Chapter 11: "PROFORMA" 2 types of CFs:Operating Expenses include:Operating ExpensesCapital Expenditures include:Donnelley Bldg Pro Forma...Section 11.2:Broad Answer: THE CAPITAL MARKETSIN DCF APPLICATIONS, KEEP IN MIND WHAT THE DISCOUNT RATE IS...How to "back out" implied discount rates from "cap rates" (OAR) observed from transaction prices in the property market...So we can get an idea what the market's expected total return (discount rate) is for different types of properties by: But, watch out for capital expenditures: Watch out for terminology: Typical per annum OCC (“going-in IRR”) rates (late 1990s) . . .Typical per annum OCC (“going-in IRR”) rates (cerca 2005) . . .Chapter 11: Chapter 11: Real Estate Cash Flow Pro Formas & Opportunity Cost of Capital (OCC)"PROFORMA" "PROFORMA" = a multi-year cash flow forecast(Typically 10 years.)Show to: Lenders, InvestorsBut the proforma can be more useful than just “window dressing”, if done properly.It is the basic vehicle to implement the DCF valuation and analysis procedure discussed in the previous chapter.The CF proforma presents the numerators in the RHS of the DCF valuation equation.2 types of 2 types of CFsCFs::• Operating• Reversion (Sale of Property, Sometimes partial sales)2 ways of defining "bottom line". . .1) Property level (PBTCF, most common in practice):• Net CF produced by property, before subtracting debt svc pmts (DS) and inc. taxes.• CFs to Govt, Debt investors (mortgagees), equity owners.• CFs due purely to underlying productive physical asset, not based on financing or income tax effects.• Relatively easy to observe empirically.• Focus of Chapter 11.2) Equity ownership after-tax level (EATCF):• Net CF avail. to equity owner after DS & taxes.• Determines value of equity only (not value to lenders).• Sensitive to financing and income tax effects.• Usually difficult to observe empirically (differs across investors).• Will be addressed in Chapter 14.Typical proforma line items...Exhibit 11-1:At Property, Before-tax Level:Operating (all years):Potential Gross Income = (Rent*SF) = PGI- Vacancy Allowance = -(vac.rate)*(PGI) = - v+ Other Income = (eg, parking, laundry) = +OI- Operating Expenses = - OE_____________________ _______Net Operating Income = NOI- Capital Improvement Expenditures = - CI_____________________ _______Property Before-tax Cash Flow = PBTCFReversion (last year & yrs of partial sales only):Property Value at time of sale = V- Selling Expenses = -(eg, broker) = - SE__________________ ______Property Before-tax Cash Flow = PBTCFQuestions…How forecast vacancy (v)?• Vac = (vac months)/(vac months + rented months) in typical cycle.• Look at typical vac rate in rental mkt; adjust for non-stabilized bldgs (e.g., gross vacancy in mkt typically > typical stabilized vac).• History of vac. in subject bldg.• Project for each space/lease: Probability of renewal & Expected vacant period if not renewed.How forecast resale value (“reversion”, V at end)?• Divide Yr.11 NOI by “going-out” (terminal) cap rate.What should be the typical relationship between the going-in cap rate and the going-out cap rate?. . .• Usually going-out ≥ going-in (older bldgs have less growth & more risk), esp. if little capital imprvmt expdtrs have been projected.-600-500-400-300-200-10001002003004001987.41988.31989.21990.11990.41991.31992.21993.11993.41994.31995.21996.11996.41997.31998.21999.11999.42000.32001.22002.12002.42003.3Mid 70s vintage Early 80s vintageBasis Point SpreadExhibit 11-2: As New Competitors Enter the Market, Spread Between Building and Submarket Vacancy Increases for Older Buildings(Source: Torto-Wheaton Research; “TWR Overview &Outlook”, Winter 2004.)Operating Expenses Operating Expenses include:include:Fixed:• Property Taxes• Property Insurance• Security• ManagementVariable:• Maintenance & Repairs• Utilities (not paid by tenants)Operating ExpensesOperating ExpensesNOTE:OE do NOT include: z Income taxes,z Depreciation expense.Must include mgt expenseeven if self-managed.Why? . . .Opportunity cost, “apples-to-apples” comparison with alternative investments that you don’t have to manage yourself.Capital Expenditures Capital Expenditures include:include:Leasing costs:• Tenant build-outs or improvement expenditures (“TIs”)• Leasing commissions to brokersProperty Improvements:• Major repairs• Replacement of major equipment• Major remodeling of building, ground & fixtures• Expansion of rentable areaTwo truths often not reflected proformas used in practice in the real world . . .• Realistic long-term rental growth projections in most commercial properties in most areas of the U.S. should average slightly less thanrealistic expectations about general (CPI) inflation.• Realistic long-term capital expenditure projections for most types of commercial property should average at least 10% to 20% of the NOI, or an annual average of about 1% to 2% of the property value.Exhibit 11-2: The Noname Building: Cash Flow Projection Year: 1234567891011 Item: Market Rent/SF: $10.00 $10.10 $10.20 $10.30 $10.41 $10.51 $10.62 $10.72 $10.83 $10.94 $11.05 Potential Revenue: Gross Rent Space 1 (10000SF) $105,000 $105,000 $105,000 $103,030 $103,030 $103,030 $103,030 $103,030 $108,286 $108,286 $108,286 Gross Rent Space 2 (10000SF) $100,000 $100,000 $100,000 $100,000 $100,000 $105,101 $105,101 $105,101 $105,101 $105,101 $110,462 Gross Rent Space 3 (10000SF) $100,000 $101,000 $101,000 $101,000 $101,000 $101,000 $106,152 $106,152 $106,152 $106,152 $106,152 Total PGI $305,000 $306,000 $306,000 $304,030 $304,030 $309,131 $314,283 $314,283 $319,539 $319,539 $324,900 Vacancy allowance: Space 1 $0 $0 $0 $51,515 $0 $0 $0 $0 $54,143 $0 $0 Space 2 $0 $0 $0 $0 $0 $52,551 $0 $0 $0 $0 $55,231 Space 3 $100,000 $0 $0 $0 $0 $0 $53,076 $0 $0 $0 $0 Total vacancy allowance $100,000 $0 $0 $51,515 $0 $52,551 $53,076 $0 $54,143 $0 $55,231 Total EGI $205,000 $306,000 $306,000 $252,515 $304,030 $256,581 $261,207 $314,283 $265,396 $319,539 $269,669 Other Income $30,000 $30,300 $30,603 $30,909 $31,218 $31,530 $31,846 $32,164 $32,486 $32,811 $33,139 Expense Reimbursements Space 1 $0 $1,833 $2,003 $0 $1,651 $964 $1,118 $2,870 $0 $1,823 $329 Space 2 $0 $2,944 $3,114 $1,814 $3,465 $0 $153 $1,905 $469 $2,292 $0 Space 3 $0 $0 $170 $0