Discretionary Capital Expenditures. Discretionary Capital Expenditure. Presented by Byron Smith, CCIM

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1 Discretionary Capital Expenditures Discretionary Capital Expenditure Presented by Byron Smith, CCIM

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3 Discretionary Capital Expenditure Case Study Overview During the holding period of a commercial real estate, investment property owners frequently make capital expenditures to maintain the value of their investment. Those investment decisions often include the decision to make discretionary capital improvements. This session will analyze the feasibility of renovating an existing office building and converting it to multi-tenant use versus renewing the lease with the existing tenant that occupies the whole building. Case Objectives Upon successfully completing this case study, you will be able to Forecast the annual cash flows before tax for renewing an existing lease Forecast the sales proceeds before tax at the end of the holding period for renewing an existing lease Forecast the annual cash flows before tax for a proposed renovation and lease-up Forecast the sales proceeds before tax at the end of the holding period for a proposed renovation and lease-up of multi-tenant space Calculate and explain net present value for the existing lease that is being renewed Calculate and explain net present value for the proposed renovation and lease-up of the multi-tenant space Calculate and explain the internal rate of return (IRR) of the differential of the cash flows from the two investment alternatives Investment Analysis for Commercial Investment Real Estate 1.1

4 NOTES 1.2 Investment Analysis for Commercial Investment Real Estate

5 Case Study 4: Discretionary Capital Expenditure Case Setup Scenario Your client owns a 50,000 rentable square foot (rsf) office building that was built approximately 15 years ago. The building is located in a very nice midsize office park in a market area that is experiencing steady growth with an expanding economic base. The owner built this building as a build-to-suit for a private corporation s headquarters. The building would be classified as generic office space, which is approximately 85 percent efficient. The original lease term was 15 years, with no renewal options. The lease is expiring in about six months. The loan on the property was amortized over the term of the lease, so the loan balance will be zero when the lease expires. The existing corporate tenant has proposed to renew the lease for 10 years under the following terms: Gross rent: $13.50 per square foot (psf) Annual escalation: 3 percent Operating expense stop: $6 psf The tenant will be responsible for cosmetic improvements The operating expenses are as follows: Current operating expenses: $6 psf Projected annual increase of operating expenses: 3 percent Property management: 3 percent of gross operating income Another alternative the owner is considering is to upgrade the building and convert it to multitenant use. Newer office buildings in the office park are renting for $20 to $24 psf for 5,000 to 10,000 square feet (sf) of space, which includes approximately $10 psf for tenant improvements Investment Analysis for Commercial Investment Real Estate 1.3

6 (TIs). Most of the leases are gross leases with expense stops based on the current year s operating expenses. Operating expenses on the newer buildings are running approximately $7 to $9 psf annually. Vacancy and credit losses for buildings in the immediate area are running five to 10 percent annually. The owner has had preliminary discussions with building contractors, lenders, and leasing brokers/property managers in the area, and following is a summary of these discussions. Information from building contractors, lenders, and property managers includes: Project costs including all hard and soft costs, leasing fees, and operating expenses during the renovation period are $45 psf. The average renovation period is six months. Lenders underwriting criteria: Interest rate: 8 percent Amortization period: 20 years Loan term: 10 years Payments per year: 12 Loan costs (percent of loan amount): 2 percent Maximum loan-to-value (LTV) ratio: 75 percent Current cap rate for determining loan value: 8.5 percent on stabilized net operating income (NOI) Minimum debt service coverage ratio (DSCR): 1.2 on stabilized NOI Loan amount is calculated using both LTV and DSCR, and the lower amount rounded down to the nearest thousand will be the approximate amount of loan available. 1.4 Investment Analysis for Commercial Investment Real Estate

7 Option A: As is Scenario Gross rent: $13.50 per square foot (psf) Annual escalation: 3 percent Operating expense stop: $6 psf The tenant will be responsible for cosmetic improvements Stabilized NOI year one`` The operating expenses are as follows: Current operating expenses: $6 psf Projected annual increase of operating expenses: 3 percent Property management: 3 percent of gross operating income Option B: Renovated Scenario Data from leasing brokers and property managers includes: Rent psf estimate for renovated space: $21 Projected annual rent escalation: 3 percent beginning in year three of the projection Type of lease: Gross with expense stop based on projected first-year operating expenses Absorption time: Six months to achieve stabilized occupancy First-year vacancy for the six months that space is available: 50 percent Stabilized vacancy rate: 6 percent Projected operating expenses: $6.50 psf Projected annual operating expense escalation: 3 percent Operating expense stop: $6.50 psf Property management: 3 percent of gross operating income Stabilized NOI year two The owner has retained you to analyze both alternatives and make a recommendation as to which is the better economic alternative. Use the following additional assumptions for the analysis: Client s target yield: 15 percent Investment Analysis for Commercial Investment Real Estate 1.5

8 Maximum financing obtainable will be utilized for both alternatives. Assume that only the total amount of a project s cost would be drawn down from the loan during the renovation period for the renovation alternative and that the balance of the loan available would be drawn down at the end of the first year and reflected in the annual debt service amount. Assume that the full amount of the loan less loan costs will be drawn down at the time of the lease extension for the as-is alternative and will be reflected in end of year (EOY) zero cash flow. Anticipated holding period: 10 years Disposition cap rate: 9 percent cap rate of year 11 NOI (round projected disposition price to the nearest thousand) Disposition cost of sale: 4 percent 1.6 Investment Analysis for Commercial Investment Real Estate

9 Task 1: Loan Calculations 1. Determine the maximum loan amount and loan proceeds for Option A. 2. Determine the maximum loan amount and loan proceeds for Option B. 3. Determine how much of the loan proceeds will be left after renovation costs in Option B. End of task Investment Analysis for Commercial Investment Real Estate 1.7

10 Task What is the net present value of the as-is, continue with the same tenant alternative, and what does it mean? 1A. If the owner s before-tax targeted yield were changed from 15% to 18%, then how would that change the net present value of these cash flows? 1B. If the owner s before-tax targeted yield were changed from 15% to 12%, then how would that change the net present value of these cash flows? 2. What is the net present value of the renovation alternative and what does it mean? 2A. If the owner s before-tax targeted yield were changed from 15% to 18%, then how would that change the net present value of these cash flows? 2B. If the owner s before-tax targeted yield were changed from 15% to 12%, then how would that change the net present value of these cash flows? 1.8 Investment Analysis for Commercial Investment Real Estate

11 3. What is the internal rate of return of the differential of the two cash flows (the IRR differential)? 3.A What is the meaning of this IRR differential? 3B. How can the IRR differential be used in the decision-making process? 4. Besides the financial feasibility analysis, what other factors would you suggest that the owners take into consideration in making their final decision in this matter? End of task Investment Analysis for Commercial Investment Real Estate 1.9

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