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Real Estate Finance and Investment

FIN549

Underwriting Development Investments, Interest Rates, and Structuring

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

Class #6

Underwriting

U N D E R W R I T I N G

Overview

Investigation made prior to acquiring an asset

Analyze facts and assumptions

Due diligence checklist

Sensitivities

External factors

U N D E R W R I T I N G

Due diligence is the investigation conducted by an investor prior to acquiring an asset.

It involves analyzing both the facts about the property and competitive market, as well as the robustness of the assumptions made for your financial model.

Due Diligence

U N D E R W R I T I N G

Business Risk Economic Conditions Tenant Mix Lease Provisions

Liquidity Risk Challenges in selling property

Inflation Risk Unexpected inflation. Does income increase enough to offset inflation?

Management Risk Competency of management’s ability to respond to market conditions

Financial Risk Increases with the amount of debt Cost and structure of debt

Interest Rate Risk The impact on variable rate debt The impact of higher rates on residual property value

Legislative Risk Regulatory changes Environmental Risk In the United States, environmental risk applies to anyone in the chain of title. If you buy a property with an environmental issue, you potentially could take on that liability regardless of whether or not you caused the issue.

Types of Risk

U N D E R W R I T I N G

Three primary tools may be employed by investors to minimize their exposure to risk: • Avoidance and identification of risk through due diligence. • Financial tools such as insurance, hedging, and option contracts. • Diversification (either into other product types or different

locations).

Due Diligence in Real Estate Investment Risk Analysis

• Financial

• Tenant

• Physical

• Title, Survey, Environmental, Legal

U N D E R W R I T I N G

Due Diligence

U N D E R W R I T I N G

Revenues - It is necessary to challenge the cash flow assumptions. Revenue can be broken into three components: creditworthiness of the tenant, current leases, and the long-term competitiveness of the property.

Revenues, Expenses & Cap Ex

EExxppeennsseess - It is necessary to understand what costs tenants pay for in a lease. For operating properties, an investor should carefully explore the property financial statements and entity tax returns from the last 3-5 years.

CCaapp EExx - Capital expenditure reserves are the cash reserves for future capital projects. The reserves should cover routine capex and additional funds for unforeseen issues.

U N D E R W R I T I N G

Lease Rollover Risk

Uncertainty of renewal by existing tenants. Tenants may not renew leases. Possible lengthy vacancy. New tenant may require money for tenant improvements. Commissions are an additional cost for new tenants.

Mpls Suburban Office Property

Rollover Variance - Full InPlace Tenancy

Tenant Name Suite Tenant Size % of

Portfolio Expiration Date (Current Term) Current Rent Ending Rate Rollover Rate

Change at

Roll Notes

Mpls Suburban Office Property

Tenant J 291 0.00% Feb-19 999 SF. 100% Vacate Tenant I 290 1,974 0.71% Mar-19 $15.50 $16.00 $16.50 3.13% Tenant W 920 5,600 2.02% May-19 $15.50 $16.00 $16.50 3.13% Tenant X 930 0.00% Jun-19 1,729 SF. Assumed 1YR Flat Renew al, Then 100% Vacate Tenant K 910 23,761 8.58% Sep-19 $17.50 $17.50 $17.50 0.00% Spec 3yr Renew al / Lease Term Blend Tenant M 340 14,243 5.14% Jun-20 $17.50 $17.50 $17.00 -2.86% 50% Renew al. $42.50 New TI / $14.50 Renew TI Tenant H 270 1,945 0.70% Jul-20 $15.60 $16.00 $17.00 6.25% Tenant G 250 2,604 0.94% Aug-20 $16.55 $17.55 $17.00 -3.13% Tenant L 330 1,505 0.54% Aug-20 $16.50 $17.00 $17.00 0.00% Tenant D 155 975 0.35% Sep-20 $17.00 $17.50 $17.50 0.00% Tenant T 800 4,677 1.69% Oct-20 $16.00 $17.00 $17.50 2.94% Tenant AA 1100 22,780 8.22% Dec-20 $15.70 $16.40 $17.50 6.71% Tenant Y 940 4,113 1.48% Jun-21 $16.00 $17.50 $17.50 0.00% Tenant B 130 2,462 0.89% Aug-21 $18.00 $19.00 $17.50 -7.89% Tenant U 810 4,263 1.54% Oct-21 $15.82 $16.90 $17.50 3.55% Tenant AB 1200 20,774 7.50% Dec-21 $15.50 $17.00 $17.50 2.94% Tenant AD 1360 1,665 0.60% Dec-21 $18.00 $19.50 $17.50 -10.26% Tenant AC 1310 10,951 3.95% Jan-22 $17.00 $17.75 $17.50 -1.41% Tenant Q 640 9,346 3.37% Apr-22 $15.50 $17.00 $17.50 2.94% Tenant F 210 2,813 1.02% Jul-22 $16.35 $17.75 $18.00 1.41% Tenant P 620/950 7,505 2.71% Jul-22 $17.75 $19.25 $18.00 -6.49% Tenant V 820 9,539 3.44% Aug-22 $16.10 $17.75 $18.00 1.41% Tenant V 825 2,274 0.82% Aug-22 $15.75 $17.75 $18.00 1.41% Tenant N 350 3,983 1.44% Dec-22 $16.00 $17.00 $18.00 5.88% Tenant Z 1080 3,365 1.21% Apr-23 $16.00 $18.50 $18.00 -2.70% Tenant A 125 3,995 1.44% Sep-23 $16.50 $19.00 $18.00 -5.26% Tenant E 175 1,733 0.63% Dec-23 $16.50 $19.00 $18.00 -5.26% Tenant R 700 18,318 6.61% Sep-24 $14.15 $15.90 $18.00 13.21% 65% Renew Probability Tenant S 710 4,522 1.63% Jun-25 $15.50 $18.75 $18.00 -4.00% Tenant C 140 3,744 1.35% Dec-26 $15.25 $17.00 $18.00 5.88% Tenant O 400-600 58,109 20.97% Apr-29 $15.50 $20.50 $18.00 -12.20%

Ending lease rate compare to projected market

U N D E R W R I T I N G

Concentration Lease Rollover Risk

Mpls Suburban Office Property

Rollover Variance - Full InPlace Tenancy

Tenant Name Suite Tenant Size % of

Portfolio Expiration Date (Current Term) Current Rent Ending Rate Rollover Rate

Change at

Roll Notes

2019 Roll Occupied SF: 31,335 Average: $16.17 $16.50 $16.83 2.08%

Weighted Average: $17.02 $17.14 $17.26 0.76%

2020 Roll Occupied SF: 25,949 Average: $16.53 $17.09 $17.17 0.53%

Weighted Average: $16.92 $17.27 $17.11 -0.88%

2021 Roll Occupied SF: 33,277 Average: $16.66 $17.98 $17.50 -2.33%

Weighted Average: $15.91 $17.32 $17.50 1.19%

2022 Roll Occupied SF: 46,411 Average: $16.35 $17.75 $17.86 0.74%

Weighted Average: $16.45 $17.78 $17.78 0.16%

2023 Roll Occupied SF: 9,093 Average: $16.33 $18.83 $18.00 -4.41%

Weighted Average: $16.31 $18.81 $18.00 -4.32%

2024 Roll Occupied SF: 18,318 Average: $14.15 $15.90 $18.00 13.21%

Weighted Average: $14.15 $15.90 $18.00 13.21%

2025 Roll Occupied SF: 4,522 Average: $15.50 $18.75 $18.00 -4.00%

Weighted Average: $15.50 $18.75 $18.00 -4.00%

2026 Roll Occupied SF: 3,744 Average: $15.25 $17.00 $18.00 5.88%

Weighted Average: $15.25 $17.00 $18.00 5.88%

2029 Roll Occupied SF: 58,109 Average: $15.50 $20.50 $18.00 -12.20%

Weighted Average: $15.50 $20.50 $18.00 -12.20%

Rolls in Investment Period Occupied SF: 168,845 Average: $16.40 $17.56 $17.50 -0.14%

Weighted Average: $16.41 $17.36 $17.50 0.96%

Total Occupied SF: 253,538 Average: $16.22 $17.63 $17.57 -0.02%

Weighted Average: $16.01 $17.99 $17.67 -1.19%

Systematize common analysis

U N D E R W R I T I N G

Concentration and Time

U N D E R W R I T I N G

Control the controllable Confirm terms Understand rights, options, restrictions Termination Clause

Read Every Lease

One Page

Cash Flows

Components

Granular Assumptions

PROPERTY X - Space Buyout Calculation (PREPARED OCTOBER 2017)

Security Deposit On-File 650,000.00$ 48,383 SF

Base Rent

CAM/Insura nce

Recoveries

Real Estate Tax

Recoveries Estimated Electric

Billbacks Total Start Date End Date

2/28/2022 1/30/2023 1,006,274.32$ 3,850.00$ 4,125.00$ 60,500.00$ 1,074,749.32$ 1/31/2023 1/30/2024 1,122,702.75$ 4,326.00$ 4,635.00$ 67,980.00$ 1,199,643.75$ 1/31/2024 1/30/2025 1,147,651.70$ 4,452.00$ 4,770.00$ 69,960.00$ 1,226,833.70$ 1/31/2025 12/30/2025 1,074,883.93$ 4,196.50$ 4,496.25$ 65,945.00$ 1,149,521.68$

12/31/2025 1/25/2026 81,955.96$ 293.55$ 314.52$ 4,612.90$ 87,176.93$ 4,433,468.66$ 17,118.05$ 18,340.77$ 268,997.90$ 4,737,925.37$

**Notes: CAM/Insurance Recoveries are based on the monthly estimate paid in 20XX.

Real Estate Tax Recoveries are based on the monthly estimate currently being paid in 20xx.

Estimated Electric Billbacks are for the 1st floor data room and are based on the 20XX monthly average.

Discount BuyOut Savings Original 25.0% $3,553,444 $1,184,000

U N D E R W R I T I N G

Lease Buyout

U N D E R W R I T I N G

Revenues, Expenses & Cap Ex

Expenses - It is necessary to understand what costs tenants pay for in a lease. For operating properties, an investor should carefully explore the property financial statements and entity tax returns from the last 3-5 years.

Cap Ex - Capital expenditure reserves are the cash reserves for future capital projects. The reserves should cover routine capex and additional funds for unforeseen issues.

Mpls Suburban Office Property Operating Expense Detail

2015 Actual 2016 Actual 2017 Actual Altus 2019 Budget

Building Occupancy 75.0% 87.0% 80.0% Building Occupancy 96.51%

Cleaning $331,834 $1.20 $375,465 $1.36 $404,332 $1.46 Repairs & Maintenance $404,004 $1.46 R&M $189,265 $0.68 $111,772 $0.40 $185,935 $0.67 Landscape $82,152 $0.30 Utilities $509,295 $1.84 $530,127 $1.91 $634,249 $2.29 Cleaning $497,700 $1.80 Salaries $328,168 $1.18 $318,129 $1.15 $290,981 $1.05 Security & Safety $98,016 $0.35 Supplies $31,771 $0.11 $19,640 $0.07 $18,666 $0.07 Utilities $652,728 $2.36 Contract Services $249,605 $0.90 $215,139 $0.78 $243,863 $0.88 Parking $53,352 $0.19 Administrative $149,925 $0.54 $166,677 $0.60 $160,470 $0.58 Management Fee (2.5%) $191,960 $0.69 Management Fee (2.5%) $125,523 $0.45 $137,439 $0.50 $161,535 $0.58 Administrative $103,908 $0.38 Electric Billback $0.00 $0.00 $0.00 Insurance $57,816 $0.21 Insurance $68,879 $0.25 $62,367 $0.23 $63,615 $0.23 Real Estate Taxes $1,402,836 $5.06 RE Taxes $1,231,593 $4.45 $1,326,693 $4.79 $1,138,426 $4.11 LL Misc NR Expenses $59,592 $0.22 LL Misc NR Expenses $942 $0.00 $3,058 $0.01 $204,418 $0.74

Totals $3,216,801 $11.61 $3,266,507 $11.79 $3,506,491 $12.66 Totals $3,604,064 $13.01

Reimbursable CAM $1,915,387 $6.91 $1,874,388 $6.77 $2,100,031 $7.58 Reimbursable CAM $2,083,820 $7.52 Insurance $68,879 $0.25 $62,367 $0.23 $63,615 $0.23 Insurance $57,816 $0.21 Real Estate Taxes $1,231,593 $4.45 $1,326,693 $4.79 $1,138,426 $4.11 Real Estate Taxes $1,402,836 $5.06 Non-Reimbursable Expenses $942 $0.00 $3,058 $0.01 $204,418 $0.74 Non-Reimbursable Expenses $59,592 $0.22

Totals $3,216,801 $11.61 $3,266,507 $11.79 $3,506,491 $12.66 Totals $3,604,064 $13.01

Staging for sale risk

Inefficiencies

Property contracts

U N D E R W R I T I N G

Historical Expenses

Staging for sale risk Inefficiencies Property contract

Cap Ex - Capital expenditure reserves are the cash reserves for future capital projects. The reserves should cover routine capex and additional funds for unforeseen issues.

U N D E R W R I T I N G

Revenues, Expenses & Cap Ex

One Page

Cash Flows

Components

Granular Assumptions

Offsets

U N D E R W R I T I N G

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

General Vacancy Inflation Credit Loss Structural

U N D E R W R I T I N G

Understanding the neighborhood and market within which your property is located is critical, as the attractiveness of the market will determine the viability of the property in the long run.

Neighborhood & Market

Relationships with brokers and accessing available information • Where are job centers, major employers • Housing stock, demographics • Nuance - art and food scene as leading indicator,

neighborhoods in transition.

Recognizing stimulants government, transportation, etc.

U N D E R W R I T I N G

Neighborhood Analysis

U N D E R W R I T I N G

Market Reports

Evaluation of supply and demand for a type of property Absorption Supply of Space Market Rents Forecasting Supply, Demand, Market Rents, and Occupancy

U N D E R W R I T I N G

Market Analysis

U N D E R W R I T I N G

Economic vs. Physical Occupancy

Economic occupancy refers to the space that generates rents, while physical occupancy refers to space currently physically occupied.

The difference is often referred to as ‘shadow’ vacancy (i.e., space that a tenant pays for, but does not physically occupy).

Categories of employment with very high proportions of office use includes service and professional employment, including attorneys, accountants, engineers, insurance real estate brokerages and related activity, banking, financial services, consultants, medical dental, pharmaceutical

Supply Influences: Vacancy rates, interest rates and financing availability, age and combination of existing supply stock, construction costs, land costs.

U N D E R W R I T I N G

Demand Influences: Office

Supply Influences: Labor access, Vacancy rates, interest rates and financing availability, age and combination of existing supply stock, construction costs, land costs.

Categories of employment with high concentrations in warehouse use include wholesaling, trucking, distribution, assembly, manufacturing, sales/service, etc

U N D E R W R I T I N G

Demand Influences: Industrial

Demand indicators include household incomes, age, gender, population, size, and tastes/preference.

Supply Influences: Vacancy rates, interest rates and financing availability, age and combination of existing supply stock, construction costs, land costs.

U N D E R W R I T I N G

Demand Influences: Retail

Number of households, age of persons in households, size of household incomes, interest rates, home ownership, affordability, apartment rents, housing prices.

Supply Influences: Vacancy rates, interest rates and financing availability, age and combination of existing supply stock, construction costs, land costs.

U N D E R W R I T I N G

Demand Influences: Apartments

Average income for the 3-mile radius

School District

Inventory analysis – Age, Supply

U N D E R W R I T I N G

Demand Influences: Apartments

U N D E R W R I T I N G

Vacancy Rate Supply and Demand Short run vs. long-run

Equilibrium Market Rental Rate

Mpls Suburban Office Property BLDG MLA - 1st Roll

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 BLDG MLA - 1st Roll Dec-2019 Dec-2020 Dec-2021 Dec-2022 Dec-2023 Dec-2024 Dec-2025 Term Length (Years/Months) 5/1 5/1 5/1 5/1 5/1 5/1 5/1 Renewal Probability† 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% Months Vacant 12.00 12.00 12.00 12.00 12.00 12.00 12.00 Months Vacant (Blended) 3.00 3.00 3.00 3.00 3.00 3.00 3.00 Market Base Rent (New, $ / SF / Year) 16.50 17.00 17.50 18.00 18.00 18.00 18.00 Market Base Rent (Renew, $ / SF / Year) 16.50 17.00 17.50 18.00 18.00 18.00 18.00 Market Base Rent (Blended, $ / SF / Year) 16.50 17.00 17.50 18.00 18.00 18.00 18.00 Fixed Steps ($ / SF / Year) 0.00 0.50 0.50 0.50 0.50 0.50 0.50 Free Rent (New, Months) 3.00 3.00 3.00 3.00 3.00 3.00 3.00 Free Rent (Renew, Months) 1.00 1.00 1.00 1.00 1.00 1.00 1.00 Free Rent (Blended, Months) 1.50 1.50 1.50 1.50 1.50 1.50 1.50 Recovery Type NNN NNN NNN NNN NNN NNN NNN Tenant Improvements (New, $ / Area) 32.50 32.50 32.50 32.50 32.50 32.50 32.50 Tenant Improvements (Renew, $ / Area) 12.50 12.50 12.50 12.50 12.50 12.50 12.50 Tenant Improvements (Blended, $ / Area) 17.50 17.50 17.50 17.50 17.50 17.50 17.50 Leasing Commissions (New, $ / SF) 7.5 7.5 7.5 7.5 7.5 7.5 7.5 Leasing Commissions (Renew, $ / SF) 7.5 7.5 7.5 7.5 7.5 7.5 7.5 Leasing Commissions (Blended, $ / SF) 7.5 7.5 7.5 7.5 7.5 7.5 7.5 Upon Expiration BLDG MLA - 2nd Roll BLDG MLA - 2nd Roll BLDG MLA - 2nd Roll BLDG MLA - 2nd Roll BLDG MLA - 2nd Roll BLDG MLA - 2nd Roll BLDG MLA - 2nd Roll

Growth Rates Market Rent. Months Vacant. Leasing Commissions. Tenant Improvements.

U N D E R W R I T I N G

Mpls Suburban Office Property Portfolio-Level NOI & Occupancy Indicator

65.00%

70.00%

75.00%

80.00%

85.00%

90.00%

95.00%

100.00%

$2,200,000

$2,700,000

$3,200,000

$3,700,000

$4,200,000

$4,700,000

$5,200,000

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Portfolio Exit Date NOI Occupancy

Tenant AA / September 2020 /

22,780 SF

Tenant AB / December 2021 /

20,774 SF

Tenant R / September 2024 /

18,318 SF

Tenant O / April 2029/ 58,786 SF

Tenant K / 23,761 SF / Spec Rollover Post 3YR Lease Term

Renewal/Blend.

Snapping it all Together U N D E R W R I T I N G

U N D E R W R I T I N G

Tenant Physical Title Survey Environmental Legal

Due Diligence

Title - Title reports contain detailed legal property descriptions and information about the property, including its previous usage and ownership.

Survey - A title survey will feature a description of the property and will detail where improvements have been made, as well as what can potentially be added. Easements which have been granted should be noted in this description.

Environmental - According to the current Superfund Law, you are liable for environmental damage regardless of whether you were the source or not. You are still permitted to collect from the original polluter via a tort claim but the capital outlay for environmental damage can be substantial. Due diligence helps determine if these problems exist before you purchase the property.

Legal - You will also need to conduct legal diligence to determine if there are outstanding legal claims associated with the property.

U N D E R W R I T I N G

Title, Survey, Environment & Legal

Title - Title reports contain detailed legal property descriptions and information about the property, including its previous usage and ownership.

Legal - You will also need to conduct legal diligence to determine if there are outstanding legal claims associated with the property.

U N D E R W R I T I N G

Title, Survey, Environment & Legal

Easements are the right to do something on, above, or under a property.

They could be “appurtenant” easements, such as rights for someone to cross through the property for transportation, ingress, or egress purposes.

Other common easements include “in gross” easements, which are for the benefit of a person or company, rather than the benefit of another parcel of land. An example is an easement for public utilities.

It is important to understand who is permitted to cross one’s property.

U N D E R W R I T I N G

Title, Survey, Environment & Legal

Title - Title reports contain detailed legal property descriptions and information about the property, including its previous usage and ownership.

Legal - You will also need to conduct legal diligence to determine if there are outstanding legal claims associated with the property.

U N D E R W R I T I N G

Title, Survey, Environment & Legal

While the previous owner of a property may not have engaged in activities that cause severe environmental damage, if a property has environmental contamination, the Superfund Law makes a property owner liable for damages whether or not they were the source.

The property owner can then take legal action against the original polluter via a tort claim. As a result, environmental problems can be devastating.

Why are environmental issues critical?

U N D E R W R I T I N G

Title, Survey, Environment & Legal

Title - Title reports contain detailed legal property descriptions and information about the property, including its previous usage and ownership.

Legal - You will also need to conduct legal diligence to determine if there are outstanding legal claims associated with the property.

U N D E R W R I T I N G

Title, Survey, Environment & Legal

Deeds Grantor & Grantee

General Warranty Deed

Covenant that the grantor has good title

Covenant that the grantor has the right to convey the property

Covenant to compensate the grantee for loss of property or eviction as a result of a superior claim

No encumbrances on title except those noted

U N D E R W R I T I N G

Title, Survey, Environment & Legal

SSppeecciiaall WWaarrrraannttyy DDeeeedd • Limits the covenants to the ownership duration of the current grantor. • No guarantees on the ownership of prior grantors.

BBaarrggaaiinn aanndd SSaallee DDeeeedd.. Conveys property without seller warranties. Sometimes called an “as-is” deed.

SShheerriiffff’’ss DDeeeedd--TTrruusstteeee DDeeeedd.. Bargain and sale deed received by a buyer from a foreclosure or other forced sale by sheriff or trustee. No warranties are added.

Title Assurance

U N D E R W R I T I N G

Title, Survey, Environment & Legal

Title search Study of relevant records Lawyer’s opinion on title Is it good and marketable? Are there any clouds on title? Is there a break in the chain of title?

Abstract and Title

U N D E R W R I T I N G

Title, Survey, Environment & Legal

Title Insurance - Components One time premium Unseen Hazards in the Public Record

Risk is spread among many property owners.

OOwwnneerrss’’ PPoolliiccyy Insures the interest of a new owner.

LLeennddeerr’’ss PPoolliiccyy Insures the interest of the lender.

U N D E R W R I T I N G

Title, Survey, Environment & Legal

May be recorded “after the fact” Seller’s affidavit Lien waiver

Title is Not Clean: Mechanics Liens

U N D E R W R I T I N G

Title, Survey, Environment & Legal

Title - Title reports contain detailed legal property descriptions and information about the property, including its previous usage and ownership.

Legal - You will also need to conduct legal diligence to determine if there are outstanding legal claims associated with the property.

U N D E R W R I T I N G

Title, Survey, Environment & Legal

It is important to understand how a property is encumbered by debt if you plan to assume that debt.

The covenants and detail in existing loan documents will determine what a new owner is permitted to do.

Loan Documents

U N D E R W R I T I N G

Title, Survey, Environment & Legal

Development

D E V E L O P M E N T

Build to X% Calculation (yield on cost) = Expected Stabilized NOI/ Expected Total Costs

• Permitting • Size and cost of the proposed development • Price an investor will pay to obtain the land • Price a project may bring when sold

D E V E L O P M E N T

Overview: The Planning and Permitting Process

D E V E L O P M E N T

• TThheerree aarree ffiivvee sstteeppss ttoo tthhee ddeevveellooppmmeenntt ooff iinnccoommee pprroodduucciinngg pprrooppeerrttyy::

1. Acquire a site 2. Entitle & Develop it 3. Finish it and get it & stabilize occupancy 4. Manage 5. Sell

The Development of Income Producing Property

Phases of Real Estate Project Development and Risk

D E V E L O P M E N T

Access the long description slide

DDeevveelloopp,, oowwnn,, mmaannaaggee,, aanndd lleeaassee pprroojjeeccttss ffoorr mmaannyy yyeeaarrss

• Leasing and management are major components of the business model

DDeevveelloopp,, oowwnn,, lleeaassee--uupp ttoo nnoorrmmaall ooccccuuppaannccyy,, tthheenn sseellll

• Buyers could be insurance companies, syndicates, etc

• Sometimes continue to manage the property after sale

D E V E L O P M E N T

Developer Business Strategies 1

DDeevveelloopp llaanndd aanndd bbuuiillddiinnggss iinn aa mmaasstteerr--ppllaannnneedd ddeevveellooppmmeenntt • Business parks and industrial parks • Some “build to suit” for a single tenant

SSoommee ddeevveellooppeerrss ssppeecciiaalliizzee iinn ssppeecciiffiicc ddeevveellooppmmeenntt pphhaasseess

MMoosstt ddeevveellooppeerrss wwiillll ccoonnssiiddeerr aa sseerriioouuss ooffffeerr ttoo ppuurrcchhaassee aatt aannyy ttiimmee

D E V E L O P M E N T

Developer Business Strategies 2

MMaarrkkeett RRiisskkss aanndd PPrroojjeecctt FFeeaassiibbiilliittyy:: • Risk begins with acquisition

• Seasoned Property

• Leasing Prior to Completion

• Demand Factors

• - Vacancy rates, rent levels, predevelopment leasing commitments

• - Post-development competition

• - What do end users want?

D E V E L O P M E N T

The Development of Income Producing Property 1

1. RSSttaabbiilliizzeedd NNOOII ppeerr G SSFF = Rental Revenues per SF – Operating Costs per SF

2. YYiieelldd oonn CCoosstt %% = Expected Stabilized NOI / Expected Total Costs

D E V E L O P M E N T

Yield on Cost

Project Risks: Site Location • Value increases with tenant perception • More valuable sites result in higher-quality developments • Density increases with value perception

Specific Component Risk • How design features and amenities are

valued by potential tenants • Uncertainty about how quantity and quality

of services should be packaged

D E V E L O P M E N T

The Development of Income Producing Property 2

DDeevveellooppeerr CChhaalllleennggeess:: • National and local economies • Competition among developers • Changes in tenant preferences

• Development is impacted by the regulatory environment

PPrroojjeecctt DDeevveellooppmmeenntt::

D E V E L O P M E N T

Project Development 1

PPeerrmmiittttiinngg:: • AApppplliiccaattiioonn

o Site o Location o Preliminary

Design

ZZoonniinngg • If in compliance, then permitted • If not in compliance, then appeals process

- City planning department input

D E V E L O P M E N T

Project Development 2

EEqquuiittyy iinnvveessttmmeenntt::

• DDeevveellooppeerr • PPaarrttnneerrsshhiipp

• CCoonnssttrruuccttiioonn ((IInntteerriimm)) llooaann:: • Often referred to as an acquisition and development loan

(“A D L”) or a construction and development loan (“C&D”)

• Appraised value of completed development

• Hard costs

Materials and labor

• Soft costs

Planning, Legal, non-contractor fees, leasing, etc

D E V E L O P M E N T

Project Development Financing 1

Source: Altus Properties

D E V E L O P M E N T

Real Estate Development Risk

LLooaann SSttrruuccttuurreess::

• Short-term financing if the intent is to sell the property after completion and lease-up

• Long-Term ownership as part of their business plan: Permanent loan with up-front construction financing period.

• Construction financing followed by extended financing (a “mini-perm”) if the developer might own the property for a short while

D E V E L O P M E N T

Project Development Financing 2

LLooaann ssuubbmmiissssiioonn iinnffoorrmmaattiioonn • Detailed description of development and market analysis

RReeqquuiirreemmeennttss bbeeccoommee ccoommpplliiccaatteedd wwhheenn mmuullttiippllee lleennddeerrss aarree nneeeeddeedd.. • Permanent commitment • Binding agreement between developer and permanent lender

PPeerrmmaanneenntt lleennddeerr oorr ““ttaakkee oouutt”” ccoommmmiittmmeenntt ““ttaakkeess oouutt”” tthhee ccoonnssttrruuccttiioonn lleennddeerr..

D E V E L O P M E N T

Lender Requirements in Financing Project Development

TThhee pphhaasseess ooff ddeevveellooppmmeenntt oovveerr ttiimmee aarree::

1. Phase I: Land acquisition

2. Phase II: Entitlement & Construction

3. Phase III: Completion and occupancy

4. Phase IV: Management

5. Phase V: Sale

The trend is the same regardless of whether the completion is ahead of, on, or behind schedule. Risk increases to Phase III then decreases, but the risk is greatest in each phase if the completion is behind schedule and the risk is lowest in each phase if the completion is ahead of schedule.

D E V E L O P M E N T

Phases of Real Estate Project Development and Risk

The llaaggggeedd ttiimmiinngg ooff ssuuppppllyy is a major factor in the success of a development.

Developers often initiate projects in a very strong market when demand for new space is high.

Due to the prolonged nature of real estate development, projects often come online after demand for the product has weakened, or alternatively, after competitive new supply has already been delivered.

Such conditions often make it difficult for a developer to find new tenants for the project while existing tenants in the area are already committed to long-term leases in neighboring buildings.

D E V E L O P M E N T

Supply Timing

A newly developed building can often remain poorly leased, while an older, inferior building is fully occupied at above-market rents.

The shift in occupancy to newer buildings will eventually occur as existing leases terminate, but developers will often incur substantial losses in the early years due to the poor timing of the project.

Demand growth (in strong locations) will eventually close the supply/demand gap, but it is important to understand that demand grows slowly, as it is directly linked to (and lags) job & household creation/migration in the market.

D E V E L O P M E N T

Macro Development

D E V E L O P M E N T

At the end of the 1990s, the tech bubble created high expectations for extensive U.S. job growth and, in fact, from 1999 to 2000, 6 million new jobs were created.

As a result, a surge of office development began, creating an excess supply of new space. However, as the tech bubble burst in 2000, the market was flooded with a surplus of newly developed office buildings in the face of negative job growth.

Supply and Demand Case Study

In fact, during 2001- 2003, the U.S. economy lost approximately 2 million jobs, bringing office vacancy rates to an astounding 18%.

Only by mid-2007, after 5 years of strong demand growth and little new supply, did vacancy rates fall below 10%.

Property Type Blank Typical Construction Periods

Apartments Suburban, garden walkup Urban mid-, high-rise

6 to 18 months 18 to 24 months

Office Buildings Suburban low-rise CBD mid-, high-rise

18 to 24 months 24 to 28 months

Retail Strips/standalone Neighborhood/community Enclosed mails

6 to 12 months 12 to 24 months 36 to 48 months

Warehouse Suburban, single level 9 to 12+ months

D E V E L O P M E N T

Determinants of Supply

GGooiinngg--iinn ccaapp rraattee ((DDeevv.. YYiieelldd)) of a development is the projected stabilized NOI for the property divided by the expected total development cost.

GGooiinngg--oouutt ccaapp rraattee is the stabilized NOI divided by the developer’s projected sales price.

GGrroossss ddeevveellooppmmeenntt pprrooffiitt mmaarrggiinn is the expected pre-income tax profit margin (i.e., the expected going-in cap rate divided by the going-out cap rate minus 1), and is typically 15-25%.

D E V E L O P M E N T

Development Proforma Analysis

D E V E L O P M E N T

VVaalluuee ccrreeaattiioonn:: ffiinnaall pprroodduucctt >> iinnggrreeddiieennttss

Build to an “X” and sell for a “Y”

Going-in cap rate (Development Yield)

Going-out (exit) cap rate

Gross development profit margin %

• (Expected cap rate on cost / expected cap rate on sale) - 1

Opportunity

D E V E L O P M E N T

DDiirreecctt DDeevveellooppmmeenntt CCoossttss

• Construction (materials and labor)

Hard Costs

D E V E L O P M E N T

IInnddiirreecctt DDeevveellooppmmeenntt CCoossttss

• Development fees

• Legal, Design, • Interim Interest & Stabilization Carry

• Consultants

• Transfer & recording fees

• Contingency reserve

• Many more

Soft Costs

Pre-leasing

Pre-sales

Certificate of occupancy unlocks the cash stream

D E V E L O P M E N T

Revenue Risk Mitigation

CCaauusseess::

• Regulatory approvals • Vendor availability • Weather • Financing • Environmental • Mistakes / changes

Impact to pre-leased / pre-sold space and financing

D E V E L O P M E N T

Delay Risk

AA ddeevveellooppeerr mmaayy cchhoooossee ttoo pprree--lleeaassee ssppaaccee ttoo mmiittiiggaattee ssoommee ooff tthhee ddeevveellooppmmeenntt rriisskk..

A pre-leasing agreement will specify the space leased, the rents agreed upon, design and improvement specifications, and other terms between the developer and a tenant, all negotiated prior to completion of the development.

Although legally binding, the agreement is contingent on many conditions.

The tenant can back out of the agreement if the development is not ready on time due to construction delays or if the design does not comply with the agreed specifications.

Also, the tenants could go out of business during construction, leaving the developer with empty space and leasing risk.

D E V E L O P M E N T

Pre-Lease

Investments, Interest Rates & More on Structuring

Interest rates correlated with cap rates? The thinking is that Treasury up, cap rates up; Treasury down, cap rates down

As a low-risk investment, appetite grows when yields on govt. debt fall.

The further demand suppresses cap rates by increasing the spread - all else equal, buyers are willing to pay more for the same investment

I N V E S T M E N T S , I N T E R E S T R A T E S & M O R E

Interest Rates and Cap Rates

Cap Rate Correlation I N V E S T M E N T S , I N T E R E S T R A T E S & M O R E

CAP RATE = REAL INTEREST RATE + SPREAD

•Spread = f (expected rent growth, debt availability, performance of other assets, etc.)

•Real long-term interest rates are the key driver of cap rates. In effect, cap rates move 1- for-1 with real interest rates in the long run.

CBRE Research: What Interest Rate Normalization Means for Global Real Estate Investors

I N V E S T M E N T S , I N T E R E S T R A T E S & M O R E

RRiisskk SShhaarriinngg

CCoommbbiinnee eexxppeerrttiissee wwiitthh ccaappiittaall

• Developer/operator/sponsor

• Investor

SSppeeccuullaattiivvee oobbjjeeccttiivveess

OOrrggaanniizzaattiioonnaall FFoorrmmss

PPrrooffiitt SShhaarriinngg

• Initial and additional capital

• Share in cash flow

• Share in sale

• Preferred return?

• Taxable allocation of income and loss

• Control operations and decisions

Joint Ventures

Committed capital vs. invested capital (drawn through capital calls)

Typical holding period of 5 to 10 years with extension option

Gathering commitments takes 12 to 24 months and perhaps $1 million in costs

Covenants regarding when subsequent funds can be raised

Sponsor typically required to invest 1% to 50% (5%-20% for middle market) of committed capital

I N V E S T M E N T S , I N T E R E S T R A T E S & M O R E

Fund Features