Real Estate Financial Modelings Guide To The Commercial Real Estate Business

Foreword
This guide has been kept concise so that it can be read in a single afternoon. It is written on a basic level and is primarily intended to bring up to speed those with little prior exposure to the world of commercial real estate. However, there is likely something of interest in the guide for readers of all levels of expertise. The guide takes a big-picture view of the industry and attempts to show how all of the pieces fit together. It is by no means an exhaustive treatment, and is best read as a companion to Wharton Professor Peter Linnemans Real Estate Finance & Investments: Risks and Opportunities textbook, with the Barrons Dictionary of Real Estate Terms at hand. I wish you all the best in your real estate endeavors. Bruce Kirsch Founder Real Estate Financial Modeling, LLC GetREFM.com

Why Real Estate?

Real estate is a dynamic, high-stakes industry where massive fortunes have been made, lost, and sometimes made again. Real estate is the suburban American dream home with the white picket fence, the tiny overpriced New York studio apartment, the Nike corporate campus, the Empire State Building, the shopping mall, the monstrous Wal-Mart Supercenter, and the Hawaiian vacation resort with the oceanside golf course, to name just a few manifestations. The business is enormous in size (the U.S. commercial market alone is a multi-trillion dollar market) and expansive in scope. Real estate is often the majority of a U.S. familys wealth, and is usually a major portion of a corporations assets. It is home to both low-key moguls such as Walter Shorenstein and Gerald Hines and flamboyant personalities like Sam Zell and Donald Trump. Real estate is about people, properties, deal making and value creation. If all of this interests you, read on!

Table of Contents

A Big-Picture Commercial Real Estate Business Framework ...... 4 Types of Real Estate .............................................................................. 5 Types of Real Estate Investors ............................................................ 6 Real Estate Investment Capital
Types of Capital ..................................................................................... 7 Uses of Capital ....................................................................................... 9

Investment Objectives and Methods

Income (Maximizing Cash Flow and Yield) ............................................ 10 Recouping of Investment and Profit Taking ......................................... 11

Valuation of Real Estate

Discounted Cash Flow and Time Value of Money Model .................. 12 NOI, Cap Rates and Comparable Sales Model .................................... 13 Replacement Cost ................................................................................ 14 Residual Land Valuation ...................................................................... 15

Conclusion ............................................................................................ 15 Additional Resources .......................................................................... 16

Copyright 2013 Real Estate Financial Modeling, LLC. All rights reserved.

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A Big-Picture Real Estate Business Framework

Below is one framework in which to view the real estate business. (It is by no means the only way!) The comprising elements are explored separately on the following pages.

Types Of Real Estate

Types Of Real Estate Investors

Real Estate Investment Capital

Investment Objectives and Methods

Valuation of Real Estate

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Types Of Real Estate

Real estate is generally separated into residential and commercial categories. Detached single family homes and townhomes are usually what fall under residential (some will also include multi-family in this category), while commercial is comprised of multiple sectors as broken out below.

REsIdEnTIAl Detached Single Family Homes Townhomes

COMMERCIAl

Office
Central Business district (generally highrise & midrise) Class A (e.g., The GM Building in NYC) Class B (increasingly lesser in quality & location) Class C suburban (generally midrise) Class A Class B Class C Medical Office Multifamily (apartments, condominiums and cooperatives) Small Properties / Suburban Garden Apartments Urban Midrise & Urban Highrise Hotels and Resorts Limited Service Extended Stay Full Service (e.g., The Ritz Carlton or Marriott) Industrial Heavy Industrial (Manufacturing) Facilities Light Assembly Storage & Distribution Facilities Research & Development Facilities Retail Shopping Center / Regional Center / Strip Commercial Super Regional Centers (e.g., Mall of America) Community Center / Neighborhood Center Convenience Center / Specialty Center Big Box (Freestanding) Store (e.g., Home Depot) Other Golf Course Land Student Housing Assisted Living Health Care Institutions
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Types Of Real Estate Investors

Real estate is a well-established investment vehicle, and unsurprisingly, real estate investors have grown in number, type and sophistication over time. Investors fall into the four main categories that are shown and described below.

Private Individual Family Investment Firms REIT Equity Mortgage Hybrid

non-REIT Pension Funds Life / Insurance Companies Private Equity Funds Other Investment Banks Commercial Banks State and City Governments

Private individuals, families, or investment operations make both small and large investments. developers, those who transform raw land or an existing property to an improved (and hopefully more valuable) state, often fall in this category. REITs (real estate investment trusts), which own about one third of the commercial investment properties in the U.S., can be either privately or publicly owned. Equity REITs develop, manage, invest in and own properties. Their revenues come primarily from rents from tenants and capital gains realized upon sales of assets. Mortgage REITs do not generally own real estate they typically loan money to people or companies that buy real estate. They also purchase existing mortgages or mortgage-backed securities. Their revenues come from the interest paid to them on the capital they loan. Hybrid REITs combine the two types of investment explained above. Non-REIT equity investors, which can be either privately or publicly owned, include large money managers such as pension funds, life/insurance companies, and private equity funds, some of which are known as opportunity funds. All make equity investments to match their respective risk/return profiles. In the other category fall investment banks that raise equity and debt for REITs and other types of real estate firms wishing to access the capital markets, and commercial banks such as Citibank, which make loans on real estate investments. Lastly are state and city governments, which issue tax-exempt real estate bonds funded by investors, whose proceeds are used by developers.

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Real Estate Investment Capital

Capital is the lifeblood of commercial real estate investment. The pages that follow describe the sources and uses of capital.

sOURCEs OF CAPITAl Equity debt 1031 Exchange Personal &/or Family Investment Commercial Mortgage Loans Private Equity Government Bonds Tax Credits

UsEs OF CAPITAl Acquisition of Existing Rental Property Rehabilitation/Repositioning Land Entitlement or Rezoning Ground-up New Property Development

Types of Capital
All real estate investments, like other business ventures, require capital to get off the ground and to come to fruition. Whether you are acquiring a highrise office complex in San Diego or building a community of detached single family homes in Ohio, neither will happen without capital. Real estate investments usually entail a mixture of equity and debt capital (see diagram on next page). The various types of capital are discussed below. Equity Equity is generally cash that is invested in return for an ownership share in an investment.2 This stake can be held indefinitely, sold back to the sponsor or another investor for cash, or traded for other assets. In the first two scenarios, the difference between the cash originally invested in the project and that received when the share is sold by the investor, less transaction costs such as legal fees, is the investors return on investment, or ROI. The main sources of equity are shown below: Personal and/or family investment personal or family wealth is often a source of equity in real estate projects, many of which are run by family-based real estate operations. Private equity this is a fancy name for cash that is invested in a fund raised by an investment management firm.3 Private equity investors include wealthy individuals and families, endowments and pension funds. These investors entrust private equity firms to achieve targeted investment returns over the life of the fund.

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