Final Case: Laguna Specialty Center

Chris Armour
REAL 3377
March 14, 2016

The Project
In the Laguna Case two projects are available to choose from: a specialty retail center or an
office building. However, each product had vastly different expectations, market relevancies, and
risk/reward profiles. As the name of the group suggests, Specialty Center Associates was a
partnership developed with the intention of investing in the development of specialty retail
centers throughout Southern California. The partnership optioned its first piece of land in
Laguna, California with the intention of beginning their first specialty retail center development.
The intended product was a relatively newer concept, aimed at drawing in higher income
shoppers. Unlike most shopping centers, the specialty retail center would not rely on any anchor
stores or large corporate brand stores, but instead offer goods from local and regional vendors.
The type of products sold through said stores includes things like jewelry, womens apparel, arts
& crafts, specialty foods, gifts and household items. These developments typically have a few
restaurants as well to help draw in customers. An additional feature of specialty retail centers in
that they are typically 100,000 200,000 square feet and have an architectural theme to them.
The specialty center that the partnership intended to develop was set to begin construction in less
than a month and they already had financing in place with an effective loan-to-value (LTV) of
83%. The $16,800,000 loan held a 9% annual interest rate with thirty year amortization and a
sixteen year term, equating to an annual payment of $1,622,119. There was also a 1.5%
commitment charge associates with this loan. Additionally, pension fund offering the loan had
offered a construction loan at the same terms, with a 1% fee.
The project would encompass 112,000 square feet and include anywhere from fifty-six to eightysix tenants, including two freestanding restaurants and three mall restaurants. Development costs,
not accounting for any entrepreneurial incentive, come to $19,863,000. Base rents for mall
shops, mall restaurants and freestanding restaurants were projected at $24.00, $27.00 and $28.50,
respectively, bringing the total base rent to $2,790,000. However, each of the tenants has a sales
percentage stipulation as well, requiring them to pay the overage, or difference between a set
percentage of their sales revenues and the base rent. A key determination in this projection is the
assumption of how much of the current and unserved market the new stores will be able to
capture. While the greater Orange County area has been growing at a state leading pace, the perperson sales in the Laguna area have noticeably lagged. In the three categories of apparel,
household and general this metric is only 16.8%, 19.3% and 22.1% of the Orange County
average. Although much of this may be attributed to a lack of service in the area, it is important
to consider that the area is not reflective of the overall countys sales demographics and data. To
forecast the proper sales projections, the expected sales per square foot in Orange County, broken
down by merchandise type, was applied to an assumed capture rate for each different type and
then multiplied by said merchandise types allocated space in the specialty center and their sales
percentage rate. The assumed capture rates of non-restaurant categories ranged from 37% for
apparel to 55% for items like jewelry, plant boutique and specialty food. In general this assumed
a 20% increase in area capture rates over their current positon, with an additional gain attributed
to the more high-end stores. For restaurants the assumed sales per square foot of $375 is
expected to be captured in full due to the large underserves market potential and the fact that

none of the seven currently existing area restaurants are actually in Laguna. As a result, the
restaurants are the only tenants that are projected to make enough sales to pay an overage beyond
their base rent.
These factors allow for a projected first year potential gross income of $2,971,500. Assuming
for first year vacancy of 15% and $180,000 for owners expenses, a first year net operating
income (NOI) of $2,345,775 is obtained. Accounting for amortization, reserves and depreciation,
as well as 50% income tax, a first year loss of $266,425 is projected, allowing for a tax shelter
for investor other income. Year two and beyond assumes 8% growth in both income and
expenses, with a stable 7% vacancy. Assuming for a disposition in early 2010, based on 2009
income and at a cap rate of 8.5%, a sale price of $52,090,076 is expected, with eventual proceeds
to limited partners totaling $26,538,583. The resulting internal rate of return (IRR) for this
project is 24.04%, with a net present value (NPV) of $3,721,772 based on the Bills expected
passive investment IRR of 15%.
The second potential product for the site is a 148,000 square foot office building, developed as
the regional headquarters for a major insurance company. The ten-story building has total
development costs, excluding entrepreneurial incentive, of $15,393,750. The insurance company
that brought this project to the partnerships attention has also offered financing for the project
with a $12,000,000 loan at an effective 77% LTV after a 1% fee. Loan terms are similar at 9%
interest and thirty year amortization, but this loan also has a thirty year term. The annual
payment for the insurance company financing is $1,158,657.
The insurance company would account for 70% .of the building occupancy, and would be locked
into a fifteen year lease at a relatively low base rent of $20.70 per year, guaranteeing annual base
income of no less than $2,070,000. Assuming the remaining 48,000 of speculative space is
leased at a market rate of $25.20 and is occupied at 85% the first year gross income of
$3,098,160 is projected, with an NOI of $2,333,160. After amortization, reserves, depreciation
and income tax, first year cash flows of $267,305 are anticipated. Speculative space occupancy
is projected to increase to 95% and remain stable thereafter, while the lease rates for speculative
space tenants are expected to be locked in for five year periods with re-adjustments to market
rates after every five year period. Market rates as well as expenses are assumed to grow at 8%
annually. Using the previous disposition assumptions a sale price of $40,331,500 is projected,
with eventual proceeds to limited partners in the amount of $21,827,983. The resulting IRR for
this project is 25.12%, with an NPV of $3,385,125.
On an initial look, both of the potential products offer meaningful returns that go beyond what is
expected by Bill Reynolds and the limited partners. The site is currently zoned as: General
Commercial; Precise Development, meaning that it can be used for either of the mentioned
products, but that it would be definitively zoned for that purpose only thereafter, so there could
be no going back once zoning was completed. This is the only real legal factor involved with the
overall project decision.

The People
The primary player in this case is Bill Reynolds; successful entrepreneur and limited partner of
Specialty Center Associates. Bill recently become a limited partner in the company, entitling
him to investment and cash flow participation, but without personally managing or making
important decisions about the investments held. Bill has $900,000 to contribute to the first
investment in the partnership and expects a 15% IRR. Bill, as a voting partner, needs to
determine whether he believes the partnership should pursue the intended specialty retail center
or the proposed office building.
Specialty Center Associates is the partnership entity through which Bill Reynolds is acting. Set
up as a partnership, there are two classes of partners, limited and general. Limited partners, such
as Bill Reynolds, supply investment funds and in turn are entitled to gains made on investments
through the fund, however they do not participate in management decisions of the partnerships
investments once they have been made. General partners take an active role in managing the
investments and do not supply capital (or at least not at significant levels) for investments,
however they are entitled to a percentage of the returns to incentivize them to maximize the
partnerships overall wealth.
A final player in this case is the major insurance company that proposes the office building
project to Specialty Center Associates. The insurance company is looking to solidify its presence
in Southern California by building a reginal headquarters and would like to do so on the site
Specialty Center Associates plans to develop. They are willing to provide the financing for their
proposed office building and are prepared to sign a fifteen year lease upon completion of
construction.
The Process
The case takes place in December 2000 and is near the beginning of the action stage. Specialty
Center Associates has already completed their conceptual stage in coming up with the idea and
specifications for the specialty retail center, as well as researching the market demographics and
retail sales data. They have also completed the pre-commitment stage because they have a loan
commitment and limited partners are ready to move. The action stage is expected to begin in
January 2001, less than a month away, and is expected to complete construction in December
2001. After such time the partnership plans to hold and operate the property for nine years
during the custodial stage, before finally selling it in 2010.
The insurance companys proposed office building has a deadline to respond of December 31,
2000, less than a month away. Although the project was just recently brought to the attention on
Specialty Center Associates in early November, it is also nearly ready for the action stage. The
conceptual stage has already been completed by the insurance company and a two week
preliminary plan write-up by the partnership, along with the general market data obtained in the
previous due diligence. With a loan commitment form the insurance company, and a tenant to
take up 70% of the space, the only part of pre-commitment to complete is getting the vote form
the limited partners. Expected to complete construction in early 2002, the property is expected

to stabilize in 2003 and be held and operated by the partnership until 2010, at which point it will
be sold and the investment completely exited.
The Panorama
The site was located in Laguna, one of the fastest growing markets in Orange County, which
itself was the fastest growing MSA in California. In fact Laguna had experience 20% population
growth in the five years prior to the time period in which the case study is based, compared to
16% for Orange County. Despite such tremendous growth, the areas in and around Laguna still
had vast amounts of undeveloped land to continue fueling further growth and expansion. This is
reflected in the estimated area populated within a five mile radius increasing from approximately
203,000 in 1999 to 234,000 in 2002. The market is fairly even in terms in employment class and
job type, but does lean towards higher-income professionals. The most common field of
employment is professional employees at 22.5%, followed by craftsmen & foremen at 20.6%.
Clerical and administrative roles are also meaningful contributions at 18% and 12%,
respectively. The median family income within a 5 mile radius of the site is $39,942, over
$3,000 higher than that if Orange County and $7,000 higher than that of Los Angeles County.
Furthermore, 39.8% of families in the area make over $45,000 a year, as compared to just 33.7%
in Orange County and 28.4% in Los Angeles County. The employment and income level data
seems to indicate that the area is suitable for a specialty retail center catering towards highincome consumers.
The retail sales environment in and around Laguna is much less promising unfortunately. In
1999, the per capita retail sales in Laguna was only $585M, as compared to $2,544M in Orange
County. With per capita retail sales having increased every year in Orange County since 1994,
the lack of retail facilities and first-class restaurants in Laguna has held the market back from
realizing its fullest potential. On a per person retail sales basis the area around Laguna is only
capturing 19.3% of the expected average in Orange County. Even with the strong supply of
developable land, a growing population and high-income residents, it is a substantial risk to
assume that a new retail development would be able to increase the capture rate too significantly,
even with a class leading product and perfect execution. However, an office building makes
more sense in light of economic risk because the professional, high income resident base is also
the type that would work in such a building. Having a strong, nationally known company as the
main tenant, as well as knowing they are dedicated to the building because utu is their regional
HQ, is likely to attract other successful companies to the office space, in addition to the existing
talent pool within a close proximity.
Other considerations include the fact that this is all occurring one year into a new president and
during the dawn of a new technological era with the internet. Stock market valuations during
this time were very high and there was much uncertainty about the near-term future of the sociopolitical environment, so it would have made sense to limit risk exposure as much as possible.
Due to the fact that the specialty retail center is a relatively new and unproven concept, it
presents much more risk in this economic environment than the office project does.

The Physical Real Estate

The actual site itself is located in the Southern California town of Laguna, which is in Orange
County, approximately 30 miles south of Los Angeles. The 12.5 acre site in the NE quadrant
rests on slightly rolling topography, meaning it will need to be graded to a level, buildable
surface. Soils tests have been performed and conclude that the ground is stable enough to build
on, and in addition all utilities are already available at the site. Access and visibility for the site
are both good, as it has a major highway, Orange Freeway, to the West and high-traffic
Greenbriar Lane to the North. To the East of the property lies the Lotus Flood Control Channel,
which blocks any access from that direction, and is less than ideal for a specialty retail center.
However, to the South of the site a new convenience shopping center is under construction,
which could eventually work to create a synergy effect with a specialty retail development.
Additionally, a new mall is being developed to the West of the site, across Orange Freeway.
While this too could drive some positive synergistic effects, it is also concerning as the mall is
already under development and will very likely be operating and building a customer base before
the specialty center can be completed, leaving it in a position to play catch up and lure away
customers from another new shopping outlet.
The design for the specialty retail center consists of a split-level structure with 112,000 leasable
square feet. The upper level would include 28,000 leasable square feet, in addition to two
freestanding, 8,000 square foot restaurants and approximately 8,000 square feet of mall
walkway/concourse area. The lower level of the specialty center is designed to have 68,000
leasable square feet, including a large 10,000 square foot restaurant. 25,000 square feet has been
allocated to the mall area on the lower level to build a traditional court as well. With
approximately 338,000 square feet of land available for parking and landscaping around the
specialty center, the design leaves room for about 800 parking spaces. Equating to about one
space per 140 square feet of retail, which is substantially more than the typical allocation for
retail parking of one space for every 200 square feet.
The office building proposed for the site is a much more traditional, straight forward
development, consisting of a ten-story, 148,000 square foot building. Assuming for an
approximate average of 14,800 square feet per floor and allowing for some additional space on
the ground level, approximately 25,000 square feet of additional space is made available for
parking. With an assumed need for parking of one space per 500 square feet of leasable space,
the office building would require approximately 296 parking spaces, indicating plenty of room
for additional space, landscaping, or possibly leasing or divesting a portion of the land remaining
land.
The Recommendation
Although both of the proposed projects show strong potential for future returns, the office
building shows a slightly higher IRR and has substantially less risk in my opinion, and therefore
I believe it is the better investment decision. The intended specialty retail center is what the
partnership originally intended to invest in when they formed, but that may also be blinding them
to the economic and market risks involved with their current site. While the site itself it great,

the surrounding demographics around retails sales do not support a strong ability to capture
market leakage and realize substantial revenues. The NPV of the specialty retail center is higher
than that of the office building, but the reliability of the cash flows is much less certain and at
risk of economic downturn. The office building is a more conservative investment because it
involves a guaranteed tenant, and associated income stream, for at least fifteen years.
Furthermore, business located in office buildings, particularly in the case of the insurance
company, are much less exposed to general economic risk than retail locations, providing a
further safety net for nearly identical returns between the two projects. However, the insurance
companys proposal does lock them into a very low lease rate compared to the current market,
and maintains that rate for fifteen years. While this does work out for the current financial
projections, it is a huge concession over the length of the lease that could definitely be negotiated
downwards. I would recommend pursuing the office building project with one of the following
three counter-offers: 1) Higher initial lease rate, maintain fifteen year lock-in, 2) adjust lease rate
in five years to amount below market price that reflect current market price concession, or 3)
receive a lower rate on the loan in exchange for keeping lease terms as-is. It is also relevant to revisit the idea of additional cash flows through the office building project by leasing or divesting
the additional land after developing the property space. With the possibility of additional returns
through excess land and renegotiating with the insurance company, as well as less associated
market and economic risk, the office building project is definitely the optimal option for Bill
Reynolds and Specialty Retail Associates.