Professional Real Estate Development: Developer's Tool Kit
June 18, 2012
The Excel spreadsheets from the Finance for Real Estate Development book are available for free download so you can use them to model your own assumptions and understand better how the concepts described in the book work.
These models are for information purposes only; the author and ULI (the Urban Land Institute) assume no responsibility for their content or accuracy. You should rely on your own assumptions and criteria to assess the feasibility of a project for investment purposes.
Chapter 2 discusses the basics of development project finance in terms of debt, equity, and the distribution of return to investors. The example at the end of the chapter illustrates the application of these basics.
Figures 2-11 through 2-17 analyze a hypothetical income project for feasibility, determining the loan amount and projecting how return could be distributed to equity investors and to the developer.
The analysis starts with 2-11, the projection of effective gross income. Figure 2-12 shows the estimate of development costs, including land. Figure 2-13 projects net operating income, and 2-14 applies a cap rate to determine the surplus (gap) for the project. Based on a viable project, figure 2-15 evaluates the loan available to the project according to the calculated lowest amount from three criteria—debt service coverage ratio (DCR), loan-to-value (LTV), and loan-to-cost (LTC).
With the loan amount determined, figure 2-16 shows the annual cash flow for the project, including two capital events—a refinancing in Year 6 and a sale in Year 10. This figure calculates the leveraged and unleveraged internal rate of return (IRR).
Finally, figure 2-17 shows a waterfall distribution to equity investors and the developer, distributing first, return of equity; second, preferred return; third, distribution of promotional return to meet investor targets; and fourth, distribution of the remainder of promotional return with higher percentages to the developer.
Chapter 3 discusses an approach to assessing project financial viability based on meeting a hurdle cash-on-cash return—i.e., meeting a minimum rate of return on costs. This approach is then applied to calculating the “residual land value,” which is the maximum amount a developer can afford to pay for a development site and expect to generate sufficient return to attract debt and equity to a project and to provide adequate compensation to the developer.
Figure 3-1 shows how a cash-on-cash hurdle is calculated based on the amount of leverage, debt, interest rate, equity target returns, and the time from start of construction to completion of close-out (the absorption period). Essentially, this calculation estimates the weighted mean return requirement to meet the demands of capital sources over the period of time to develop and close out the project. Projects with similar financing and absorption profiles will have the same hurdle to achieve project viability.
Calculating residual land value starts with an assessment of the project value and a determination of the “maximum supported investment”—i.e., the maximum that a developer can afford to spend and still have a viable project. The residual land value is simply the maximum supported investment less all the nonland costs.
Figure 3-2 applies a hurdle rate analysis to three different sites, each with its own development plan, and shows the calculation of residual land value for each of these plans. Note that the calculation of residual land value depends on accurate estimates of both project value and costs. Note, also, how the hurdle rate of return changes with the financing structure and absorption period.
Accurately estimating residual land value requires validating the assumptions about market and costs. Figure 3-4 shows the range of a typical due diligence budget to investigate a site before the end of the refundable period under a purchase and sale contract.
Finally, Figure 3-5 shows a simple pro forma, which can be used to evaluate residual land value for a development plan on a site of interest. This spreadsheet can help analyze the sensitivity of residual land value to different development scenarios, market prices, and costs, and is a very useful tool to have during land negotiations.
Remember: the estimate of residual land value is valid only if it is based on valid market and cost information. Validating the assumptions is a principal focus of the due diligence investigation that is conducted during the refundable deposit period of a purchase and sale contract. If the assumptions that were the basis of the contract terms are found to be invalid, you must either renegotiate the contract or abandon the site purchase.
Chapter 4 discusses the tasks needed to effectively manage a project through predevelopment, development, and close-out. These tasks must be planned to generate information early to inform later tasks. So, for instance, early validation of the market and costs informs later work to develop conceptual designs. Each task requires a budget and a funding source, which means that the developer must plan where to obtain and how to deploy the necessary funding for each stage of the project.
Figures 4-1, 4-2, and 4-3 illustrate a conceptual approach to planning, budgeting, and funding the development tasks. Figures 4-1 and 4-2 begin by describing a hypothetical development project with its cost and financing structure.
Figure 4-3 lists the tasks and their budgets and assigns the funding responsibility for each task to one of three funding sources—developer capital, outside equity investors, and the lender. The order of tasks reflects both the priority of needed information and the availability of capital for each task.
A developer should plan the tasks and budgets at project inception and update the management plan as the project proceeds. As information is developed, the priority for investing in additional information may change. For instance, if contamination is discovered on a site, it may make sense to defer design work until after further investigation determines that the contamination can be remediated at a reasonable cost.
As shown in Figure 4-3, developer capital funds the early stages of predevelopment tasks until project viability can be demonstrated to outside investors. Thereafter, the developer capital will continue as the primary funding source until the co-investment amount (10 percent in the example) has been met. Thereafter, capital will flow from the outside equity investors, who fund tasks through the close of escrow on the land and start of construction. The lender will fund the construction loan only after all the required equity has been invested in the project. Note that marketing costs for the project are funded out of sale proceeds and, consequently, do not need to be financed with the debt or equity sources.
It is worth reiterating the importance of the tasks for monitoring market and cost conditions as the project proceeds through predevelopment. Such revisiting of the original assumptions allows midcourse corrections that avoid overcommitment to a project that has become infeasible through market or cost changes.
Chapter 7 discusses how development entities are structured to deploy debt and equity, and to share control among the developer and outside investors. Typically, the developer and outside investors form an entity called a joint venture, which can take several different legal forms, that addresses the funding obligations, profit distribution, and shared control of project decisions. Within the joint venture framework, the developer will act as the operating entity with primary responsibility for carrying out the venture’s business plan.
Figures 7-8, 7-9, and 7-10 model one aspect of the joint venture structure—the distribution of profits within the operating entity that is part of the larger joint venture.
Figure 7-10 models the hypothetical profit distribution to two partners that make up the operating entity. The figure shows profits distributed between the partners in two parts: half is distributed in proportion to the amount invested by each partner (investment); the other half is distributed according to a negotiated formula based on what the parties agree is the relative contribution of each partner to value creation (talent). In this example, the operating entity is composed of two partners, with one partner designated as senior and the second as junior according to a negotiated agreement.
The formula for the distribution according to talent will require extensive negotiation between the parties about the relative contribution each partner makes to creation of project value. For instance, one partner may have acquired the site, while the other partner may have a business relationship with a major tenant. The parties will determine the relative contribution each makes to the success of the project and divide the “talent” component of profit distribution accordingly. In the hypothetical example shown in Figure 7-10, the senior partner receives a 30 percent share, with the junior partner receiving 20 percent.
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