real estate finance II

Class 1: Introduction to Real Estate Development Finance: Project

Feasibility
OBJECTIVES OF THIS CLASS

•  Financial Feasibility of Development Projects:

•  Highest & Best Use
•  Back-of-the Envelope
•  SFFA: Front Door
•  SFFA: Back Door

Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015
9/11/16 2
Property Development Industry
CAPITAL
Resources
(investment)
FINANCIAL Development New
ANALYSIS Activity Built
Space
PHYSICAL
Resources
(construc9on)

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 SPACE MARKET
LOCAL
ADDS SUPPLY DEMAND &
NEW (Landlords) (Tenants) NATIONAL
ECONOMY

RENTS
&
OCCUPANCY FORECAST
FUTURE

DEVELOPMENT
INDUSTRY
ASSET MARKET
IF IS SUPPLY
YES DEVELPT CASH
(Owners
PROFITABLE FLOW
Selling)
?
CAPITAL
PROPERTY MKT MKTS
CONSTRUNCTION MARKET REQ’D
D EMAND
COST VALUE CAP
INCLUDING (Investors
RATE
Buying)
LAND

= Causal flows.
= Information gathering & use.

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
GO Decision
¤  SITE

¤  DRIVING FACTORS for FEASIBILITY”

1.  Market analysis
2.  Regulatory constraints
3.  Financial conditions
4.  Context/community constraints

¤  STRATEGIC RESOLUTION:
¤  Financial <+>Design

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
GO Decision
¤  PRELIMINARY SCHEME <+> CONSTRUCTION COST

Ø  CONSTRUCTION DOCUMENTATION

¤  LINE UP FINANCING:
¤  Equity
¤  Permanent Loan
¤  Construction Loan

Ø  GO DECISION

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
GO DECISION:

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
Graaskamp also coined the concept that most
development projects can be characterized as either:
1.  A site looking for a use, or
2.  A use looking for a site.
1. Site Looking for a Use:
• è Developer tries to determine & build the “HBU”, or
• è Public entity seeks developer to build a use determined
through a political process (presumably also “HBU”).

2. Use Looking for a Site:

• è Developer has a particular specialization, or
• è Developer is working for a specific user.

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 1. SITE LOOKING FOR A USE

•  VALUATION OF LAND FOR DEVELOPMENT

•  Highest & Best Use Decision

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 9/11/16
Land Values
¤  What determines land values?
1.  Usual market pricing: comparables, clearing price.
2.  Potential of land as component of total value of
developed site.

¤  Called RESIDUAL LAND VALUE

¤  Equals:
¤  TOTAL DEVELOPED PROPERTY VALUATION
¤  Less COST OF CONSTRUCTING IMPROVEMENTS
¤  I.E. NET VALUE of developing the site

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
Example
Office Development

¤  Total Property Valuation:

¤  NOI = $500,000
¤  Cap Rate = 10%
¤  Capitalized Value = $5M

¤  Construction Cost: $4M

¤  Residual Land Value:

TOTAL Valuation – Construction Cost
= $1M

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
VARIATIONS in Residual Land Value

¤  By definition, Residual Land Value (RLV) is dependent

upon:
1.  Net Operating Income of developed property.
2.  Construction Cost of development.
3.  Cap Rate applied for Capitalized Valuation

¤  IF THESE VARIABLES CHANGE:

¤  Higher NOI => Higher RLV
¤  Lower Construction Cost => Higher RLV
¤  Lower Cap Rate => Higher RLV

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 HIGHEST & BEST USE

•  Alternative uses compared for DEVELOPMENT of a site:

•  If site has various complying alternative uses.
•  If developer has capability for various uses.

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 9/11/16
Highest & Best Use (H&BU)
¤  Maximizing Residual Land Value requires:
¤  Comparing alternatives for NOI, Cap Rate & Construction
Cost.

¤  This OPTIMIZATION is the Highest & Best Use analysis.

¤  For a given SITE consider:

1.  Different allowable property types developed to maximum
area.
2.  Cap Rates for respective property types at this location.
3.  Most economical construction budget for respective
property types at this location.

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
Example: H&BU Analysis Summary
Highest and Best Use Analysis

Data Input Box:

Office Retail Apartment Warehouse
NOI yr 1 $500,000 $600,000 $405,000 $400,000
Return or r 13.00% 13.00% 12.00% 10.00%
Growth or g 3.00% 5.00% 3.00% 2.00%
Building Costs 4,000,000 6,750,000 3,000,000 4,000,000

HIGHEST and BEST USE ANALYSIS:

Implied Property Implied Land
Use Year 1 NOI Cap Rate Value (NOI/Cap rate Building Costs Value
Office $500,000 10.00% 5,000,000 4,000,000 1,000,000
Retail 600,000 8.00% 7,500,000 6,750,000 750,000
Apartment 405,000 9.00% 4,500,000 3,000,000 1,500,000
Warehouse 400,000 8.00% 5,000,000 4,000,000 1,000,000

Textbook reference; Brueggeman Chapter 10

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 2. USE LOOKING FOR A SITE

•  Back-of-the-envelope
•  SFFA “Front Door”
•  SFFA “Back Door”

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 9/11/16
 USE LOOKING FOR A SITE
Is a specific development feasible?
¤  FIRST: Back of the Envelope Analysis
¤  Quick technique to evaluate the further expenditure of time and
capital

¤  LATER: Feasibility Analysis PROFORMA

¤  Detailed Discounted Cash Flow Projections

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 “Back-of-the-Envelope” EXAMPLE
¤  You are driving around and locate a one acre site- you think
about an office building

¤  You know the site is zone commercial

¤  (before financing)

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
Back-of-the-Envelope Facts

1.  You call the listing broker, and are told the site is
listed for $50.00 per sq. ft
2.  You know the FAR allows for a 50,000 sq. ft building
3.  You know that construction costs for an office
typically are $120.00 per sq. ft
4.  Your hurdle cap rate is 8%
5.  You know that total operating expenses, including
RE taxes, are $16.00 per sq. ft
6.  Market rents in the area are $32.00 per sq. ft

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
“Back-of-the-Envelope” Example

¤  STEP 1. Determine the total cost of acquiring the site and

constructing the building:

¤  Land acquisition
¤  43,560 sq. feet x $50 sq. ft = $2,178,000

¤  Construction cost
¤  50,000 sq. ft x $120 sq. ft = $6,000,000

¤  Total Cost $8,178,000

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 “Back-of-the-Envelope” Excel
DEVELOPMENT:
Land Price (per sf) $ 50
Sq Ft/acre 43,560
TOTAL LAND COST $ 2,178,000
Construction Cost (psf) $ 120
Building Size (sf) 50,000
TOTAL BUILDING COST $ 6,000,000
TOTAL PROJECT COST $ 8,178,000

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
Back-of-the-Envelope Facts

1.  You call the listing broker, and are told the site is
listed for $50.00 per sq. ft
2.  You know the FAR allows for a 50,000 sq. ft building
3.  You know that construction costs for an office
typically are $120.00 per sq. ft
4.  Your hurdle “Cap Rate” is 8%
5.  You know that total operating expenses, including
RE taxes, are $16.00 per sq. ft
6.  Market rents in the area are $32.00 per sq. ft

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
“Back-of-the-Envelope” Example
¤  STEP 2. Working backwards, you apply a Return Hurdle
Rate , so you can calculate the breakeven NOI
necessary for the project

¤  Total Cost = $8,178,000

¤  Min. “Quick & Dirty” Cap Rate = 8%

¤  using Cost as “hurdle” Value:

¤  Value = NOI/Cap Rate = $8,178,000
¤  So, “hurdle” NOI = Value x Cap Rate = $8,178,000 * 8%
= $654,240

¤  Do we pass this first hurdle rate test?

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 “Back-of-the-Envelope” Excel
DEVELOPMENT:
Land Price (per sf) $ 50
Sq Ft/acre 43,560
TOTAL LAND COST $ 2,178,000
Construction Cost (psf) $ 120
Building Size (sf) 50,000
TOTAL BUILDING COST $ 6,000,000
TOTAL PROJECT COST $ 8,178,000

INVESTMENT RETURN HURDLE:

Cap Rate 8%
NOI formula =cost*cap rate
NOI $ 654,240
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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
Back-of-the-Envelope Facts

1.  You call the listing broker, and are told the site is
listed for $50.00 per sq. ft
2.  You know the FAR allows for a 50,000 sq. ft building
3.  You know that construction costs for an office
typically are $120.00 per sq. ft
4.  Your hurdle cap rate is 8%
5.  You know that total operating expenses, including
RE taxes, are $16.00 per sq. ft
6.  Market rents in the area are $32.00 per sq. ft

9/11/1
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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
“Back-of-the-Envelope” Example
¤  STEP 3. Calculate property rents required to deliver this
breakeven NOI

¤  NOI = $654,240

¤  Op Ex = 50,000 x $16 = $800,000

Ø  Revenues = $1,454,240
Ø  Bldg. Size 50,000 sf
Ø  Rent per sq. ft = $29.08

¤  Is this achievable in the market?

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 “Back-of-the-Envelope” Excel
DEVELOPMENT: BREAK-EVEN OPERATIONS:
Land Price (per sf) $ 50 Operating Expenses (psf $ 16
Sq Ft/acre 43,560 TOTAL OPERATING EXP $ 800,000
TOTAL LAND COST $ 2,178,000 NOI $ 654,240
Construction Cost (psf) $ 120 REVENUES (NOI +OpExp) $ 1,454,240
Building Size (sf) 50,000 RENT REVENUES (PSF) $ 29.08
TOTAL BUILDING COST $ 6,000,000
TOTAL PROJECT COST $ 8,178,000
INVESTMENT RETURN HURDLE:
Cap Rate 8%
NOI formula =cost*cap rate
NOI $ 654,240

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
Back-of-the-Envelope Facts
1.  You call the listing broker, and are told the site is
listed for $50.00 per sq. ft
2.  You know the FAR allows for a 50,000 sq. ft building
3.  You know that construction costs for an office
typically are $120.00 per sq. ft
4.  Your hurdle cap rate is 8%
5.  You know that total operating expenses, including
RE taxes, are $16.00 per sq. ft
6.  Market rents in the area are $32.00 per sq. ft

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 “Back-of-the-Envelope” Example
¤  STEP 4. Compare with current market data of rent/sf for similar
properties:

¤  Current Market rent $32.00

¤  So, market rental rate > breakeven rate of $29.08 is achievable

in this market.

¤  THEREFORE, project is ESTIMATED to deliver a return of above

your Required “cap rate” of 8% (before leverage).

¤  SO, WE PROCEED TO MORE DETAILED ANALYSIS

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 “Back-of-the-Envelope” Excel
DEVELOPMENT: BREAK-EVEN OPERATIONS:
Land Price (per sf) $ 50 Operating Expenses (psf $ 16
Sq Ft/acre 43,560 TOTAL OPERATING EXP $ 800,000
TOTAL LAND COST $ 2,178,000 NOI $ 654,240
Construction Cost (psf) $ 120 REVENUES (NOI +OpExp) $ 1,454,240
Building Size (sf) 50,000 RENT REVENUES (PSF) $ 29.08
TOTAL BUILDING COST $ 6,000,000 MARKET COMPARISON:
TOTAL PROJECT COST $ 8,178,000 Market Rental Rate (psf) $ 32.00
Project Rental Rate $ 29.08
INVESTMENT RETURN HURDLE:
SPREAD: market - hurdle $ 2.92
Cap Rate 8%
NOI formula =cost*cap rate SO, WE PROCEED TO MORE
NOI $ 654,240 DETAILED ANALYSIS…..
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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 DEVELOPMENT FEASIBILITY

•  NEXT STEP FEASIBLITY ANALYSIS

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Simple Financial Feasibility Analysis (SFFA)

¤  Most widely employed method for analysis of financial

feasibility of development projects.
¤  SFFA is based on the inputs utilized in commercial
mortgage market (for permanent loans).
¤  Assumes developer will take out largest permanent loan
possible upon completion of the building.
¤  Assumes that LAND + DEVELOPMENT COSTS will equal
market value of the completed property.
¤  See Geltner textbook Chapter 28

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
Simple Financial Feasibility Analysis (SFFA)

¤  Obviously, SFFA leaves something to be desired from a

normative perspective, but:
•  It is simple and easy to understand.
•  It requires no specialized knowledge of capital markets
other than familiarity with the commercial mortgage
market (does not even require familiarity with the relevant
property asset market).

¤  SFFA comes in two modes: “Front Door”, & “Back

Door” (See Geltner Text 28.4)

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
(SFFA) “Front Door” Procedure: part 1

START WITH COSTS AND END WITH REQUIRED RENT FOR

FEASIBILITY:
Site Acquisition Costs + Construction Costs
= Total Expected Development Cost
X Loan to Value Ratio
= Permanent Mortgage
X Annualized Mortgage Constant or Debt Yield (or =PMT calc)
= Cash Required for Debt Service
X Lender Required Debt Service Coverage Ratio
= Required Net Operating Income or NOI

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
(SFFA) “Front Door” Procedure: part 2

Required Net Operating Income or NOI

+ Estimated Operating Expenses (Not passed through to
tenants)
= Required Effective Gross Income
÷ Expected Occupancy Rate
= Required Gross Revenue
÷ Leasable Square Feet
= Rent Required Per Square Foot

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
(SFFA) “Front Door” Procedure:
outcome

¤  Question: Is this average required rent per square foot

achievable in current market?

¤  What buffer?

¤  Typical approach for “Site looking for a Use”.

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
“Front Door” Example

•  Class B office building rehab project: 30,000 SF (of which

27,200 NRSF).
•  Acquisition cost = $660,000;
•  Rehab construction budget: $400,000 hard costs +
$180,000 soft costs.
•  Estimated operating costs (to landlord) = $113,000/yr.
•  Projected stabilized occupancy = 95%.
•  Permanent loan available on completion @ 11.5% (20-yr
amort) with 120% DSCR.
•  Estimated feasible rents on completion = $10/SF.

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 “Front Door” Example
Site and shell costs: $ 660,000
Lender will base
+ Rehab costs: 580,000
mortgage on Market
= Total costs: $1,240,000 Value, not on
What major X Lender required LTV x 80% construction cost.
issue is left = Permanent mortgage amount: $ 992,000
X Annualized mortgage constant: x 0.127972
out here? = Cash required for debt svc: $ 126,948
X Lender required DCR: x 1.20 Or, as per Debt Yield:
= Required NOI: $ 152,338 Debt Yield = NOI/loan
+ Estd. Oper. Exp. (Landlord): 113,000 NOI = Loan *Debt Yield
= Required EGI: $ 265,338 Loan = 992000*12.8%
÷ Projected occupancy (1-vac): ÷ 0.95 = 126,976
= Required PGI: $ 279,303
÷ Rentable area: ÷ 27200 SF
-------------- ---------
= Required rent/SF: $10.27 /SF

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
(SFFA) “Back Door” Procedure: part 1

START WITH RENTS & OPERATING COSTS AND END WITH DEVELOPMENT
BUDGET FOR FEASIBILITY:

Total Leasable Square Feet (based on the building efficiency ratio times the
gross area)

X Expected Average Rent Per Square Foot

= Projected Potential Gross Income (PGI)

- Vacancy Allowance

= Expected Effective Gross Income

- Projected Operating Expenses

= Expected Net Operating Income

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
(SFFA) “Back Door” Procedure: part 2

= Expected Net Operating Income

÷ Debt Service Coverage Ratio

÷ Annualized Mortgage Constant or Debt Yield

÷ Maximum Loan to Value Ratio

= Maximum Supportable Total Project Costs

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
(SFFA) “Back Door” Procedure:
outcome

Question: Can it be DEVELOPED for this including all costs?

Maximum Supportable Total Project Costs
- Expected Construction Costs (Other than Site)
= Maximum Supportable Site Acquisition Cost

¤  Can the site be acquired for this or less?

¤  What profit margin on this site acquisition?

¤  Typical approach for “Use Looking for a Site”.

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
“Back Door” Example
•  Office building 35,000 SF (GLA), 29,750 SF (NRA) (85%
“Efficiency Ratio”).
•  $12/SF (/yr) realistic rent (based on market analysis, pre-existing
tenant wants space).
•  Assume 8% vacancy (typical in market, due to extra space not
pre-leased).
•  Preliminary design construction cost budget (hard + soft) =
$2,140,000.
•  Projected operating expenses (not passed through) = $63,000.
•  Permanent mortgage on completion available at 9% (20-yr
amort), 120% DCR.
•  Site has been found for $500,000: Is it feasible?

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 “Back Door” Example
Potential Gross Revenue = 29,750 x $12 = $ 357,000
Less Vacancy at 8% = - 28,560
= Effective Gross Income $ 328,440
Less Operating Expenses - 63,000
= Net Operating Income $ 265,000 18433 ⎡ ⎛ 1 ⎞
240
⎤
÷ 1.20 = Required Debt Svc: $ 221,200 = ⎢1 − ⎜ ⎟ ⎥
.09 / 12 ⎢⎣ ⎜⎝ 1 + .0912 ⎟⎠ ⎥⎦
÷ 12 = Monthly debt svc: $ 18,433
è Supportable mortgage amount = $ 2,048,735
÷ 0.75 LTV = Min. Reqd. Value: $ 2,731,647 Or, as per PV calc:
Less Construction Cost - 2,140,000 Interest Rate: 9%
------------ ----------- Term: 20 years
è Supportable site acquisition cost: $ 591,647. Loan =PV(9/12,240,-18433)
= $2,048,735
So, the project seems feasible... What major
issue is left out
here?

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Problems with SFFA:
¤  Do NOT confuse an SFFA feasibility analysis with a
normatively correct assessment of the desirability of a
development project from a financial investment
perspective.
¤  SFFA does not compute the value of the completed
property.
¤  Hence, does not compute the NPV of the development
investment decision:
¤  NPV = Value – Cost
¤  SFFA merely computes whether it is possible to take out a
permanent loan to finance (most of) the development
costs.

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 DEVELOPMENT PROJECT
FEASIBILITY

•  DETAILED ANALYSIS INCLUDES:

1.  Detailed development budget - cost
2.  Detailed operating proforma – value
3.  Feasibility of Project: Value less Cost

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
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 FEASIBILITY ANALYSIS ITERATIONS
Determining if the Deal is Worthwhile

¤  Back of the Envelope Analysis

¤  Quick technique to evaluate the further expenditure of
time and capital
ALTERNATIVES & ITERATIONS

¤  Detailed Feasibility Analysis

¤  Detailed Discounted Cash Flow Projections
INPUT CHANGES & ITERATIONS

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 DEVELOPMENT PROJECT FEASIBILITY
q  TWO TYPES OF PROJECT BUDGETS ARE IMPORTANT FOR
PROJECT FEASIBILITY:
§  Construction & Absorption Budget:
§  Covers construction (& lease-up, for “spec” projects);
§  Relates to the “COST” side of the NPV Equation.
§  Operating Budget:
§  Covers “stabilized” period of building operation after lease-up
is complete;
§  Typically developed for a single typical projected “stabilized
year”;
§  Relates to the “BENEFIT” side of the NPV Equation.
q  FINAL EVALUATION OF INVESTMENT RETURNS:

NPV = Benefits – Costs = Value of Property – (Cost of Devel+Land)

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
LIMITATIONS OF FEASIBILITY ANALYSIS
¤  Just because a project is financially feasible, does
not necessarily mean that it is desirable as an
investment.

¤  Just because a project is not feasible using debt

financing, does not necessarily mean that it is
undesirable:
¤  A project may appear “not feasible” with debt
financing, yet it might be a desirable project from
a total return to investment perspective (say with
more equity financing).

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
NPV = BENEFITS - COSTS

¤  Benefits and costs must be measured as “apples vs apples”.

¤  That is, in dollars over time:
•  As same point in time (such as Present Value at start).
•  Adjusted to account for different risk at different stages.
¤  Use detailed DCF analysis: time and risk can be accounted for by
using risk-adjusted discounting of cash flow projections.
¤  Key is to identify: opp. cost of capital (OCC) or Discount Factor
•  Reflects amount of risk in the cash flows in that phase.
•  Can be applied to either discount CFs back in time, or
•  To grow (compound) CFs forward in time.
•  Optimally, to the projected time of completion of the
construction phase.

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 FEASIBILITY => INVESTMENT ANALYSIS
•  The correct way to evaluate the financial economic
desirability of a development project investment:
NPV = Benefit – Cost
= Value of PROPERTY – Cost of DEVELOPMENT

“THE NPV INVESTMENT DECISION RULE”:

1.  MAXIMIZE THE NPV ACROSS ALL MUTUALLY-EXCLUSIVE ALTERNATIVES; AND
2.  NEVER CHOOSE AN ALTERNATIVE THAT HAS: NPV < 0.

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
FEASIBILITY => INVESTMENT ANALYSIS
¤  Three considerations are important and unique about
applying the NPV rule to evaluating investment in
development projects vs stabilized operating properties:
1.  “Time-to-Build”: Investment cash outflow occurs over time, not
all at once up front, due to the construction phase.
2.  Construction loans: Debt financing for the construction phase is
almost universal (even when the project will ultimately be
financed entirely by equity), and adds financing costs.
3.  Phased risk regimes: Investment risk is very different (greater)
between the construction phase (the development investment)
and the stabilized operational phase. (Sometimes an
intermediate phase, “lease-up”, is also distinguishable.)

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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
FEASIBILITY ANALYSIS is NOT…
¤  Don’t confuse a FEASIBILITY ANALYSIS with an assessment
of the investment returns of a development project.
¤  FEASIBILITY ANALYSIS does not compute the comparative
investment value of the completed property:
¤  NPV
¤  IRR
¤  Equity dividend
¤  FEASIBILITY ANALYSIS does not indicate the best capital
structure (how much debt & equity).
¤  SIMPLE FEASIBILITY ANALYSIS just provides the FIRST CUT
analysis that Completed PV covers Development Cost, given
a basic debt structure.

¤  THAT IS, WORTH FURTHER DETAILED INVESTMENT RETURN

ANALYSIS OR NOT? DO DCF PROFORMA => RETURNS
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Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real
Estate Finance 2007;Brueggeman/Fisher, Real Estate Finance & Investments 2011, modified by Dr P Derrington 2015 6
 LESSONS OF THIS CLASS

•  FINANCIAL CHANGES OVER

DEVELOPMENT PHASING
•  FEASIBILITY OF DEVELOPMENT PROJECTS:
•  BOE
•  DETAILED SFFA
•  Need to proceed to detailed DCF
investment return analysis

Copyright ©: Richard Peiser & David Hamilton Professional Real Estate Development 3rd Ed;, Geltner/ Miller/Clayton/Eichholtz Real Estate
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