Value Added Transactions Mastery Lesson 04

Lesson Four: The Key Information for Making Good Investment Decisions

The value added investor needs to understand certain terms and basic information to make sound real estate decisions. This lesson discusses the information that you need to make the right decisions.

4.1 Capital Structure

One of the first items that the investor must understand in value-added bridge lending is the proposed capital structure, also called the capital stack. The capital stack is merely the different layers of financing, stacked on top of one another, to show the risk profile of the transaction.

You must understand where you are or where you want to be in the capital stack. The capital structure drives the debt and equity structure and determines your degree of financial risk. The capital stack is the total cost to buy and improve the property.

Simple Capital Stack

Complex Capital Stack

4.2 Source and Uses

Real estate investors cannot make an intelligent decision until they understand the sources and uses of funds for the transaction, including all capital needed to bring the property to stabilization. Sources and uses must equal each other, and the capital structure should total the amount of sources and uses.

Typical sources of cash are equity, mezzanine debt, and first-trust debt. Typical uses of cash are acquisition, capital improvements, interest reserves, soft costs, tenant improvements, lending fees, and financing costs.

Example of Sources and Uses of Cash

A good real estate investor spends time in order to understand the costs to get a value added property to stabilization. This includes the following:

  • Acquisition price
  • Project improvements
  • Third party costs
  • Interest and fees

A mistake in the capital improvement budget could turn a good deal into a bad deal!

4.3 Current and Historical Operating Statements

A good real estate investor must understand the prior and current project-level profit and loss statements (operating statements). Operating statements are the key to any property analysis. Before you can develop a plan for where your project is going, it is important to fully understand where you have been and where you stand now. Therefore, underwriting and decisions should be made with historical operating statements as a basis. The upside for the project is how much the investor can improve upon the historical results. The figure below shows an easy way to outline this information.

Planning with Historical Operating Statements

A good investor has to focus on the change in net operating income (NOI). He/she must understand the magnitude of the change and what is causing this change to occur. The operating statements are the “soul” of the property. You must know where you have been and where you are, before you can develop a plan as to where you are going.

4.4 Rent Roll

A property’s rent roll represents its revenue sources. The skilled investor will study the rent roll to determine the following:

  • Tenant risks: What are the risks of tenants defaulting or not renewing their leases? Ask the following questions:
  • Will they pay the rent even if they leave the space? Typically only large and financially strong companies do this.
  • How is the company doing? Can you see its financial statements?
  • What are the tenant’s sales per square foot (for retail properties)?
  • What other options exists in the market? For example, have other properties in the market been foreclosed?
  • Lease expirations: When do leases expire? This information reveals your re-leasing risk. You must review the following key questions:
  • Do leases all roll at one time or are they staggered?
  • If leases all roll close to the same time, is there a risk that the property could end up empty?
  • What is the re-leasing history of the tenants whose leases expiring? Do they have a history of renewing?
  • Extension options: Look closely at the extension options of larger tenants. If they are locked in at good rates, they are likely to stay. A good investor will know whether tenants have extension options./li>
  • Co-tenant provisions: Co-tenancy provisions are common in retail. These provisions prohibit the property owner from leasing to other similar tenants or allow smaller tenants to leave if an anchor tenant leaves.
4.5 Project Pro Forma

The project pro forma is the investor’s plan for the property. It is the culmination of all the historical analyses and their projected results. After investors finalize the capital improvements budget and study the rent roll and historical operating statements, they should prepare a future or forward-looking operating statement. This statement shows the potential for the property and concludes with the investor formulating a future stabilized NOI. The stabilized NOI is the wealth driver in every real estate transaction. If it can be achieved, the investor should do very well. The purpose of the project Pro Forma is to derive the property’s exit value.

4.6 Exit Strategies

Value added investments are easy to get into, but much more difficult to get out of with a profit. Every value added investor must start with the end in mind. This means having a specific exit strategy. In value added real estate, there can only be two exit strategies: Refinance Exit and Sale Exit.

Exit value is a crucial number that the value added investor is trying to achieve. This value is based on the stabilized net operating income (NOI), which is derived from all the analyses that go into the project pro forma.

The exit value is a combination of the pro forma NOI and the assumed exit capitalization (cap) rate. The exit cap rate will be estimated by the investor, who muse use “stressed” cap rates and a valuation matrix to derive exit value. Stress is adding basis points to the cap rate to account for future cap rate increases. The value added investor projects what cap rates will be in the future. An incorrect (too low) guess can result in loss on the investments. The value added investor should pick a conservative cap rate and “stress” today’s cap rate. The amount of stress depends on the length of time to stabilize the property. Projecting the exit cap rate is one of the most important decisions that a value added investor will make.

Remember to always begin with the EXIT in mind!

Assignment:

Real estate investors cannot make an intelligent decision until they understand the sources and uses of funds for the transaction, including all capital needed to bring the property to stabilization. Sources and uses must equal each other, and the capital structure should total the amount of sources and uses.

Explain each of these sources and which source might be “best” for value added transactions?

This assignment is your study guide to ensure you have learned these materials before you take the required quiz.


Downloads
You may need to right-click the following links and select "Save Link As" to download the file to your computer.