1Chapter 29:Chapter 29:Economic Analysis of Investment in Real Economic Analysis of Investment in Real Estate Development Projects,Estate Development Projects,Part 2Part 22Three considerations are important and unique about applying theThree considerations are important and unique about applying theNPV rule NPV rule to evaluating investment in development projects as compared to to evaluating investment in development projects as compared to investments in stabilized operating properties:investments in stabilized operating properties:1.1.““TimeTime--toto--BuildBuild””::Investment cash outflow occurs Investment cash outflow occurs over timeover time, not all at , not all at once up front, due to the once up front, due to the construction phaseconstruction phase..2.2.Construction loans:Construction loans:Debt financing for the construction phase is Debt financing for the construction phase is almost almost universaluniversal(even when the project will ultimately be financed entirely (even when the project will ultimately be financed entirely by equity).by equity).3.3.Phased risk regimes:Phased risk regimes:Investment risk is very different (greater) Investment risk is very different (greater) between the construction phase (the between the construction phase (the development investmentdevelopment investmentper se) per se) and the stabilized operational phase. (Sometimes an intermediateand the stabilized operational phase. (Sometimes an intermediatephase, phase, ““leaselease--upup””, is also distinguishable.), is also distinguishable.)We need to account for these differences in the methodology of hWe need to account for these differences in the methodology of how we ow we applyapplythe NPV Rule to development investments. . .the NPV Rule to development investments. . .3NPV = Benefits NPV = Benefits ––Costs Costs The benefits and costs must be measured in an The benefits and costs must be measured in an ““apples apples vsvsapplesapples””manner. That is, in dollars:manner. That is, in dollars:••As of theAs of thesamesamepoint in point in timetime..••That have been adjusted to That have been adjusted to account for riskaccount for risk..As with all DCF analyses, time and risk can be accounted for by As with all DCF analyses, time and risk can be accounted for by using using riskrisk--adjusted discountingadjusted discounting. . Key is to identify: Key is to identify: opportunity cost of capitalopportunity cost of capital••Reflects amount of Reflects amount of riskriskin the cash flowsin the cash flows••Can be applied to either Can be applied to either discountdiscountCFsCFsback in time, orback in time, or••To To growgrow(compound) (compound) CFsCFsforward in time forward in time ••e.g., to the projected time of completion of the constructione.g., to the projected time of completion of the constructionphase.phase.4Hereandnow Place:• Twin buildings, $75,000/mo net rent perpetuity• OCC = 9%/yr (Î 0.75%/mo, Î 1.007512– 1 = 9.38% EAR)•in total, V0is:000,000,10$0075.000,75$0075.1000,75$0075.1000,75$2==++ LNPV0= V0– P0= $10,000,000 – $10,000,000 = 0Futurespace Centre:• Across the street from Hereandnow.• Will be same asset as Hereandnow, complete in 12 mos• Constr cost $1,500,000 X 4 payable @ mos 3, 6, 9, 12.• First building complete in 6 mos.• This is definitely HBU of site; irreversible commitment to develop now is appropriateTypical investment deal for this stablized property:5Development investment valuation question : What is the price that can be paid today for the What is the price that can be paid today for the FutureSpaceFutureSpaceland site such that the development investment will be zero land site such that the development investment will be zero NPV?NPV?. . .. . .This is the value of the land, the price the FutureSpace land site would presumably sell for in a competitive market. Hence, equivalently: What is the NPV of the development project investment What is the NPV of the development project investment apart from the land cost? . . .apart from the land cost? . . .Answer:NPV0= V0–P0= V0–(K0+ Land)So, what is V0?, and what is K0? For Futurespace Project . . .6000,000,5$0075.500,37$0075.1500,37$0075.1500,37$2==++ LFirst consider V0…In 6 mos Furturespace One will be complete, expected to be worth:And in 12 mos Futurespace Two is expected to be worth:000,000,5$0075.500,37$0075.1500,37$0075.1500,37$2==++ LThus, gross PV of project benefit is:000,352,9$0075.1000,000,5$0075.1000,000,5$1260=+=V000,352,9$0075.1000,000,10$0075.1500,37$121270=+=∑=ttVOr, equivalently:Why is Futurespace worth less than Hereandnow ? . . .Why do we cut off the analysis at month 12 ? . . .7Now consider K0…Construction cost is 4 quarterly pmts of $1,500,000 each.These CFs have very little “risk” as capital mkt defines “risk”:• Low beta, low correlation w financial mkts.Hence: OCC for constr CFs near rrff, say 3%3% per annum (0.25%/mo, Î 3.04% EAR).*So, PV of construction costs is:000,889,5$0025.1000,500,1$0025.1000,500,1$0025.1000,500,1$0025.1000,500,1$129630=+++=K* Note that by using a lower OCC for construction CFs, we discount them to a higherPV, thus causing construction costs to figure more prominently in the development investment decision.In this sense we are treating construction cost as a greater “risk”factor to be considered in the decision.This is not the capital market definition of “risk”, but it is consistent with common parlance.8Thus, excluding Land cost, we have Futurespace project valuation:V0– K0= $9,352,000 – $5,889,000 = $3,463,000.If the price of the Land is x, then:NPV0= $3,463,000 – x .For any Land price <= $3,463,000, the Futurespace project makes economic sense.Because of the way we have defined economic value (based in market opportunity cost), if the project passes the above criterion, it should be possible to put together financial arrangements to make it happen (otherwise, $$$ are being “left on the table” – recall: NPV rule based on wealth-maximization).If the project does not pass the above criterion, it will either be difficult to put together financing, or at least one of the parties is likely to regret it later on if they did contribute…9Further investment analysis . . .29.1.2. Operational Leverage and Estimation of the OCC for Development InvestmentsRecall that we are dealing with a high-risk/high-return phase (“style”) of investment (the yellow or