Properties P R O D U C T T Y P E S

Deemed non-essential—apparel retailers, salons, gyms, and movie theaters, for example—were temporarily shut down across much of the U.S. due to COVID-19.

On the other hand, businesses believed to be essential to daily life, including grocers, home improvement stores, pharmacies, banks and gas stations, were allowed to remain open.

Savvy retailers are also accelerating their innovations in store locations, formats, layouts, branding and marketing, supporting the idea that brick-and mortar shopping is not going away — it’s just evolving.

Bifurcation: Essential and Non-Essential Retail P R O D U C T T Y P E S | R E TA I L P R O P E R T I E S

2020: omnichannel

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2021 U.S. Real Estate Market Outlook. CBRE. 2020. Accessed 5 January 2021.

Brick-and-mortar retail sales are expected to grow in 2021 as e-commerce sales decline after the 2020 COVID-fueled surge.

New opportunistic and emerging retailers will capitalize on market conditions to absorb some of the vacancies from bankrupt retailers and store closures.

Adaptive reuse and conversion will drive the repositioning of Class B and C malls, which have been hardest hit by COVID restrictions.

Bifurcation: Essential and Non-Essential Retail P R O D U C T T Y P E S | R E TA I L P R O P E R T I E S

2021: repositioning

Retail Trends P R O D U C T T Y P E S | R E TA I L P R O P E R T I E S

After plunging briefly during the lockdown at the beginning of the pandemic last spring, retail sales quickly rebounded, with overall sales (including e- commerce) recovering to pre-COVID levels by the fall and physical retailers matching pre-COVID levels by year-end. Retail spending has only continued to grow from there.

2021 PWC Emerging Trends in Real Estate

Every major category registered sales

exceeding pre-COVID levels by mid-2021.

Reimagination of Retail

2021 U.S. Real Estate Market Outlook. CBRE. 2020. Accessed 5 January 2021.

Malls will require a strategic evaluation of the highest and best use of the underlying land and demand drivers for adaptive reuse and conversion.

Off-mall big-box retailers will increasingly consider acquisition of mall sites for redevelopment given favorable pricing for prime locations.

While the fastest-growing conversion category is retail to industrial, adaptive reuse with multifamily, office and hotel components will still be viable on a market and asset-specific basis.

Alternative uses also include medical, education, cultural centers and open space.

P R O D U C T T Y P E S | R E TA I L P R O P E R T I E S

Malls

Adaptive Reuse

Alternatives

Adaptative Reuse

2021 U.S. Real Estate Market Outlook. CBRE. 2020. Accessed 5 January 2021.

Successful adaptive reuse and conversion require overcoming complex regulatory issues, as well as greater flexibility in municipal zoning and department store cooperation granting consent and modifications to reciprocal easement agreements permitting redevelopment.

To avoid the further loss of retail uses and sales tax revenue, some local and state jurisdictions may provide more public financing and subsidies for these redevelopments.

P R O D U C T T Y P E S | R E TA I L P R O P E R T I E S

Regulatory Zoning

Easements

Financing Subsidies

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Warehouse & Industrial Properties

Manufacturing Facilities: CCaatteeggoorriizzeedd aass ‘‘hheeaavvyy’’ oorr ‘‘lliigghhtt’’.. HHeeaavvyy mmaannuuffaaccttuurriinngg ffaacciilliittiieess ccaarrrryy lloonngg--tteerrmm lleeaasseess bbeeccaauussee tthheeyy aarree nnoott eeaassiillyy ttrraannssffeerraabbllee ttoo nneeww tteennaannttss..

Warehouses: UUsseedd ffoorr ssttoorraaggee aanndd ddiissttrriibbuuttiioonn aanndd aarree uussuuaallllyy llooccaatteedd nneeaarr mmaajjoorr ttrraannssppoorrttaattiioonn hhuubbss.. WWaarreehhoouusseess aarree nnoottaatteedd oonn aa ccuubbiicc ssqquuaarree ffoooottaaggee bbaassiiss ssiinnccee hheeiigghhtt iiss iimmppoorrttaanntt ffoorr ssttaacckkiinngg ggooooddss..

Light Assembly

Flex Buildings

P R O D U C T T Y P E S

Industrial Demand P R O D U C T T Y P E S | WA R E H O U S E & I N D U S T R I A L

E-commerce sales expected to increase by up to 26% by 2025, further increasing the demand to build and acquire industrial real estate.

Retail Dive, “US needs 330M square feet of warehouse space to keep up with e-commerce: CBRE”, https://www.retaildive.com/news/warehouse-ecommerce-construction-fulfillment-center/602308/, June 2021 7CNBC, “Commercial Real Estate: Warehouse Demand Offsets Vacant Office Space”, https://www.cnbc.com/2021/07/10/commercial-real-estate-warehouse-demand-offsets-vacant-office-space.html, July 2021

+26%

Construction Inflation P R O D U C T T Y P E S | WA R E H O U S E & I N D U S T R I A L

Construction cost inflation has continued to cool off from the peaks seen in Q1 and Q2 of 2022.

Engineering News Record’s (ENR) Building cost index measuring year of year inflation peaked at just above a 16% YOY inflation rate in April of 2022.

ENR’s most recent reporting in January of 2023 has this YOY inflation rate at 9.4%.

It would be typical to see this rate fluctuating between 2-4%. Consistent with the macroeconomic environment , construction cost inflation remains at elevated levels but has pulled back significantly from its recent peaks.

Slowdown? P R O D U C T T Y P E S | WA R E H O U S E & I N D U S T R I A L

The ABI is seen as a leading indicator of the health of the construction industry, as demand for architectural services is typically a precursor to construction activity.

On a forward looking note, the Architectural Billing Index (ABI), reporting by the American Institute of Architects, remained below 50 for the 4th straight month indicating architecture firms are seeing a reduction in billings/demand for services over the past 4 months, possibly signally continued softening in demand for construction services.

Generally the market for design and construction services appears to be reflective of many developers and owners “wait and see” position as many variables, including the ongoing impact of the pandemic, global economic conditions, and government policies related to, inflation, trade and infrastructure spending begin to take shape

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E-Commerce, an Outsized Driver P R O D U C T T Y P E S | WA R E H O U S E & I N D U S T R I A L

Alicia Phaneuf, Insider Intelligence, “Ecommerce Statistics: Industry Benchmarks & Growth,” https://www.insiderintelligence.com/insights/ecommerce-industry- statistics/ , July 29, 2021

It is predicted for every $1 billion in e-commerce sales made, businesses will require 1.25 million square feet of industrial space.

It is predicted for every $1 billion in e- commerce sales made, businesses will

require

1.25 million square feet

of industrial space.

Central Business District (Cbd)

Class A

Class B

Class C

Highrise

Suburban / Garden

Office Properties P R O D U C T T Y P E S

Cushman Wakefield

P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

The United States has 5.56 billion sf (bsf) of office space and inventory will likely reach over 5.68 bsf by theend of the decade.

Office Market Size

Current size of US office market

5.56 billion square feet

https://www.bisnow.com/national/news/office/return-to-work-levels-post-pandemic-high-110514

P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

A survey conducted by international architecture and design firm Gensler found that the time workers spent collaborating with colleagues fell to 27 percent during the pandemic from 43 percent before, while individual focus time more than doubled to 62 percent of time spent working.

The Physical Office and Remote Work

Collaboration fell from 43% to

27% 21

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1The Office Hub and Spoke Model is Coming, Globest.com, June 2020. Accessed 9/18/2020.

P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

CEOs are feeling the impact of COVID among their workforce.

In all candor, it’s not like being together physically. And so I can’t wait for everybody to be able to come back into the office.

I don’t believe that we’ll return to the way we were because we’ve found that there are some things that actually work really well virtually.

TIM COOK, CEO, APPLE INC.

1W hat CEOs Really Thing About Remote W ork. The W all Street Journal. September 23, 2020. Accessed 11/11/2020.

“That unplanned kind of interaction that contributes so much to how we build relationships with people and

how we build culture, those things are what are missing.

ANDI OWEN, CHIEF EXECUTIVE, HERMAN MILLER INC.

P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

More than three-quarters of those surveyed said it is of “considerable” or “great” importance to go to an office to enable effective collaboration and company culture, with more than 60 percent saying it is important to “deliver inperson coaching or training.”

EMERGING TRENDS IN REAL ESTATE® 2022, PWC, ULI

P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

The Work from Home (WFH) environment and need for additional space per employee offset each other. Ultimately, we believe that the revenue benefits from in person collaboration more than offset the savings from WFH. Further, we believe well-located suburban infill office properties are uniquely positioned to benefit coming out of this crisis.

1What CEOs Really Thing About Remote Work. The Wall Street Journal. September 23, 2020. Accessed 11/11/2020.

“What I worry about the most is innovation. Innovation is hard to

schedule — it’s impossible to schedule.

ELLEN KULLMAN, CEO OF 3-D PRINTING STARTUP CARBON INC., ON HER CONCERNS ABOUT

REMOTE WORK1

P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

Companies also recognized the growing trend of “work from anywhere” knowledge workers who use technology to boost their mobile productivity and lessen their dependence on physical offices.

1What CEOs Really Thing About Remote Work. The Wall Street Journal. September 23, 2020. Accessed 11/11/2020.

“There’s sort of an emerging sense behind the scenes of executives saying,

‘This is not going to be sustainable.’

LASZLO BOCK, CHIEF EXECUTIVE OF HUMAN-RESOURCES STARTUP HUMU AND

FORMER HR CHIEF AT GOOGLE, ON THE STATE OF REMOTE WORK1

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P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

Well-located, thoughtfully designed and tech-enabled physical spaces – combined with the power of choice over when and how to use them – will deliver good productivity and engagement outcomes for employees and employers alike.

1What CEOs Really Thing About Remote Work. The Wall Street Journal. September 23, 2020. Accessed 11/11/2020.

“It’s a much harder way to work for anything that requires a personal relationship. And as a consequence, I think we’re going to find that we maybe not go back to 100% in the office all the time. Because remote work clearly works for

many things, but I think we’re going to find that being together delivers value in productivity and creativity and relationships that is irreplaceable

ARNE SORENSON, CEO OF MARRIOTT INTERNATIONAL INC., AT WSJ’S 2020 FUTURE OF

EVERYTHING1

P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

Great offices of the future will do what great offices of today already do: serve as important hubs for the human elements and experiences that technology can’t provide – relationships, teamwork, chemistry and culture.

1What CEOs Really Thing About Remote Work. The Wall Street Journal. September 23, 2020. Accessed 11/11/2020.

“I am concerned that we would somehow believe that we can basically take kids from college, put them in front of Zoom, and think that three years

from now, they’ll be every bit as productive as they would have had they had the personal

interaction [of work in offices].

RONALD J. KRUSZEWSKI, CHIEF EXECUTIVE OF STIFEL FINANCIAL CORP., ON PROFESSIONAL DEVELOPMENT WHILE

WORKING REMOTELY 1

Flight to Quality P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

We expect Class A properties to experience much faster improvement in demand, vacancy and rents, as they have done in past recovery periods.

Well-located and well-amenitized properties could thrive while lesser-quality and poorly located properties struggle with obsolescence.

EMERGING TRENDS IN REAL ESTATE® 2022, PWC, ULI

Less overall demand and occupiers’ need for technology and amenities create a doubtful future for older, class B/C buildings that require increased capital expenditures.

Usage was already in long-term decline, as firms maximize the efficiency of their office space. Class B and C markets have really borne the brunt of this trend. Recruit and retain top talent by offering a luxurious work environment. Employers cut costs by reducing excess space, pushing employees closer together in back office areas. Obvious trends: Telecommute, flex time, unassigned desks, framed photos replaced by digital pics on their phones, instead of needing tall cubicle walls to help them focus, workers listen to music on earbuds.

190 SF PRE-PANDEMIC 2020

165 SF 2028

Cushman Wakefield

A Reduction in Square Footage P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

SHRINKING SQ FEET PER WORKER

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A Reduction in Square Footage P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

Sanitation stations

Increased space and barriers between workers

Offices continue to be reconfigured to suit a post-COVID world, featuring:

Updated floor plans adding larger interior pathways

Reimagined common areas

The Pandemic and the Physical Office P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

The Pandemic and the Physical Office

Companies are reconsidering total space needs as well as design and health and safety concerns. “Employers need to take seriously that people are looking for a good place to do work,” said one senior executive at an architecture firm. The industry “took design for granted,” but that is no longer an option, she said.

Another analyst noted that working remotely has shed light on issues such as loneliness and burnout. “We’re starting to see a growing recognition [of how design impacts] mental health issues,” he said.

EMERGING TRENDS IN REAL ESTATE® 2022, PWC, ULI

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What's Next for Offices, Cushman & Wakefield, Live Webcast, November 05, 2021

P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

Offices must now show added value.

Tenants and owners must significantly raise the bar for what it takes to be an office.

P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

Physical Workplace Transformed

Placemaking by owners can deliver what might be missing by not be in the central business districts

Office property owners may increasingly find that providing an experience for tenant users is key to maintaining sustainable demand.

“The competition for talent will make it hard to force people to come back five days a week,” said a partner at an office industry consulting firm. “You have to give employees a reason to come to the office; otherwise, they won’t come in.”

P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

Placemaking and Community Building

We need to talk more about the experiences people want to have in the office. The office has to be a place for community socialization, even with people who are not in your immediate work group. Sociologists talk about people having strong and weak ties.

“Some companies asked me that. I said to them, you’ve been cooking from home over past year, right? So have you ever asked if we need restaurants anymore? Of course we do. We cherish the experience of the restaurant. We connect there. So why are you not feeling that way about your office?”

https://www.bloomberg.com/news/articles/2021-10-13/how-to-design-an-office-for-a-hybrid-work-future

RYAN ANDERSON, VICE PRESIDENT OF RESEARCH AND GLOBAL INSIGHTS FOR OFFICE FURNITURE MAKER HERMAN MILLER

Bringing more enhanced amenities and services to aiming for higher usage and tenant retention.

Placemaking and Community Building P R O D U C T T Y P E S | O F F I C E P R O P E R T I E S

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Multifamily Properties

Highrise: Yardi Matrix, an apartment market data provider and our sister company, defines high-rises as apartment communities of 10+ stories in height.

Better views More privacy More natural light Less noise Fewer insects Better ventilation

Low Rise/Garden: A garden apartment complex is characterized by a cluster of low-rise buildings, usually no more than two or three stories high

Easier street access Less walking/waiting Lower energy costs More green spaces in sight

P R O D U C T T Y P E S

76% Built before 1990

P R O D U C T T Y P E S | M U LT I FA M I LY

Multifamily Demand P R O D U C T T Y P E S | M U LT I FA M I LY

Only the leading edge of the millennial cohort—ages 35 to 40—have pivoted toward homeownership, meaning most of the rest of the 75 million millennial generation wants to rent.

Further, with an enormous generation Z filtering into real-world adulthood, the demand side of the apartment sector shows no sign of ebbing through at least another decade.

Multifamily rents have outperformed those of the other major property sectors during and after the 2008-2009 recession in three ways: 1) Lowest level of rent decline 2) Fastest recovery to pre-recession

peaks 3) Longest post-recession period of rent

growth.

Historically Resilient P R O D U C T T Y P E S | M U LT I FA M I LY

Cumulative Effects on Rent During and After 2008-09 Recession

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However, let’s unpack the 2008-2009 recession… The recession's single-family housing collapse helped multifamily demand by moving households from homeownership to rentals (via foreclosures) and by diminishing the appeal of homeownership given falling home values.

Based on CBRE Research’s analysis of effective rent change during and after the past two recessions, multifamily outperformed office and industrial in the 2001 recession and all major property sectors (office, industrial, retail) during the 2008-2009 recession.

Recessions P R O D U C T T Y P E S | M U LT I FA M I LY

St. Louis Absorption to Construction Ratio

St. Louis supply has not kept up with demand for the past five years.

Even with new supply, vacancy has declined and rental rates continue to increase.

0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6

Austin

C ha rlo tte

C in cinn ati

C le ve la nd

C olum bu s

Den ve r

K ans as Ci ty

M in ne ap ol i s-St. P au l

Nash vi l le

Oma ha

Sa lt La ke C ity

St. Lo uis

Absorption to Construction Ratio 2018 – Selected Secondary Markets

Absorption to Construction Ratio P R O D U C T T Y P E S | M U LT I FA M I LY

1.6

Consumer-Driven Amenities P R O D U C T T Y P E S | M U LT I FA M I LY

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Consumer-Driven Amenities P R O D U C T T Y P E S | M U LT I FA M I LY

Increase in renter households earning $100,000 a year or more from 2012 through 2018 36% Increase in Baby Boomers moving into the rental market from 2007 through 201743%

Renters by Choice P R O D U C T T Y P E S | M U LT I FA M I LY

Full Service

Limited Service

Extended Stay

Owner Operated vs. Management Company

Hospitality property sales helped lead the surge to new highs. Hospitality sales of $44.1 billion bested 2017 by 35 percent. However, it was not enough to top the last peak of $48.2 billion in 2015.

Hotel Properties P R O D U C T T Y P E S

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Commodity product by design

Climate-controlled

Non-climate controlled

Self Storage P R O D U C T T Y P E S

Investment Cycles

What Are Cycles?

Real estate markets are rarely near equilibrium

Prolonged periods of property supply and demand imbalance

I N V E S T M E N T C Y C L E S

Four Phases of the Real Estate Cycle

I N V E S T M E N T C Y C L E S

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Contractual Agreements and Market Frictions

Real estate takes years to plan, build, and lease

Long-term nature of real estate leases

Landlord perspective vs. tenant perspective

Certainty vs. flexibility and upside potential

Construction to completion lag

Timing is everything

I N V E S T M E N T C Y C L E S

Demand Dynamics

Population growth and job growth often do not match in any given year

Excess supply results in large vacancy à downward pressure on rents and new supply creation ceases

Excess supply is slowly absorbed, destroyed, or re-used

I N V E S T M E N T C Y C L E S

Capital Cycle

If a developer can source funds, they will build

If debt is cheap, owners will overpay and over-leverage

Short-term illiquidity often results in an opportunity to purchase at bargain prices

Having substantial equity is a tremendous advantage

I N V E S T M E N T C Y C L E S

Market Cycle Quadrants – Rent Growth Rates

I N V E S T M E N T C Y C L E S

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Office Cycle Overview

Office employment growth was constrained by full employment, as firms found it difficult to hire from a smaller hiring pool.

New supply is moderate, as higher construction and financing costs are creating better rationalization.

Short term rentals like WeWorks is leading new demand for space as small startups need the growth flexibility and larger firms realize that the tax code now favors short terms rentals that do not have to be accounted for as debt on their balance sheets like long term leases.

I N V E S T M E N T C Y C L E S

Office Market Cycle Analysis

I N V E S T M E N T C Y C L E S

Glenn R. Mueller – Professor - University of Denver - Burns School of Real Estate & Construction Management glenn.mueller@du.edu

Industrial Market Cycle Analysis

Glenn R. Mueller – Professor - University of Denver - Burns School of Real Estate & Construction Management glenn.mueller@du.edu

I N V E S T M E N T C Y C L E S

Apartment Market Cycle Analysis

I N V E S T M E N T C Y C L E S

Glenn R. Mueller – Professor - University of Denver - Burns School of Real Estate & Construction Management glenn.mueller@du.edu

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Real Estate Cycle

Phases do not necessarily occur in equal periods.

Cycles have different durations.

Cycles vary on geography and asset class.

Application of investment strategies

I N V E S T M E N T C Y C L E S

Investment Strategies

Core

RISK

RE TU

Core Plus

Value Add

Opportunistic

Returns derived primarily from Positive Cash Flow

Returns derived primarily from Reversion

I N V E S T M E N T S T R AT E G I E S

Stabilized, Class A, assets in major core markets

Often featuring long-term leases and tenants with strong credit profiles

Core

Synonymous with ‘income’ in the stock market.

Property investors are conservative investors looking to generate stable income with very low risk.

Properties require very little hand-holding by their owners and are typically acquired and held as an alternative to bonds.

This type of investing is as close as one can get to passive investing when buying properties directly.

A core property requires very little asset management and is typically occupied with credit tenants on long-term leases.

Core

I N V E S T M E N T S T R AT E G I E S

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I N V E S T M E N T S T R AT E G I E S

Stabilized assets with diversified multi-tenant income streams

Institutional quality attributes in infill locations

Core Plus

‘Core Plus’ is synonymous with ‘growth and income’ in the stock market and is associated with a low to moderate risk profile.

Core plus property owners typically have the ability to increase cash flows through light property improvements, management efficiencies or by increasing the quality of the tenants.

Similar to core properties, these properties tend to be of high-quality and well-occupied.

Core Plus

Strategy hinges on being able to buy low and sell at an opportune time

Value Add

Value-add real estate investments may require additional leasing or capital improvements with the goal of better positioning the assets to achieve greater total returns.

Properties require physical improvement and/or suffer from captial contraints; little in-place cash flow

Value Add

I N V E S T M E N T S T R AT E G I E S

Properties require a high degree of enhancement

Development, raw land and niche property sectors

Opportunistic

Opportunistic is the riskiest of all real estate investment strategies. It is also synonymous with ‘growth’ in the stock market, like ‘value add,’ but it is even riskier.

Opportunistic investors take on the most complicated projects and may not see a return on their investment for three or more years.

These investment strategies require years of experience and a team of people to be successful.

Ground up developments, acquiring an empty building, land development and repositioning a building from one use to another are examples of opportunistic investments.

Opportunistic

I N V E S T M E N T S T R AT E G I E S

Property Sector Investing

Contrarian Investing

Market Timing

Investing for Future Growth

Value Investing

Investing in “Trophy” or “Blue Chip” Properties

Strategy as to Size of Property

Strategy as to Tenants

Turnaround/Special Situations/Liquidation/Spin Offs

Geography Investing

Specialized Strategies

I N V E S T M E N T S T R AT E G I E S

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Click to edit Master Click to edit Master subtitle style

Risk

Possible Investor Risks

Operating Cost Vacancy / Demand Natural Disaster

Leasing Liquidity Capital Markets

R I S K

Market Risk

Investors can’t eliminate market shocks, but they can hedge their bets against booms and busts with a diversified portfolio and strategy based on general market conditions.

All markets have ups and downs tied to the economy, interest rates, inflation or other market trends.

R I S K

Business Plan Risk

Is the investment a ground-up development that requires substantial planning, effort and cost to achieve the end result or is it more of a passive investment in a project with a credit tenant who has a decade or more left on their lease? The less business and asset level risk, the lower the DCF discount rate, or required return, will be.

Business plan risk refers to the investment strategy behind the project.

R I S K

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Asset Class

In real estate investing, there’s always demand for apartments in good and bad economies, so multifamily real estate is considered low-risk and therefore often yields lower returns.

Office buildings are less sensitive to consumer demand than shopping malls, while hotels, with their short, seasonal stays and reliance on business and tourism travel, pose far more risk than either apartments or office.

Hotels tend to have more asset-level risk than apartments due to higher operating leverage and shorter duration of leases (nightly versus annual leases for apartments).

Some risks are shared by every investment in an asset class.

R I S K

Property Risk

Construction, for example, will add risk to a project because it limits the capacity for collecting rents during this time.

And when developing a parcel from the ground up, investors take on more types of risk than just the construction risk.

There’s also entitlement risk – the chance that government agencies with jurisdiction over a project won’t issue the required approvals to allow the project to proceed; environmental risks that range from soil contamination to pollution; budget overruns and more, such as political and workforce risks.

Idiosyncratic risk is specific to a particular property. The more risk, the more return.

R I S K

Lease and Obsolescent Risk

As demand for space in the market drives lease rates higher in older properties, it’s only a matter of time before those lease rates justify new construction and increase supply risk. What if a new building makes your investment property obsolete because there’s a better facility with comparable rents? It may not be possible for an investor to raise rents, or even attain decent occupancy rates.

A property leased to Apple for 30 years will command a much higher price than a multi-tenant office building with similar rents.

The length and stability of the property’s income stream is what drives value.

R I S K

Capital Risk

The more debt on an investment, the more risky it is and the more investors should demand in return. Leverage is a force multiplier: It can move a project along quickly and increase returns if things are going well, but if a project’s loans are under stress – typically when its return on assets isn’t enough to cover interest payments – investors tend to lose quickly and a lot.

A lack of alignment can create a divergence of incentives between the manager and the investor.

R I S K

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Operating cost synergies by combining services to reduce expenses associated with managing the asset.

Scale Expertise

Commercial real estate is local business.

R I S K

Investment Analysis

CRE Cash Flows Rental income, expenses, offsets, capital

expenditures, fees, debt service, distributions

Sources and Uses Understanding the stakeholders,

types of debt and financing constraints

Valuation Valuation techniques: DCF,

capitalization rates, appraisal techniques

Underwriting Comparables, market research, assumption

building

Development Return on cost, entitlement

process

Investment Analysis I N V E S T M E N T A N A LY S I S

Acquisition Process

DEAL SOURCING UNDERWRITING DUE DILIGENCE / CONTRACT ACQUISITION ASSET

MANAGEMENT DISPOSITION

UNDERWRITING Granular, data-driven approach

Investment analysis includes tenant-by-tenant cash flow forecasts Rooted in quantification, disciplined underwriting

DECISION Comprehensive risk assessment of underwriting process Investment Committee grants/ rejects approval

ACQUISITION Transaction and legal documents structured

Physical due dilligence

Letter of intent / Purchase Contract

ASSET MGMT Best position the asset in fluid economic environment Identifies optimal exit strategies for value maximization

Ensure asset positioning is aligned with investment objectives

I N V E S T M E N T A N A LY S I S

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Required Reading C O U R S E O B J E C T I V E

Real Estate Finance and Investments: Risks and Opportunities Fifth Edition Dr. Peter Linneman and Bruce Kirsch

The text can be purchased directly from the author/publisher at: https://www.linnemanassociates.com/product-page

Online Companion: www.getrefm.com/textbook/index.php/toc.

Class Handouts: Research Sources (today)

Net absorption is the sum of square feet that became physically occupied, minus the sum of square feet that became physically vacant during a specific period.

Key Metric: Absorption I m p o r t a n t s t a t i s t i c t o m e a s u r e t h e m o m e n t u m a n d p e r f o r m a n c e o f a r e a l e s t a t e m a r k e t

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Net absorption is an important concept to help measure and understand demand and supply in the commercial space market.

• Net Absorption = Total Space Leased - Vacated Space - New Space

• Gross absorption is the total gross amount of space leased up in the commercial space market. Gross absorption is a measure of total lease activity in a given market.

Key Metric: Absorption I m p o r t a n t s t a t i s t i c t o m e a s u r e t h e m o m e n t u m a n d p e r f o r m a n c e o f a r e a l e s t a t e m a r k e t

Since positive and negative net absorption are measurements that help understand demand and supply in commercial space markets, they are useful to understand pricing pressures and market dynamics, and identify market risks and opportunities.

Why is Absorption a Key Metric? I m p o r t a n t s t a t i s t i c t o m e a s u r e t h e m o m e n t u m a n d p e r f o r m a n c e o f a r e a l e s t a t e m a r k e t

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Acquisition Underwriting Model

$47.5 MM 270,000 SF OFFICE

I N V E S T M E N T A N A LY S I S

One Page

Cash Flows

Components

Granular Assumptions

Underwriting Pyramid Presentation

I N V E S T M E N T A N A LY S I S

Mpls Suburban Office Property Executive Summary

Project Detail Summary Uses Mpls Suburban Office Property 277,044 sf Acq NOI (12M From Analysis Start Date) $3,895,105 Reporting Start Date / Analysis Start Date Jan-19 Jan-19 Purchase Price 8.20% $171.45 $47,500,000 Analysis Presentation 2/19/19 Altus Acquisition Fee 1.00% % of purchase price $475,000

Bank Fee (A & B) 0.55% % of loan $170,418 Building Name Occupied Total SF InPlace NOI InPlace Cap Purchase Price PSF Broker Fee $0 Mpls Suburban Office Property 97% 277,044 sf $3,806,844 8.01% $47,500,000 $171.45 Due Diligence 0.05% % of purchase price $22,329

Legal (Buyer & Lender) 0.22% % of purchase price $105,300 Title & Mortgage Registration 0.18% % of purchase price $85,038 Entrance Basis 8.05% $174.55 $48,358,084 Initial Project Cash Reserve $0.36 $100,000 Total Initial Capitalization $174.91 $48,458,084

Sources Initial Equity Funding 46% 22,333,084$ Initial Debt Funding 54% 26,125,000$ Total Initial Capitalization 100% $48,458,084.28

Totals 97% 277,044 sf $3,806,844 8.01% $47,500,000 $171.45 Follow on Equity Funding Mar-18 $0

Financing & Underwriting General Underwriting

General Inflation 2.50% Portfolio Permanent Vacancy Impact Over Invest Period 0.31% Expenses (Year 1) $13.01 PSF Portfolio General Vacancy $1,421,977 5.00% Market Rent Growth $0.50 PSF Structural Offset $173,153 $0.10 PSF Specific Identified Capital Improvements $2,639,985 Economic Offset $2,952,994 10.23%

Initial Debt Financing Initial Loan to Purchase Actually Gets Drawn 54.02% LTC 55.00% LTP $94.30 26,125,000$ DSCR (Intial / Full Balance, InPlace NOI) 2.31 x 1.95 x Additional Draw Proceeds $4,860,000 84m Max Draw Period $17.54 4,860,000$ Debt Yield (Initial / Full Balance, InPlace NOI) 14.57% 12.29% Total Loan Amount 54.71% LTC 65.23% LTP $111.84 30,985,000$ Prepayment Penalty 0.00% -$ Loan Term 7.0 years Dec-25 84 months Balance at Refinance $0.00 -$ Interest Only Period 3.0 years 36 months Balance at Sale $106.35 29,464,000$ Amortization Acq Fixed Draw Float Index Spread Buffer $39,000/month 30 years Interest Rate 4.77% 2.51% 2.20% 0.25% 4.80%

Disposition Summary Project AVG RENT

(Day 1) AVG NOI

(Inv Period) Occupancy at

Sale 12M NOI

(Sale Date) AVG RENT

(At Sale) Accelerated

Debt Sale

Month Exit Date

Cap Rate

Sales Price

PSF Sales Price Allocation

Mpls Suburban Office Property $15.34 PSF $4,230,094 100% $4,946,515 $18.01 PSF 100.00% 75 Mar-25 8.01% $61,780,812 $223.00 PSF 100.0%

Total Capital Offset @ Sale $140,000 $4,230,094 $4,946,515 75 6.3 yr hold 8.01% $61,780,812 $223.00 PSF 0.75% Offset

Project Structure Partnership Structure General Partner Fees and Promote

Structure: ARIF II Acquisition Fee 1.00% $475,000 Step 1: Simple Interest Preferred Return to Member 6.00% Asset Mgmt - Annual 1.25% $279,164 Step 2: Return of Capital to Member 100.00% Disposition Fee 0.50% $308,904 Step 3: Manager Catchup 0.00% Step 4: Manager Cash Flow Split After Catchup 20.00%

Project Performance Limited Partner Level Project Level Return on Equity (Cash on Cash )

Investors Altus Promote Levered Unlevered On Equity Outstanding On Capital Invested

Investment $22,333,084 $22,333,084 $48,358,084 Y1 22,333,084 6.0% 22,333,084 6.0% Total Return $16,403,287 $2,062,558 $18,465,844 $27,401,900 Y2 22,333,084 6.0% 22,333,084 6.0% Cash Multiple 1.7 11.17% 1.8 1.6 Y3 22,333,084 6.0% 22,333,084 6.0% IRR 10.6% 11.58% 8.3% Y4 22,333,084 6.0% 22,333,084 6.0% IRR % From Operating / Reversion Cash Flows 26.1% 73.9% Average Over Investment Period 6.0% 6.0%

Mpls Suburban Office Property Executive Summary

Sources Initial Equity Funding 46% 22,333,084$ Initial Debt Funding 54% 26,125,000$ Total Initial Capitalization 100% $48,458,084.28

Totals 97% 277,044 sf $3,806,844 8.01% $47,500,000 $171.45 Follow on Equity Funding Mar-18 $0

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Financing & Underwriting General Underwriting

Disposition Summary Project AVG RENT

(Day 1) AVG NOI

(Inv Period) Occupancy at

Sale 12M NOI

(Sale Date) AVG RENT

(At Sale) Accelerated

Debt Sale

Month Exit Date

Cap Rate

Sales Price

PSF Sales Price Allocation

Mpls Suburban Office Property $15.34 PSF $4,230,094 100% $4,946,515 $18.01 PSF 100.00% 75 Mar-25 8.01% $61,780,812 $223.00 PSF 100.0%

Total Capital Offset @ Sale $140,000 $4,230,094 $4,946,515 75 6.3 yr hold 8.01% $61,780,812 $223.00 PSF 0.75% Offset

One Page

Cash Flows

Components

Granular Assumptions

Underwriting Pyramid Presentation

I N V E S T M E N T A N A LY S I S

Leases

EECCOONNOOMMIICC TTEERRMMSS::

Rent & Expense

Positive & Negative Clauses

Lessor = Owner

Lessee = Tenant

Leases Reflect Business Realities L E A S E S

Material Contents of Leases

Rental Income

Expenses

Tenancy Costs

Underwriting Tenants

Leases by Property Type

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Parties, Dates, Length

Base rent

Condition

Tenant Improvements

Use of common areas and facilities

Responsibility for maintenance and repair

Insurance requirements

Parking

Material Contents of a Lease: General L E A S E S

Security: Deposits, Guarantee, LOC Allowable uses

Restrictions on assignment or subletting Financial Statement Transparency Touring / Access

Estoppels & SNDAs Relocation Rights Go-Dark Acceleration

Hours of Operation

Material Contents of a Lease: LL Value L E A S E S

Renewal Option

Expansion Option

Right of First Refusal (ROFR)

Right of First Offer (ROFO)

Co-Tenancy Use Restrictions

Co-Tenancy Operating Requirements (anchors)

Material Contents of a Lease: Tenant Value L E A S E S

FFllaatt RReenntt:: No rent change over lease term

SStteepp--UUpp RReennttss:: Specified rent increases at specified times

IInnddeexxeedd RReennttss::Periodic rent adjustment (example: CPI, porter’s wage)

RReennttss aaddjjuusstteedd bbaasseedd oonn rreevveennuuee//ssaalleess ppeerrffoorrmmaannccee:: Percentage rent, breakpoints and overages

Rental Income L E A S E S

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GGRROOSSSS LLEEAASSEESS ((FFUULLLL--SSEERRVVIICCEE))

Tenant pays rent only

Property owner pays all operating expenses

Base stops

TTRRIIPPLLEE NNEETT LLEEAASSEESS

Direct “pass throughs”

MMOODDIIFFIIEEDD GGRROOSSSS LLEEAASSEESS

Blend via one of the “Nets” (tax, ins, CAM)

Responsibility for Expenses (Recoveries) L E A S E S

Common Area Maintenance (CAM), Ins & Tax Expense Stops & Caps

Capital Provisions

Tenant improvements (TIs) are improvements made to the leased space according to the specifications of the tenant and are negotiated into the leasing agreements.

These can include changes to the layout of the space (such as taking down or adding divider walls), existing fixtures or infrastructure.

Funded via an Allowance or “Turn Key”

Market allowances are factored into listed lease rates – overages (if acceptable to LL) are amortized over base rent.

LL’s approve layouts and restrict usage of TI funding – Do improvements benefit the property?

Tenant Improvements L E A S E S

Types of Leases L E A S E S

Office

Industrial Property

Retail

Apartment

100

Rentable area

Usable area

Load factor

Gross Square Feet

Office Leases L E A S E S

101

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RReennttaabbllee aarreeaa Usable area

Load factor

Gross Square Feet

Office Leases L E A S E S

RReennttaabbllee ssqquuaarree ffeeeett is defined as the usable square feet plus a portion of the building’s common space (“common areas”).

Common spaces are areas usable by all tenants in the building and include, but are not limited to, hallways, lobbies, public restrooms and fitness facilities.

102

Rentable area

UUssaabbllee aarreeaa Load factor

Gross Square Feet

The uussaabbllee ssqquuaarree ffeeeett of a space is defined as the total area unique to the tenant. Think of it as the space specifically set aside for your company’s use. Once you walk into your suite, the area inside is considered usable square feet.

Office Leases L E A S E S

103

Load Factor L E A S E S

Load factor is calculated by dividing building’s total rentable square feet by the total usable square feet.

It is a tool that tenants and landlords use to understand the difference between a facility’s rentable square feet and usable square feet, a figure based on the percentage of common area found in the building.

10,000 usable feet x .20 = 2,000

2,000 + 10,000 = 12,000 rentable square feet

10,000 usable feet x .15 = 1,500

1,500 + 10,000 = 11,500 rentable square feet

So how can the load factor help tenants evaluate different properties? Consider this example. A tenant is considering two different office spaces, both with the same square footage of usable space and the same rental rate, but differing load factors.

The second option with the lower load factor would save the company money since they would be paying less per month for the same amount of usable space.

However, the smaller load factor also means there are less common areas in the building, so paying more in rent may be necessary if more common area and amenities are desired.

104

Rentable area

Usable area

Load factor

GGrroossss SSqquuaarree FFeeeett

Office Leases L E A S E S

• Gross square feet, also referred to as gross area, simply refers to the total square footage of a building.

• It includes everything accounted for in usable and rentable square feet, along with building core, elevator shafts and other areas of the building that are used for maintenance and operations.

• In other words, the gross square footage is the total space a facility takes up, regardless of whether or not the space is used by the tenant. The only spaces excluded are open areas like pools, playing fields, courts, light wells, parking lots, and unexcavated basements.

• Gross square footage is an important metric for planning and budgeting in construction.

105

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Similar to office leases

More individualized for the tenant

Term tends to be longer than office leases

Tend to be pass-through (NNN / Absolute Net)

Industrial Property Leases L E A S E S

106

Provisions on operations may include limits on other tenants

Continuous Operation Clauses

Anchor and In-Line Tenants (cross collateralized)

Rent Differences

Percentage Rent Lease

Common Area Maintenance (“CAM”) – Marketing Pools

Retail Leases L E A S E S

107

RRaaddiiuuss RReessttrriiccttiioonn

A ‘radius restriction’ is a lease item that restricts tenants from opening stores within a certain distance of the leased store.

This clause protects the landlord from tenants potentially cannibalizing sales at the leased retail center.

Retail Leases L E A S E S

108

Shorter Terms

Impact of Consumer Protection Laws

Full Occupancy

Cancellable

RUBS

Apartment Leases L E A S E S

109

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It is important to note that non-economic terms are just as important as economic items

A landlord needs to negotiate clauses such as restrictions on signage, go-dark provisions, and defining hours and days of operation.

Tenants may want to negotiate expansion rights and limit usage restrictions by the landlord.

It is important to remember that most items negotiated in a contract are non-monetary, yet affect the underlying value of a property.

Non-Economic Lease Terms L E A S E S

110

Direct vs. Representation: Leverage due to market

knowledge & fees

Leasing Deal Cycle L E A S E S

RFP – Proposal – Tour – Short-List –

Final Terms Subject to Pricing/Credit

Lease – Build-out – Lease Commencement – Rental Commencement

111

Variable expenses vary based on property occupancy

Both economic and non-economic lease terms are important.

It is essential to understand different aspects of leases, the reasoning behind them, and the negotiating leverage of each party, all of which ultimately play into property value & liquidity.

Lease Fundamentals = Property Value L E A S E S

112

Cash Flow Components

113

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Lease by Lease Analysis

Line Item Analysis

Types of Analysis C A S H F L O W C O M P O N E N T S

114

Pro-Forma begins with Suite-by-Suite Analysis.

Tenant Retention is Paramount to Returns.

Binary Outcomes

Retention Rate and Capital Implications

Vacate – Downtime / Absorption / Deal Costs / Debt Implications

Tenant / Suite Underwriting C A S H F L O W C O M P O N E N T S

115

Lease Summaries

C A S H F L O W C O M P O N E N T S

116

C A S H F L O W C O M P O N E N T S

117

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C A S H F L O W C O M P O N E N T S

118

C A S H F L O W C O M P O N E N T S

119

C A S H F L O W C O M P O N E N T S

120

Existing 5,000 SF Office Tenant Expenses

Renew Carpet & Paint $10 sf $ 50,000

Commission $ 27,000

Total Cost $ 77,000

New 5,000 SF Office Tenant Expenses

12 months downtime $135,000

Whiteboxing $ 50,000

TI Allowance $30 sf $150,000

Commission $ 40,500

Total Cost $375,500

Turnovers are expensive!

Tenant Retention is Key to Performance C A S H F L O W C O M P O N E N T S

121

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C A S H F L O W C O M P O N E N T S

122

Gross Potential Revenue (100% Leased)

Absorption, Turnover, Abatements

Other Income

Expense Reimbursements (CAM, Ins, Tax)

Vacancy Offset

Effective Gross Income

CRE Cash Flow: Rental Income

C A S H F L O W C O M P O N E N T S

123

C A S H F L O W C O M P O N E N T S

124

Unexpected changes in vacancy can have a large effect on the accuracy of a financial model.

In a weak or over-supplied market, buildings may have occupancy well below expectations for long periods of time.

Operating costs can easily be incorrectly forecasted.

An increase in expenses will reduce net operating income.

Line Item Analysis: All Components Matter

C A S H F L O W C O M P O N E N T S

CRE Cash Flow: Rental Income

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Reimbursable Expenses

CAM (Utilities, Cleaning, R/M, Fee, etc.)

Insurance

Tax

Non-Reimbursable Expenses

CRE Cash Flow: Expenses C A S H F L O W C O M P O N E N T S

126

C A S H F L O W C O M P O N E N T S

127

FFUULLLL SSEERRVVIICCEE // GGRROOSSSS // FFSS

No Base Year Stops

Base Year Stops

MMOODDIIFFIIEEDD GGRROOSSSS // MMGG

Anything in-between

Per Market

Expense Reimbursement Methods C A S H F L O W C O M P O N E N T S

TTRRIIPPLLEE NNEETT // NNNNNN

Carve-outs on CapX per Markets

Controllable / Non-Controllable

Caps

128

Effective Gross Income

less

Operating Expenses

Net Operating Income C A S H F L O W C O M P O N E N T S

129

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C A S H F L O W C O M P O N E N T S

Capital and Leasing Costs: (“below the line”) Debt Service

Tenant Improvements (TI)

Leasing Commissions (LC)

Other Fees (NR)

Capital Expenditures

Offset

Identified

130

C A S H F L O W C O M P O N E N T S

131

C A S H F L O W C O M P O N E N T S

132

C A S H F L O W C O M P O N E N T S

CFADS & Unlevered CF

Cash Flow After Debt Service (& Cap.)

Unlevered CF

133

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Actual vs. tax accounting

After-Tax Cash Flow

Reserves vs. actual expenditures

Depreciable basis: Land vs. structure

Expensing vs. capitalizing

Depreciation vs. Cap Ex C A S H F L O W C O M P O N E N T S

134

It is important to note that depreciation is an accounting concept and does not relate to the physical capital expenditures needed in a financial reporting period.

The original cost basis includes all costs associated with acquiring the property and transferring the title.

Land value cannot be depreciated

The depreciable basis is the total value that can be depreciated over the recovery period

DDeepprreecciiaabbllee BBaassiiss == CCoosstt BBaassiiss –– LLaanndd AAmmoouunntt

Depreciable Basis C A S H F L O W C O M P O N E N T S

135

DDeepprreecciiaattiioonn

• Depreciable Basis / Recovery Period

RReeccoovveerryy PPeerriioodd iiss ddiiffffeerreenntt bbaasseedd oonn pprrooppeerrttyy ttyyppee

• Residential income producing property (27.5 Years)

• Non-residential income producing property (39 Years)

• Note that the recovery period is a product of the tax code. It will vary based on the laws of the country that the real estate is located in.

• Cost Segregations Studies – Variable / Componentized Depreciation Schedules

Depreciation C A S H F L O W C O M P O N E N T S

136

After-Tax C A S H F L O W C O M P O N E N T S

Real Estate Depreciation Results in Higher After-tax Distributions

The depreciation tax shelter can be used to:

Shield income generated from the real estate strategy.

Offset gains elsewhere in an investor’s portfolio providing a rebalancing opportunity.

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After-Tax C A S H F L O W C O M P O N E N T S

Altus Realty Income Fund I – Actual Results

$19,741,493 While generating a depreciation expense of

$25,307,444 in annual operating distributions

From 2015-2019 ARIF I has made

138

Investment Decision Making

139

CRE Cash Flows Rental income, expenses, offsets, capital expenditures, fees, debt service, distributions

Sources and Uses Understanding the stakeholders, types of debt and financing constraints

Valuation Valuation techniques: DCF, capitalization rates, appraisal techniques.

Underwriting Comparables: market research. assumption building

Development Return on cost, entitlement process

I N V E S T M E N T D E C I S I O N M A K I N G

140

Investment Goals

Expertise

Synergies

Liquidity

Holding Periods

Opportunity Cost

CRE Investment Decision Making I N V E S T M E N T D E C I S I O N M A K I N G

141

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NNeett PPrreesseenntt VVaalluuee

A way to solve for the initial price that an investor may pay given a specified discount rate.

Discounted value of the cash flows.

The discount rate is the rate of return that an investor will require in order to make this investment.

If we include the initial equity investment in this calculation, we can solve for the difference and see how much more or less the investor may pay and still receive a rate that is equivalent to their discount rate.

Investment Analysis I N V E S T M E N T D E C I S I O N M A K I N G

142

Discounted Cash Flow Analysis (“DCF”) is the foundation for valuing all financial assets, including commercial real estate.

Review: Discounted Cash Flow Analysis I N V E S T M E N T D E C I S I O N M A K I N G

$= 143

The value of a dollar today is worth more than a dollar in the future. The value of an asset is simply the sum of all future cash flows that are discounted for risk.

The timing of the future cash flows and the likelihood they will occur greatly influences the price an investor would be willing to pay for an asset today.

Riskier cash flow streams are discounted at higher rates, while more certain cash flows are discounted at lower rates.

Review: Basic Concept I N V E S T M E N T D E C I S I O N M A K I N G

144

Solving for a leveraged return, while ignoring the other risk components.

An investment generating a 15% annualized return using 60% leverage actually produces a better risk- adjusted return than one generating 20% using 90% leverage, all other things being equal.

Using financial leverage responsibly will enhance the return on equity, but it doesn’t change the asset’s inherent value.

DCF Common Mistake I N V E S T M E N T D E C I S I O N M A K I N G

145

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To provide some context, unleveraged discount rates in real estate fall between 6% and 12%.

Think of the discount rate as the expected rate of return, or IRR before using leverage, an investor would expect to receive.

What’s the Discount Rate? I N V E S T M E N T D E C I S I O N M A K I N G

% 146

Every cash flow in a DCF forecast is based on the probability of occurrence.

In reality, these outcomes can be vastly different than what was originally projected. In some cases, actual investment results will far exceed expectations and in other cases, they will underperform

DCF analysis is the most comprehensive method utilized to evaluate all of the risk factors that are considered in a real estate investment.

A key is to understand the nuances of the inputs and market variables.

Review: Discounted Cash Flow I N V E S T M E N T D E C I S I O N M A K I N G

147

Review: IRR Metrics I N V E S T M E N T D E C I S I O N M A K I N G

<> IInntteerrnnaall RRaattee ooff RReettuurrnn ((IIRRRR))::

The discount rate at which the net present value of the cash flows is equal to 0. If IRR >= r; accept Project. If IRR < r; reject Project. Where r is the discount rate, or more colloquially, the “hurdle rate.” You are financially indifferent between investing in a Project ONLY IF the IRR is the “correct” discount rate (i.e. risk-equivalent rate)

148

Firms often cite two metrics to describe their assets’ return on investment: the internal rate of return, or “IRR,” and the equity “multiple.”

While both the IRR and multiple analyze cash flow, the IRR describes the compounded annual percentage rate every dollar earns during the period it is invested.

This number also accounts for the time value of money — the idea that a dollar you have today is worth more than a dollar you have in the future, and the longer it takes to realize future earnings, the less valuable it becomes. We can forecast an expected IRR, or use actual results to calculate a realized IRR.

Source: Origin Investments

Return on Investment I N V E S T M E N T D E C I S I O N M A K I N G

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Many investors mistakenly compare IRR to annualized returns to make investment decisions, which can be a costly mistake.

It’s important for investors to understand how IRR differs from annualized returns to make smarter real estate investing decisions.

Annualized return is the amount of money an investment made or is anticipated to make every year it is invested. For example, a $1 million investment that achieves an annualized return of 8% will be worth more than $10 million in 30 years, after factoring in compounding.

Source: Origin Investments

Internal Rate of Return as a Metric I N V E S T M E N T D E C I S I O N M A K I N G

150

IRR attempts to give investors the equivalent annualized rate of return but takes into account the timing of cash flows, even if money is invested for short periods of time such as days or weeks.

IRR also assumes all distributions will be reinvested immediately, which means there is a built-in compounding assumption that actually doesn’t happen.

Source: Origin Investments

Internal Rate of Return Issue? I N V E S T M E N T D E C I S I O N M A K I N G

151

The first example resulted in a total gain of 28.5%, while the second example yielded a total gain of 52%. This example illustrates the reason why comparing two investment opportunities to one another using IRR alone can be costly.

Source: Origin Investments

SScceennaarriioo ##11 SScceennaarriioo ##22

15% Internal Rate of Return I N V E S T M E N T D E C I S I O N M A K I N G

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To be fair to IRR, getting money back sooner, rather than later, is better and certainly helps in reducing risk.

Cash flows that happen far out in the future are generally riskier than ones expected to occur earlier. Discount rates should not be the same for each year of an investment period (ops vs. gain).

An investor would presumably be immediately investing any cash flow they receive into other investments.

However, you don’t know what investments will be available at that point in the future and those investments would most likely not be generating the same IRR. It also takes time, energy and discipline to find a suitable place to reinvest those distributions.

Source: Origin Investments

Internal Rate of Return Issue I N V E S T M E N T D E C I S I O N M A K I N G

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A private real estate manager who produces high IRR may not actually produce any real wealth, which is why one needs to also look at the metric of total return or multiple on equity.

Sometimes it’s better to find good long-term investments and let the power of compounding work for you. You may be better off, in the long run, achieving a 10% annualized return than chasing 20% IRR’s.

The equity multiple reflects the amount of money an investor gets back by the end of a deal. If a commercial real estate investor puts $1 million into a property and eventually gets back $2 million, the multiple is 2x.

Knowing the multiple on equity shows an investment’s true impact on wealth. Over five years, it takes just a 15 percent IRR on $1 million to build the sum to $2 million.

Source: Origin Investments

Case for Multiple Evaluative Measures I N V E S T M E N T D E C I S I O N M A K I N G

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I N V E S T M E N T D E C I S I O N M A K I N G

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I N V E S T M E N T D E C I S I O N M A K I N G

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I N V E S T M E N T D E C I S I O N M A K I N G

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CRE Cash Flows Rental income, expenses, offsets, capital expenditures, fees, debt service, distributions

Sources and Uses Understanding the stakeholders, types of debt and financing constraints

Valuation Valuation techniques: DCF, capitalization rates, appraisal techniques.

Underwriting Comparables: market research. assumption building

Development Return on cost, entitlement process

I N V E S T M E N T D E C I S I O N M A K I N G

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Partnership Structure I N V E S T M E N T D E C I S I O N M A K I N G

The correspondences related to this investment, including the attachments, are for prospective qualified and accredited investors. W hile the source of all content supplied herein has been provided from sources believed reliable, Altus and its affiliates cannot guarantee its accuracy or completeness. This investment involves certain risks. It must be recognized that other risks, not foreseen, may present themselves in the future and that the risks which are foreseen, may affect to a greater extent or in a manner not now contemplated. Prospective investors should carefully consider, among other things, the risk factors and speculative factors as enumerated in the materials.

Project Level Entity Member Entity

Sponsor Member Co-Investment

OUTSIDE MEMBERSDebt Financing

Asset 100% Owned

Provides 100% of Equity

Altus controlled entity

Minimum ~35% of project equity

Sponsor Manager

Altus controlled entity

Sponsor to accept recourse obligations

En ti

ty M

an ag

Entity Member

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Significant Sponsor Member Co-Investment ~35% Minimum Sponsor Member Co-Investment – Shoulder-To-Shoulder with Outside Members.

Front Loaded Sponsor Member Co-Investment Sponsor Member Co-Investment Front Loaded – Mitigates development risks ahead of Outside Members.

Sponsor Manager Accepts Recourse Sponsor Manager takes on the required recourse risks associated with debt financing without charging Recourse Fee.

Aligned Waterfall Structure Between Sponsor and Members Members receive yield protection through a preferred return hurdle on invested capital (6.0% per year). The preferred return accrues during the construction period and begins payment upon stabilization. Moreover, the Sponsor Manager does not participate in cash flows until 100% fulfillment of the annual preferred return and return on Member invested capital.

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Partnership Alignment Features I N V E S T M E N T D E C I S I O N M A K I N G

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All Components Matter I N V E S T M E N T D E C I S I O N M A K I N G

OOppeerraattiinngg ccoossttss can easily be incorrectly forecasted.

An increase in eexxppeennsseess will reduce net operating income.

Unexpected changes in vvaaccaannccyy can have a large effect on the accuracy of a financial model as well.

In a weak or over-supplied mmaarrkkeett, buildings may have occupancy well below expectations for long periods of time.

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Cap Rates/ Valuation

162

SSAALLEESS CCOOMMPPAARRIISSOONN AAPPPPRROOAACCHH

IINNCCOOMMEE CCAAPPIITTAALLIIZZAATTIIOONN

AAPPPPRROOAACCHH

CCOOSSTT AAPPPPRROOAACCHH

Appraisal / Valuation Process C A P R AT E S / VA L U AT I O N

163

Sales Comparison Approach

Use data from recently sold “comparables” to derive a “subject” market value.

Adjust comparable sales prices for feature, age, and size differences, etc.

Lump sum adjustments and square foot adjustments.

Subjective process.

C A P R AT E S / VA L U AT I O N

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NOIValue R

Recent similar property sales. Blank 1 2 3 4 Sales Price $368,000 $425,000 $310,000 $500,000 NOI $50,000 $56,100 $42,700 $68,600 R 13.57% 13.20% 13.77% 13.72%

The higher the cap rate, the lower the value.

Three methods for the income approach:

• Gross Income Multipliers (“G I M”)

• Direct Capitalization Method

• Discount Present Value Method

Capitalization Rate

Income Capitalization Approach C A P R AT E S / VA L U AT I O N

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Are Cap Rates a valuable tool?

• Cap rates are generally used in real estate valuation analysis and are the inverse of a traditional corporate earnings multiple.

• A cap rate is defined as stabilized NOI divided by property value (stabilized NOI/property value = Cap Rate).

• Cap rates are determined by the market as the expected yield an owner should get on a stabilized income- producing property given a certain risk level (similar to valuation of coupon-paying bonds).

Cap Rates Overview

Income Capitalization Approach C A P R AT E S / VA L U AT I O N

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Are all ‘Cap Rates’ the same? How can valuation formula be viewed in different ways?

• Market cap rates change as the market perception of risk, cash flow, or growth changes.

• While cap rates are a good “quick and dirty” tool for pricing real estate assets, students should be aware that cap rates can only be applied when using stable NOI estimates.

• Determining the stabilized NOI of a property is a subjective matter and can result in very different valuations for the same property.

More on Cap Rates

Income Capitalization Approach C A P R AT E S / VA L U AT I O N

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Understanding the Components of Valuation

Some people do not distinguish between NOI and adjusted NOI which includes deductions for TIs, leasing commissions, and cap ex. These items are costs associated with operating the property, but are generally not included in NOI

Project different NOIs, with some using last year’s, others using the first year’s, and others using stabilized NOI.

Understanding the valuation calculation means understanding the parts of the valuation formula.

The simple calc of dividing NOI by a cap rate isn’t so simple.

Income Capitalization Approach C A P R AT E S / VA L U AT I O N

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Considerations when determining Cap Rate

Consider the comparables

Similarity to subject

• Physical Attributes

• Location

• Lease Terms

• Operating Efficiency

How is NOI determined?

• Backward, forward looking, one month annualized, Trailing 3 months annualized, etc.

• Nonrecurring capital outlays • Was NOI skewed by a one-time outlay?

• Composition and quality of rent roll

Income Capitalization Approach C A P R AT E S / VA L U AT I O N

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Does a seller prefer higher or lower cap rates?

A seller prefers to sell at a low cap rate since a low cap rate yields a higher value for a given NOI.

A buyer prefers to pay less for an asset and, thus, prefers a high cap rate.

Income Capitalization Approach C A P R AT E S / VA L U AT I O N

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Replacement cost is an indication of what it would cost to build a building today and can be used as an additional tool to benchmark the value of a property.

If a building sells for more than its replacement cost, an investor might be better off developing a new building instead of buying.

Replacement Cost Approach C A P R AT E S / VA L U AT I O N

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Reconciliation of Value Estimates The sales comparison and income approaches should yield similar value estimates.

Changing Market Conditions and “Going in” Cap Rates Supply & demand. Capital markets. Capital markets & spatial market changes.

Valuation Fundamentals C A P R AT E S / VA L U AT I O N

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Leverage

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Need to understand the fundamentals of the real estate business before you can select the appropriate financing structure.

If you do not understand the risks and opportunities of a property, you will never be able to efficiently select your financial structure.

L E V E R A G E

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Introduction to Financial Leverage

What is financial leverage? Benefit of borrowing at a lower interest rate than the rate of return on the property.

Why use financial leverage? There are diversification benefits that come from investing less equity. One can buy additional properties.

Mortgage interest tax benefit.

Magnify returns if the return on the property exceeds the cost of debt.

L E V E R A G E

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Summary

Positive leverage means that the property cash flow yield (NOI after standard reserves) is greater than the interest rate paid to the lender.

Negative leverage means that the property cash flow yield is less than the interest rate paid to the lender.

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Leverage Topics

Bank, Permanent, CMBS, Alternative (Seller, Hard Money, Debt Funds)

Secured and Unsecured, Line of Credit, Term note, Letter of credit

Amortization

Sourcing

Sponsorship evaluation: Credit / Credit score, Net worth, Liquidity, Experience, Income

Project evaluation: “The 5 C’s”

Ratio analysis

Note, Mortgage key provisions

Covenants, positive and negative

Typical process

Types of Financing and Why

Lender Evaluation

Loan Documents and Process

L E V E R A G E

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Why would someone choose to use debt?

You do not have sufficient cash to cover the full cost of acquiring or development. Real estate is capital intensive. Debt allows you to buy or build real estate that you can otherwise not afford solely with your own money.

To diversify your investments

To enjoy the interest tax shield

To enhance your equity returns

L E V E R A G E

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At least 3 times in the last 35 years, real estate has failed to meet the stress test of maintaining equity value when financed in excess of 55% to 65% LTV, yet the industry continually strives to achieve higher leverage levels and is surprised each time extreme economic and capital market distress wipes out large numbers of equity holders and their lenders.

Over Leverage L E V E R A G E

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SOURCE: Technical Note on Financial Leverage in Real Estate – Harvard Business School April 2,2012, Charles F. Wu, Arthur I Segel, Reference 9-208-041

Debt can be used by the owner of real estate as a tool to enhance returns or (at the extreme levels) to serve as a “stop loss” to limit the amount of equity capital exposed to a particular property.

These benefits come at a cost, however, since leverage can accelerate and magnify the severity of capital loss if the property value declines.

The following cases demonstrate the accelerating impact of leverage on returns under different scenarios of property performance. The scenarios represent two points in time: the inception of the investment, and the liquidation.

Technical Note on Financial Leverage in Real Estate

L E V E R A G E

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Case #1

No Leverage.

Without leverage, the investment performance of the equity matches that of the property

SOURCE: Technical Note on Financial Leverage in Real Estate – Harvard Business School April 2,2012, Charles F. Wu, Arthur I Segel, Reference 9-208-041

L E V E R A G E

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Case #2

Leverage.

Instead of investing $100 in equity, the property is capitalized with $50 debt and $50 equity (1:1).

SOURCE: Technical Note on Financial Leverage in Real Estate – Harvard Business School April 2,2012, Charles F. Wu, Arthur I Segel, Reference 9-208-041

L E V E R A G E

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SOURCE: Technical Note on Financial Leverage in Real Estate – Harvard Business School April 2,2012, Charles F. Wu, Arthur I Segel, Reference 9-208-041

Case #3

67% Leverage.

The property is capitalized with $67 debt and $33 equity (2:1).

L E V E R A G E

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SOURCE: Technical Note on Financial Leverage in Real Estate – Harvard Business School April 2,2012, Charles F. Wu, Arthur I Segel, Reference 9-208-041

L E V E R A G E

Case #4 Impact on Mezzanine Debt: An alternative form of equity investing is done in the form of mezzanine debt. Here, the investor takes a “horizontal slice” of the capital stack. By doing so, the investor can achieve equity-like returns in the upside, with downside protection in the (moderate) downside case. A traditional “mezz debt” structure would involve investing in the trance of the capital structure that represents 60%-80% of the property value, in return for an interest rate coupon of plus 50% of the asset’s appreciation. The mezz debt capital is at risk only if the property value declines by more than 20%.

184

An unsecured loan is supported by the borrower’s cash flow, but does not include a specific lien on the asset.

A secured loan is supported by the borrower’s cash flow and also grants the lender a priority claim to the specific asset as additional security for the loan.

Letters of credit and third-party guaranties are other types of credit enhancements and both of these may also be secured or unsecured.

Security: Collateral and Sponsorship L E V E R A G E

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Non Recourse…really non recourse?

Standing offer to put the property to lender in non recourse

Completion Guaranty

Bad Boy – fraud, theft, environmental

L E V E R A G E

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L E V E R A G E

What objectives are most important to you as well as to determine the risk return profile Value have risen substantially - access trapped liquidity Interest rates have fallen Position for future / optimal time When cost of equity and cost of debt are the same…

Refinance Reasons

187

Loan Docs

188

Laser Pro Documents (“off the shelf”) versus attorney drafted.

Deposit for third parties – bank’s legal and due diligence costs are typically borne by the borrower.

Documentation

Promissory Note

Mortgage Instrument

Loan Agreement

Other

L O A N D O C S

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Promissory Note

Typically are short documents that refer and incorporate information in a business loan agreement; the promissory note heavily favors the lender instead of the issuer of the note (the borrower).

Borrower signs the promissory note, but the loan agreement is signed by both the lender and the borrower; as the lender is not a party to the promissory note, it does not have any obligations it would otherwise have in a loan agreement (such as obligations to mitigate damages, act reasonably, or provide certain notices).

The borrower undertakes all obligations under the promissory note: such as promise to pay a monthly amount or the entire loan on demand or at certain times.

Promissory note is a liquid asset and can be negotiated by the lender (transferred or sold). Under many jurisdictions, the rights and obligations provided under a promissory note are easier to enforce than those provided under a loan agreement.

L O A N D O C S

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Note Components

• Amount borrowed • Rate of interest • Dollar amount, due dates, and number of

payments • Maturity date • Reference to security for the loan • Application of payments • Default • Penalties for late payment and forbearance

provisions

• Prepayment conditions • Provisions for unscheduled (early) payments • Notification of default and acceleration clause • Nonrecourse clause

Note that even if there is a nonrecourse clause, loans are generally with “recourse” if the “bad boy” provisions are violated. This could include fraud or misrepresentation. Another example would be if the borrower willfully damages the asset, the borrower will generally be held personally responsible for the damage.

• Loan assumability

• Assignment clause

• Future advances

• Release of lien by lender

Evidence of Debt Major Provisions

L O A N D O C S

191

The Mortgage Instrument

Note & Mortgage • The note and the mortgage are not the same thing

• Note: Obligation to pay

• Mortgage: Pledges property as security

The mortgagor is the borrower. The mortgagee is the lender.

This is often confused by people who are new to the industry.

L O A N D O C S

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Loan Agreement

The loan agreement will contain the majority of the obligor/creditor language.

Features include: • Definitions • Mechanics – ie spells draw features if a

construction or draw note • Representations and Warranties • Affirmative and Negative Covenants • Events of Default • Casualty and Condemnation

L O A N D O C S

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Other Loan Docs

Corporate Resolutions

Subordination Agreement, Intercreditor Agreement

Assignment Agreement, Pledge Agreement

Disbursing Agreement

Guaranty

Security Agreement; Deposit Account Control Agreement

Disclosures

L O A N D O C S

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Loan-to-Value – The principal amount of the loan divided by the collateral value.

Debt Yield – The property NOI divided by the loan amount.

Interest Coverage Ratio – The property NOI divided by the annual interest payment.

Debt Service Coverage Ratio – The property NOI divided by the annual debt service payment.

Fixed Charges Ratio – The property NOI divided by all fixed charges incurred annually.

Five Key Lender Ratios

L O A N D O C S

195

The fixed charges ratio allows the lender to understand what type of position the borrower will be in given his existing commitments.

Most Conservative Lender Ratio L O A N D O C S

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Lender may require provides copies of all new pending leases prior to execution

Lenders focus on quality

Lenders may require that the building be leased to tenants of a specified minimum credit quality or make considerations accordingly

The more risk, the more control / structure features the lender will require

L O A N D O C S

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Key Loan Sizing Ratios

Loan-to-Value (LTV)

• Principal amount / appraised value

• 50%-70%

Loan-to-Cost (LTC) – based on eligible loan costs

• Principal amount / eligible loan costs

• 55%-70%

Debt yield

• NOI /principal amount

• 8%-13%

Debt Service Coverage Ratio (DSCR)

• NOI / annual debt service including amortization

• 1.2x and greater

L O A N D O C S

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Other Key Loan Terms

Loan Covenants

Negative – things you cannot do

Positive – things you must do

L O A N D O C S

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Common Negative Covenants Prepayment penalty

Distributions

Operating restrictions

Additional debt

Common Positive Covenants Deposits

EBIT, Cash Flow, or NOI

Leases

L O A N D O C S

Covenants

200

Capital Structuring

Change in building value will occur regardless of debt

• Values do not always go up

Residual value after debt

• Impact of varying debt amounts on return of and to equity

Debt is a friend on the way up and an enemy on the way down

Equity return from capital appreciation = (residual value at sale – original equity invested)/original equity invested

L O A N D O C S

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Positive and Negative Leverage

Positive leverage means that the property cash flow yield % (NOI after standard reserves / Purchase Price) is greater than the interest rate paid to the lender.

Negative leverage means that the property cash flow yield % is less than the interest rate paid to the lender.

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Structuring

203

Partnership Structure

The correspondences related to this investment, including the attachments, are for prospective qualified and accredited investors. While the source of all content supplied herein has been provided from sources believed reliable, Altus and its affiliates cannot guarantee its accuracy or completeness. This investment involves certain risks. It must be recognized that other risks, not foreseen, may present themselves in the future and that the risks which are foreseen, may affect to a greater extent or in a manner not now contemplated. Prospective investors should carefully consider, among other things, the risk factors and speculative factors as enumerated in the materials.

Project Level Entity

Member Entity

Sponsor Member Co-Investment

OUTSIDE MEMBERSDebt Financing

Asset 100% Owned

Provides 100% of Equity

Altus controlled entity

Minimum ~35% of project equity

Sponsor Manager

Altus controlled entity

Sponsor to accept recourse obligations

En ti

ty M

an ag

Entity Member

S T R U C T U R I N G

204

Partnership Alignment Features

The correspondences related to this investment, including the attachments, are for prospective qualified and accredited investors. While the source of all content supplied herein has been provided from sources believed reliable, Altus and its affiliates cannot guarantee its accuracy or completeness. This investment involves certain risks. It must be recognized that other risks, not foreseen, may present themselves in the future and that the risks which are foreseen, may affect to a greater extent or in a manner not now contemplated. Prospective investors should carefully consider, among other things, the risk factors and speculative factors as enumerated in the materials.

Altus believes the Project Partnership Structure provides investors (including Sponsor Member) with many best-in-market alignment features to ensure Sponsor Manager is continually incentivized to protect Member capital, and deliver optimal risk-adjusted returns, over both short and long term durations. Said alignment features are summarized as follows:

S T R U C T U R I N G

Significant Sponsor Member Co-Investment ~35% Minimum Sponsor Member Co-Investment – Shoulder-To-Shoulder with Outside Members.

Front Loaded Sponsor Member Co-Investment Sponsor Member Co-Investment Front Loaded – Mitigates development risks ahead of Outside Members.

Sponsor Manager Accepts Recourse Sponsor Manager takes on the required recourse risks associated with debt financing without charging Recourse Fee.

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Organizational Forms

Sole Proprietorship

Partnerships

• General partnership

• Limited partnership (“LP”)

• Limited liability partnership (“LLP”)

Limited liability company (“LLC”)

Corporations

C Corporation

S Corporation

• No more than 100 shareholders

• No corporations as shareholders (shareholders must be individual persons)

• No nonresident alien investors

• No more than one class of stock

S T R U C T U R I N G

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Joint Ventures

Risk Sharing

Combine expertise with capital

• Developer/operator/sponsor

• Investor

Speculative objectives

Organizational Forms

Profit Sharing

• Initial and additional capital

• Share in cash flow

• Share in sale

• Preferred return?

• Taxable allocation of income and loss

• Control operations and decisions

S T R U C T U R I N G

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Initial Capital Contributions

The money partner may put up 90 to 95 percent of the money. The developer/manager may put up 5 to 10 percent.

The key concept here is that the developer/manager needs to put up something so there is an alignment of interests.

S T R U C T U R I N G

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Sharing Cash Flow from Operations

In Proportion

• Pari-Passu distribution

Preferred Distribution

• Preferred Return

• Disproportionate sharing

• Cumulative versus non-cumulative

• Promote

Specified Fees

S T R U C T U R I N G

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Sharing of Cash Flow from Sale

Repay any debt

Return of initial investment (if not repaid previously)

Remainder Distributed

• Predetermined portions

• IRR Preference

• IRR Lookback

S T R U C T U R I N G

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A P P E N D I X

Loan Docs - Appendix

211

DSC Fine Print Matters Debt Service Coverage Ratio shall mean, for the twelve (12) month period prior to the date of calculation, the ratio of Operating Cash Flow to Debt Service.

Operating Cash Flow shall mean, during any calculation period, all Gross Revenues actually received in the applicable calculation period arising from the ownership and operation of the Property less the sum of all Operating Expenses for the same period.

Sounds simple and straight forward…

A P P E N D I X

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Revenue – does it include MTM leases? What about condemnation proceeds? What about lease buyouts? What about leases inked but the tenant hasn’t taken occupancy? Or has taken occupancy and is in a free rent period?

What about the differences in asset classes? Multi family DSC is treated differently?

How are revenues calculated example: “in the event that the average occupancy of the Property over the twelve (12) months period prior to the date of calculation drops below ninety-two percent (92%), Gross Revenues shall be calculated based on the annualized rental for the 12 month period subsequent to the date of calculation of actual leases in place as shown on the most current Rent Roll on the date of calculation, plus annualized rental under signed leases which provide for rental to begin within the twelve (12) month period subsequent to the date of calculation.

DSC Fine Print Matters A P P E N D I X

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Operating Expenses shall mean costs, taxes, expenses and disbursements in connection with the leasing, management, operation, maintenance and repair of the Property, including a replacement reserve of $0.20 per square foot and a management fee of the greater of the actual fee or three percent (3%) of Gross Revenues. Operating Expenses shall exclude (i) non-cash expenses, such as depreciation and amortization costs, (ii) state and federal income taxes, (iii) capital expenditures determined in accordance with Accounting Principles, and (iv) Debt Service payable on the Loan.

DSC Fine Print Matters A P P E N D I X

214

Debt Service shall mean the payments of principal and interest that were due payable on the Loan during the period referred to above, assuming required monthly principal and interest payments that would be necessary to fully amortize the Loan over a thirty (30) year period at an interest rate per annum equal to the greater of (i) the then highest applicable Interest Rate; (ii) six percent (6.0%) percent per annum or (iii) two hundred fifty (250) basis points in excess of the rate of ten year United States Treasury Notes as published in The Wall Street Journal on the fifteenth (15th) day preceding the determination of Debt Service Coverage Ratio.

How is debt service calculated? Understanding that part of the ratio is seldom straight forward.

DSC Fine Print Matters A P P E N D I X

215

Option 1: Borrower shall deposit funds with Lender in an amount which equals the amount of principal and interest payments calculated by Lender to be due under Note A and Note B during the twelve (12) month period following such default based on the then principal balance due (and in such event, 1/12th of the amount in such account shall be applied each month towards payments of principal and interest then due B until the balance in such account equals zero or such account is released to Borrower.

Option 2: Borrower shall deposit funds with Lender in an amount, which when subtracted from the aggregate principal balance at such time, the result of which would be a principal amount which would produce Debt Service which would meet the minimum Debt Service Coverage Ratio. Such amounts shall be deposited into an account in the name of Borrower with Lender within thirty (30) days following such failure and shall be pledged to Lender as additional security for the Indebtedness pursuant to a pledge agreement in form and substance satisfactory to the Lender in the Lender’s reasonable discretion.

DSC Cure “Ideas” A P P E N D I X

216

Market Study and Appraisal

Borrower Financials

• Nonrecourse clause. If nonrecourse, it’s sort of like the loan has a built in put option for the borrower.

The Loan to Value Ratio

The Debt Coverage Ratio

Debt Yield

Underwriting Loans on Income Properties A P P E N D I X

217

3/27/23

Lockout Clause

• Prohibits prepayment of loan for a specified period of time

Yield Maintenance Fee

• Guarantees a yield to the lender after a lockout period expires

Sometimes the fee is fixed as a percentage of the outstanding balance.

This percentage may also vary based on the remaining term of the mortgage.

Underwriting Loans on Income Properties A P P E N D I X

218

Existing debt may or may not be assumable

Loan covenants

Equity kicker

Prepayment penalty

Interest rate risk – Fixed versus floating rate

Interest rate hedge products – pros and cons

Loan Documents A P P E N D I X

219

Draws

Amortization

Insurance

Sweep

Secured

Recourse

Guarantees

Receivables

Term

Loan Terms A P P E N D I X

220

Fees for originating the loan

30-100 basis points of the loan size

Paid at loan closing

Loan Points A P P E N D I X

221

3/27/23

Replacing one debt facility with another

May entail fees and prepayment penalties

Reasons to refinance:

• Cash out excess loan proceeds

• Mortgage interest rates

• Increase in property value allows you to borrow more (and take have fallen relative to existing rate

The Refi Decision A P P E N D I X

222

Prepayment Penalties

Sliding scale %-based

Defeasance

Yield Maintenance

A P P E N D I X

223

30/ 360 = 0.0833 daily equivalent rate. Nominal interest rate / 360

Actual / 365

Actual / 360 … most expensive to borrower

Interest Calculation Bases A P P E N D I X

224

Reporting

Covenants - Debt Service Coverage or Debt Yield

Lease approvals

Draw process and procedure

Deal Abstracts A P P E N D I X

225