REAL 4000 - EXAM 4 - DIETZ

STEPS IN THE PROCESS OF DEVELOPMENT

1. Establishing Site Control 2. Feasibility Analysis, Refinement, and Testing 3. Obtaining Permits 4. Design: Architect and Other Professionals 5. Financing 6. Construction 7. Marketing and Leasing 8. Operation

VALUE OF U.S. CRE

42% Private Equity 34% Private Debt 12% Public Equity 12% Public Debt

INSTITUTIONAL VS. NONINSTITUTIONAL PROPERTIES AND INVESTORS

$1.8 Trillion (48%) of $3.7 Trillion in Private Equity by Institutional Investors Remaining $1.9 Trillion (52%) held (mostly) by High Net Worth Investors

TWO CATEGORIES OF MANAGEMENT DECISIONS

TWO CATEGORIES: 1. Those that have to do with the Day-to-Day Operations of the Property - i.e., "PROPERTY" Management 2. Those that affect the Physical, Financial, or Ownership Structure of the Property - i.e., "ASSET" Management

INDIRECT INVESTMENT - REIT INTERMEDIARIES: In What do REITs Invest?

"CORE" REITs invest in Retail, Apartment, Office, & Industrial Properties But many "NON-CORE" REITs Exist

INDIRECT INVESTMENT - REIT INTERMEDIARIES: Measuring REIT Income - Funds From Operations (FFO)

According to the Generally Accepted Accounting Principles (GAAP), A Corporation's "Net Income" includes a Tax Deduction for the Depreciation and Amortization of certain Financial and Fixed Assets. Tax Depreciation, is the process whereby the Cost of Depreciable Improvements is Allocated (i.e., Expensed) over the Cost Recovery Period of the Asset. Mechanically, Depreciation and Amortization Expenses therefore Reduce reported Net Accounting Income. However, these Expenses do NOT represent Actual Cash Outflows. Thus, if a Corporation's Assets are primarily Depreciable, as are most of the Assets of an Equity REIT, Accounting Income may understate the Actual Net Cash Flow available to distribute to Investors as Dividends. The REIT Industry's Response to this Issue was to create a Supplemental Earnings measure that Adds Back Depreciation and other Amortizing Expenses to GAAP Net Income. This Measure is termed Funds from Operations (FFO) and is defined as: FFO = Net income (GAAP) excluding Gains and Losses on Property Sales + Depreciation (Real Property) + Amortization of Leasing Expenses + Amortization of Improvements made to Tenants' Space - Gains (Losses) from infrequent and unusual Events Similar to Depreciation Deductions, charges to Amortize certain Leasing Expenses and the Cost of Tenant Improvements paid for by the Owner are Added back to net Accounting Income when estimating the REIT's Cash Flow. Many Industry Analysts and Observers argue that FFO is too easily manipulated by REITs, thus reducing its usefulness as an Income Measure.

FUNCTIONS OF PROPERTY MANAGER: Selecting Tenants

In Leasing Commercial Property, care must be taken to assure the Prospect is WILLING and ABLE to PAY the RENT. Tenant Quality is a significant determinant of the Income-Producing Ability of the Property. Ideally, the Property is of Sufficient Quality and Desirability to allow some choice of Tenants, thereby Minimizing Rental Collection Issues and other Problems. "CREDIT" TENANTS (CREDITWORTHINESS): Credit Tenants are Companies or Corporations whose General Debt Obligations are Rated "Investment Grade" by one or more of the U.S. Rating Agencies. A VAST MAJORITY of Potential Tenants are NOT Credit Tenants. The Majority of Commercial Properties in the United States are Relatively Small Projects Leased to Small- and Medium- Sized Businesses that do not bring in Investment-Grade Rating with them to the Lease Negotiations. TENANT MIX: Tenant Mix is the Synergism Created by the Current Collection of Tenants. Synergism means that with the Right Mix of Tenants "The Whole can be Greater than the Sum of its Parts"

WHEN WILL LEVERAGE INCREASE NPV & IRR?

HOLDING EVERYTHING ELSE CONSTANT . . . . - Increased Leverage will INCREASE Calculated NPV when Opportunity Cost of Equity Capital (Discount Rate) exceeds Effective Borrowing Cost - Increased Leverage will INCREASE Going-In IRR when Unlevered IRR exceeds Effective Borrowing Cost

INVESTOR IN PRIVATE RE EQUITY MARKETS (NON-INSTITUTIONAL)

High Net Worth Individuals & Families - "Indirectly" in JVs/LLCs organized by others - "Directly" (although they form LLCs, etc.)

FUNCTIONS OF PROPERTY MANAGER

MAINTAINING TENANT RELATIONS: Leases Expire and a High Rate of Turnover Adds significantly to Operating Costs; Tenant Dissatisfaction can be VERY Damaging to both Current and Future Occupancy. COMMUNICATING WITH OWNERS: In addition to the Standard Reports on Property Performance (e.g., Vacancies, Turnover Rates, and Collection Losses), a Good Property Manager will also Offer her Perspective and Advice on Decisions that ultimately rest with the Asset Manager or Owner. COMPLYING WITH LANDLORD-TENANT LAWS: - Designed Primarily to protect Households Renting Apartments & other Residential Properties - Governed by State Law - Attempt to "Level the Plating Field" between Owners and Renters

STEP 5: FINANCING - Post-Construction Financing (Continued)

MINIPERM LOAN: - This is a Construction Loan that Serves as a "Permanent" Loan for a few years AFTER the Property is Completed. The Typical Term might be Five Years from inception. - Combines Construction Loan and Short-Term Post Construction Financing - Allows Project to achieve "Track Record: of Operations - May extend for Two or Three Years beyond Completion of Construction - A Developer could get BETTER TERMS with "PERMANENT" Financing for a Project that has "GRADUATED" from the Lease-Up Stage and shows Two or Three Years of Stable Operations. In this case, the MINIPERM could offer a Cost-Effective way of deferring Permanent Financing until more Favorable Terms are available due to the Reduced Risk of Stable Operations.

INVESTMENT VALUATION USING DISCOUNTED CASH FLOW MODELS

Similar to the Discounted Cash Flow (DCF) Method used for Market Valuation, the Calculation of Net Present Value and the Internal Rate of Return for an Existing Property have THREE Basic Components: - Estimating Net Cash Flows from Annual Operations - Estimating Cash Proceeds from the Eventual Sale of the Property - Converting these Uncertain Cash Flow Projections into Present Value

STEP 1: ESTABLISHING SITE CONTROL

Site Control is the Entry Ticket to Development. Without it, nothing else matters. No Site? No Development . . . but how do you get it? LAND ALREADY OWNED: Farms on Edge of Development; Ranches near Large Cities - E.g., Irvine Ranch south of Los Angeles; Railroad and Timber Company Land LAND ASSEMBLED FOR SPECIFIC PURPOSE: Difficulty of Land Assembly often justifies Government Involvement in Urban Renewal - E.g., Assembly of Land for Walt Disney World

STEP 2: FEASIBILITY ANALYSIS, REFINEMENT, AND TESTING

THREE POSSIBLE FEASIBILITY OUTCOMES: 1. "Slam Dunk": Go Ahead 2. NO GO: Don't Look Back 3. IN BETWEEN: Obtain More Information and Refine Analysis - More Cost Analysis - Market Research TESTS and SURVEYS that may be Necessary (DUE DILIGENCE): - Soil Test (Load Bearing Capacity, Drainange) - Environmental Tests - Critical Habitats (Endangered Species) - Hydrological Tests (Runoff and Water Flows) - Seismic Tests (Earthquakes and Vulnerability) Archeological (Prehistoric Ruins)

TENANCY IN COMMON (TIC)

TIC: One of the Oldest Forms of Co-Ownership Essentially, Fee Simple Ownership Interest with Multiple Owners: - Investors receive Separate Deed, are Direct Owners - Investors may hold different Ownership Percentages, otherwise Interests are indistinguishable - (i.e., Investors share "Pro Rata" in CFs, Tax Consequences, & Price Appreciation) - < (or equal to) 35 Investors Avoid this form, 100% Liability Generally considered BAD FORM for investing in CRE - Joint & Severe Liability

OCCASIONS FOR DEVELOPMENT

A USE IN SERACH OF A SITE: - New Locations for Expanding Franchise - Need for a New School A SITE IN SEARCH OF A USE: - Raw Land in Path of Urban Growth - Land Adjacent to New Freeway Intersection RESOURCES IN SEARCH OF AN OPPORTUNITY: - Pension Fund with Money to Invest - Private Investor looking for High-Yield Investment

C CORPORATION

A C CORPORATION constitutes a Legal and Taxable Entity separate from the Owners who are the Shareholders in the Corporation. Thus, a C Corporation earns income and incurs Tax Liabilities. C Corporations pay Income Taxes on taxable Corporate Income and have their own Tax Rate Structure and Rules. Dividends paid to Shareholders are not Deductible by the Corporation and are Taxable to the Shareholders. Thus, One of the Major Disadvantages of using a C Corporation to invest in Commercial Real Estate is that the Income from the underlying Property or Properties may be Taxed Twice. C Corporation Income is currently subject to Federal Tax Rates as high as 21% and, in 2019, Individuals can be Taxed at Federal Rates exceeding 40%. Thus, the effective Federal Tax Rate on Income from Properties held by Corporations can exceed 50%. For Shareholders, a C Corporation provides Limited Liability for the Obligations of the Corporation. This Limited Liability includes Liability from Contractual Obligations as well as Obligations arising from Tort Actions brought against the Corporation. This Limited Risk extends to all Owners of the Corporation, unlike Limited Partnerships, where only Limited Partners are afforded such Protection. Another similarity with Limited Partnerships is the Separation of Ownership and Control. In a C Corporation, Operating Decisions are made by Managers who may or may not own much of the Firm and who act as Agents on behalf of the Principals, the Stockholders. This separation allows for the Managerial Expertise and helps resolve coordination problems (imagine trying to get all of a Large Corporation's Shareholders to agree on every Operating Decision) but comes at the Cost of potential Conflicts of Interest. C Corporations are not generally a Desirable Structure for entities whose Primary Purpose is to Acquire and Own Commercial Real Estate because there are alternative Ownership Structures that provide Limited Liability but avoid Potential Double Taxation of Income. Although C Corporations are not typically used if the Primary Business of an Ownership Entity is to make Long-Term Investment in Commercial Real Estate, many Regular C Corporations fo own a Significant amount of Real Estate. (e.g., General Motors and Microsoft).

STEP 1: ESTABLISHING SITE CONTROL (Continued)

A Common Tool for a Developer to Gain Control of a Site is to Purchase an OPTION on the Land that Allows the Developer, at a Predetermined Price, to choose by a Certain Date whether to go through with the Purchase. Ideally, it allows the Developer Sufficient Time to Conduct Feasibility Analysis, to Run Soil and Environmental Tests, to obtain Necessary Zoning Changes or other Permits, and possibly long enough to Arrange Financing. The Terms of an OPTION can be very Creative and will depend on the Bargaining Position of the Two Parties. It could involve giving the Landowner a Participation in the Development in Lieu of Cash Up-Front. Further, Options can come in Disguise, such as a CONTRACT OF DEED. If the Developer purchases the Land on a CONTRACT OF DEED with a Small Down Payment, then it may be easy to simply Abandon the Contract if the Project turns out to be Infeasible. JOINT VENTURE: Landowner puts Land into Development in Return for a Share of Profits. Another way to manage Equity for Land Acquisition is to bring a Future Tenant into the Development as a Partner. This Arrangement might be the Formula that enables a New Developer with Few Resources to Enter the Industry. For a Tenant needing a Facility, the Arrangement could provide Sufficient Reward to justify Risking Involvement with the Untested Developer, particularly if the Tenant can tolerate Uncertainty in Date of Completion. If the Tenant will Occupy a Large Portion of the Facility to be Built, the Risks of the Development are further reduced since Market Uncertainty is Resolved. An Important Variation on Joint Venturing with a Tenant is BUILD-TO-SUIT. The Developer Preleases to a Financially Strong, frequently National, Tenant to Build to the Tenant's Specifications. EX: A Restaurant for a National Fast-Food Chain, or a Free-Standing Facility for a National Retailer. Another possible Solution to Land Acquisition is the GROUND LEASE. Under this Arrangement, only the Initial Land Rent must be Paid out before Development actually gets under way. The Ground Lease can Offer the Owner of the Land an Attractive Arrangement since it provides a Long-Term, Inflation-Protected Income (assuming that Rents are Reviewed and Adjusted Periodically) and, in Case of Default, gives the Landowner ALL the Improvements. EX: The Rockefeller Center was built during the 1930s on Land then Owned by Columbia University. This ultimately turned Landholdings of Marginal Value into a Fabulous Source of Wealth for the School.

ASSET MANAGEMENT FUNCTIONS

AFTER Commercial Property is Acquired, Asset Manager MUST; Monitor and Control Operating Performance - Entails making Periodic Site Visits, Preparing Long-Term Budgets for Capital Expenditures (CAPX), and Appealing Property Tax Assessments when Necessary Recognize and Report to Owners Value-Enhancing Opportunities for Rehabilitation or, Remodeling (Deterioration vs. Obsolescence) Modernization, or Conversion to a more Profitable Use The Asset Manager should Periodically consider whether the Owner's Cost of Capital could be Reduced by Changing the Loan-to-Value Ratio or by otherwise Altering the Financing Package Must be Aware of Opportunities to Restructure the Equity Ownership, perhaps through Joint Venture Partnerships, Joint Venture Buyout Options, or Sale-Leasebacks Must Continually Monitor Local Market Conditions and Assess whether or not to Recommend the Sale of the Property - Buy vs. Hold Decision for Owners

DEBT & EQUITY REVIEW

All Properties are Purchased with Money Money to Finance Property generally comes in TWO PRIMARY "COLORS": - EQUITY (Ownership) - DEBT (Loan to Ownership) Within Debt and Equity there can be numerous SUBCATEGORIES making a Capital "Stack" including: - Sponsor Equity - Common Equity - Preferred Equity - Mezzanine Debt - Junior Debt - Senior Debt

ADVANTAGES OF POOLING EQUITY

Allows Investors to purchase Interest in Large Properties Diversification of Portfolio Economies of Scale in Acquisitions, Management and Deposition Access to CHEAPER Debt Capital - Lenders like Lending to Groups Expertise of Management Team hired by Organizer/Syndicator

STEP 5: FINANCING - Mezzanine Debt

Banks Seldom Loan 100% of Construction Costs, except on very strong projects with strong Developers. More commonly, they may Fund 70 to 80% of Project/Construction Costs, or LESS in times of tight Money. Frequently, therefore, the Developer either Needs or Prefers to find Additional Capital to Complete the Construction Stage. Equity Capital is One Option, but Equity Money requires a High Yield, and Funding with more Equity Dilutes Returns to the Original Equity. Therefore, Developers often turn to Mezzanine Financing, which can take a Range of Forms. While is sometimes is Second Mortgage Debt, it often is NOT Mortgage Debt at ALL. RATHER, Ownership Shares in the Development Entity are pledges to the Mezzanine Lenders as Security. Thus, in the Event of Default, no Foreclosure Procedure is necessary for the Mezzanine Lender to Exercise their Recourse. Developer may seek High Interest Rate to Fill the GAP. Mezzanine Debt is MORE EXPENSIVE than Normal Construction Financing. Where Construction Loans might run 150 Basis Points to 250 basis Point Above the underlying Interest Rate, Mezzanine Debt will run Several Hundred Point ABOVE. However, this will still be BELOW the Required Yield on Equity Money, and, thus more Attractive to the Developer. MORE EXPENSIVE than First Mortgage Construction Debt, but CHEAPER than Equity Financing

STEP 6: CONSTRUCTION

Clear Understandings between Developer, Architect, and the General Contractor are Vital to Keep the Project on Schedule and on Budget. Always a Construction will require CHANGE ORDERS in the Plans because of Material Changes, Oversights in the Planning, or New Market Information that Dictates Modification in the Project. These can become Extremely Costly once the Original Contracts have been Signed. Poor Initial Understandings Lead to a High Incidence of Change Orders. No matter what Problems arise on the Construction Project or what Agreements Exists with the General Contractor, the Developer bears the burnt of any Failure. Therefore, the Developer needs to Monitor and Process and be Represented when Decisions Arise. Often a CONSTRUCTION MANAGER Serves as the Developer's Liaison and Representative on the Project Site. The Construction Manager may Stand in for the Developer in Discussions between the General Contractor and Architect. The Construction Manager could also Stand in for Developer for Decisions about "Change Orders". - Avoid Change Orders by Good Planning up front

INVESTMENT IN COMMERCIAL REAL ESTATE THROUGH INTERMEDIARIES: Commingled Real Estate Funds

Commingled Real Estate Funds (CREFs) are offered by Major Banks, Life Insurance Companies, Investment Banks, and Real Estate Advisory Firms to Pensions Funds and other Institutional Investors for Investment in Real Estate. Legally, they are Organized as limited Partnerships, LLCs, or Private REITs. Because many Pensions Funds do not have (or wish to acquire) the In-House Expertise required for Real Estate Investment, Fund Managers collect Contributions from multiple Pension Funds and Pool or "Commingle" them to purchase Properties. In addition to Expertise, these Structures allow for better Diversification, as Smaller Institutions are able to own a portion of bigger, better Diversified Portfolio than they would be able to afford their own. Commingled Funds can be Closed- or Open-End, although a majority are Open-Ended. Closed-End Funds have a Finite Life but offer very little to no Liquidity before the Fund begins to Sell Properties and distribute the Proceeds to Investors. Open-End Funds have an Infinite Life but allow Investors to redeem their Interests. It should be noted that this "Internal" Liquidity Solution has some Drawbacks and Risks. EX: Many Investors may want out of the Fund in Tough Economic Times, but it is at those Times that it is difficult for the Manager to Sell Properties Quickly at Fair Value -- and the Properties in the Fund that are most liquid may be the "Best" Properties, ones that the Manager and Investors most want to Retain. As a result, there may be a "Redemption Queue" of Investors waiting for Cash Flows to Exit the Fund, and the Notion of Liquidity during Real Estate Market Downturns may be Illusory. The Fee Structure of Commingled Funds typically includes an Ongoing Asset Management Fee (e.g., 1 - 2 Percent of the Market Value of the Fund's Assets per year). The Manager may also receive Front-End Fees as Compensation for Acquiring the Properties. (e.g., 1 - 2 Percent) and Back-End Fees upon Disposition of the Properties (e.g., 5 - 6 Percent for acting as the Sale Broker). The Manager typically has Limited or No Ownership Interest in the Fund. These Fee Structures can cause Incentive Alignment Issues. EX: The Fund Manager may have an Incentive to Hold Properties (especially ones that have Declined in Value) to continue Collecting Fees. and some Investors may prefer that the Compensation to Managers were more closely Linked to Investors' Returns.

FUNCTIONS OF PROPERTY MANAGER: Signing Leases

Since the Lease is the Document that describes the Rights and Obligations of the Owner and the Tenant, it is the Primary Determinant of a Property's Net Rental Income. In short, Leases are the Engines that Drive Property Values.

"DEVELOPMENT YIELD" AND "DEVELOPMENT SPREAD"

DEVELOPMENT YIELD = Stabilized NOI / Development Cost - Development Yield is often called "Yield on Cost" - Measured in BPS (Basis Points) 9.5% - 7% = 150 bps DEVELOPMENT SPREAD = Development Yield - Projected Going-Out Cap Rate

DEVELOPMENT DEFINED

DEVELOPMENT: The Continual Reconfiguration of the Built Environment to meet Society's Needs. Development is a Necessity, Demanded by Society to Meet its Needs for Shelter, Working Space, and other Permanent Facilities. Constant Social Change implies Constant Alteration of the "Built Environment"

STEP 7: MARKETING & LEASING

Developers are Increasingly recognizing the Value of a Public Relations Program for a Property. ADVERTISING and PUBLIC RELATIONS for the Property is Important. Community Awareness can be Increased through Adroit "Positioning of Good Events in the Course of Development, including Groundbreaking, Topping out of a High-Rise Structure, or Announcing of New Tenants to the Project. In all cases, an Important Part of Public Relations is for the Developer to work closely with the Press and with Public Land Use Authorities. The Developer wants to Build Relationships with Regulatory Officials early in the Process. A "NO SURPRISE" Policy is Advisable wherein the Developer Anticipates any Regulatory Problem or Issue to Arise with the Development and Presents it to the Regulatory Officials -- before Third Parties bring it to their Attention -- with a Recommended Solution and a demonstrated Willingness to be Flexible.

FUNCTIONS OF PROPERTY MANAGER: Collecting Rent

Maintenance and Repair Expenditures, Property Taxes, Utility Bills, and other Expenses of the Property are Paid out of Rental Income. The Timely Collection of Rental income is Imperative.

IMPACT OF LEVERAGE ON RISK OF EQUITY INVESTMENT

The Mean (Expected) IRR INCREASES with Leverage BUT . . . Risk/Variability of the Expected IRR on Equity INCREASES with Leverage RESULT: Expected (Mean) IRR per Unit of Risk DECREASES for 0% to 75% Leverage

S CORPORATION

A Subchapter S CORPORATION possesses the same Limited Liability Benefits for its Shareholders as C Corporations. Although an S Corporation is a separate LEGAL Entity, it is not a Separate TAXABLE Entity; that is, S Corporations pay no Income Taxes, and Taxable Income is passed through to its Stockholders who become Liable for the Tax at their Individual Tax Rates. S Corporations must not have more than 100 Shareholders. Shareholders cannot be a Limited Liability Company, C Corporation, or Limited Partnership. Also, the S Corporation's Cash Flow and Taxable Income must be allocated to each Shareholder in proportion to his or her Ownership Percentage of the Corporation. Allocation of these items based on some other Criteria -- that is, Special Allocation -- is NOT allowed. Although used in some Cases by individuals and families to own Real Estate, the Use of S Corporations by Real Estate Investment Sponsors is uncommon since the advent of Limited Liability Companies.

INVESTMENT IN COMMERCIAL REAL ESTATE THROUGH INTERMEDIARIES

A large amount of Equity Investment in Commercial Real Estate takes place through Intermediaries. Why is their role so significant? This goes back to the Drawbacks of Investing Directly. Depending on the Specific Structure, Intermediaries who Sponsor Investment Opportunities can help mitigate the various cons of Direct Investment by supplying Expertise (including better information), improving Liquidity, and allowing the Investor to more fully Diversify her Portfolio and Share Risk. On the other hand, using an Intermediary typically involves another layer of Costs -- the Investor has to pay for Expertise, for example -- and shifts more Control from the Investor to the Sponsor/Intermediary. The use of an Intermediary can lead to Conflicts of Interest. Thus, creating poor Incentives for the Delegates Managers to maximize the objectives of the Investors is an important issue. Generally, Investments through Intermediaries occur via Real Estate Securities. Securitized Investments pool money from Multiple Investors. Securitized Investments are sold to Investors in either "Public" or "Private" Markets. We define Public Markets as those in which Securities are Bought and Sold on an Exchange that is broadly accessible to Investors, such as the New York Stock Exchange. Private Markets are characterized by Individually Negotiated Transactions that take place without the aid of a Centralized Market. Exchange-Traded Assets provide Investors with a High Degree of Liquidity and relatively Low Transaction Costs. In contrast, Private Markets are generally characterized by High Transaction Costs and Low Liquidity. Securitized Investments are the Norm in Commercial Real Estate, due to the Advantages of Investing through Intermediaries, plus the sheer access to Greater Amounts of Capital that Commercial Real Estate Investments typically require. Even modest Office Buildings, Shopping Centers, and Apartment Buildings often require more Equity Capital than Individual Investors are able or willing to contribute. The Large Capital Requirements lead to the Common Practice of Groups of Private Investors pooling their Equity Capital and purchasing Commercial Real Estate through a Securitized Investment Vehicle sponsored by an Experienced Real Estate Professional. The Pooling of Equity Capital by Investors to purchase Real Estate in the Private Market is often referred to as Syndication. A Syndicate is a Group of Persons or Legal Entities who come together to Carry Out a Particular Activity. A Real Estate Syndicate, therefore, is a Group organized to develop a Parcel of Land, buy an Office Building, purchase an Entire Portfolio of Properties, make Mortgage Loans, or perform other Real Estate Activities. Syndicates take place among both Institutional and Non-institutional Investors. EX: Some Sponsors of Syndications Market their Securitized Investment Opportunities with High Front-End Fees to Small "Mom and Pop" Investors on through Wall Street Brokers and Financial Advisors. Higher-Income Investors often access the Market by buying into Small- to Medium-Size Deals structured and Sold by Local Developers/Sponsors. And, Institutional Investors with High Net Worth Investors participate in a wide variety of Pooled/Syndicated Structures.

DIRECT INVESTMENT IN COMMERCIAL REAL ESTATE: Pension Funds

Are an important participant in Commercial Real Estate Equity Markets. They want Reliable Income from stable Real Estate Investments to pay out Retirement Benefits to Increasing numbers of Retirees/Beneficiaries. The Total Value of Real Estate owned by Pension Funds is estimated to be $542 Billion. This includes their Indirect Real Estate Investments through Private Equity Real Estate Funds and Joint Ventures. Pensions Funds account for less than 7 Percent ($542 Billion / $7.9 Trillion) of Commercial Real Estate Equity. Nevertheless, because of the Capital they have to Invest, Pension Funds and their Consultants have an influence on Commercial Markets that is disproportionate to the percentage of Assets they own.

STEP 6: CONSTRUCTION

Construction often involves a Significant Number of Changes; and Resulting Renegotiations between the Architect, the General Contractor, and Subcontractors are very Costly. As a Result, an Alternative Arrangement has Evolved known as DESIGN-BUILD where the Architect and General Contractor are the same Person/Entity. In Complicated Projects, this Arrangement Reduces inherent Design-Cost Conflicts that otherwise must be Negotiated when Plans are Changed. Since the Changes will be worked out IN ONE FIRM, the Solutions should be Efficient, Affording Savings for the Project. DESIGN BUILD aims to reduce Needed Changes and makes Changes LESS Costly and Time Consuming since they are Within ONE FIRM. FAST-TRACK CONSTRUCTION: Rather than Waiting for the Architect to Complete the Entire Project Design before Construction, the Design will be Broken into SEQUENTIAL PHASES, beginning with Site Design, Footings and Foundations, Building Shell, and so forth. Then Construction will begin before the Last Phases of Design are Complete. While this Procedure Greatly Accelerates the Process, the Procedure has been known to Result in Dramatic Failures where the Architect discovered After Construction was Under Way that Something in an Early Phase is Incompatible with what must follow. Can be VERY COSTLY if Early Design Steps are FLAWED.

SOURCES OF COMMERCIAL REAL ESTATE DEBT: Development & Construction Lending

Development and Construction Lending can be extremely Risky. The Primary Risk is that the Developer will fail to complete the Project in a timely manner or Fail to Complete it at all. Builders may experience Cost Overruns, Poor Weather, Strikes, Structural or Design Problems, or Difficulties with Subcontractors. The Builder may simply be a Bad Manager. In addition, Failure to Pass various Building Code Inspections may Delay the Ability of Tenants to Occupy the Building (and Pay Rent). All of these Risks are assumed by the Construction Lender. Thus, Construction Lenders must have Specialized Skills in Monitoring and Controlling the Construction Process. Because of the Risks of Development and Construction Financing are significant and much different in Nature than the Risks of Long-Term Lending, the Capital Sources for Short-Term Development and Construction Loans differ from the Providers of Permanent Financing. Construction Lenders generally require Recourse to other Borrower Assets to protect their Capital from Potential Losses. They may also require the Borrower to obtain a "Take-Out" Loan Commitment from a Long-Term Lender to pay off the Construction Loan once the Project is Built and Stabilized. The Construction Loan Market is dominated by Commercial Banks. The remainder of the Construction Market is served primarily by Saving Institutions, Federal, State, and Local Credit Agencies and, increasingly, Private Equity Lenders/Funds.

STEP 5: FINANCING

Development has Multiple Phases, each with a Different Set of Risks and Different Combinations of Financing. We will consider Financing for Land Acquisition, Construction, and Post-Construction. Typically, Debt Financing is involved in EACH of these Stages, but of course there must be Equity Capital as well. Frequently a Combination of Debt Financing and Equity is Insufficient to Carry the Project through the Construction Stage. Thus, Gap Financing through Mezzanine Debt also can Play an Important Role. DEVELOPMENT has a Sequence of FINANCIAL NEEDS: A. Land Acquisition and Preconstruction B. Construction C. Gap or "Mezzanine" Financing D. Postconstruction

FORMS OF OWNERSHIP FOR POOLED EQUITY

Due to the typical size of Commercial Real Estate Investments, the eventual owners of Investment Properties almost always Pool their Capital using some form of Ownership, allowing them access to a larger amount of Equity to invest and more efficiently Share the Risk of the Investment with others. It is important to understand that there are two levels of organizations commonly at work in Commercial Real Estate Investments. A particular Property might be Owned through a certain Form of Ownership, while the Ultimate Owners of that Organization may in turn have a different Structure. - EX: An Office Building may be Owned by a Limited Liability Company whose Investors are a Private Equity Fund and a Publicly Traded Real Estate Investment Trust (REIT).

ASSEST MANAGEMENT: Performance Evaluation and Compensation

During the 1970s and 1980s, Investment/Asset Manager's Compensation typically was Based on % of Assets under Management (AUM) Typical Asset Management Fees Ranged from 0.5 to 1.5 % (Annually) of the Estimated Value of Managed Assets This PRODUCES CLEAR AGENCY PROBLEM: If Managers are Compensated Based on the Value of the Assets Under Management, they have an INCENTIVE to Find, Acquire, & HOLD Assets on behalf of the Investor (Principal) as Sales REDUCE their FEE But Investors' Return may NOT be Maximized by Continuing to Hold

INDIRECT INVESTMENT - REIT INTERMEDIARIES: REIT Valuation (Net Asset Value)

Equity REITs typically use Income Capitalization and Discounted Cash Flow Valuation Techniques to make Individual Property Acquisition and Disposition Decisions. That is, REITs seek to Purchase Properties that have Positive Net Present Values (NPVs) and Internal Rates of Returns (IRRs) in excess of the REIT's Opportunity Cost of Capital. But how are the REITs themselves Valued? Said differently, how do Capital Market Investors determine the Appropriate Price to pay for a Share of Stock in a REIT, which in turn holds a Portfolio of Commercial Properties or Mortgages? In general, REIT Stocks are Valued similarly to the Stocks of other Public Companies; that is, Investors attempt to Forecast the Stream of Dividends the REIT will Pay out over time. The Projected Dividend Stream is, in turn, based on projections of Future Funds from Operations. The Projected Dividend Stream is the converted into a Present Value using a Discounted Cash Flow Model. In practice, however, Long-Term Dividend Projections are difficult to Develop. Thus, Investors also use Indicators of Relative Value in their REIT Acquisition and Disposition Decisions.

THE "NUMBERS" OF DEVELOPMENT

Even Before Control of the Site is Acquired, the Developer has Concept of the Project, but also will have done Back-of-the-Envelope Calculations to "Pencil Out" the Prospects. The Project must have a Positive Estimated NPV or Cash Multiple (Known in Class as "Equity Multiple") The Developer will NOT go Forward on a Project UNLESS the Prospective Value EXCEEDS its Cost sufficiently to Justify the Venture. The Developer Explicitly or Implicitly watches Estimated NPV or Multiple at EVERY Decision Point. - Must Understand Costs - Must have Good Sense of Future Cash Flows

STEP 4: DESIGN - Land Planner

For Land Developments, the Developer gives the Key Design Role to a Land Planner. In Large Projects involving Multiple Structures, Extensive Grounds, Parking Areas, and Drainage and Water Retention Systems, the Developer will rely on a Land Planner to "SOLVE" the Complex Land Planning Puzzle. The Developer works Closely with the Land Planner to evolve the Basic Site Plan within which any Structures must Fit. The LAND PLANNER in turn Uses Input from a Number of Specialists, including Hydrologists, Architects, marketing Consultants, Engineers, Soils Engineers, and others. Concerns of the Land Planner include Aesthetics, Optimal Use, and Preservation of the Site, Traffic Flows, Utility Systems, and Drainage Systems. LAND PLANNER: Creates Development Layout or "Map". There are many Objectives and Constraints. Land Planners must COORDINATE Inputs from Others: - Hydrologists - Marketing Consultants - Soil Engineering - Archaeologists

STEP 7: MARKETING & LEASING

For all but the Largest of Developers, the Marketing and Leasing of the Project will be through an OUTSIDE or EXTERNAL BROKER. The Broker must understand the Market relevant to the Project. Thus, for a Locally Oriented, General-Purpose Office Building, the Broker needs to be familiar with, and be known in, the Local Business Office Community in order to have Knowledge of Prospective Tenants who are Approaching Lease Turnover, who must Expand to Larger Facilities, and so forth. The Developer is Wise to bring in a Broker into the Process during the Design Stage to Review and Advise on the Evaluation of the Design. Not only does this Increase the Likelihood of Achieving a Marketable Property, but also Allows the Broker to have more of a Stake in the Product and Establish "Buy-In" and more Reason for Enthusiasm about it.

DIRECT INVESTMENT IN COMMERCIAL REAL ESTATE: Other Institutional Investors

Foreign Investors, especially Sovereign Wealth Funds, often grab headlines for their active participation in U.S. Real Estate Markets. Although it is difficult to quantify their Holdings, in late 2018, Foreign Investors controlled approximately $175 Billion in U.S. Real Estate. Foreign Investors tend to concentrate their Acquisitions in Major U.S. Cities, acquiring mostly Office and Retail Properties. E.g., China Life Insurance Co. recently purchased a $1.65 Billion Manhattan Office Tower EX: Hedge Funds, College Endowment Funds, Real Estate Private Equity Funds

STEP 6: CONSTRUCTION

GENERAL CONTRACTOR: Construction must be Controlled and Coordinated by a Central Authority, the GENERAL CONTRACTOR, who in turn is responsible for Subcontracting the Completion of the Various Elements of the Project to SUBCONTRACTORS. These include Excavation, Pouring and Finishing Concrete, Components of the Structure, Building Systems such as Electrical, Plumbing, HVAC, Landscaping and more. General Contractors Oversee and Control the Project by selecting Subcontractors and Establishing Schedule and Sequence. COMPENSATION BY: - FIXED PRICE BIDDING: Government Projects usually are made through Bidding to Meet the Requirements of the Public for Arm's-Length Competitive Contracts. - COST-PLUS FEE: Common but NOT Advised; Most other Construction Contracts are Completed through Negotiation. - MAXIMUM COST-PLUS FEE: If the Cost Runs LESS than Maximum, the Developer and General Contractor SPLIT the Overrun; if the Cost Runs LESS than Maximum, they SPLIT the Savings.

LEVERED VS. UNLEVERED CASH FLOWS

In many cases, Property Owners use a combination of Equity Capital and Mortgage Debt to Finance an Acquisition such as Centre Point. Therefore, the Investor's Cash Flows from Rental Operations will be Reduced by any Payments Required to stay Current on (i.e. "Service") the Mortgage. The use of Mortgage Debt to help Finance an Investment is commonly referred to as LEVERAGE. Thus, the Expected Annual Stream of NOIs and the Expected NSP are UNLEVERED CASH FLOWS because they represent the Income-Producing Ability of the Property BEFORE Subtracting the portion of the Annual Cash Flows that must be Paid to the Lender to Service or Retire the Debt. LEVERED CASH FLOWS measure the Property's Remaining Income AFTER Subtracting any Payments due to the Lender. Valuation of the Cash Flows to the Equity Investor is accomplished by Discounting the expected Before-Tax Cash Flows (BTCFs), rather than the NOIs. The BTCF is calculated by Subtracting the Estimated Annual Mortgage Payment from the NOI. Note that the Equity Investor(s) has a Residual Claim on the Property's Cash Flow Stream. The Lender has the First Claim on the Cash Flows generated by the Property because it has been pledged as Collateral for the Mortgage Loan. The BTCFs are considered Levered Cash Flows because they represent Cash Flows to the Equity Investor AFTER the effects of Financial Leverage (i.e., Debt Service) have been Subtracted.

IMPACT OF LEVERAGE ON EXPECTED RETURNS

Increases in Leverage will Increase the Calculated NPV if the Equity Discount Rate (Required IRR) exceeds the Effective Cost of the Additional Borrowing. The use of an Additional Dollar of Leverage will Increase the Calculated IRR if the Unlevered IRR exceeds the Effective Borrowing Cost of the Mortgage. Increased Leverage usually Increases both NPV & IRR -- Holding Mortgage Rate & all other Assumptions Constant. Conversely, Decreases. in the Leverage Rate Reduce NPVs and IRRs, all else Constant. Despite its potential Return-Enhancing Effects, Financial Leverage Increases the Riskiness of the Equity investment by Increasing the Risk of Default and by making the Return on Equity more sensitive to changes in Actual NOIs from Expected NOIs. This Increased Sensitivity occurs because a Given Amount of Variation in NOI will have Increasingly larger effects on the Equity Return as the Use of Debt Increases (and the Dollar Amount of Invested Equity Capital Decreases). Thus, Equity Discount Rates SHOULD Increase as the Amount of Leverage Increases, all else Equal. As a Result, the Decision to substitute more Debt Financing for Equity Financing is complicated because the Increase in EXPECTED Return from the Increased Use of Debt may NOT be large enough to OFFSET the Corresponding Increase in Risk and Required Return.

INVESTMENT VALUATION VS. MARKET VALUATION

Investment Value is defined as the Maximum the Buyer would be willing to Pay and the Minimum the Seller would be Willing to Accept. How is Investment Value calculated for Potential Buyers and Sellers? The Investment Calculation begins where the Market Valuation ends. The Calculation of Market Value will have already taken into Account the General, or Average, Current and Expected Future Investment Conditions in the Market. To the extent that a particular Investor's Situation is different, the Price the Investor is willing to Pay will differ from Market Value. EX: Investors may vary with respect to their Expectations of Future Rental Rates and Vacancies. The Amount and Cost of both Equity and Debt Financing also may vary somewhat across Investors and these differences in the Cost of Capital may affect how much a particular Investor is willing to Pay for a Property or how much a Seller is willing to accept. Thus, Explicit Assumptions about how the Acquisition is to be Financed should generally be included in an Investment Valuation. Finally, Expected Income Tax Consequences are usually significant; thus, Investors may choose to incorporate Future Income Tax Calculations into their Analysis of a Proposed Investment.

ULTIMATE EQUITY INVESTORS

Investors can Purchase Ownerships (Equity) Positions in Commercial Real Estate either Directly or through Intermediaries. For our Purposes, an Intermediary is an Entity that invests in Real Estate and Sells Claims on those Investments to the Ultimate Investors. Examples of such Intermediaries include Real Estate Limited Partnerships and Limited Liability Companies, a variety of Private Equity Fund Structures (e.g., Closed- and Open-Ended Funds) and Real Estate Investment Trusts (REITs). But most Investors CANNOT Invest DIRECTLY Much like the Trade-Offs inherent in choosing a form of Ownership, for Well Capitalized Investors the choice of Direct Investment versus Investment through an intermediary involves Trade-Offs between Control, Access to Managerial Talent and Expertise, Liquidity, and Risk Sharing.

LIMITED LIABILITY COMPANY

Is a Hybrid Ownership Structure that combines the Corporation Characteristics of Limited Liability for the Owners with the Tax Characteristics of a Partnership. All 50 States have adopted LLC Legislation. Compared with S Corporations, LLCs offer Greater Flexibility in Terms of the Number of Owners, Types of Owners, and Ownership Structure, as well as the Inclusion of Debt in the Owner's Tax Basis. Special Allocations are allowed. Relative to Limited Partnerships, LLCs permit all Owners to particpate in the Managament of the Business Entity and to have Limited Liability (so there is no need for a General Partner who is subject to Unlimited Liability). In most States, an LLC is Cheaper and Easier to set up and run than a Limited Partnership. To create an LLC, typically the "Managing Member" (i.e., the Sponsor) Files Articles of Organization with the State on behalf of all Members (Investors). The Managing Member also creates the "Operating Agreement" that explains the Operation and Management of the LLC. Some have characterized LLCs as "Super Passthrough Entities". In fact, LLCs have become the preferred Ownership Form for many Private Real Estate Investors. However, Private Equity Real Estate funds are typically set up as Limited Partnerships, not as LLCs. Perhaps it is more accurate to say that LLCs are generally used for small, local Investments marketed to Higher Income, but Non-institutional, Investors, whereas LPs are used by Private Equity Funds that are trying to attract Capital from very high Net Worth and Institutional Investors.

LIMITED PARTNERSHIP

Is created and taxed in the same way as a General Partnership. However, a LIMITED PARTNERSHIP (LP) introduces an important trade-off by creating two types of Partners -- "General" and "Limited" -- and a Limited Partnership must have at least One Partner of each type. The Advantage of this Structure is that is allows the Limited Partners to cap their Personal Liability to an Amount equal to their Total Equity Investment in the Partnership. The General Partner still faces Unlimited Liability for the Debts and other Obligations of the Partnership. One Disadvantage of this form of Ownership is that in exchange for Limited Personal Liability, the Limited Partners give up Day-to-Day Control of the Partnership and are prohibited from participating in Management or Policy Making. They must rely on the General Partner(s) to make Decisions on their behalf. This is an example of a "Principal-Agent" Relationship, where the Agent (the General Partner) makes decisions that ultimately affect the Cash Flows of the Principals, the Limited Partners, who typically provide the majority of Equity Capital. At times, the Limited Partners may be involved in major decisions, such as whether to Sell or Refinance the Property. Situations are likely to arise where the Interests of these Two Parties are in Conflict -- termed "Agency Problems" -- potentially leading to a Loss in the Value of the Investment, or "Agency Costs". It is important that Limited Partners understand the Motives of the General Partner(s) when they decide to cede Management Control in exchange for more favorable Liability Exposure. The General Partner, who is sometimes referred to as the "Syndicator" or "Sponsor" of the LP, creates the "Limited Partnership Agreement" that details the Operation and Management of the LP.

COMPONENTS OF A CONSTRUCTION BUDGET

LAND COSTS: About 12% of the Total. They include the Purchase/Acquisition Price, Site Development in Preparation for the Building, Interest or Carrying Costs, and Property Taxes on the Land (Real Estate Taxes). HARD COSTS: Are about 66.3% of the total, and are Mainly the Actual Building Construction, i.e., Materials, Labor, Subcontracts, Permits, Security, Contingency, Landscaping and Hardscaping, and Contingency Reserve (to Cover Change Orders) SOFT COSTS: - CONSTRUCTION: Architect, Engineering, Insurance, testing, Utility Fees, Permitting Costs - MARKETING: Marketing and Feasibility Studies, Title Insurance, Furnishings for Show Units, Advertising and Public Relations CONSTRUCTION INTEREST (A Soft Cost) DEVELOPER'S FEE: (A Soft Cost) Not usually the Main Source of Profit, Covers Administrative Overhead, "Puts Food on Table"

FUNCTIONS OF PROPERTY MANAGER: Marketing the Property

Leases are the Engines that Drive Property Values, but they are Perishable Assets. Most Commercial Space must therefore be Marketed on a Continual basis so that Desirable Replacement Tenants can be found in a Timely Fashion as Leases Expire. Leases are Perishable Assets that MUST be Replenished. Marketing is NON-STOP, not just "When Needed" WHO SHOULD MARKET/LEASE AVAILABLE SPACE? In the case of APARTMENT PROPERTIES, the On-Site Manager or Staff usually shoes Vacant Apartments. Because Standard Form Leases are Used and Relatively little negotiation occurs with Potential Tenants, the On-Site Apartment Manager may handle the Entire Leasing Process. Leasing is more complex, however, in the Case of OFFICE BUILDINGS, SHOPPING CENTERS, INDUSTRIAL BUILDINGS, and OTHER COMMERCIAL SPACE. The Commercial Property Owner has THREE Basic Leasing Options: USE.... 1. Independent Leasing Broker 2. In-House Leasing Broker 3. Property Manager Independent Licensed Sales Associates (working for a Licensed Broker) are usually Paid on Commission Basis once the Lease is Consummated. - Commissions typically is Equally to a Predetermined % of the Face Amount of the Lease. - The Face Amount of the Lease is Equal to the Total Scheduled Payments over the Entire Lease Term. EX: If an Office Tenant Signs a Five-Year Lease with Monthly Payments of $10,000, and if the Percentage Commission Rate is 4%, the Leasing Agent will be Owed a $24,000 Commission. [0.04 ($10,000 x 12 x 5)], which is typically Paid when the Lease is Signed.

DIRECT INVESTMENT IN COMMERCIAL REAL ESTATE: Life Insurance Companies

Life Insurance Polices involve the Payment of Premiums by the Insured in exchange for Benefits to be paid upon the Death of the Insured. Using Mortality Tables, Life Insurers are able to predict the Mortality rates of Policyholder Groups with a High Degree of Accuracy. As a result, the Liabilities of Life Insurers can be characterized as both Long Term and Fairly predictable. To match the Maturity of their Assets to the Maturity of their Liabilities, it makes sense for Life Insurance Companies to invest on a Long-Term basis. Moreover, it is not necessary for that their Assets be highly Liquid; large unexpected Payments to Policyholders are unlikely. These characteristics make Life Insurance Companies well suited for Long-Term Investments in Commercial Real Estate Markets, which are typically characterized by Low Liquidity and High Transaction Costs. In late 2018, Life Insurers owned $99 Billion of Commercial Real Estate Assets. As we shall see, however, they are made much more active as Suppliers of Commercial Mortgage Debt.

OPTIMAL OWNERSHIP FORMS

Limited Partnerships and LLCs are the Dominant Ownership Structures in the United States for Private Real Estate Investment Vehicles, suggesting the combination of Single Taxation, Limited Liability for most, if not all, of the Owners and the ability to provide Special Allocations of Cash Flows are of Primary Importance when Investors Structure Commercial Real Estate Investments. Re and Private Equity Funds typically set up as LPs Small "Local" Investments marketed to Accredited, but Non-Institutional, Investors typically set up as LLCs. A publicly traded C Corporation may Invest in Commercial Real Estate through its pension fund to meet some of a Particular property through a Limited Partnership. Thus, while the C Corporation Structure meets the Needs of a Shareholder of an Industrial Company (such as General Electric), the Corporation may hold Commercial Real Estate through an alternative Form of Ownership.

STEP 3: OBTAINING PERMITS

MULTIPLE LAYERS OF PERMITS MAY BE NEEDED: - Site Plan Review - Environmental Impact Review - Zoning Change - Land Use Plan Revision - Other? Virtually all Development Projects Require at least a SITE PLAN REVIEW. Many others will require a ZONING CHANGE, possibly coupled with a Parallel Change in an Official Land Use Plan. Large Scale Developments are likely to face some form of Environmental Impact or Regional Impact Review. The Cost of these Reviews can reach hundreds of thousands of Dollars for a Large, Complex Development, and Require a Year or More to Complete. If even a Simple Zoning Change is required, the Time and Legal Expense can be considerable and can require Months, even Years, with the Ultimate Outcome Uncertain. It seems to be Automatic that a Developer who proposes Apartments or Commercial Development near existing Single-Family Neighborhoods will become the Target of Vigorous Political Resistance against the Change. Even when the Developer has ALL the Necessary Permits in Hand, Preexisting Homeowners who perceive the Project as an Intrusion into their Neighborhood and a Source of Uncertain Change often Resort to a Multitude of Political Maneuvers to Delay and Obstruct the Project. They may even Resort to Filing Lawsuits that Challenge the Existing Zoning and Permits on the Slimmest of Arguments. (Often a Suit that Fails still DELAYS the Developer enough to Stop the Project). Since Delay is one of the Developer's Biggest Enemies, she must attempt to lay the Groundwork in Advance for Neighborhood Cooperation. This may be by providing Generous Provisions for Buffering (i.e., Providing Transition Zones that Separate Surrounding Land Uses from Development), or by Offering Gifts to the Neighborhood such as a "Vest-Pocket" Park or other Desirable Neighborhood Improvement. Being prepared for Constructive Negotiation with Both Land Use Authorities and Neighborhood Homeowner Groups is an essential Component of the Developer's Resources. Probably, the most Dramatic Failures (and Successes) in Development Experience take place in Public Hearings with Land Use authorities whose Decisions can Kill a Project Instantly. These Meetings frequently are Dramatized by being Packed Standing Room only with intense and resistant Homeowners. SITE PLAN REVIEW: An Inevitable Hurdle - Complex set of Issues - Rules and Criteria involve interpretation by Authorities - Neighbors usually Resist Change - Negotiation is Critical Skill: Important to Building Support of Authorities and Citizens in Advance - Negative Decision can KILL a Project in One Meeting

WHY IS MANAGEMENT SO IMPORTANT?

Making Good Property Acquisition and Development Decisions is Important because they CANNOT be Undone EASLIY or COSTLESSLY But what about AFTER a Property is Acquired? The Long-Term Ownership of Real Estate puts Investors in the Business of Providing Services to Users of the Space; the Provision of these Services is Extremely Management Intensive. Owners or their Agents must Repeatedly make Management Decisions that Affect the Value of the Property and the Investors' Return on Equity.

AGENCY RELATIONSHIP

Management Contract creates an Agency Relationship - Owner (Principal) and Manager (Agent) Empower Manger/Agent to Serve as Owner's Fiduciary in matter related to Management of Property. - Words and Actions of Manager are Binding on Owner Agent has an Obligation to Exercise Care in Managing both Money and Property for Owner

WHY WE USE NPV AND IRR (AND OTHER MULTI-YEAR METRICS)

Most Real Estate Decisions are made with an Investment Motive and that the Magnitude of Expected Cash Flows -- and the Property Values they Create -- is the Center of Investment Decision Making. Previous Chapters (e.g., CH. 18) mainly focused on a set of widely used Single-Year Return Measures, Ratios, and Income Multipliers, such as Capitalization Rate (NOI / Acquisition Price) and the Effective Gross Income Multiplier (Acquisition Price / Effective Gross Income). These Investment Criteria are relatively easy to Calculate and Understand -- a decided Advantage in the eyes of many Industry Professionals. INVESTOR'S SOLUTION: Perform a Mutli-Year Analysis of the Income-Producing Ability of Potential Acquisitions. These Multi-Year Discounted Cash Flow (DCF) Valuation and Decision-Making Methods differ from Single-Year Valuation Metrics in several important ways: 1. The Investor must Estimate how long she will Hold the Property. 2. The Investor must make Explicit Forecasts of the Property's Net Operating Income for each year of the Expected Holding Period, not just a Single Year. This Forecast must also include the Net Cash Flow produced by the Sale of the Property at the end of the Expected Holding Period. 3. The Investor must also select the appropriate Required Rate of Return at which to Discount all Future Cash Flows.

MANAGING CORPORATE REAL ESTATE ASSETS

Non Real Estate Corporations own Trillions in Dollars of Commercial Real Estate. Corporate Real Estate includes Specialized Production and Storage Facilities, Retail Outlets, Industrial Warehouses, Office Buildings, etc. These Assets often Account for 25-40% of Total Assets of Large Industrial Firms Historically, Non Real Estate Corporations have Expended Little Effort to Manage these Assets Effectively. Although Firms carefully examine the Initial Acquisitions of Real Estate Assets, many Spend Insufficient Time thinking strategically about these Assets once they have been Added to the Corporate Balance Sheet. In Recent Years, Many Corporations have begun to Pay Increased Attention to their Real Estate Assets. - More Employ In-House Corporate Real Estate and Facilities Management Personnel - Others rely primarily on Asset Management Consultants to help them rethink and restructure their Real Estate Holdings ISSUES/REQUIRED WORK: - Site Analysis - Buy vs Lease Decisions - Acquisitions and Dispositions - Portfolio Refinancing - Facility Management - Property Tax Appeals - Sale and Leaseback Arrangements

DISADVANTAGES OF POOLING EQUITY

Often must relinquish Management Control to Active Managers Most compensate Sponsor/Organizer with Fees, Salary, and/or Disproportionate Share of Equity Ownership - Lower Return on Equity, all else equal - Sponsor/Organizer is the Guys with the Original Idea to Invest in some CRE

STEP 8: OPERATION

Once a Project has been Largely Rented/Occupied, it is in the Operating Phase. Effective Operational Management of Rental Real Estate is Fundamental to Maintaining and Increasing the Value of Property.

STEP 5: FINANCING - Construction Financing

Once the Developer and Architect have Completed the Design Stage, the Developer can Apply for Construction Funding. The most COMMON Source of Construction Funding is the a Bank. Loans have been Tied to a Broader Short-Term Banking Rate, Floating perhaps 150 to 250 Basis Points ABOVE the Market Rate. The Construction Loan, at most, will Finance the Cost of Land, Soft Costs and Hard Costs. HARD COSTS: The Direct Costs of Materials, Labor, and Subcontractors for Actual Construction). The Construction Loan is NEGATIVELY AMORTIZED, with Balloon Payment due at the END of Construction. The Loan will be Disbursed in STAGES as Construction Progresses on the Basis of Invoices from Venders for Construction Costs or as the Project reaches Various Predetermined Stages of Completion. The Risks of Construction Lending are LESS in a Number of Respects than with the Land Acquisition Stage. The Remaining Risks are those that the Banks can Manage Efficiently, and thus will Underwrite. These Remaining Risks include the Ability of the Developer to Manage and Complete the Construction Process; Risks of Construction such as Weather Interruptions, Material Shortages, Work Stoppages, Strikes, or Construction Accidents; and, finally, Rent-Up following Construction. - Equity "Burns Off" First - NO Payments during Construction - Principal Balance grows with each "Draw" (incl. Interest Charged on Interest, aka, these Loans have Negative Amortization) - Typically Construction Costs follow a "BELL CURVE"

INDIRECT INVESTMENT - REIT INTERMEDIARIES: REIT Valuation (Net Asset Value)

One commonly Employed Approach to Assessing the Attractiveness of an Equity REIT centers on the concept of Net Asset Value (NAV). NAV is equal to the Estimated Total Market Value of a REIT's underlying Assets, less all Liabilities having a Prior Claim to Cash Flow -- including Mortgages. To estimate the Market Value of the REIT's Property Holdings, Analysts estimate the Aggregate Net Operating Income (NOI) of the REIT's Property Holdings. This Aggregate NOI is then converted into an estimate of Market Value by capitalizing it at the Appropriate (Weighted Average) Cap Rate for the Portfolio. The Capitalization Process uses Information from the Private Real Estate Market to perform something resembling a Mass Appraisal of the REIT's Properties. The ability to use Information from the Well-Functioning Private Real Estate Market to Value Shares of Listed REITs is unique and distinguishes the REIT Market from other Industries where the Assets are NOT separately Traded in a Private Market. How is the estimate of Net Asset Value used to make Acquisition Decisions? If the Per-Share Stock Price of a REIT is greater than its Per Share NAV, the REIT is said to be Selling at a Premium to NAV. Although some of this Premium may reflect the Market's Assessment of the ability of the REIT's Management Team to create Value for Shareholders, a Stock Price in Excess of Per Share NAV may indicate the REIT is Overpriced relative to the Value of the Real Estate Assets currently in the Portfolio. Conversely, REITs Selling at Discounts to Net Asset Value may signal Buying Opportunities for Investors or, perhaps, takeover Opportunities for other management Teams. REITs typically provide Periodic estimates of their NAV; however, these estimates can be higher than those generated by Independent Investment Banks and Advisory Firms (Such as Green Street Advisors).

INVESTMENT IN COMMERCIAL REAL ESTATE THROUGH INTERMEDIARIES: Separate Accounts

Perhaps the closest alternative to Direct Ownership that still involves some degree of Intermediation is the Use of Separate Accounts with a dedicated Real Estate Investment Manager. EX: A Large Investment Management Company (e.g., AEW Invesco) will Buy, Hold, and Dispose of Assets on behalf of Investors, where each Investor's Assets are treated independently. This Structure allows the Investor to utilize the Expertise of the Investment Manager (the Intermediary), in exchange for Fees. By maintaining Separate Accounts, the Investment Manager is better able to tailor the Assets (and their Expected Returns and Risks) to the Needs and Objectives of the Ultimate Investor. This Structure provides an Intermediate Degree of Liquidity; it may allow the Ultimate Investor to Time the Sale of Assets by Requesting or Pushing the Manager to do so, but the ability to Execute Sales still depends on the Liquidity of the underlying Commercial Real Estate Market. Separate Accounts also provide no additional aid in Diversification or Risk Sharing relative to Direct Ownership.

SOURCES OF COMMERCIAL REAL ESTATE DEBT

Providers of Commercial Mortgage Debt tend to Hold Mortgages or Mortgage-Backed Securities as Long-Term Investment. 75% of Outstanding Commercial Mortgage Debt (or $2.98 Trillion) is PRIVATELY HELD by Individual & Institutional Investors. Commercial Banks and Savings Associations are the Largest Single Source of Private Commercial Real Estate Mortgage Funds, holding $2.23 Trillion (or 47%) of the Total Commercial Mortgage Debt Outstanding. Life Insurance Companies are also major Participants in the Long-Term Commercial Mortgage Market, Holding $509 Billion, or 11%, of the Total Commercial Mortgage Debt Outstanding. The Long-Term Nature of their Liabilities encourages Life Insurance Companies to seek Long-Term Investments. The remaining Privately Held Mortgage Debt is Owned by Government-Sponsored Enterprises (e.g., Freddie Mac and Fannie Mae) (7%); Federal, State, and Local Governments (4%); Pension Funds (<1%); Private Equity Funds that Investment in Commercial Real Estate Debt (2%); and "Other" Investors, such as Finance Companies. We also include the Mortgage Loans held as Assets by Mortgage REITs. The Importance of Private, Noninstitutional Lenders, including Private Equity Funds that invest in Debt (i.e., "Debt" Funds), has grown in recent years as Increased Regulatory Constraints have impeded Traditional Bank Lending. These Private Lenders are more active in providing Transitional and Development Loans to Investors and Owners, including Bridge and Mezzanine Loans. CMBS are backed by a Pool of Commercial Mortgages or, perhaps, a Single Large Commercial Loan. The Outstanding Principal Balances of CMBS backed by the Government-Sponsored Enterprises (GSEs, such as Fannie Mae and Freddie Mac) totaled $342 Billion at the end of 2018. These GSE-Backed CMBS consist entirely of Multifamily Mortgages. The Outstanding Principal Balances of "Private Label" CMBS Securities (i.e., those not issued or backed by a Government Agency) totaled $385 Billion. Thus, the Total Outstanding Value of CMBS was $727 Billion, which represents 15% of Total Commercial Mortgage Debt Outstanding. The remaining $325 Billion in Publicly Traded Commercial Debt represents Unsecured Corporate Debt issued by listed REITs.

STEP 4: DESIGN - Architect (Continued)

RANGE OF POSSIBLE ROLES: - Represents Developer in Hearings for Permits - Provide Predesign Schematics of User Functions and Resulting Spatial Interactions - Provide Complete Design - Usually Serves as Project Manager METHOD OF COMPENSATION: - Hourly Fee (for Predesign Services) - Percentage of Construction Costs - Fixed Fee NATURAL STRESS BETWEEN ARCHITECT AND DEVELOPER: - DEVELOPER is Cost and Time Oriented - ARCHITECT is Aesthetics Oriented

ASSEST MANAGEMENT: Performance Evaluation and Compensation

RECENT TRENDS IN COMPENSATION? Industry is Moving to including Performance-Based Compensation for Asset Managers The Fee is tied Directly to Portfolio Performance Owner and Manager must AGREE on the Performance Benchmark - Actual Performance of Agent typically Evaluated over Period of Management Contract (typically 3 to 5 Years)

NET PRESENT VALUE

Real Estate Decision Making fundamentally involves comparing the Costs of various Decisions, including the Decision to purchase a Property, to the Benefits. The Net Present Value (NPV) of an Investment Decision is defined as the difference between the Present Value of the Expected Cash Inflows (PVin) and the Present Value of the Expected Cash Outflows (PVout) or: NPV = PVin - PVout Net Present Value is interpreted using the following very simple, but very important, Decision Rule: If the NPV is Greater than Zero, the Property should be Purchased, assuming the Investor has adequate Capital Resources, because it will increase the Investor's Wealth. If the Calculated NPV is Negative, the Investment should be Rejected because the Investor expects to earn a Return Less than his or her Required Rate of Return for such an Investment. Only if the NPV Equals Zero, is the Investor Indifferent to the Investment Opportunity.

INDIRECT INVESTMENT - REIT INTERMEDIARIES: Real Estate Investment Trusts

Real Estate Investment Trusts (REITs) are a Special Type of Corporation and Creature of the U.S. Tax Code. The growing importance of REITs can largely be attributed to their appealing features in terms of both Investor Liability and Taxation. Shareholders receive the same Limited Liability Protection as Shareholders in regular C Corporations. Unlike C Corporations, however, REITs are NOT Taxed at the Entity Level if they satisfy a set of Restrictive Conditions on an ongoing basis. The most important of these Conditions are as follows. At least 100 Investors must own a REIT's Shares; to further ensure Diversified Ownership, no Five Investors can own more than 50 Percent of a REIT's Shares. A REIT must distribute at least 90 Percent of its Taxable Income to Shareholders in the form of Dividends, which limits the ability of a REIT to retain Earnings for Future Investments. Fully 75 Percent of the Value of a REIT's Assets must consist of Real Estate Assets, Cash, and Governmental Securities. Real Estate Mortgages and Mortgage-Backed Securities are considered Real Estate for the purposes of this test. At Least 75 Percent of the REIT's Gross Income must be derived from Real Estate Assets. These last two Requirements ensure that REITs Invest primarily in Real Estate. In exchange for meeting these and several other Requirements, REITs can avoid Federal Income Taxes. This leaves more Cash Flow available to Pay Dividends to Investors (Who do pay Taxes on the Dividends).

INVESTMENT IN COMMERCIAL REAL ESTATE THROUGH INTERMEDIARIES: Real Estate Private Equity Funds

Real Estate Private Equity Funds originated in the Early 1990s. These Funds were created to address some of the perceived Drawbacks of the CREF Structure. The Funds are usually Closed-End with a Finite Life, typically 7 - 10 Years with an option for the Fund Manager or Sponsor to extend the Life by an Additional Year or Two. Because of this Finite Life, the Fund Manager is forced to eventually Dispose of the Assets and Return the Investors' Capital (mitigating the Potential Conflict of Interest where the Manager has the Incentive to continue to Hold Assets). Unlike CREFs, Real Estate Private Equity Funds typically have Economically meaningful SIDE-BY-SIDE Investment by the Fund Sponsor/Manager, which better aligns the Manager's Economic Outcomes with those of the Investors. The Fee Structures of the Closed-End Funds are also usually Richer and More Complex, allowing more Features that further Align Interests. Most Real Estate Private Equity Funds are organized as Limited Partnerships. The Fund Manager is the General Partner (GP) of the Fund, while the Investors are LPs. The Fund Manager typically provides something like 1 - 5 Percent of the Fund's Equity, with any further Investment by the Manager occurring as an LP, Side-by-Side with other LPs (and thus experiencing the same Returns on that Capital). The LPs typically earn a Preferred Return on their Invested Capital, such as 8 Percent, often before the GP receives any Cash Flow Distributions. Once the LPs have earned their Preferred Return, the GP then usually receives any Disproportionate Share of the remaining Cash Flows produced by the Underlying Properties, often 20 Percent. This 20 Percent is termed the GPs "Carried Interest" and is sometimes called a "Promote". Note that the GP does not receive Carried Interest unless the Fund performs well enough to provide the LPs with their Preferred Return. There are a number of Variations of this theme, allowing the Fund Manager and LP Investors to tailor the Contract and Incentives as they see fit (and as the Market dictates at that Point in Time).

STEP 4: DESIGN - Architect

The ARCHITECT can take on a Range of Roles. The Architect can provide Predesign Services or Schematics, which relate needed Building Functions to each other and to Space, Yielding a Preliminary Indication of the Basic Building Design. From there follows the Actual Design, which may evolve through Several Stages of Completeness. A Increasingly important Objective in this Process is to Create "Green" Buildings. Design Development brings Refinement of the Interior Space and Exact Specification of Building Systems such as Plumbing, Electrical, and HVAC (Heating, Ventilation, and Air Conditioning). The Design Process finally leads to several Outputs, including the Contract Documents. the Actual Design Specifications for the Building, Working Drawings, and Rules and Forms for Bidding Process. Sometimes the Architect Assists or Manages the Bidding Process. Other times, the Architect actually MANAGES the OVERALL Project, including the Agreement between the Developer and the Contractor, though this Role is infrequent. Architects also can play another Role EARLIER in the Process. Often they are very Effective in Representing the Development in Public Meetings with Land Use Authorities. This is due in part to their Expertise in presentations and perhaps to their Comparatively Favorable Professional Image relative to Developers and Attorneys. The Architect can be COMPENSATED according to SEVERAL METHODS. Early in the Development Process, probably during the Permitting Stage, the Architect may be Retained on an Hourly Basis. In the Design Stage, when the Project is much more Narrowly Defined, the Compensation is likely to be based on either a Percentage of the Construction Cost or a Fixed Fee PLUS Expenses. When the Percentage Cost is Used, the Amount will likely depend on the Complexity of the Project. For Moderately Complex Designs, Compensation can range from 3 and 7 %; For Simple Garden Apartments, it can range as Low as 1 to 2 %. Unusual Projects might pay 10%. Obviously, a Potential Problem with the Percentage Compensation is that it Rewards the Architect for a more Costly Design. Thus a Fixed Fee PLUS Expenses may be Used instead. Selection of the Architect for a Development is obviously a Critical Step. The Choice will be Based on a Combination of Considerations, including Competence and Reputation, Compatibility of Values and Goals between the Developer and Architect, and ability of the Two to Communicate Effectively. Since there is, in Principal, Inherent TENSION between the the Design Function (i.e., Aesthetically Oriented) and the Developer (i.e., Cost and Time Oriented) Communication of Views and Priorities is VITAL for a Successful Outcome.

EFFECTS ON LEVERAGE ON CASH FLOWS FROM SALE

The Before-Tax Equity Reversion (BTER) is defined as the Net Selling Price MINUS the Remaining Mortgage Balance (RMB) at the Time of Sale. Discounted Cash Flow Analysis has become the main Financial Analysis Tool used to evaluate the Investment Desirability of Commercial Real Estate. Although much of the effort in DCF Analysis goes toward the Estimation of Future Cash Flows, Net Present Value and the Internal Rate of Return on Equity are the Bottom-Line Decisions Tools of Investors.

STEP 5: FINANCING - Post-Construction Financing

The Construction Lender usually expects her Construction Debt (Loan) to be Paid Off within Two or Three Years, usually shortly AFTER Issuance of CERTIFICATE OF OCCUPANCY from the Local Government Certifying that the Structure is Safe for Use. The Payoff can happen either through Financing arranged by the Developer as the Project nears Completion, or through a Take-Out Commitment arranged Prior to Construction Funding. Normally the Take-Out "Permanent" Loan will be Funded when the Certificate of Occupant is Issued. It may be FUNDED IN STAGES that depend on the Level of Leasing or Occupancy starting with a relatively Small FLOOR LOAN. "Floor Loan" for Part of Full Amount until a Certain Occupancy or Other Conditions are Achieved. "GAP" or MEZZANINE FINANCING" may be used until Requirements for Full Loan are Reached. An Alternative to Gap Financing that sometimes is Used is an SUBORDINATION AGREEMENT with the Construction Lender, which makes the Construction Loan Lien Inferior to the Lien Securing the Take-Out Loan that follows. If the Amount of the Take-Out Loan will NOT Pay off the Construction Loan completely, the Developer may be able to Negotiate with a Friendly Construction Lender to Subordinate the Remaining Portion of the Loan to the Take-Out Loan. This gets most of their Money back to the Construction Lender while allowing the Take-Out Lender to have a First Lien Position.

STEP 4: DESIGN - Engineers

The Expertise of Several Types of Engineers must be Coordinated by the Architect in bringing together the Final Structure Design. These Engineers commonly Work as Sub-Contractors to the Architect, but their Qualifications need to be Reviewed by the Developer. A SOIL ENGINEER will Determine the Sufficient Specifications to Achieve Safety and Stability for a Structure's Foundation. A STRUCTURAL ENGINEER will Determine the Requisite Structural Skeleton to maintain the Building's Integrity. A MECHANICAL ENGINEER will Provide Specifications and Design for the HVAC System and other Building Systems. AN ELECTRICAL ENGINEER will Design the Power Sources and Distribution System. A CIVIL ENGINEER will Design On-Site Utility Systems, including Sewers, Water, Streets, Parking, and Site Grading.

LIMITED PARTNERSHIP

The General Partner(s) is frequently a knowledgeable Real Estate Broker, Builder, or Investor and is typically the Party who organized the Partnership to make the Investments. Note that the General Partner can in turn have its own Organizational Structure, including one that creates Limited Liability for the Ultimate Owners. EX: The General Partner may be a Corporation. With regard to Cash Distributions and Double Taxation, Limited Partnerships are similar to General Partnerships -- Double Taxation does not exist. Ownership Interests in an LP can be divided in any reasonable way, as in a General Partnership. EX: With 21 Partners, 20 Limited Partners each may have a 4.5% Ownership Share, for a total of 90%. The General Partner would then have a 10% Ownership Share. Often, the General Partner receives a larger distribution of available Cash Flows than her Percentage Equity Investment would warrant. This disproportionate Share of Cash Flows (sometimes referred to as a "Special" or "Unique" Allocation) generated by the underlying Property or Properties provides the General Partner with at least Partial Compensation for her efforts in Organizing and Structuring the Limited Partnership. The Flow-Through feature of a Limited Partnership coupled with limited liability for the Limited Partners largely explains why the LP form of Ownership is an attractive option.

INTERNAL RATES OF RETURNS

The IRR on a Proposed Investment is the Discount Rate that makes the Net Present Value of the Investment Equal to Zero. To Decrease the Net Present Value, we must Increase the Discount Rate. The Decision Rule for the Internal Rate of Return is: If r > (or equal to) Ye Accept If r < Ye Reject Where r is Calculated IRR and Ye is the Required IRR on Equity

STEP 4: DESIGN - Landscape Architect

The LANDSCAPE ARCHITECT normally serves in a more Detail Oriented Role than the Land Planner. The Landscape Architect Focuses on the Topography, Soil, and Vegetation that are the Context for a Structure, with the Goal of giving a Suitable Harmonious and Enhancing Immediate Setting for the Structure. This involves Numerous Ingredients including, Grading, Ground Covers, Shrubs, Trees, Flowerbeds, Sign Character and Placement, Fountains, Benches, or other Amenities. The Landscape Architect's Work may also Contribute to Energy Efficiency or Drainage Needs.

PROPERTY MANAGEMENT FEES

The Management Agreement provides for a MANAGEMENT FEE, which is usually a Percentage of the Property's Effective Gross Income (EGI) (Actual Rental Income Collected). Because the Typical Property Management Fee is a Percentgae of Effective Gross Income, it would seem to Create an Agency Problem in that the Agreement does NOT give Managers the Incentives to Control Operating Expenses while they attempt to Increase Rental Income. EX: The Manager may be tempted to Over-maintain the Property in an Attempt to Boost Occupancy and Effective Gross Income. WHAT ABOUT BASING MANAGEMENT FEE ON NET RENTAL INCOME INSTEAD OF GROSS? One Explanation for basing the Management Fee on EGI is that the Amount of Collected Rental Income is easy to Verify, whereas the Calculation of NOI is Complicated by the Requirement to Fully Account for ALL Operating Expenses. EX: Manager may try to boost NOI by neglecting Maintenance and Service Repairs

MORE DETAILED CASH FLOW PROJECTIONS

The Pro Formas detailed in Exhibits 19-2 - 19 - 12 display Major Categories of Revenues & Expenses However, Most RE Pro Formas provide Significantly More detail on Projections of - Revenue Sources - Vacancies - Operating Expenses - Capital Expenditures

FORMS OF OWNERSHIP FOR POOLED EQUITY

The choice of Ownership form for a Property or Portfolio of Properties to be Owned by an Investment Equity is driven by Trade-offs along multiple dimensions 1. Federal Income Tax Issues 2. The desire to avoid Personal Liability for the Debts and Obligations of the Entity 3. Management Control Issues (including the potential for Conflicts of Interest to arise) 4. The ability to access Debt and additional Equity Capital 5. The ability to reduce Return Volatility and share the Risk of the Investment with other Investors. Including "Special Allocations" 6. The ability of Investors to dispose of their Interests in the Organization 7. The ability to distribute Cash Flows to Investors based on percentages that differ from the percentage of Equity Capital Contributed - This last dimension allows the Promoters/Sponsors of the Investment Opportunity to potentially earn higher Returns than the Passive Investors who also contribute Equity Capital.

GENERAL PARTNERSHIP

The simplest form of Pooled Ownership is a GENERAL PARTNERSHIP. One of the biggest advantages of this Form is that General Partnerships are treated as Conduits for Tax Purposes; Taxable Income and Losses flow through to the Individual Partners who Pay the Tax. Thus, Investors who own Commercial Real Estate through a General Partnership do not face "Double Taxation", where the Entity that owns the Real Estate pays Tax first, followed by a second Tax Obligation at the Investors Level. Other Advantages of General Partnerships are the ease with which one can be created, and the fact that the Partners also make the Operating Decisions, such as how much money to borrow or when to dispose an Asset. Thus, there is no Separation between the Ownership and control of the Organization, and Conflicts of Interest are lessened, although Partners might disagree over some decisions, of course. A Partner's Share of the Cash Flow produced by the Investments is determined by the Partnership Agreement and may vary from item to item. In particular, if certain Conditions are met, a Partnership can allocate Cash Flow and Tax Liabilities generated by the Property or Properties it owns in a manner different from each Partner's Percentage Ownership Interest in the Partnership. This ability to Structure Cash Flow rights and Taxable Income enables the creation of Multiple Classes of Investors. A major Disadvantage is that all Partners have Unlimited Liability. General Partners are Liable for ALL Debts of the Partnership, including Contractual Debts and Debts arising from Legal Actions against the Partnership. General Partners are also Liable for Wrongful Acts committed by other Partners in the course of the Partnership's Business. Therefore, the Personal Assets of the General Partners are subject to the Claims of the Partnership's Creditors. For this reason, Real Estate General Partnerships are fairly Uncommon, and those that do exist tend to have only a Few Partners.

DIRECT INVESTMENT IN COMMERCIAL REAL ESTATE (As Opposed to Passive Investing)

These Issues help explain observed Patterns in Direct Ownership of Commercial Real Estate. Direct Ownership is a frequently used means of Ownership for the Largest Institutional Market Participants and High Net Worth Investors and Families. As the size of an Investor's Portfolio increases, the Economies of Scale of retaining In-House Real Estate Expertise, the ability to diversify Risk, and the ability to generate Portfolio Liquidity across various Asset Classes (Stocks, Bonds, etc.) help to mitigate the Primary Disadvantages of Direct Ownership. At the same time, these Investors are able to take Advantage of Greater Control over their Real Estate Portfolios to tailor their Construction and Operation to meet their specific objectives. Direct Ownership is also prevalent at the Smaller End of the Investor Spectrum. Examples of this include Single-Family Rental Homes and Single-Tenant Office Buildings occupied to Family Businesses. Depending on the magnitude of these Real Estate Investments relative to the Investor's Total Wealth, there may be significant Implicit Cost of Direct Ownership in some Cases due to inadequate Diversification and/or Liquidity. As a result, a Smaller Private Properties is placing a large weight on the Value of Control and/or her Relative Advantages versus the Market (e.g., due to Greater Expertise or Better Information)

COMPARE TO PUBLIC STOCK & BOND MARKETS

Unlike many Publicly Traded Stock & Bond Investments, which can be Bought and Sold Inexpensively in Liquid Markets, the Going-In and Going-Out Transaction Costs of Private Commercial Real Estate Investments are HIGH. (as a Portion of Asset Value). As a Result, "INVESTOR" IRRs are generally Maximized by Holding the Assets for Longer Periods of Time, often in Excess of 5 Years or more. This is NOT the same for a "Developer", who tries to Sell at the Optimal Time near Stabilization (a Shorter Period, Opportunistic Strategy). For Core and Core Plus Investments (Investments in Existing Properties), the Majority of Real Estate Return comes from Periodic Net Rental Income NOT from Price Appreciation. Commercial Real Estate Returns are Significantly Affected by how WELL the Ongoing Asset Management Function is Performed.

STEP 5: FINANCING - Land Acquisition/Pre-Construction Financing

Usually, a Developer is Reluctant or Unable to Commit Substantial Funds in the Acquisition of Land for Development. The Period before Actual Construction could last Many Months or Several Years, and the Limited Capital of a Typical Developer bears a Very High Opportunity Cost because of its Value in Providing Liquidity for Current Projects. BUT INSTITUTIONAL LENDERS, such as BANKS, Thrifts, and Insurance Companies, are Reluctant to Lend on Land that generated Little to NO Cash Flow. In the Rare Case when an Outside Source Provides a Land Loan, the Total is likely to be for no more than 50% of the Value of the Land. Thus, a Developer must look to other Sources. We have already noted the importance of OPTIONS as a Solution. However, when the Developer must Exercise, or "GO HARD", on the Option, more Complete Funding must be Found. Again, the Contract for Deed or a Purchase Money Mortgage from the Land Seller is a Common Solution. Others, as noted, may be to Bring the Land Seller into the Development as a JOINT VENTURE PARTNER, or to Acquire Use of the Land through a Ground Lease. SOLUTIONS: - Option - Contract for Deed - Joint Venture with Landowner or Future Tenant - Build-to-Suit Arrangements - Use of Equity Partners But Financing the Land itself is NOT Sufficient. The Developer will incur Significant SOFT COSTS before reaching the Stage of Construction Financing, including the Title Examination, Environmental and Ecological Evaluation, Legal and other Costs of Permitting Process, and Architectural and Engineering Fees. Thus a Developer must RAISE EQUITY CAPITAL. This will come mainly from Outside Investors through any of the Business Entities, including a Subchapter S Corporation or, for a Large-Scale Development Organization, through a REIT. However, the most Common Structure Used is either a Limited Partnership, or the Limited Liability Company (LLC). The Financial Investors will Contribute Funds for their Share of the Ownership Interest, while the Developer will contribute mainly Expertise for a Share of the Venture. The Financial Investors must have CONFIDENCE in the Developer. The ability for the Developer to Raise Capital depends heavily on her Relevant Track Record. (Developer with Extensive Experience).

COMPARING NET PRESENT VALUE AND THE INTERNAL RATE OF RETURN

When Calculating NPV, we selected a Discount Rate and solved for Present Value. With IRR, we are Solving for the Discount Rate that makes NPV = 0. However, Net Present Value and the Internal Rate of Return use the same Cash Inflows and Outflows in their Calculations. Therefore, we would expect that Investment Decisions using the two DCF Methods would be consistent and, to a large extent, this is true. Both NPV and IRR produce the Same Accept/Reject signal with respect to a particular Investment Opportunity -- if a Project's NPV is Greater than Zero, the Estimated IRR will exceed the Required IRR (Ye). However, the IRR has some inherent Assumptions that make its Use as an Investment Criterion Problematic in some Situations. For example, the IRR Method does not Discount Cash Flows at the Investor's Required Rate of Return (Ye). This is significant because both NPV and IRR (implicitly) assume that the Cash Flows from an Investment will be Reinvested. With the Net Present Value Method, Cash Flows are assumed to be Reinvested at the Investor's Required (Internal) Rate of Return. However, with the Internal Rate of Return Method, it is Implicitly assumed that Cash Flows are Reinvested at the IRR, not the Actual Rate Investors expect to Earn on Reinvested Cash Flows. A related problem with the Use of the IRR asa Decision Criterion is that it will not necessarily result in Time Zero Wealth Maximization for the Investor. In particular, the IRR may produce a different ranking than NPV of Alternative Investment Opportunities. If all Positive NPV Investments available to the Investor cannot be purchased by the Investor -- perhaps because of Limited Financial Resources of the Time needed to Execute the Acquisitions -- the use of IRR instead of NPV may therefore lead to the Selection of a Project with a Lower NPV than one of the rejected Projects. An additional difficulty with the IRR Decision Criterion is that multiple Solutions are possible for Investments if the Sign (+ or -) of the Cash Flows changes more than once over the Expected Holding Period. That is, more than One Discount Rate may Equate the Present Value of Cash Flows with the Initial Investment. In most Commercial Real Estate Investments in Stabilized Properties, an Initial Cash Outflow ( - ) is followed by a series of Expected Positive Cash Inflows ( + ) from Operations and Sale of the Property. It is possible, however, that the Expected Net Cash Flow to the Investor from Rental Operations could be Negative in some Future Year(s) -- perhaps due to Large Capital Expenditures. This Additional "Sign Flip" could result in Multiple IRRs. This is problematic because Investors may not be aware that Multiple IRR Solutions to their Investment Problems exist, and it is not clear which IRR Investors would choose even if they were aware of the Existence of Multiple Solutions. The Use of Net Present Value (NPV) avoids the Potential Problems associated with the use of IRR; that is, Decisions made using NPV are always consistent with maximizing the Investor's Wealth at Time Zero. Nevertheless, the IRR is widely used for making comparisons across different Investment Opportunities.

VARYING THE ASSUMPTIONS

When considering a Proposed Acquisition, Investors should Recalculate NPV and IRRs using both Optimistic and Pessimistic Input Assumptions in order to draw Contrasts to the Base Case (i.e., Most Likely) Scenario, such an exercise allows Investors to determine how sensitive their Estimates of NPV and IRR are to Variations in important Input Assumptions. Although Values and Rates of Return can be determined by Hand Calculation, the Computations are greatly facilitated by the Use of Personal Computers, especially when a Variety of Input Assumptions are considered. The use of Spreadsheet Programs such as Excel allows Investors to quickly Calculate the effect of a Changed Variable Assumption on Cash Flows, Values, and Estimated Rates of Return. Numerous Spreadsheet Programs that facilitate the Valuation and Investment Decision-making Process are available for Investors to purchase, or the Analysts may Custom-Design an Excel Spreadsheet. For complex analyses involving Numerous Existing Leases, properties, or both, Sophisticated Programs such as ARGUS Enterprise can be purchased. SENSITIVITY ANALYSIS - Most Likely Scenario - Worst-Case Scenario - Best-Case Scenario VALUE OF COMPUTER - Excel Spreadsheets - Specialized Software such as ARGUS Enterprise MONTE CARLO SIMULATION

STEP 7: MARKETING & LEASING

When the Actual Marketing for the Project should BEGIN depends on the TYPE of PROPERTY. NO Marketing of Apartments until READY TO USE. It is NOT Productive to launch Advertising for Apartments until shortly Before the Actual Units are Available. (Student Housing being an EXCEPTION). In Contrast, Leasing for Office Buildings and other Facilities with Long-Term Tenants not only CAN Begin during the Design Stage, but NEEDS to Start Earlier since Prospective Commercial Tenants will Contract for Space WELL in ADVANCE of their Actual Move. Similarly, there needs to be PRESELLING of Units in a Condominium Project. Preleasing (or Preselling) is likely to be Required for Construction Financing. For Retail and Office Projects, nothing really can go Forward until the Anchor Tenants have been Secured. Only then will Construction Funding be Available, which enables Closing on the Land. Further, where the Construction Loan depends on a Take-Out Commitment, the Take-Out Commitment is likely to require a Preleasing to be well under way. Leasing Commercial Space (e.g., Retail, Office, or Industrial) will be through a Leasing Agent.

STEP 4: DESIGN

When the Developer has Control of the Property, is Assured of NO Undiscovered Legal, Environmental, and Ecological Problems, and has the Basic Zoning Required, it is time to turn the Initial Concept into a Complete Design. Selection of the Architect is a Vital Step in the Process, though Numerous Design professional and Engineers will play important Subsidiary Roles

DIRECT INVESTMENT IN COMMERCIAL REAL ESTATE (As Opposed to Passive Investing)

With Direct Private Investment, Individuals, Families, and Institutional Investors purchase and hold Title to the Properties. They do NOT Invest alongside others. Although Purchasing directly, these Investors will typically form an LP or LLC to acquire Property to limit Potential Loss of Capital. Purchasing Individual Properties directly in the Private Market gives Investors complete Control of the Asset: Who Manages it, How much Debt Financing is used, and when it is Sold. In order to have such control, however, the Investor must also Supply the Real Estate Expertise. For a Wealthy Individual or Family, the Principal herself could Provide this Expertise, Conducting the necessary Analysis to make the many Decisions involved or working with a Local Broker or other Real Estate Professional. For a Larger Organization, such as Institutional Investor (e.g., a Pension Fund), Direct Investment implies the Fund must retain In-House Experts (perhaps in Conjunction with Consultants and Advisors) to manage the Real Estate Portfolio. The Liquidity of Direct Equity Investment corresponds to the Liquidity of the Commercial Real Estate Market as a whole. Thus, while Direct Investment implies the Investor can decide when to Sell a Specific Property, Market Conditions at a given point in time may make a Timely Sale at a Reasonable Price more or less likely. The Limited Liquidity of Direct Investments in Private Real Estate Markets has especially been a Problem in declining Markets, such as the Commercial Real Estate downturn that began in 2008. More generally, by owning an Asset directly, the Investor bears the Full Risk of that Investment.

STEP 2: FEASIBILITY ANALYSIS, REFINEMENT, AND TESTING

With a Site under Control the Developer has time to evaluate the FEASIBILITY of the Project. She will normally perform a Feasibility Analysis FIRST. The Feasibility Study will Project the Expected Cash Flows from the Project. Using these Cash Flow Projections the Developer will determine whether the Project works Financially, as indicated by a CASH MULTIPLE or by an NPV ANALYSIS (preferred indicator). FINANCIAL FEASIBILITY QUESTION: Does the Value, when Built, Exceed the Cost? - An Application of Net Present Value (NPV) THREE POSSIBLE FEASIBILITY OUTCOMES: Deriving the Value of the Project may be very Informal, particularly if the Cash Multiple or NPV appears to be so HIGH as to constitute a "SLAM DUNK". On the other hand, if the Signal is Marginally Positive, then the Developer must decide whether to Retain Additional Market Research in an Effort to Narrow the Range of the Feasibility Outcomes. The additional Market Research also may give the Developer useful Guides to Improve and refine the Project Concepts. If the Signal is Negative, then the Developer must decide whether a Revised Plan might be Feasible. If not, she will ABANDON the Project, allowing an OPTION on the Land to Lapse. Even if a Development appears Financially Feasible, it still depends on the Land being Free of Soil Problems, Environmental Concerns, Ecological Complications, Seismic Concerns, Hydrological Concerns, or Anthropological or Historical Sensitivities. Thus, a Developer commonly turns to an Environmental Consultant, a Geologist, or other Scientific Experts at this Point. The Consultants will examine the Site for underlying Structural Concerns, for any Evidence of Toxicity, Wetlands, and Sensitive Wildlife Habitat that may be Protected, for example, under the Endangered Species Act. In addition, if there is Evidence of Ancient Ruins, the Developer will need to retain an Archaeologist or Anthropologist to assess the Presence of Sensitive Areas. Local Regulatory Agencies Increasingly Require this Assessment in the form of an Environmental SiteAssessment (ESA) or Environmental Impact Report (EIR) before issuing the Necessary Development Permits. If the Consultant reports an underlying Structural or Environmental Complication, the Feasibility Analysis must be Reconsidered. The Developer and Consultant must determine whether the Problem can be Solved through wither Project Redesign or Mitigation, and whether the Resulting Cost affects Feasibility. If Project Feasibility survives Structural and Environmental Tests, it must then make it through further Hurdles. The Land must have Marketable Title and it would be prudent for the Developer to affirm through Title Search at this Point before significant Additional Investments in the Project begin to occur.