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organizedhomecase.zipOrganized home questions.docx
Organized home questions
(1) With an initial loan commitment of $1,225,000 and using the initial terms outlined in the case, what is ARP's expected return if the property is held for six years? Eleven years? Assume that ARP and its investors are in the 31% marginal tax bracket at the federal level and the 6% bracket at the state level. Assume a 28% capital gains tax rate and standard depreciation schedules. Similar projects in the Atlanta market have sold at cap rates of between 8.5% and 11%.
(2) What are the pros and cons of the transaction excluding the new cost uncertainty?
(3) Does the enhanced design required by The Organized Home add value to the real estate? Does it add value to the company's brand? If The Organized Home moved out of the building, would the design increase/decrease leasing opportunities?
(4) Do you think the development process, primarily the building design process, is different for major national retailers such as Walgreen's, CVS, or Revco?
(5) Review TOH's financial statements. What is the company's financial condition? What will be the financial impact of the company's growth plans?
(6) What is your impression of the value placed upon limited out-parcel availability at North Point Mall? Is the location really as good as Adams thinks?
(7) Has Adams missed any options during his thought process?
(8) Assess the risks of each of the options defined by Adams as well as any options you believe to be superior.
(10) With the new debt and equity structures that might result from the potential options, quantify ARP's return using a discounted cash-flow model similar to that required in Question 1. Use the same basic cap rate and tax assumptions. List and defend any additional assumptions.
(11) Develop and summarize an action plan for Adams. What should he do and what should his negotiating strategy be? This should be in the form of an executive summary
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Teaching Notes Teaching notes are available and stress various objectives from the actual calculation of investment returns to potential discussion topics on the develop- ment process, construction lending, lease negotiations, the value of design, and differences in build-to-suit projects for national versus local retail chains. The actual negotiated deal structure is presented along with a summary of subsequent property performance.
PRELUDE Don Adams, President of Atlanta Retail Properties (ARP) was ready for a break. He had been working on the The Organized Home (TOH) project for the last few months and hoped to move from the planning stage to the actual development stage of the project by August 1, 1996. After several rounds of negotiation, he had received a commitment letter for a construction loan with an option to convert to a permanent mortgage from Alabama Life earlier in the day and only needed to reconfirm the cost components of the deal before heading out for a long weekend at his vacation house on Lake Lanier. Don was less confident than normal in his own cost estimates because the TOH management team had requested that the architect make a couple of changes to the building's design. Since this store was to be the chain's signature store, management wanted to improve the design of the building's entrance and change the texture of the building's exterior. Don didn't believe the changes would be too costly, but wanted to enjoy the long Fourth of July weekend by eliminating any doubt.
However, before Adams could get David James of Metropolitan Contractors on the line, his phone rang. As luck would have it, it was David, "Don, I don't think you're going to like the new cost numbers. I think we are looking at about $250,000 in additional costs to build in the design features the client wants. The atrium design they want is an additional $120,000 and the split-block design they have selected will cost at least $80,000 over the original construction estimate. When you add these costs to a couple of the other smaller changes they want, like more office space than originally projected, we are easily $250,000 over our original $1,750,000 development cost estimate. Needless to say, that's a lot of money on a 16,000-square foot building. I'll fax the details over when I get the final numbers on all the changes."
Adams was frustrated by the news, but decided to think about his options over the weekend. He had a good working relationship with the management team at TOH and had already discussed his required investment returns. Still, Adams' primary concern was how to fund the additional costs, given the limitations created by the loan commitment he had just received and his investors' required investment returns. Too much time and too much creativity had already gone into the deal to have it unravel.
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Case Study: Single-Tenant Retail Development Hardin and Aycock
THE DEVELOPMENT GROUP Atlanta Retail Properties (ARP) is a family-controlled real estate management, leasing and development firm. Since none of the present family members take an active interest in the day-to-day operations of the firm, this responsibility is placed on Don Adams, 47, the company's president who has been with the firm for seven years. Adams was hired by the firm after the firm's founder and family patriarch died unexpectedly in 1989. Adams oversees the company's operations and is actively involved in new development, property management and the brokerage of large commercial projects. Most of the firm's activity is in retail property. The company and family partnerships control approximately seventy-five retail pro- perties with most being less than 10,000 square feet in size. Although the family has developed larger neighborhood centers, its niche is in providing build-to-suit space for local and regional retail chains.
The company's board of directors, composed of Adams and four family members, must approve investments made by affiliated entities or partnerships. The board is relatively conservative, but is willing to take some risk if properly compensated. The board attempts to mitigate the inherent risk of dealing with local and regional tenants via diversification of its tenant base, the use of relatively large amounts of equity capital on a specific transaction basis, and by the selection of development sites in areas with above-average population growth and potential for retail development.
Because the firm and family-controlled partnerships have acquired a substantial real estate portfolio over the last forty years, the firm and the partnerships it controls have little debt, excellent cash flow, and a substantial line of credit available for development activities. The line of credit, provided by a regional bank, allows the firm to make equity investments in new projects and is repaid from existing operating cash flows. Most new development deals are structured as separate limited partnerships with ARP as the general partner. The new deals are financed via equity contributions generated from existing family partnerships and transaction-specific debt.
In the last eighteen months, Adams has completed three build-to-suit projects on behalf of the firm and family interests. He has also been looking for new build-to- suit opportunities with companies requiring multiple locations. Because ARP is a small firm, with only four salaried employees, the opportunity to do multiple-site deals is efficient.
THE TENANT The Organized Home (TOH) was founded in Atlanta in late 1993 by a group of three recent Vanderbilt University graduates. Ed Brown is the company's CEO. The company was initially capitalized with $250,000 in equity and a $250,000 line of credit that was sufficient for the company's first 8,000 square foot location which opened in 1994 in the affluent Buckhead neighborhood in Atlanta. The store specializes in selling all types of containers, including household and office
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storage systems. On a stand-alone basis, the first store was marginally profitable by fiscal year-end 1995 (see Exhibit 1) as the group looked for additional locations for expansion. Unlike its primary competition, The Container Store which concentrates on one store per metropolitan area, TOH plans to have multiple locations within any given metropolitan area. After Atlanta, the group plans stores in Charlotte, Nashville and Jacksonville.
During the final half of 1995, TOH management was successful in raising additional financial commitments to implement its growth strategy. Using Ed Brown's connections within the retail industry, an additional $2,000,000 in capital was raised by January 1996. A venture capital group composed of ex-retail industry executives provided $1,000,000 in equity capital and guaranteed a $1,000,000 line of credit. The executives were looking for retail opportunities and felt that TOH might be a "category killer" in the home storage and container retail submarket. The venture capital group added substantial credibility to the company and provided the young TOH management team with needed experience. The additional capital would support the two or three additional stores the company planned to open in 1996. The capital infusion, however, does not mitigate the fact that the company was not profitable on a GAAP basis in fiscal 1995 and continues to have a negative operating cash flow due to its expansion activities.
Although the management team at TOH had planned to only open stand-alone buildings, the next site the company selected was in a retail strip center adjacent to Perimeter Mall in North Atlanta. Negotiations for the store site started in mid- 1995 with the store opening in April 1996. Concurrent with the selection of the Perimeter Mall site, the company was also looking for a site adjacent to the new North Point Mall in Alpharetta, Georgia to build its prototypical store and maintain a strong presence in the fast growing, affluent North Atlanta suburban market.
THE NORTH POINT MALL MARKET North Point Mall is the newest enclosed mall in metropolitan Atlanta. Developed by Homart, the mall is anchored by Rich's, Dillard's, J. C. Penney, Lord & Taylor, and Sears. In early 1996, Parisian's, a well-regarded Alabama-based department store, committed to build a store at the center. The land adjacent to the mall is controlled by Cousins Properties, an Atlanta-based real estate investment trust. Development around the mall has included single-tenant build-to-suits, power centers, hotels, and class A office. The North Point Mall area is accessible via GA 400, a major highway, and several major surface streets. Most real estate professionals see the GA 400 corridor as the major real estate market in the city for the next ten years.
Because the North Point market is so new there is little available data on comparable retail space. However, as noted, there is limited land adjacent to the mall, the premium location in the North Point retail market. Consequently, rental
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Case Study: Single-Tenant Retail Development Hardin and Aycock
Exhibit 1 The Organized Home Income Statement and Balance Sheet
Revenue Cost of Goods Sold Gross Profit Selling Expense Corporate Selling Expense Store 1 G&A Expense Corporate G&A Expense Store 1 Org. Expenses Store 2 Depreciation Total Operating Expenses Operating Profit (Loss) Interest Expense Net Profit before Tax (Loss) Taxes Net Profit after Tax
Assets Cash Accounts Receivable Inventory Prepaids Total Current Assets
Gross Fixed Assets Less: Depreciation Net Fixed Assets
Total Assets
Liabilities and Shareholders Equity Accounts Payable Accruals Bank Line of Credit Total Current Liabilities Shareholders' Equity Convertible Preferred Stock Common Stock Paid-in Capital Retained Earnings Total Shareholders' Equity
Total Liabilities & Equity
Income Statement 1994
1,204,000 758,521 445,480
37,821 34,825
111,450 371,750
0 11,425
567,271 (141,791)
6,321 (148,112)
(56,282) (91,830)
Balance Sheet
1994
41,321 21,165
411,502 14,457
488,445
65,580 11,425 54,155
542,600
153,782 38,214
192,434 384,430
0 100,000 150,000
(91,830) 158,170
542,600
1995
1,528,000 932,080 595,920
11,263 49,654
112,634 437,135
0 17,425
628,111 (32,191)
22,315 (54,506) (20,712) (33,794)
1995
32,363 27,198
448,387 19,816
577,777
95,920 28,850 67,070
644,847
220,760 49,711
250,000 520,471
0 100,000 150,000
(125,624) 124,376
644,847
1996*
811,323 494,907 316,415
19,924 18,364 57,325
216,957 31,334
9,861 353,765 (37,350)
25,147 (62,497) (23,748) (38,749)
1996*
554,325 31,568
683,979 37,586
1,297,458
186,415 38,711
147,704
1,445,162
321,808 51,643
136,084 509,535
1,000,000 100,000 150,000
(164,373) 935,627
1,445,162
•through June YTD
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Exhibit 2 North Point Mall Market—Comparable Rents
Size Yr Occupancy Rental Center Anchors (sq. ft) Built (%) Rate
North Point Market Circuit City, Target,
Marshall's, PetsMart 485,000 1994 98 $19 p.s.f. NNN
Mansell Crossing Toys R' Us, T.J. Maxx,
Service Merchandise 440,011 1993 98 $18 p.s.f. NNN
Haynes Bridge Village Publix 101,000 1994 100 $16 p.s.f. NNN
Haynes Market Kroger 130,515 1988 99 $15 p.s.f. NNN
Alpharetta Crossing Winn-Dixie,
Eckerd Drugs 95,500 1989 99 $15 p.s.f. NNN
rates should be in the range evidenced by existing retail rental rates. As shown in Exhibit 2, the minimum rental rate from existing competition is $15.00 per square foot. Because North Point Market and Mansell Crossing are located within a mile of the mall, they are the most noteworthy. The two power centers are 98% leased and have quoted rental rates of $4.00 to $5.00 above the proposed lease rate for TOH.
T H E TRANSACTION Initial Exposure Don Adams was introduced to Ed Brown in February 1996 by Ron Curtis, a broker with contacts at Homart Corporation and Cousins Properties. Because Homart Corporation developed North Point Mall on land acquired from Cousins, most of the land adjacent to the mall is owned by Cousins Properties. Prior to talking with Adams, Curtis, on behalf of TOH, had approached Cousins Properties about a build-to-suit on one of the out-parcels Cousins planned to develop, but Cousins was not interested due to the relatively small transaction size, the weak financial capacity of the prospective tenant, and a strategy based upon ground-leasing most of the out-parcels adjacent to the mall. Homart, however, would sell one of its three out-parcels to a developer willing to work with TOH, but would not sell to speculators and would retain, via deed restrictions, final "reasonable" approval of out-parcel usage . Two additional developers Curtis contacted prior to the introduction of Adams and Brown were not interested in a deal with TOH due to the transaction size and the company's weak financial condition.
Adams and Brown hit it off immediately. Adams had been a TOH customer since 1994 and was always impressed with the service he received. Additionally, ARP
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had wanted to make an investment in the North Point area, but had not been able to put a workable deal together due to the limited amount of land not controlled by Cousins and restrictions on out-parcel usage dictated by Homart Corporation. Even though Adams had not received financial statements on TOH, he knew the company had limited financial capacity. However, because he was aware of the venture capital infusion, he decided to place a 1.550-acre out-parcel under contract for $14 per square foot. A standard purchase agreement with an expiration date of August 30, 1996 was executed between ARP and Homart Corporation. Earnest money of $10,000 was required. If ARP canceled the contract prior to May 15, 1996, the earnest money would be refunded. At the time, Adams had not made up his mind with regard to the feasibility of the transaction, but wanted to give himself a chance to evaluate the potential deal and get investment approval.
General Return Requirements After reviewing the financial statements from TOH, Adams felt that a transaction was doable provided Brown was willing to pay rent that would generate an unleveraged initial yield on cost of 13%. Because the venture capital participants did not want to guarantee the lease, Adams needed to get a return premium to justify ARP's risk in the deal. With debt accounting for 65% to 70% of the total capital required for the transaction, a rental rate generating a 13% yield on cost would generate the 17% to 23% equity returns ARP generally earned from its retail development activities.
During the ARP Board of Director's monthly meeting, the deal was approved as long as the cost structure was reasonable and financing on a non-recourse basis was attainable for at least 65% of total costs. One of the board members outlined the group's general position with the following, "Once again, we have enough spreadsheets and scenarios to sink the Titanic, but the real question is can we rent the space either to one tenant or maybe two for an average rental rate of $14.00 a square foot if TOH tanks? With the building's location adjacent to the newest mall in Atlanta, limited competition, and top demographics, if we can't get about $14.00 a foot we need a new man running the shop." The ARP board also was interested in starting a new development project in order to consummate a 1031 Tax Deferred Exchange to defer taxes on another project under contract for sale.
Subsequent to approval from the ARP board and after additional discussions with Ed Brown, Adams felt confident that TOH could work with the basic return structure ARP required. It, however, took about three weeks for TOH to generate a letter of understanding. The company finally agreed to the 13% net yield on cost, but wanted to have some input into the building's actual design. Brown was willing to execute a lease with an estimated construction budget provided by Adams so long as there were provisions in the lease that the tenant must approve the design prior to construction. Since Adams had included such a provision in many past transactions, a lease was executed between an ARP-controlled limited partnership and TOH.
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In addition to the provision requested by Brown, Adams retained the right to terminate the lease prior to starting construction if financing is unattainable. At an estimated rental rate of about $14.00 per square foot, the base rental rate is comparable to what TOH has been paying for in-line space. The lease has an initial term of ten years with a 15% rental rate increase after five years. TOH has two five-year renewal options with rent adjusted for each period based upon the cumulative change in the CPI Index during each prior five-year period with a minimum 15% increase in rent. The lease is a triple net lease, meaning that the tenant pays all building operating costs.
The Project Cost Having built numerous single-tenant buildings, Adams was initially confident that his core cost estimates were accurate. Since the site was already graded and there were no potential site problems nor utility access problems the cost estimates were straightforward. The construction budget (see Exhibit 3) as estimated by Adams and incorporated into the lease dated April 26, 1996 had a total cost of $1,750,000. The major cost items were the price of the land and the building shell. The budget was for a functional retail building with split-block siding and windows along the front and back of the building to give the building exposure to both North Point Mall and an adjacent major access road. The only uncertainty in the budget estimates were the costs created by TOH's design requirements.
The Loan Commitment Working with the local mortgage broker that placed many of ARP's permanent loans, Adams applied for a construction/permanent loan from Alabama Life. Alabama Life in partnership with an Alabama-based S&L had developed a single, tri-party closing construction/permanent loan product. The S&L handles the construction portion of the transaction inclusive of construction draws and inspections with Alabama Life paying off the construction loan after the issuance of a certificate of occupancy.
The basic loan terms Alabama Life offered to Adams included a six-month construction period priced at the Prime Rate plus 2% with a 1.0% fee followed by a ten-year permanent mortgage at a rate of 9% with a 1.0% fee. Loan repayment is monthly based upon a twenty-year amortization schedule. The mortgage broker is compensated with an additional 1% fee. The loan amount is $1,225,000 and is non-recourse. The loan commitment contains the normal contingencies with respect to appraisal, permits, plans and specs review, etc.
Having negotiated the terms of the commitment, Adams knows that Alabama Life's primary risk mitigation requirement is the loan-to-cost ratio as opposed to the loan-to-value ratio or debt coverage ratio. Since the tenant is not creditworthy and ARP applied for a non-recourse loan, Alabama wants ARP and its affiliates to have real money at risk. During negotiations, Alabama Life indicated that with a tenant as weak as TOH, the property's cash flows and value were uncertain.
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Case Study: Single-Tenant Retail Development Hardin and Aycock
Exhibit 3 Development Cost Breakdown for The Organized Home at North Point Mall
Cost Items
Land Purchase Costs
Construction Costs
Site Preparation (Paving & Landscape)
Tenant Finish Allowance
Architect's Fees
Engineering Fees
Sewer/Water Taps
Hazard Insurance Premiums
Performance Bond Premium
Real Estate Taxes
Intangible Tax
Title Insurance Premium
Attorney's Fees/Recording Fees
Permanent Lender's Fee
Loan Commitment Brokerage Fee
Appraisal Fee
Real Estate Commissions
Surveyor's/Soils Test Fees
Inspecting Agent's Fees
Overhead/Organizational Expense
Developer's Fee
Contingency Reserve
Loan Interest
Total Amt ($)
945,000
558,000
40,000
45,000
12,500
8,000
5,000
2,500
2,375
6,200
3,675
1,500
7,500
12,250
24,500
5,000
0
1,000
2,500
0
12,500
25,000
30,000
Paid by Loan
($)
420,000
558,000
40,000
45,000
12,500
8,000
5,000
2,500
2,375
6,200
3,675
1,500
7,500
12,250
24,500
5,000
0
1,000
2,500
0
12,500
25,000
30,000
Equity Requirem't
($)
525,000
Initial Total Cost & Equity 1,750,000 1,225,000 525,000
Additions
Office Space
Atrium
Split Block
50,000
120,000
80,000
0
0
0
50,000
125,000
80,000
Revised Total Cost & Equity 2,000,000 1,225,000 775,000
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90 Hardin and Aycock Case Study: Single-Tenant Retail Development
Alabama Life wanted to make sure that ARP has an economic reason to support potential negative cash flow during any time period the building might be vacant due to the loss of its single tenant. Although the terms require 30% cash in the transaction, Adams believes the commitment to be fair given the project's tenant profile and the negative responses he had been given when describing the transaction to other lenders and mortgage brokers.
THE PRESENT SITUATION AND POSSIBLE ALTERNATIVES After taking a break for the Fourth of July, Adams is ready to outline a strategy and develop options to deal with the increased cost estimates required to keep the TOH project on track. The options Adams feels he has range from killing the deal to funding the entire additional costs with equity. Specifically, Adams wants to know how a few basic choices would affect his investors' returns and to get a feel for the risks involved with each potential option. Before his meeting with Brown later in the week, Adams wants to determine his funding choice and negotiating strategy. Specifically, he plans to quantify the risk and return of the following options:
Kill the deal. Because of the provisions in the initial lease and concerns with financing under the new cost scenario, Adams has the right to cancel the lease. The purchase contract would then be allowed to expire.
Eliminate the changes requested in the building design. Adams, after talking with James over the weekend, is not convinced that the changes add much, if any, value to the building. Also, since, Brown and TOH agreed to the initial construction budget, Brown could possibly be convinced that the changes do not represent a good business decision.
Renegotiate the loan amount with Alabama Life based upon the new construction budget. The loan amount would be higher, but the maximum 70% loan-to-cost ratio would be retained. Only minimal additional equity capital would be required.
Fund the difference with equity and raise the rental rate. This option could entail using the same 13% yield on cost or could require an additional return premium. It could also require personal guarantees of the TOH lease by the new venture capital partners.
Combine additional equity with a cash contribution from TOH to cover the difference.
Try to convince The Organized Home to pay the difference. Since the design changes may add value only to the company, maybe the company should pay for these "image"-related costs.
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Questions
(1) With an initial loan commitment of $1,225,000 and using the initial terms outlined in the case, what is ARP's expected return if the property is held for six years? Eleven years? Assume that ARP and its investors are in the 31% marginal tax bracket at the federal level and the 6% bracket at the state level. Assume a 28% capital gains tax rate and standard depreciation schedules. Similar projects in the Atlanta market have sold at cap rates of between 8.5% and 11%.
(2) What are the pros and cons of the transaction excluding the new cost uncertainty?
(3) Does the enhanced design required by The Organized Home add value to the real estate? Does it add value to the company's brand? If The Organized Home moved out of the building, would the design increase/decrease leasing opportunities?
(4) Do you think the development process, primarily the building design process, is different for major national retailers such as Walgreen's, CVS, or Revco?
(5) Review TOH's financial statements. What is the company's financial condition? What will be the financial impact of the company's growth plans?
(6) What is your impression of the value placed upon limited out-parcel availability at North Point Mall? Is the location really as good as Adams thinks?
(7) Has Adams missed any options during his thought process?
(8) Assess the risks of each of the options defined by Adams as well as any options you believe to be superior.
(9) Assess the probability of the options defined by Adams as well as any new options. Which outcome do you believe is most likely.7 Which mitigates the greatest amount of risk?
(10) With the new debt and equity structures that might result from the potential options, quantify ARP's return using a discounted cash-flow model similar to that required in Question 1. Use the same basic cap rate and tax assumptions. List and defend any additional assumptions.
(11) Develop and summarize an action plan for Adams. What should he do and what should his negotiating strategy be? This should be in the form of an executive summary.
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