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Preparing, Evaluating, & Analyzing

the Real Estate Pro Forma

Contents
Introduction ........................................................................................................................................................1
What is the Financial Analysis ..............................................................................................................................1
Risk ................................................................................................................................................................ 2
Discounted Cash Flow .................................................................................................................................... 2
How do you prepare the Financial Analysis and how to start ............................................................................. 3
Stage 1 Initial Analysis .................................................................................................................................. 5
Stage 2 Refinement of Assumptions & DCF Analysis ..................................................................................... 5
Stage 3 Final Refinement and Cash Flow Distributions ................................................................................. 6
What are the components of the Financial Analysis ............................................................................................ 6
How should the Financial Analysis be organized ................................................................................................ 6
How do Financial Analyses change based on the asset type?............................................................................... 7
Types of Investment Analyses ............................................................................................................................. 8
Land Development Analysis ............................................................................................................................ 8
Land Development Case Study .................................................................................................................... 9
Back of Envelope Analysis for Land Development .................................................................................... 9
Land Development Discounted Cash Flow ..............................................................................................12
Assumptions ........................................................................................................................................13
Summary of Project Returns ................................................................................................................14
Project Schedule ..................................................................................................................................15
Construction Budget ...........................................................................................................................16
Hard Cost Construction Detail & Lot Release Pricing ...........................................................................17
Before Tax Pro Forma Cash Flow Analysis...........................................................................................18
Cash Flow Distribution ........................................................................................................................19
New Development Analysis .......................................................................................................................... 20
Office ........................................................................................................................................................ 20
Preliminary Analysis ............................................................................................................................... 20
New Development Discounted Cash Flow Analysis.................................................................................21
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The Assumptions Page .........................................................................................................................21


Assumptions, Facts, & General Information .........................................................................................21
Sources & Uses ................................................................................................................................ 22
Sources........................................................................................................................................ 22
Uses ............................................................................................................................................ 22
Summary of Income & Expense .......................................................................................................... 23
Rent Assumptions............................................................................................................................... 24
Project Schedule ................................................................................................................................. 25
Development Costs ............................................................................................................................ 26
Hard Costs ......................................................................................................................................... 27
Soft Costs ........................................................................................................................................... 28
Operational & Holding Period Costs .................................................................................................. 29
Operating Costs .............................................................................................................................. 29
Holding Period Costs ...................................................................................................................... 29
Financing Costs ............................................................................................................................... 29
Cash Flow .......................................................................................................................................... 30
Capitalized Interest .............................................................................................................................31
Owners Equity .................................................................................................................................. 32
Operating Pro Forma ......................................................................................................................... 33
Debt Service Schedule......................................................................................................................... 34
Existing Operated Asset Analysis ................................................................................................................... 35
Reconstructing the Operating Statements................................................................................................... 35
Operating (Income) Statement Example................................................................................................. 36
Forecasting Income & Expenses ................................................................................................................. 37
Revenue Projections .............................................................................................................................. 37
Building the Analysis ................................................................................................................................. 38
Detailed Research & Financial Analysis ...................................................................................................... 38
Assumptions Sheet ................................................................................................................................. 38
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Rent Roll & Stacking Plan (if the project is a multi-tenant office building and occupied) ......................... 39
Operating Expense Summary ................................................................................................................. 40
Lease Expiration & Market Rent Analysis................................................................................................ 40
Income In-place & Projected NOI Summary ............................................................................................41
Replacement Cost Analysis..................................................................................................................... 42
Cash Flow Projections ........................................................................................................................... 43
Estimated Project Cash Flows ............................................................................................................. 44
Valuing the Real Estate Asset .................................................................................................................. 45
Estimating the Cash Flows to Equity ....................................................................................................... 45
Sensitivity Analysis............................................................................................................................................ 45
What are the important metrics and how should project be evaluated? ............................................................ 47
Financial Ratios ................................................................................................................................................ 47
Categories of Financial Ratios ........................................................................................................................... 48
Liquidity Ratios ............................................................................................................................................. 48
Operating Expense Ratio ........................................................................................................................... 48
Payback Period ......................................................................................................................................... 48
Breakeven Ratio ........................................................................................................................................ 48
Debt Ratios................................................................................................................................................... 49
Loan to Cost Ratio .................................................................................................................................... 49
Loan to Value Ratio .................................................................................................................................. 49
Debt Coverage Ratio ................................................................................................................................. 49
Debt Constant ........................................................................................................................................... 49
Profitability Ratios ........................................................................................................................................ 50
Holding-Period Returns ............................................................................................................................. 50
Periodic Return ......................................................................................................................................... 50
Before-Tax Return ..................................................................................................................................... 50
After-Tax Return ....................................................................................................................................... 50
Leveraged Return ...................................................................................................................................... 50
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Unleveraged Return ...................................................................................................................................51


Positive & Negative Leverage .....................................................................................................................51
Total Return.............................................................................................................................................. 52
Income Return .......................................................................................................................................... 52
Appreciation Return .................................................................................................................................. 52
Return on Equity ....................................................................................................................................... 53
Cash on Cash Return ................................................................................................................................. 53
Equity Multiple ......................................................................................................................................... 53
Internal Rate of Return.............................................................................................................................. 54
Net Present Value ..................................................................................................................................... 54
Profitability Index ..................................................................................................................................... 55
Market Ratios ............................................................................................................................................... 56
Capitalization Rates................................................................................................................................... 56
Gross Income Multiplier ............................................................................................................................ 56
Net Income Multiplier ............................................................................................................................... 57
Conclusion ....................................................................................................................................................... 57

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Introduction
The financial analysis of any real estate project is generally the meat of the story. Like most books, you have
one chance to grip your reader. The structure is the backbone of the analysis beneath the surface, it holds
everything together and imposes order on the flow. Without a coherent and logical structure, the analysis is
unclear.
Like writing a novel, you may need to play around with the structure before you feel the analysis is ready to
publish. Experiment. The process of experimentation and iteration allows you to refine your thoughts, the
facts, the assumptions, format, and other aspects to ensure the results support the story. Ask yourself questions.
Seek input from your team or other professionals.

Are the assumptions correct?


Does the analysis support the idea?
Does the analysis flow?
Is it easy to read?
Are the individual parts linked (properly)?
Is the math correct?
Can you sum up the story in a simple chart?
Does the story start in the right place and reach a conclusion?
Will someone want to invest in the project?

The financial analysis is a report forecasting income, expenses and expected returns associated with a real estate
project. The cash flows are projected for a period of time through study, research, analysis, and experience
although there is sometimes looking through a crystal ball. The analysis is prepared for a variety of purposes but
mostly to attract capital (debt and equity) to a specific project. The pro forma will be evaluated by potential
equity partners and lenders. As a result, the information included in the pro forma is required to be verifiable
and reliable. Most importantly, the mathematics must be correct.
In most cases, it is best to keep the analysis simple. It is important that the reader, without explanation, can
make sense of the assumptions, analysis, and results. The format and the results should make it easy to
understand the time without knowing how you built the watch.
What is the Financial Analysis
The analysis of real estate, like other cash flow producing assets, it to determine the value based on the present
value of the expected cash flows. The financial analysis is a tool used to estimate the expected cash flows on the
real estate investment for the life of the investment as well as to measure the risk of the real estate investment.

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Risk
The risk of the investment extends to diversifiable and non-diversifiable risk (sometimes referred to as systematic
and unsystematic risk).
Diversifiable risk (also known as unsystematic risk) represents the portion of an assets risk that is associated with
random causes that can be eliminated through diversification. It is attributable to firm-specific events, such as
strikes, lawsuit, regulatory actions, and loss of a key account. Unsystematic risk is due to factors specific to an
industry or a company like labor unions, product category, research and development, pricing, and marketing
strategy. Factors such as estimation errors, legal and tax changes, and volatility in specific real estate markets fall
into this category.
While the non-diversifiable risk (also known as systematic risk) is the relevant portion of an assets risk
attributable to market factors that affect all firms such as war, inflation, international incidents, and political
events. It cannot be eliminated through diversification and the combination of a securitys non-diversifiable risk
and diversifiable risk is called total risk.
Discounted Cash Flow
The Discounted Cash Flow analysis (DCF) is a valuation method used to estimate the investment opportunity
using future free cash flow projections and discounts the future income to derive the present value. If the value
arrived through the DCF analysis is higher than the current cost of the investment, the opportunity may be
worth pursuing. DCF can be summarized by:
1. Forecasting the expected future cash flows
2. Assessing the required total return (Appreciation return + income return = Total Return)
3. Discounting the cash flows to present values at the required rate of return.
The result returns the present value. This amount should equal the maximum amount that could be paid so the
expected return will equal the required return.
Discounted cash flow analysis is used to make investment forecasts in the real estate market by estimating the
quantity, variability, timing, and duration of cash flows. The data is generated by pro forma or from financial
statements. Discounted cash flow analysis is used to solve for present value given the rate of return or for the
rate of return given the purchase price. DCF accounts for all cash flowing into and out of the real property
interest over time, so the time value of money is recognized.
The data required to perform the DCF analysis includes:

Estimates of property income

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Vacancy rates,

Operating expenses,

Debt service (when appropriate),

Pre- or after-tax cash flow for each year of the ownership period, and 3

The residual income from sale of the property at the end of the forecast period ( A typical ownership
period of 10 years is often assumed).

Calculating the cash flows is the foundation of the financial analysis. The cash flows that constitute the periodic
income, the NOI for the property and the reversion (resale of the property at the end of the holding period) are
discounted with the DCF formula:

+
+
+

.
.
+
( + ) ( + ) ( + )
( + )

Where r represents the appropriate periodic yield or discount rate and n is the number of periods in the
projection. Any series of periodic incomes, with or without a reversion, can be valued with this formula. The
formula can be used to estimate total property value (VO), loan value (VM), equity value (VE), leased fee value
(VLF) or leasehold value (VLH).
The primary difference between the DCF analysis and the annuitized static models such as front door/back door
and residual land value models is recognizing that net income changes over time. Since income is rarely, if ever,
even, the DCF analysis will convert the income into a Present Value more accurately. Further, for new
developments or existing assets, the positive lump sum receipt upon the sale of project, Net Reversion, allows
the debt (mortgage) to be repaid and the balance added to the returns (Total Return).
How do you prepare the Financial Analysis and how to start
Preparing the financial analysis in Excel is not for the faint of heart or the person without a great deal of
patience. Without experience or guidance, it is easy to become focused on detail that factors that will have little
effect on the results. Rarely is the DCF analysis straightforward. Focus is required to input the assumptions but
more important to understand and analyze the results.
The financial analysis can be prepared on a piece of paper, in an Excel workbook, or using sophisticated
software programs such as Argus, that calculate results based on input assumptions. Fortunately, or
unfortunately there is no industry standard on the form of the analysis. Therefore, as an investor or lender, you
might see numerous variations and forms. Many large real estate corporations and real estate investment trusts
are moving to software programs like Argus to standardize review, analysis, assessment, and management.
Regardless of the method used, the DCF model consists of a series of periodic cash flows that are discounted to
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the present time using a discount rate. The discount rate can be defined as the required rate of return by the
investor.
Each real estate project is unique due to its location, the timing, the capital requirements, and type of project.
Most projects include several worksheets that provide information and detail about the project. What is similar
between projects is the multi-period discounted cash flows. This process is an application of the capital asset
pricing model (CAPM) to real estate. The cash flow analysis assigns revenues and expenses to periods of time
(annual, semi-annual, quarterly, or monthly). The purpose of the analysis is to compute returns for the project,
evaluate the loan requirements, and returns to the venture participants.
The benefit of this type of analysis is that if there is relative certainty of the future cash flows and the true cost of
capital is correct, the value of the asset and a fair market price established for the asset. The challenge is the
prediction of future cash flows (income and expenses) for extended periods and the sensitivities of pricing
relative to the prediction of the cash flows.
There are numerous programs available to prepare the financial analysis however many analyses are prepared
using Microsoft Excel based template since it is widely available, inexpensive, and easy to learn. The analysis
can be static or dynamic, simple or complex. The type of analysis is dependent on the type of project, the
requirement to attract capital, and complexity (multiple buildings, phased construction, or mixed-uses) of the
project. To create a dynamic pro forma, cells and sheets are linked through named and cell references allowing
the user or users to quickly change assumptions without manually adjusting information. Further the use of =IF
formula will allow the analyst to make changes to input assumptions without adjusting each individual
worksheet.
Regardless of the perspective of the user (lender, rating agency, securities analyst, and other capital market
investors) the forecasting and discounting of cash flows must begin with market evidence for the baseline
assumptions. Discounted cash flow analysis is extremely sensitive to the precision of these inputs. A small
change in any of the input variables such as income, cost, yield, interest rate, or time, can disproportionately
affect the value or profit. Therefore, thorough market research, a careful analysis of cost, and the assumptions
and projection of future cash flows will enhance the investment analysis.

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The financial analysis is an iterative process that is refined during the feasibility, pre-construction and
development process. The analysis uses the information that is collected, vetted, and refined throughout the

process.
The analysis evolves over the stages of the process beginning with a simple capitalization of net operating
income (back of envelope analysis), to a more complex monthly cash flow where the level of analysis
correspond to major hurdles in the course of financing the project. Real estate investment requires specific
information about specific conditions of the real estate. This information takes time to research, assemble, and
can be costly to obtain.
Stage 1 Initial Analysis. During the idea inception phase, the initial feasibility analysis is based on simple pro
forma income and cost estimates. The analysis estimates value through direct capitalization using approximate
values for rents and expenses for the stabilized development. Inputs for this back of envelope analysis include
determining the type and size of the units (apartments, office space, retail spaces, or other units), vacancies, and
operating expenses. Historical data and analysis of local conditions provide the basis for the estimates. The
results of the analysis should point to go, no-go decision points based on investor criteria.
Stage 2 Refinement of Assumptions & DCF Analysis. Assuming the initial analysis points to a feasible project,
the input information regarding revenues and expenses is refined. This stage of analysis justifies the value of the
investment as an operating real estate venture and is typically used for attracting debt and equity. The analysis
is typically made numerous times as detailed and accurate information regarding development costs and
anticipated revenues become available.
The analysis during this stage defines returns based on yield capitalization. The net present value and internal
rates of return are calculated for the annual unleveraged returns for the project on the total project costs. The
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returns represent the relationship between the present value of the cash flow and the capital invested. The
unleveraged return focuses on the returns as single, undivided investment where all of the capital requirements
and all of the returns are to a single entity.
During the later parts of this stage, prior to commitments on earnest deposits or land purchase, the cash flows
are converted to monthly amounts during the development and operating period. The monthly cash flow
model shows when equity and debt funds will be needed and how long they will accrue interest before the
projects cash flow can support the debt service payments.
Stage 3 Final Refinement and Cash Flow Distributions. The final stage of the analysis is to further refine the
input assumptions based on contract pricing, and divide the cash flows into the investor and developers shares.
This is the joint venture/syndication analysis. This analysis is used to structure the deal between the developer
and the equity investor. The analysis typically focuses on the before tax cash flows.
What are the components of the Financial Analysis
The specific components of the financial analysis will vary based on the asset type however the basis of any
analysis includes income estimates, vacancy (in the case of operating assets) or the velocity of sales (as the case in
land development, expense and capital improvements, development schedule or investment holding period and
yield analysis.
Most financial analyses include information regarding the project revenues, expenses, and the timing of cash
flows. Since each real estate asset is as unique each analysis will be unique in the information that each analysis
will include. The process requires number crunching and accounting of all potential costs and revenues over a
holding period. Projecting revenues, expenses, and other costs related to the development or operation of the
real estate is not an easy task. The reliability of the results is dependent on the basis for revenues, costs, and
expenses as well as projections for changes in demand, supply, and other forecasts for inflation.
How should the Financial Analysis be organized
Whether the financial analysis is prepared for an operating asset, a new development, or land development, the
analysis should have a clear sense of organization and support the story of the project. Some analyses may
require more information than others but generally each analysis should include:

Cover Sheet. The cover sheet should provide the reader with information about the project including:
o Name of the project and the address of the project
o Name of Developer
o Who prepared the analysis
o When the analysis was prepared
o Table of Contents to use for navigation
o General Project Information

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o An illustration of the project


Assumptions & Facts. Many analysts use a single page to place all of their key assumptions and known
facts. Depending on the quantity of information, this may require more than a single page. For
example, soft costs and construction costs will generally have their own individual sheet but the
summary information can be shown on this page.
o Property Information such as areas, location,
o Key Dates
o Sales (Revenue & Absorption) Information (Can be provided on a separate page if necessary)
o Other information such as holding period costs, financing assumptions, or equity distributions
Summary of Project Returns
o Summary of Sources and Uses
o Investment summary
o Project Returns
Project Development Schedule identifying the major tasks
Loan Summary illustrating the loan allocation and release amounts if applicable
Cash Flow Analysis summarizing annual costs based on monthly draws.

Added detail may be necessary to substantiate the expenses. The detail may include:

Residual Land Value calculations for each land use


Construction Budget including hard costs and soft costs
Loan Summary illustrating the loan allocation and release amounts if applicable

How do Financial Analyses change based on the asset type?


Financial analysis of real estate development and investment is a quantification of future expectations. The
analysis relies on the developer having an understanding of the future including the marketability of the project,
operational expenses, and capital costs for the development. For operated assets, projection of revenues and
costs can be found by analyzing the historical income statement describing the revenues, expenses, profits, and
losses.
Unlike operated assets that have monthly cash flow from rental income, revenues from new development
projects and land development projects are derived from rents or from the sale of the property. Further, future
expenses will be predicted from plans and reports and are at best estimates (depending on the completion of
the plans, bids, and contracts for construction).
Therefore, the type of analysis will vary based on the asset type, particularly with respect to income and
expenses. For commercial buildings, the cash flow is determined by rental or lease income and affected by
changes in rents and vacancies, expenses for operations, taxes, tenant improvements, and mortgage payments.
The reversion price becomes a critical factor and subject to sensitivity in calculating the property value. For land
development projects, the cash flow is determined by the sale of properties. This is non-recurring income.

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Types of Investment Analyses


The following sections cover the land development analysis where revenue is derived from the sales of
property, new commercial development where the costs may be similar to the land development but revenues
after development are derived from rents, and existing operated assets where the investment opportunity is to
purchase the asset with cash flow and enhance the value through increasing rents, decreasing costs, or both.
Land Development Analysis
Land development is the
process of converting land to
housing or commercial uses
through improvements such as
streets and utilities. Through
the process of re-division or
subdivision of larger land
parcels divided into smaller lots
suitable for residential uses or
commercial uses, land
development is a precursor for
an income producing property. For some investors, land is often held for appreciation as an investment. The
development of land for residential or commercial uses is often considered a commercial real estate activity.
Land development like other types of real estate development, rarely follows a linear path. Nevertheless, the
general process includes selecting a suitable site, preparing a market analysis and preparing one or more concept
plans illustrating the land uses and infrastructure requirements, Initial due diligence is typically performed to
uncover facts about the property and reveal challenges and opportunities for development. Each of these
challenges and opportunities has financial implications.
The land development analysis is typically prepared at various points in the life of the project as information on
cost, sales and revenues, or as information becomes more accurate and refined. The primary difference between
land development analysis and income property analysis is the financing. Land development financing is a form
of construction loan that is paid off as the land is sold whereas income property is analyzed from operating the
asset for a period of time with a mortgage that is not paid off until the property is sold.
Diagrammatically, the process calculates the revenues less expenses minus debt service.

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The input assumptions and variables may change based on the specific project however as with other financial
analysis, the focus is on revenue, expenses, and the schedule of cash flows. The result of any financial model is
dependent on the inputs provided. Costs, revenues, operating expenses, reserves for replacements, repairs, and
interest, turnover costs, the reversion price, and the timing of the cash flows (schedule) take careful
consideration.
Land Development Case Study
To illustrate the format of the financial analysis consider a 90 acre parcel of land that has the potential for a
mixed use land development with office, hotel, and retail uses. The property is well located near the
intersection of two freeways, existing housing, and other industry. The benefit of the property is the city has
designated the property for office/employment uses that are not restricted similar to properties south that
require a minimum of forty acres. The owner is asking a price of $6.50 per square foot. Based on the current
market conditions and forward commitments by third-party developers, a 36 month development (very
aggressive) and hold period is estimated.
Back of Envelope Analysis for Land Development
The initial analysis for land development estimates the revenues and expenses to calculate the profit margin.
Based on debt and equity investment criteria, interest reserves and the return on equity can be calculated to
assess feasibility. The back of envelopment analysis begins with the initial sketch showing the possible land
division and the infrastructure required to serve the divided properties. This initial sketch serves as the basis for
the revenues and expenses.
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This case study assumes forward


commitments for the property based on
market pricing. The expense estimates are
based on information from consultants,
contractors, and historical information
from prior projects. Note that with the
exception of the revenues, expenses are
rounded to the nearest $1,000.

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Gross Lot Sales


Lot 1
Lot 2
Lot 3
Lot 4
Lot 5
Lot 6
Lot 7
Lot 8
Lot 9
REVENUES
Gross Lot Sales
Less Commissions
Net Lot Sales

Acres
23.76
8.00
4.01
9.40
6.07
6.04
6.14
6.17
20.41
90.01
$53,240,605
$3,726,842
$49,513,763

Price per SF
$13.50
$15.00
$12.83
$12.83
$12.83
$12.83
$12.83
$12.83
$14.50

Gross Sales
$13,972,527
$5,228,460
$2,243,351
$5,254,488
$3,394,125
$3,376,946
$3,428,920
$3,447,459
$12,894,328
$53,240,605

Assumes 7% Cost of Sales

ACQUISITION & DEVELOPMENT BUDGET


Land Acquisition Price
$25,500,000
Incentive Sales Fee Advance
$250,000
Closing & Formation Costs @ 1%
$270,000
SUBTOTAL
$26,020,000

$/Acre
$283,294

$/SF
$6.50

$289,071

$6.64

SOFT COSTS
Due Diligence, Loan Commitment
Design - Master Plan
Engineering - Master Plan
Other Consultant Fees
Miscellaneous Expenses
Legal Expenses
Outside Accounting Fees
Liability Insurance
Environmental Insurance
Travel & Marketing
Project Management
Development Fees
Contingency @ 7.5%
SUBTOTAL

% of Total
3.14%
8.71%
5.57%
5.23%
3.48%
10.45%
3.14%
4.18%
10.45%
5.23%
12.54%
20.91%
6.97%

% of HC

CONSTRUCTION HARD COSTS


West Road
North Road
Center Street
Contingency @ 5%
SUBTOTAL
Pre-Financing Total Project Costs
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$45,000
$125,000
$80,000
$75,000
$50,000
$150,000
$45,000
$60,000
$150,000
$75,000
$180,000
$300,000
$100,000
$1,435,000

29.7%
% of Total Cost

$900,000
$1,200,000
$2,500,000
$230,000
$4,830,000

14.96%

$32,285,000
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Pre-Financing Profit
Profit on Cost

$17,228,763
53%

Loan to Value @ 65%


Interest Reserve @ 6%

$20,985,250
$1,259,115

Equity Investment
Estimated Profit
Cash on Cash multiple

$12,558,865
$4,669,898
1.37

The results of the analysis illustrate the profit of approximately $4,670,000 on an initial investment of
$12,102,000. The cash multiple is approximately $0.37 for every dollar invested. Depending on the capital
partner, the risk of development would need to be further assessed.
Land Development Discounted Cash Flow
As the design is refined, the revenues and expenses are also refined. The discounted cash flow analysis begins
with preparing a project schedule to establish the timing of the cash flows. While this project establishes a thirty
six month development and hold period, based on the forward commitments and a careful consideration of the
jurisdictional processes, the revenues and expenses are continuously refined to reflect contracts, bids, and
address unforeseen conditions.
As the project cash flows are refined and programmed over time, the result of the analysis indicates the
unlevered cash on cash return is 1.46 and the levered return is 1.86. The project returns equal 33.24% on an
unlevered basis and 46.51% on a levered basis. Based on the results of the analysis, the project seemingly meets
the requirements of the investor returns. Once the analysis is prepared and the results returned, sensitivity to
input assumptions can be made to test probabilities that may increase or decrease returns. For example, what if
one of the purchase contracts is not completed or the time to complete the entitlements or construction of
improvements takes longer than expected.

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Assumptions

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Summary of Project Returns

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Project Schedule

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Construction Budget

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Hard Cost Construction Detail & Lot Release Pricing

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Before Tax Pro Forma Cash Flow Analysis

Cash flow is calculated on a monthly basis but is illustrated annually.


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Cash Flow Distribution

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New Development Analysis


Office
The office development case study analyzes a project where the land was purchased well in advance of
development. Due to a downturn in the economy, the development was delayed from the initial timeframe for
development until a recovery took place. The land was originally purchased at $14.00 per square foot. THe
current value of the property was fifty (50%) percent of the original purchase price.
The initial analysis solves for land value based on a contribution of land value and the expected cost of the
improvements. Concept plans were prepared and cost estimates were provided by a local contractor.
Preliminary Analysis
The preliminary analysis solves for land value using a direct capitalization of income and subtracting the cost
from the exit value. The land was contributed at a value of $7.00 per square foot with an exit value
SITE AREA

Acres

Square Feet

Gross Area

20.41

889,264

Net Area

20.41

889,264

BUILDING AREA CALCULATIONS


Allowable FAR
Allowable Gross SF
Building Efficiency %
Total Leasable

0.31
280,000.00
0.88
246,400.00

Square Feet
Estimate
Square Feet

HARD & SOFT COSTS


Shell costs

55.00

Estimate - steel frame

Site Development

12.00

Estimate - surface parking

40.00

Estimate Allowance

Tenant Improvements
Total Hard Costs
Total Soft Costs
Total Cost/SF
Total Hard & Soft Cost

107.00
32.10
139.10

per square foot


Estimate at 30% of Hard Cost
per square foot

38,948,000.00

VALUATION ESTIMATE
Land Cost per SF
Estimated Land Cost
Total Project Cost
NOI
NOI/Gross SF
Exit Valuation at 7% Cap (NOI /
Exit Cap)
Profit (Difference between Value &
Cost)

7.00

per square foot

6,224,848.00
45,172,848.00
3,839,692.08
13.71
54,852,744.00

161.33
Project Cost capped at 8.5%
per square foot
195.90

9,679,896.00

Exit Value per SF land cost

10.89

per square foot land

Exit Value per SF plus land

17.89

per square foot land

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New Development Discounted Cash Flow Analysis


Similar to the land development analysis, the discounted cash flow analysis begins with preparing a project
schedule to establish the timing of the cash flows, refinement of the assumptions, and detail required to develop
the project. Initial analysis may use estimates but the final analysis requires bids, contract pricing, and other
detailed information to provide reliable results.
The Assumptions Page
Some analysts will try and create one page listing all of the inputs. This may work well for simple projects
however most projects are generally complex. As with any analysis, the greater the detail, the more reliable the
results. The Assumptions Page should provide information regarding the site, such as location, size of the
property, required dedications of roads, tracts, or open space, identification of how the parcel will be
subdivided, and other information such as holding period costs and the types of land uses.
The development analysis begins with the development schedule. The development schedule provides an
outline of the major tasks and milestones for the project. Categories include Business Planning & Due Diligence,
Pre-construction activities such as zoning and other entitlements required before the project can be constructed,
Construction of the infrastructure, and unit sales. If the schedule is prepared in Excel, the information can be
integrated with the cash flow.

Assumptions,
Facts, &
General
Information
General
information
such as the
size, location,
use, and
analysis date
should be
included on
one sheet.

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This sheet should identify each project assumption and clearly organized. Items that may be subject to
sensitivity should be prepared using DATA VALIDATION allowing for changes to information quickly and
efficiently. Specific information should be provided a NAMED REFERENCE for use in formula.
The information should be organized showing General Information regarding the project such as site area,
building area, FAR, parking requirements, Source & Uses showing equity contributions and loans, Financing
Terms, Leasing information, Operating Costs, and Performance Measures.
Sources & Uses
A Source describes the capital received or is needed in connection with the project. The sources of capital can
be income, equity, or debt. Uses describe the expenses made in connection with the project. The expenses can
include hard costs, soft costs, operational costs, and holding period costs.

Sources
The sources of capital include equity, debt, and income. Each source should be clearly identified along with a
schedule showing contributions, interest accrual or payment, the return of capital, and the return on capital. As
an example, if the project costs total $1,000,000 and the lender has agreed to a 60% loan to value (LTV), the
equity required would be $1,000,000 x 40% = $400,000 and the debt source is $1,000,000 x 60% =
$600,000. A schedule should be prepared showing the distribution of the money as well as the return of the
money including interest.
Income is also a source. If the project is a land development project where lots, homes, or buildings are sold,
the sales schedule will reflect the individual sales projections. If a commercial building, the rents (minus the
operating costs) are reflected.

Uses
Uses include all of the expenses made in connection with the project. The expenses can include development
expenses, management fees, operating costs, holding period costs, and financing costs. Schedules should be
included articulating the individual uses.

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Summary of Income & Expense


This sheet provides a snapshot summary of the income for the building and the operating budget before sale.
The cash flow analysis for this project was extended for 20 years covering the first lease through the last lease.
This project is intended to be sold upon stabilization of occupancy. The schedule identifies the tenant (rent roll),
area of the tenant space, first year rental rate, and the annual escalation (inflation) of the rental payments.

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Rent Assumptions
This sheet schedules the income and operating expenses for the building calculating the Net Operating Income
(NOI). The lease for this building is a triple net lease (NNN). Triple net leases require the tenant to pay their
pro-rata share of the operating expenses. Upon full occupancy, the building owner does not pay any of the
operating expenses.

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Project Schedule
The project schedule was prepared using Excel to be interactive and dynamic with the cash flow model. As
dates are changed in the schedule, cash flow is recalculated based on the change. An independent schedule was
prepared for each Project Phase. The schedule identifies the major tasks and sub-tasks along with the start date,
number of months required for the work, and the end date. The schedule is used to help time cash flows for
each major task.

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Development Costs
The development costs identify those costs required for the development of the project including construction
costs (hard costs), indirect costs (soft costs), developer fees, and financing costs (interest during construction).
The costs are organized by description, phase of the work and summarized.

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Hard Costs
Hard costs represent the costs associated with the construction of project, including material, labor, and
equipment. The general contractor will prepare an itemized budget based on the contract documents (or
whatever design level is available). The materials, labor, and equipment required to construct the project is
referred to as Direct Costs. The Direct Costs include specific construction disciplines such as site work, landscape,
concrete, masonry, and structural steel. The costs are summarized into a summary page identifying the square
footage cost and total cost by description.

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Soft Costs
Soft costs are another form of indirect costs. The Soft Cost budget should include the costs for engineering,
architecture, other design consultants, The Soft Cost budget or indirect cost budget should also include the costs
for entitlement, jurisdictional review and permit fees, construction administration, utility permit fees, legal fees,
material testing, special inspections, and security costs (during construction).
Rather than estimating the soft costs for the project as a percentage of hard costs, individual soft costs were
researched and described.
For this example, the costs were categorized by preconstruction, city review and permit, and construction
related items. For this project, the soft cost budget (not including financing costs) was approximately 9% of the
cost of construction or $8.17 per gross square foot (building area).

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Operational & Holding Period Costs


Operating Costs
Operating expenses (OpEx) include expenses common to the operation of the real estate. The list of expenses
may vary based on property type and region however the expenses generally include the following:
o
o
o
o
o
o
o
o
o
o
o
o
o
o

Administration
Cleaning
Insurance
Landscaping
Maintenance and Repairs
Management Fee
Marketing
Property Taxes
Salaries
Security
Snow removal
Supplies
Trash removal
Utilities

The costs should be determined and analyzed carefully including those specific to the project. The timing of the
expenses should also be determined (for example Property Taxes are paid twice annually).
Holding Period Costs
There may be projects where there is a period of time between acquisition, development and/or operation.
The costs associated with holding the property should be properly accounted. The expenses may include
Developer Management Fees, Property Taxes, Insurance, Accounting Fees, Interest Expense, Legal Fees,
Association Management Fees, Assessments, and other costs required to maintain the property during the
Holding Period.
Financing Costs
Financing costs (interest payments or accrual) should be scheduled based on the distribution of the debt.

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Cash Flow
The cash flow sheet was organized by the project phase. Since this project had a gap between the start of the
project investment and the start of the project, a vertical format was used showing the expenditures by month
of the project. The cash flow model and the schedule are linked by numerous references in the formulas. The
formulas embedded place the correct amounts into the appropriate phase of the project dividing the total cost
by the number of months shown on the Project Schedule.

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Capitalized Interest
This worksheet provides the month by month accounting of equity or debt. When equity is contributed, the
amount accrues interest at the prescribed preferred rate. In this example, the amount of preferred return is 10%.
When the maximum amount of equity is contributed, debt is contributed and interest calculated on the
outstanding balance. This schedule is prepared on a monthly basis through the completion of the project
including the loan payoff.

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Owners Equity
This schedule shows the contribution of equity along with the date of the contribution. The purpose of showing
the date and contribution amount is to calculate the Internal Rate of Return (IRR). For this example, since the
contributions are not sequential and equal payments, the =XIRR command was used. This project had a
negative IRR after the sale of the first building but a positive 10.6% IRR upon the sale of the second building.

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Operating Pro Forma


As a development project, an Operating Pro Forma was prepared to illustrate to a potential investor, the before
tax cash flow for a stabilized building. For a project that is purchased for investment, this may be one of the
few schedules that is prepared. The operating pro forma was prepared showing a ten year operating plan with
a sale in the final year based on capitalizing the NOI.
Performance measures (shown in green) are provided on the report for easy evaluation.

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Debt Service Schedule


As a support to the Operating Pro Forma, a Debt Service Schedule showing the amortization of the loan was
prepared. This schedule identifies the total project value at purchase, equity requirement, and loan amount.

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Existing Operated Asset Analysis


Evaluating and analyzing operated assets (existing buildings) and the returns is based on the principle of
maintaining or increasing the cash flow. Since the formula for total return involves income returns and
appreciation returns, the analysis of cash flow from operations and the eventual sale of the property require
careful consideration ( = + ). Most investment purchases of
operated assets capitalize the current cash flow from operations ( = /) and approximate the

future sale of the asset at a point in the future at a lower cap rate considering improvements to the project and
improvements to the cash flow (cap rate compression). The challenge for the investor is to estimate the cash
flows. Too often, investors assume rent and income growth follow inflation. Usually, rents and income within
a given building do not keep pace with inflation over the long term due to the term of the leases. Secondly,
capital improvements can erode cash flow from operations if not projected and estimated appropriately.
Capital improvements for new building equipment or tenant improvements will have an adverse effect on the
cash flows from operations. Many investors over-estimate the terminal cap rate projection including lower rates
than the going-inn cap rate. Unless the project is unique in its location and market, older properties have more
risk and less growth potential thus the going-out rate should be at least as high as the going-in cap rate. Lastly,
since the process involves calculating the present value of the investment
Reconstructing the Operating Statements
Real estate income statements or operating statements report cash receipts and disbursements whereas
traditional income statements show revenues and expenses when earned or incurred. Analyzing the income
statement is the starting point for forecasting income and expenses by looking into the operating history of the
property.
The typical operating statement will provide sufficient detail that is verifiable. The statement should include
information from not less than the current year. Rental income and revenues should be compared with the
current leases. A rent roll, a listing of the building tenants and other information regarding the lease, should be
evaluated and verified. The rent roll should include the tenant, the area of the lease, the type of lease (gross
lease or net lease), term including start and expiration, and the rental income including any abatements and
other information such as renewal options. The operating statement should be analyzed with the gross
potential rent, total base rent amounts subtracting vacancy and rent abatements, and adding back expense
reimbursements and other revenues.

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Operating (Income) Statement Example


Revenues
Scheduled Base Rent
Gross Potential Rent
Absorption & Turnover Vacancy
Base Rent Abatements
Total Scheduled Base Rent
Expense Reimbursements
Parking Revenues
Other Rents
Total Gross Revenue
General Vacancy Loss
Effective Gross Revenue
Operating Expenses
Cleaning
Repair & Maintenance
Utilities
Roads & Grounds
Security
General Administrative
Management Fees
Real Estate Taxes
Insurance
Non-recoverable cleaning
Total Operating Expenses
Net Operating Income
Capital Costs
Tenant Improvements
Leasing Commissions
Capital Reserves
Other Costs
Total Capital Costs
Operating Cash Flow

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Forecasting Income & Expenses


Market supported forecasting is the basis of valuation of income properties. Therefore, diligent and careful
analysis and verification is required. As a guide, the following categories should be determined during the
analysis:

Current rental rates and expected changes in the rents

Analysis of the existing base rents, contractual rent adjustments, and renewal options

Escalation provisions and expense recovery

Turnover of tenants

Re-leasing assumptions

Operating expenses

Capital improvements

Debt service costs and adjustments including refinancing

Net Reversion (sale of the property)

After-tax adjustments (including effects of depreciation)

Appropriate discount rate used to determine present value.

The challenge for the investor is to accumulate the market data and exercise appropriate judgment to determine
changes that will affect the valuation of the project. Forecasting is used to determine the future income and
expenses based on historical trends with some judgment applied. An industry of economists and analysts
forecast and create projections based on economic and real estate indicators. Since there is reliance on
judgment, it is important to assess the quality of the information and assumptions used in the forecasts and
projections.
Revenue Projections
The revenues projections should be assessed from the current lease agreements showing escalations or changes
to the lease rate. Forecasting changes based on the market are important to determine in the event a tenant
vacates the space or is looking to renegotiate. Market lease assumptions (MLA) are used to control what
happens to a contract lease after it expires and goes to market. Inputs into the market lease assumption include:

Probability of Renewal. This is the percentage that the expiring tenant will renew the lease

Market Rent at Renewal

Number of months the space is vacant (to determine lost revenue)

Tenant Improvements

Rent Abatements

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The MLA should also address what happens to a rented space upon expiration of the lease term. The options
typically include:

Changes in rent amount

Renewal under the current lease terms

Vacating the space

Building the Analysis


Whether the analysis is prepared using and Excel-based template or a commercial software program, the
information should be verifiable and reliable. Similar to a real estate development project, the analysis can be
divided into an initial analysis and more detailed analysis. The initial analysis may include reviewing the
operating statement and projecting the cash flow over a specific hold period. The net reversion may be
estimated based on general market data and the cap rate you may use when purchasing the property. The
levered and unlevered net present value and rate of return can be easily calculated providing a decision point
whether to proceed or pass on the investment.
Detailed Research & Financial Analysis
If the decision is to proceed with the investment, the analysis requires refinement and detail. Learning, using,
and becoming more comfortable with Excel or Argus will allow the real estate investor more tools to use in
sorting through and using available data. Becoming proficient using Excel allow the user to turn data into
answers and structure the presentation in a clear and understandable format. Sensitivity analyses can be
developed to account for probability of occurrences, changes in the market, and other variables that allow the
user to address the risk of investment. While beyond the scope of this writing, learning how to write and
combine formulas such as SUMIF, SUMPRODUCT, VLOOKUP, INDEX+MATCH, CHOOSE, and TABLE
functions.
If preparing an Excel based template, a workbook is prepared summarizing the detailed research. Typical of an
analysis, the following sheets would be prepared.
Assumptions Sheet
This sheet will provide information regarding the building and analysis period. The assumptions/data will
include:

General information including project name, location, address, analysis period and investment holding
period, area of the building (net leasable square feet

Income Assumptions including market rents and annual growth percentages, other income such as
parking revenues and antenna revenues, annual escalation, credit loss, and general vacancy loss
percentage

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Vacant Space Lease-up including total vacant space, absorption period, lease terms, tenant
improvements, leasing fees, initial market rent per square foot, annual rent adjustment, and rent
abatements

Second Generation Space assumptions including initial market rents per square foot, annual rent
adjustments, recoveries, retention percentage, lease term, rent abatements, tenant improvements, leasing
commissions, and months spaces are not leased (Market Lease Assumptions can be prepared for the
building as a whole or multiple MLAs used for leased areas. For example, for spaces less 5,000 square
feet, for spaces between 5,000 and 15,000 square feet, and spaces greater than 15,000 square feet).

Operating Expense including initial year expenses per square foot, management fees, property taxes,
capital reserves per square foot and the capital reserve annual escalator

Rent Roll & Stacking Plan (if the project is a multi-tenant office building and occupied)
The rent roll is a chart identifying the building tenants. The rent roll may also identify the market lease
assumptions for the tenant.

The stacking plan is a representation of the tenant spaces in the building graphically illustrating the spaces
occupied.

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Operating Expense Summary


The operating expense summary provides the detail of building operating costs. The summary is commonly used
to calculate the expense reimbursement. The expenses will vary by product type however the general categories
of operating expenses is similar and include
personnel, cleaning, supplies, repairs &
maintenance, contract services (landscape,
window cleaning, parking lot sweeping),
utilities, administrative, management fees,
property taxes, and insurance. Operating
expenses can be considered fixed, that is they
do not change with occupancy, or variable,
meaning they do change with occupancy.
Fixed expenses include insurance and property
taxes whereas management fees, utilities, and

Operating Expenses
Cleaning
Repair & Maintenance
Utilities
Roads & Grounds
Security
General Administrative
Personnel
Supplies
Management Fees
Real Estate Taxes
Insurance
Total Operating Expenses

Cost/SF
0.98
1.03
0.93
0.71
0.51
0.26
1.12
0.16
0.33
3.84
0.17
10.04

FY 1
Actual
$47,732
$50,167
$45,297
$34,581
$24,840
$12,664
$54,551
$7,793
$16,073
$187,031
$8,280
$489,008

FY 2
Budget
$47,732
$51,171
$46,203
$35,273
$25,337
$12,917
$60,006
$7,403
$16,073
$194,512
$8,446
$505,071

some maintenance may vary based on occupancy.


Lease Expiration & Market Rent Analysis
The lease expiration combined with market rent analysis provides a tool for forecasting and projecting the
number of tenants leaving the building and market rent assumptions.

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Income In-place & Projected NOI Summary


The income in-place summary provides an illustration of the income, expenses, and operating cash flow of the
project. The summary can show per square foot, annualized, and monthly amounts. Consider our example
with added information.

Income In Place

The base rents are calculated using the weighted

Building Area (NLA)

48,706
SF

Income

Per SF

Annualized

Monthly

Base Rent

$25.63

$1,248,334.78

$104,027.90

Less Rent Abatements

($0.54)

($26,301.24)

($2,191.77)

Less Lag Vacancy

($5.62)

($273,727.72)

($22,810.64)

Total Minimum Rents

$19.47

$948,305.82

$79,025.49

Recoveries

$0.72

$35,068.32

$2,922.36

Total Parking Income

$1.82

$15,000.00

$1,250.00

($0.03)

($1,461.18)

($121.77)

Antenna Income
Storage & Other
Income

$0.23

$11,202.38

$933.53

$0.10

$4,870.60

$405.88

Gross Rental Income

$22.31

$1,012,985.94

$84,415.50

($0.18)

($8,767.08)

($730.59)

$0.00

$1,004,218.86

$83,684.91

$22.13

$2,008,437.72

$167,369.81

Operating Expenses

$5.70

$277,624.20

$23,135.35

Management Fees

$0.33

$16,072.98

$1,339.42

Property Taxes

$3.84

$187,031.04

$15,585.92

Insurance

$0.17

$8,280.02

$690.00

Total Expenses

$10.04

$489,008.24

$40,750.69

Net Operating Income

$12.09

$1,519,429.48

$126,619.12

Tenant Improvements

$0.00

$0.00

$0.00

Leasing Commissions

$0.00

$0.00

$0.00

Capital Reserves

$0.20

$9,741.20

$811.77

Total Capital Costs

$0.20

$9,741.20

$811.77

Operating Cash Flow

$11.89

$1,509,688.28

$125,807.36

average of the leases. Rent Abatements are


credits provided to tenants for signing or
renewing leases. Lag vacancy is the period of time
between consecutive leases. The lag vacancy (or
gross-up) will vary based on market conditions
and other factors such as location, type of
building, age of the building, and functional
efficiency of the building.

Parking Expenses

Credit Loss
Vacancy Loss
Total Net Effective
Income
Expenses

Capital Costs

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Replacement Cost Analysis


The replacement cost analysis is
prepared as a comparison of
value. The replacement cost for
direct, indirect costs, and soft
costs are calculated based on
current market pricing. The land
cost can be estimated using the
residual land value analysis
and/or the land value can be
established by comparable
analysis.
For the example above, the
building has a net leasable area
of 48,706 square feet. The
building has an efficiency of
approximately 90% so the gross
square foot of the building is
54,064 (48,706 x 1.10). Your
contractor has looked at the
building and estimated the shell
cost including site improvements
and contingency at $100 per
square foot. Tenant
improvements are estimated at
$40 per square foot. The soft

Residual Land Value Analysis


Property Information
Gross Area
Net Area

Acres
4.11
4.11

Building Information
Allowable FAR
Allowable SF
Bldg Efficiency %
Total Leasable

Values
0.30
54,064 SF
0.90
48,706 SF

Construction Cost Information


Shell costs
Site Development
Tenant Improvements
Total Hard Costs
Total Soft Costs
Total Cost/SF
Total Hard & Soft Cost

Cost
$95.00
$5.00
$40.00
$140.00
$35.00
$175.00
$9,461,200.00

Income Information/Estimates
Stabilized Occupancy
Gross Rent Stabilized
Rental Concessions
Effective Gross Rent
Expense Stop
Net Effective Rent
Net Effective Adjusted
Net Operating Income

Values
0.90
$25.63
$0.00
$25.63
$7.00
$18.63
$16.77
$816,653.50

Value Estimate
Rate of Return
TOTAL REPLACEMENT COST
Residual Land Value
Residual Land Value /SF Net Site Area
Residual Land Value /SF Leasable Area

Values
8.00%
$10,208,168.78

Notes
179,031.60
179,031.60
Notes

Notes
Estimate per square foot
Estimate per square foot
Estimate per square foot
Estimate at 25% of Hard Cost

Notes
Estimate
From average rent

Notes
Cap rate
V=NOI/r (Land+HC+SC)

$746,968.78
$4.17
$26.69

costs are estimated at 25% of the construction costs.


The weighted average rent is calculated with an estimate for expenses (assumed as a full gross lease with a $7.00
per square foot expense). Therefore, the Net Operating Income is approximately $816,654. Using a cap rate of
8% for this class of office, the total replacement cost is approximately $10,208,000 including land.

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Cash Flow Projections


Once the cash flows are verified and projected or forecasted for future years, the value of the income property
by discounting the cash flows. The cash flows prior to debt payments are calculated for the proposed holding
period of the investment. Revenues and expenses are summarized into a table identifying the gross rental
income, total income when accounting for credit and vacancy loss, expenses, net operating income, and total
operating cash flow.
The example shown on the following page provides an example of the cash flows, before and after debt
payments, and before and after tax to the investor.

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Estimated Project Cash Flows

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Valuing the Real Estate Asset


Whether preparing the materials for analysis or analyzing the information provided, a purchase or sales price for
the asset needs to be established and agreed between buyer and seller. As reviewed, the value of real estate
assets should be the present value of the expected cash flows. The challenge for the investor is to determine the
uncertainty associated with the cash flows and the expected growth in the cash flows. The higher the level and
growth in the cash flows, and the lower the risk associated with the cash flows, the greater the value of the
asset.
Beyond the revenues and expenses, the terminal value is a key input to value the property. The terminal value
can be derived from the terminal cap rate should be close to the going-in cap rate to avoid over estimating the
growth rate or appreciation value of the asset. A second method to establish the terminal value is to increase
the value of the property at the expected inflation rate.
Choosing the discount rate is dependent on the cost of capital to the firm. This is why some companies can
afford to pay more, or less, than others. Once the discount rate is determined and the cash flows are estimated,
the value of the asset is estimated by discounting the cash flows by the cost of capital and discounting the cash
flows to equity at the cost of equity. The cost of equity is sometimes referred to as the hurdle rate quoted as the
minimum investment return required by the investors. The true cost of capital can be calculated using the
weighted cost of capital formula, estimating levered and unlevered beta and risk premiums, but most times, this
amount is a stated amount by the investor.
Estimating the Cash Flows to Equity
The estimated cash flows to equity are estimated each year by netting out the debt payments from income. At
the end of the investment holding period, the terminal value of the equity is calculated by subtracting the
remaining principal payment from the terminal value. The present value of the equity can be calculated for
each year of the investment, discounting the present value or using the net present value formula for the entire
period of the investment. The cash flows can be calculated before and after tax.
The reason cash flows are calculated before taxes is they can be more easily compared to other competitive
investments whereas cash flows and returns after taxes provide the real returns to the investors.
Sensitivity Analysis
Financial analysis of real estate development and investment is a quantification of future expectations. The
analysis relies on the developer having an understanding of the future including the marketability and cost of the
development. In few cases does the developer have the control over all of the possible variations of variables
involved during the development or investment period. Most sensitivity analyses focus on best and worst
scenarios but not always the uncertainty and range of outcomes that may occur.
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Among other factors, sensitivity analysis provides the opportunity to assess the risk involved in the layers of
development. There are various methodologies of sensitivity including the use of Monte Carlo analysis. It is
important to recognize and assess the sensitivity of the returns relative to changes in the assumptions. The
assumptions can include the property use, density, expenses, schedule/cash flow, and revenue sources.
Depending on the capital structure, the project could be subject to sensitivity in rising interest rates. In the event
the schedule suffers delays, the effects could erode returns quickly.
Sensitivity analysis consists of studying the effects of changes in variables on the outcomes of a mathematical
model. A model may consist of numerous input variables and one or more output variables. By changing an
input variable, and measuring how the outcomes are affected by that change, the analyst can gauge how
sensitive the model is to the individual input variable.
Sensitivity Analysis in Business Decision-Making
Sensitivity analysis can be used in business decision-making. It is a way of measuring and quantifying uncertainty.
The analyst can create a model based on the relationships between inputs and outputs. Once the model is set
up, the analyst can tweak the inputs to see how the outputs are affected. For example, an analyst might use
sensitivity analysis to measure a projects net present value (NPV) for various expectations of costs, revenues,
capital investment, macroeconomic factors, and other relevant variables. The analyst can also alter the model to
create hypothetical scenarios such as a best case scenario, a worst case scenario, and a most likely scenario.
There are several tools in Microsoft Excel that can be used for sensitivity. For example, Data Validation can be
used to create drop-down menus allowing variables and assumptions to be changed easily. The What-if Analysis
tool allows the user to perform a sensitivity analysis by selecting specific assumptions to test the results and
provide a report of the findings. The Goal Seek function allows the user to solve for a specific amount based on
fixing certain data. These functions are found on the Data Tab. As the user becomes more comfortable with
writing formula and creating data tables, formulas using CHOOSE and VLOOKUP commands.
Problems with Sensitivity Analysis
First, the accuracy of the sensitivity analysis depends on the quality of the assumptions built into the model. If
the model contains erroneous assumptions, the output of the sensitivity analysis will be inaccurate. Second,
sensitivity analysis may not account for interdependencies among input variables. Third, the assumptions built
into the model may be based on historical data which cannot necessarily be relied upon to predict future results.
Also, subjectivity may taint the analysis.

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What are the important metrics and how should project be evaluated?
Most new development projects compute the ex ante return distributions; that is, the expected or anticipated
return of an investment. Ex ante returns are always projections and cannot be known with certainty. The
analysis of the results will vary based on the asset and whether the project is a development project or an
investment in an operated asset. Real estate development financial analysis is extremely sensitive to the
precision of the inputs. A small change in any of the input variables such as income, cost, yield, interest rate, or
time, can disproportionately affect the value or profit.
The analysis of returns may require the separation of development and operation and decisions such as Build
and Hold or Build and Sell. Evaluation of the performance of a project is like art; that is, in the eye of the
beholder. The performance is dependent on whether you are a lender, investor, or developer. Lenders have
specific measures that will identify risk whereas investors will look to maximize yield.
Real estate return measures are very valuable tools for property investors in terms of evaluating the viability and
profitability of potential real estate investment opportunities, and comparing them against their financial
objectives. Besides return, investors are also interested in the risk that is associated with the opportunity
evaluated in order to assess whether the expected return is in line with the risk that is being undertaken.
Once the DCF model is complete, there are numerous metrics that can be calculated for evaluation. Each of the
metrics provides perspective and information for managers and decision makers.
When analyzing and making decisions regarding new development or property investments, there are several
real estate return measures that can be used to help with decision making.
Financial Ratios
Financial Ratios are used to measure financial performance against standards. Analysts compare financial ratios
to:
1. Industry averages (benchmarking),
2. Industry standards or rules of thumbs and
3. Internal trends (trends analysis).
The most useful comparison when performing financial ratio analysis is trend analysis. Financial ratios are
derived from the three financial statements;
1. Balance Sheet,
2. Income Statement, and
3. Statement of Cash Flows.
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Categories of Financial Ratios


There are generally five (5) categories of financial ratios:
1. Liquidity Ratios. Liquidity ratios measure whether there will be enough cash to pay vendors and
creditors of the company.
2. Activity Ratios. Activity ratios measure how long it will take the company to turn assets into cash.
3. Debt Ratios. Debt ratios measure the ability of the company to pay their long term debt.
4. Profitability Ratios. The profitability ratios measure the profitability and efficiency in how the company
deploys assets to generate a profit.
5. Market Ratios. The market ratios measure the comparative value of the company in the marketplace.
Liquidity Ratios
Liquidity ratios measure whether there will be enough cash to pay vendors and creditors of the project.
Operating Expense Ratio
Operating Expense Ratio (OER) is a ratio of property performance. OER measures the relationship between the
income of the property (which is primarily derived from rents) and a basic recurring cost element, the operating
expenses. The OER can be calculated on potential gross income (PGI) or effective gross income (EGI). These
ratios are usually below 1. If greater than one, it means that the operating expenses are greater than the income
the property is expected to produce or is producing.

Payback Period

The Payback Period measure provides the number of years required to recoup the initial cash investment in a
project or property. Where,
=

The limitations of this calculation is that annual cash flows are rarely constant. Secondly, the metric ignores cash
flows to the investor after the payback period. Lastly, this measure ignores potential appreciation gains.
Breakeven Ratio
The property breakeven ratio is a ratio measuring the risk of negative cash flow of a property investment. This

metric expresses the operating cash outflows of the property, including debt service, as a percent of the
propertys gross effective income. The formula for calculating the property breakeven ratio is the following:
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( + )

The closer the ratio is to 100% the higher the risk of negative cash flow. If the ratio is greater than 100%, it
indicates that the property is experiencing a negative cash flow. If the ratio is below 100%, the lower the risk
the property cash flow will turn negative.
Debt Ratios
Debt ratios measure the ability of the company to pay their long term debt. Common metrics include:
Loan to Cost Ratio
The amount of money borrowed in relation to the development costs (loan amount divided by the
development costs including hard costs and soft costs).
Loan to Value Ratio
The amount of money borrowed in relation to the market value of the property (loan amount divided by the
property value or sales price).
Debt Coverage Ratio
Debt Coverage Ratio (DCR) or Debt Service Coverage Ratio (DSCR) is the ratio of net operating income (NOI)
and its annual debt service (ADS).
=

If the calculation produces a result of greater than 1.0, the implication is the property net operating income is
higher than the annual payment required to service the debt payments. If the debt coverage ratio is less than 1, it
indicates that the property produces insufficient income to cover both operating expenses and the mortgage
payment. While lending requirements fluctuate with market cycles, lenders are usually requiring a DCR of at
least 1.2, which means that property net operating income needs to be at least 1.2 times higher than the
mortgage payment. If the property has more than one loan, then the debt service used to calculate this ratio will
be the sum of the annual payments due for all loans.
Debt Constant
This represents the total cost of debt service as a percentage of the loan amount. This is of interest to investors
because it is the total cash cost of debt service to the project. The higher the debt constant is, the greater the
relation of debt to equity

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Profitability Ratios
The profitability ratios measure the profitability and efficiency in how the company deploys assets to generate a
profit. The ratios can be calculated on a periodic or over the holding period. The returns can be calculated
before tax or after tax and as either leveraged (with debt) or unleveraged (without debt).
Holding-Period Returns
Holding-period real estate return measures calculate the return of a property investment over the investment
horizon. Holding-period return calculations contemplate an expected resale (reversion) price of the property at
the end of the investment horizon. Capital gains or losses that are realized upon the termination of the
investment are therefore included in the return calculations. This metric takes into account any potential
fluctuations in the net income of the property.
Periodic Return
Periodic return is the expected return of an investment over a given period internal, which does not necessarily
reflect the planned holding period of the investment. Typical real estate returns measures refer to one-year or
one-quarter intervals. Periodic returns are rarely quoted in one-month time periods. The National Council of
Real Estate Investment Fiduciaries (NCREIF), is a good source to research return measures for comparable
commercial properties throughout the United States.
Before-Tax Return
Real estate return measures may differ in terms of whether income and/or corporate taxes are taken into
account. Before-tax real estate return measures are estimated without taking into account any income and/or
corporate taxes that the owner may have to pay in connection with income earned by the property (property
taxes are generally considered an operational cost rather than a specific tax to the owner). The most common
before-tax measure is the income return, calculated using the propertys net operating income.
After-Tax Return
After-tax real estate return measures calculate investment return using the after-tax and net of debt-service (if
there is a loan involved) cash flows of the property. The after tax cash flows are calculated taking into account
any income taxes (and deductions) in association with income earned by the property, as well as any payments
to service any loans associated with the property.
Leveraged Return
Leveraged return is the return of a property investment when debt is used to finance the acquisition of the
property or any other capital needs in association with the operation, renovation or modification of the
property. The leveraged return represents the Return On Equity capital contributed by the investor.
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Unleveraged Return
Unleveraged return is the return of a property investment assuming the investor uses its own capital without
debt to finance any capital needs for the acquisition of the property as well as during the holding period of the
investment.
Positive & Negative Leverage
Positive leverage is the term used to describe the case in which the use of borrowing contributes to a higher
return on capital compared to the return that would be obtained without borrowing, while negative leverage
refers to the case that the effect of borrowing reduces the return on capital.

Profitability ratios include:

Total Return

Appreciation Return

Income Return

Gross Profit Margin


Operating Profit Margin Ratio
Net Profit Margin
Return on Equity Ratio (ROE Ratio)
Return on Investment Ratio (ROI Ratio)

While there are no specific measures or ratios in commercial real estate that are called Return on Investment
(ROI), there are many that can be described as Return on Investment (ROI) type ratios. All the ROI ratios are
essentially a single year cash flow divided by an investment corresponding to the cash flow. Since almost all
commercial real estate investments last multiple years, and it is highly unlikely that the sale of the property will
return the exact amount of the original investment, none of the ratios produce a number that is a rate of return
number (like the IRR) that can be compared to yields on other multiple year investments. The ROI ratios,
sometimes referenced as profitability ratios, attempt to spotlight how the investment is doing each year. The
following are all ratios that show a Return on Investment (ROI):
1. Net Capitalization or Cap Rate
2. Adjusted Capitalization Rate
3. Cash on Cash
4. Adjusted Cash on Cash
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5. Current Rate of Return


6. Accounting Rate of Return
7. NOI/Property Value

Total Return
Total real estate return measures includes both the income and appreciation return. This is the most complete
measure of periodic return since it includes both the change in capital (income earned or lost) as well as the
appreciation of the asset.
The Total Return can be calculated using the following formula:
=
Where, the Total Return in period t equals:

( + )

The net amount of cash flow or income paid out to the investor in the asset during period t ( ) plus

the market value of the asset at the end of the period t ( ) divided by the market value in the
prior period ( 1 ), minus 1. The formula assumes the entire cash flow ( ) occurs

entirely at the END of period t. The equation also assumes valuations at the beginning and end of each period-

as if the asset were bought at the beginning of the period and sold at the end of the period.
Income Return
Income return is the return associated with all income earned by the property (may be referred to as current
yield). The income return equals the cash flow paid out to the owner during period t, as a fraction of the value
(or % of change)of the asset at the beginning of the period. The formula to calculate the income return is:
( ) =
Appreciation Return

Appreciation return measures the change in value over the period. This return metric is also referred to as
capital return, capital gain, or growth. The cumulative appreciation return over the holding period measures the
percentage change in value at the end of the holding period in comparison with the acquisition price.
The appreciation return is the change in the market value during period t, as a fraction (or % change) of the
market value at the beginning of period t. The appreciation return can be calculated using the following
formula:
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() =

Note Total Return equals Income Return plus the Appreciation Return. The Total Return formula can therefore
be described as:
= +

The income return is relevant to the income objective of investors while the appreciation return is relevant to
the growth objective
Return on Equity
Return on equity is the return to the investors capital used in acquiring the investment. If no borrowing is used
then the investors capital or equity will include all acquisition and pre-acquisition costs (legal, market study,
valuation and any other due diligence costs associated with the purchase of the property). If debt is used to
finance the project, then the investors equity will be a portion of this amount.
When debt is used to finance the project, the Return On Equity requires a Leveraged Return calculation that will
take into account the effect of borrowing on property cash flows. If debt is not used to finance the project, the
investors Return On Equity will be equal to what is referred to as the unleveraged return, the calculation of
which assumes no borrowing on the part of the investor. The most commonly used holding-period return-onequity measure is Internal Rate of Return (IRR).
Cash on Cash Return
Cash-on-Cash Return is a return measure calculated as the before-tax equity cash flow over the equity
investment. It is also referred to as equity dividend rate. This measure of return is used very often in the case of
property investments because the financing of real estate acquisitions involves typically the use of both equity
and debt.

Equity Multiple

The Equity Multiple is known as the return on investment. The Equity Multiple is the sum of the total equity
(distributions and appreciation upon sale) returned to an investor over a holding period divided by the
investor's initial investment.
=
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Internal Rate of Return


The internal rate of return (IRR) is the rate of return (discount rate or yield) that makes the net present value of
an investment equal to zero. The IRR of a real estate project is the dollar weighted average return capturing the
effect of capital flow timing. The IRR is the measure of Total Return achieved by the investment including the
initial income flows, growth or decline in income d and the capital value appreciation or decline reflected in the
reversion price (terminal value).
It is a highly significant measure of investment performance, but it has limitations. It may produce multiple
solutions or a negative IRR, and is less useful when little or no equity is invested or unusual reinvestment
concepts are involved. By comparing the IRR before taxes with the IRR after taxes. an investor can assess how
taxation and tax shelters affect the profitability of an investment. IRR is based on Net Cash Flows and does not
differentiate between return OF and return ON the investment.
Some analysts and investors prefer to use the IRR before taxes because it is simpler, less prone to error, not
dependent on outside influences, and can be compared with other investment yields that are reported on a pretax basis. Those who favor the IRR after taxes argue that the income-tax bracket of the typical investor is an
important consideration which must be included if the analysis is to simulate the decision-making process of the
typical investor.
There is no algebraic formula to solve for IRR since the calculation is non-linear. Calculating IRR by hand
requires a great deal of trial and error process. Software programs like Excel and financial calculators have made
these calculations easier. When using Excel, use the =IRR command and select the range of relevant cash flows.
For non-sequential cash flows that are not periodic, use the =XIRR command.
Net Present Value
Net Present Value is a measure of investment performance. The NPV is the Present Value of all cash flows
associated with a real estate investment over its holding period discounted at the investors required rate of
return. All cash flows are considered in the calculation of the NPV including the initial cash outlay for acquiring
the property, development and construction, and income during the holding period. If the NPV is greater than
zero, the investment return exceeds the investors required rate of return. If NPV is negative the investment will
provide a return lower than the required return by the investor. The formula to calculate the Net Present Value
is:
= 0 +

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1
2
3
4

+
+
+
+ +
2
3
4
1 + (1 + )
(1 + )
(1 + )
(1 + )

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Where CF represents the cash flow of each period within the investment analysis horizon, r is the discount rate
and n, the last period of the investment horizon. As indicated earlier, the first cash flow CF0 represents the initial
cash outlay or investment cost. The last cash flow CFn includes any income expected to be received during the
last period of the investment horizon plus the market value or sales price of the property at that point in time
(reversion). Typically this is calculated as the ratio of the expected NOI in the last period of the investment
horizon over an expected exit cap rate.
When using Excel, the formula is =NPV(rate, value 1, value 2,value n) where rate is the investors hurdle rate
or minimum yield on the investment.
NPV is an indicator of how much value an investment or project adds to the firm. In financial theory, if there is
a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected.
If...

NPV > 0

NPV < 0

NPV = 0

It means...

Then...

the investment would add value to


the firm
the investment would subtract value
from the firm

the investment would neither gain


nor lose value for the firm

the project may be accepted

the project should be rejected

We should be indifferent in the decision whether to accept or reject the project. This
project adds no monetary value. Decision should be based on other criteria, e.g.
strategic positioning or other factors not explicitly included in the calculation.

Profitability Index
The Profitability Index (PI) is a measure used to evaluate whether the property meets the investment
return objectives. The PI shows how many times the present value (PV) of the propertys cash flow stream over
the holding period is higher (or lower) than acquisition or investment cost.
A PI greater than 1 indicates that the expected return over the holding period is higher than the investors
required rate of return. A PI smaller than 1 indicates that the property's expected cash flows will not be high
enough to provide the minimum return required by the investor.
=

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Market Ratios

The market ratios measure the comparative value of the company in the marketplace.
Capitalization Rates.
The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income-producing properties. The
cap rate is equal to the net operating income divided by the sales price or value of a property. Cap rate is
expressed as a percentage or decimal. Investors, lenders and appraisers use the cap rate to estimate the purchase
price for different types of income producing properties.
A market cap rate is determined by evaluating the financial data of similar properties which have recently sold in
a specific market. The Cap Rate calculation incorporates a property's selling price, gross rents, non-rental
income, vacancy amount and operating expenses thus providing a more reliable estimate of value. Investors
expect a larger return when investing in high risk income properties.
The cap rate is calculated as:

Where income is the propertys NOI and value is the Purchase Price or Replacement (constructed) Value. When
preparing a financial analysis, the going-in cap rate would be based on market conditions (including assessment
of risk) whereas the terminal cap rate is considered an estimate since it would be a forecasted ratio. As noted
above, the terminal cap rate should be close to the going in cap rate to avoid over estimating the value of the
project and inflating the returns
Gross Income Multiplier
The Gross Income Multiplier (GIM) or Gross Rent Multiplier indicates how many times the price/value of
a commercial real estate investment is greater than the gross income it delivers to its owner. It is a metric
commonly used for multi-family developments.
A method of estimating or expressing a property's value as a multiple of its gross rental income. The GIM is
much like the Capitalization Rate except the gross rental income rather than the net operating income (NOI) is
used to determine the value of a property. The GIM is calculated by dividing the fair market value of the
property by the gross rental income.
=
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The Gross Income Multiplier is also used to determine the number of years the property would take to pay for
itself in gross received rent. Generally, the lower the GIM, the better the investment. The GIM calculation only
considers a property's selling price (Value) and gross rents (Income).
Net Income Multiplier
NIM is actually the reverse of the capitalization rate, and denotes how many times the asking price or market
price is greater than the Net Operating Income of the property.
=

Conclusion
The Discounted Cash Flow (DCF) model can take various forms and contain generalized summary of sources
and uses or more detailed information. The level of detail available may be based on the stage of the project
(preliminary versus permitting) however it is the opinion of this author that the greater the detail, the less
chance of missing an important item.
Preparing a DCF cash flow model is time consuming, gathering the information can be costly, and preparing the
analysis requires patience, review, and discussion to ensure completeness and accurate reporting. With practice,
the time to prepare a model will be reduced.

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