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Real Estate Finance and Investment

FIN549

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 #3

Readings: Chapter 6, 7

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

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

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

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

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

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

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

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

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

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

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

Investment Decision Making

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

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

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

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

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

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

An investment generating a 15% annualized return using 60% leverage can 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

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

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

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

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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)

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

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

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

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

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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

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

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

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

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

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. 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

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Entity Member

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

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

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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.

Cap Rates/ Valuation

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Appraisal / Valuation Process C A P R A T E S / V A L U A T I O N

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 A T E S / V A L U A T I O N

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 A T E S / V A L U A T I O N

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 A T E S / V A L U A T I O N

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 A T E S / V A L U A T I O N

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 A T E S / V A L U A T I O N

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 A T E S / V A L U A T I O N

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 A T E S / V A L U A T I O N

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 A T E S / V A L U A T I O N

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 A T E S / V A L U A T I O N

Leverage

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

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

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.

+ - L E V E R A G E

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

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

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

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

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

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

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

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%.

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

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

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

Loan Docs

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

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

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

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

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

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

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

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

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

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

Other Key Loan Terms

Loan Covenants

Negative – things you cannot do

Positive – things you must do

L O A N D O C S

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

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

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.

+ - L O A N D O C S

Structuring

Partnership Structure

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 tit

y M

an ag

Entity Member

S T R U C T U R I N G

Partnership Alignment Features

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.

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

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

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

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

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

A P P E N D I X

Loan Docs - Appendix

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

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

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

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

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

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

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

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

Draws

Amortization

Insurance

Sweep

Secured

Recourse

Guarantees

Receivables

Term

Loan Terms A P P E N D I X

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

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

Prepayment Penalties

Sliding scale %-based

Defeasance

Yield Maintenance

A P P E N D I X

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

Reporting

Covenants - Debt Service Coverage or Debt Yield

Lease approvals

Draw process and procedure

Deal Abstracts A P P E N D I X