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© 2018 MIT SA+P All Rights Reserved MODULE 6 UNIT 3 Identifying real estate development risk © 2018 MIT SA+P All Rights Reserved Tel: +1 224 249 3522 | Email: info@getsmarter.com | Website: getsmarter.com Page 2 of 12 sap.mit.edu Table of contents 1. Introduction 3 2. Using construction IRR to quantify real estate development project risk 4 3. Difference in risk due to operational leverage 6 4. Nature of real estate development project OCC 8 5. Canonical form of real estate development OCC 9 6. Conclusion 11 7. Bibliography 12 © 2018 MIT SA+P All Rights Reserved Tel: +1 224 249 3522 | Email: info@getsmarter.com | Website: getsmarter.com Page 3 of 12 sap.mit.edu Learning outcome: LO4: Derive the opportunity cost of capital of a real estate development project from the NPV. 1. Introduction The previous unit covered how to calculate a real estate development project’s net present value (NPV). As you will recall, this is done by subtracting the present value of the construction costs (K0) from the present value of the expected future productive asset(s) to be created by the project (V0). The NPV is the crucial and determinative measure for the economic evaluation of the project, including the determination of the highest and best use (HBU) of the site, based on the wealth maximization principle. However, investors are focused on the return on their investments (i.e., the expected return and the risk in the return, as discussed in Modules 1 and 3). Once you have determined the NPV of a development project, you can use that valuation to determine the expected return on the development project investment at fair market value. Thus, you can “back out” the project’s opportunity cost of capital (OCC) in a rigorous manner. This OCC will be unique to each project, reflecting its particular degree and nature of operational leverage. This in turn enables you to quantify the amount of investment risk in the development project (as the capital market values such risk), relative to the risk in similar stabilized asset investments. This can be of great interest to investors and developers in formulating designs and plans for the project. Note that with development projects, the classic procedure is inverted. Classically, you first determine the relevant OCC of an investment, and then use that OCC as the discount rate applied to the investment’s cash flows to evaluate the present value of the investment and its resulting implied NPV. However, in the case of a real estate development project, you first compute the project’s NPV in the manner described in the previous unit and, only then, using that NPV as an input, you compute the project’s implied OCC. The reason for this reversed order is, in part, because development projects tend to be scarcer and more unique than stabilized asset investments, so it is more difficult to observe the relevant OCC directly as is the case in a well-functioning market such as that for stabilized assets. It is relatively easy to determine the appropriate OCC for stabilized assets with some confidence (for example, as described in Module 3), whereas it is difficult to directly observe or determine the appropriate OCC for development projects. Once you have calculated the development project’s OCC, it is straightforward to quantitatively compare the project’s riskiness and expected return to alternative investments, and to gain insight into its investment characteristics, which this set of notes covers. Thus, for stabilized property investment, the process is: Risk → OCC → NPV © 2018 MIT SA+P All Rights Reserved Tel: +1 224 249 3522 | Email: info@getsmarter.com | Website: getsmarter.com Page 4 of 12 sap.mit.edu For development projects, the process is: NPV → OCC → Risk The next section covers analysis of the risk and return in real estate development projects. 2. Using construction IRR to quantify real estate development project risk The first step is to simply use the project’s going-in internal rate of return (IRR), based on fair market valuation, to quantify the project’s investment risk. The NotYetBuilt Center example from the Unit 2 video is used to solidify this concept. Two buildings set for completion in 6 and 12 months, respectively, are each expected to produce future cash flows worth $5 million. Construction costs will be paid in 4 instalments of $1.5 million each after 3, 6, 9, and 12 months. This is illustrated in Table 1. Table 1: NotYetBuilt cash flows. NotYetBuilt Month 3 Month 6 Month 9 Month 12 K −$1,500,000 −$1,500,000 −$1,500,000 −$1,500,000 V +$5,000,000 +$5,000,000 Net cash flow (CF) −$1,500,000 +$3,500,000 −$1,500,000 +$3,500,000 Recall that the development project’s market value (the economic value, or maximum bid price for the land, based on an NPV of zero, net of land cost) was calculated as $3.463 million. Therefore, the following formula determines the going-in IRR of the development project at market value: As calculated in Excel or with a business calculator, this gives the project an IRR of 1.29% per month, which equates to 16.59% per annum: (1.0129)12 − 1 = 16.59% per year Recall that the risk-free rate in this example is 3.04%. Therefore, the 16.59% going-in IRR for the development investment phase reflects the capital market’s required going-in risk premium and the risk-free rate, as illustrated in Figure 1, which puts this analysis in the framework of the Security Market Line (SML), introduced in Module 1. $??,??????,?????? = −$??,??????,?????? (??+ ??????/????)?? + $??,??????,?????? (??+ ??????/????)?? + −$??,??????,?????? (??+ ??????/????)?? + $??,??????,?????? (??+ ??????/????)???? © 2018 MIT SA+P All Rights Reserved Tel: +1 224 249 3522 | Email: info@getsmarter.com | Website: getsmarter.com Page 5 of 12 sap.mit.edu Figure 1: The capital market’s risk premium. The risk premium is calculated as: 16.59% − 3.04% = 13.55% Recall from the video included in Unit 2 of this module that, for an unlevered investment in a stabilized property asset like the one being built, the IRR is 9.38% (AlreadyHere Place), and, therefore, the risk premium is 6.34% (9.38% − 3.04%). By dividing the development project risk premium by the stabilized asset risk premium, you find that, in this case, the development project has a risk premium 2.14 times that of the unlevered investment (13.55% ÷ 6.34% = 2.14). Given that these IRRs are based on fair market valuations (equilibrium in the capital market), this risk premium ratio must reflect the ratio of investment risk, as the capital market prices such risk, between the development project and its corresponding stabilized asset, as illustrated in Figure 2. If this relationship does not hold, disequilibrium will exist in the market, which will prompt asset managers to either buy underpriced assets or sell overpriced assets until the market is in equilibrium again, as described earlier in the program. © 2018 MIT SA+P All Rights Reserved Tel: +1 224 249 3522 | Email: info@getsmarter.com | Website: getsmarter.com Page 6 of 12 sap.mit.edu Figure 2: The equilibrium of proportional risk and return. 3. Difference in risk due to operational leverage The fact that the NotYetBuilt project has 2.14 times more risk than AlreadyHere reflects the development project’s operational leverage. Operational leverage arises whenever a project’s costs do not all occur upfront at Time 0. The higher the risk ratio, the more operational leverage a project has. Higher construction costs relative to the realization value, and construction costs incurred later in time relative to when realization is expected to occur, will lead to greater operational leverage. Because all the investment costs occur at Time 0, investments in stabilized properties have no operational leverage. (They may have financial leverage if the investor chooses to finance the investment using debt, as described in Module 4.) Example 1: To see how the operational leverage in the development project exposes the investor to more risk than the unlevered investment in the stabilized asset, consider this simplified example. Refer to the previous illustration with the two different developments: AlreadyHere and NotYetBuilt. Consider their performance assuming a 12-month investment horizon. For AlreadyHere, there is a cash outflow of $10 million at Time 0 (to purchase the property), followed by 11 months of $75,000 net rental income, and then in Month 12, $10,075,000, reflecting the Month 12 income and the resale of the asset at the end. © 2018 MIT SA+P All Rights Reserved Tel: +1 224 249 3522 | Email: info@getsmarter.com | Website: getsmarter.com Page 7 of 12 sap.mit.edu NotYetBuilt has a negative cash flow upfront at Time 0 of $3,463,000 (to purchase the land), followed by two cash outflows of $1.5 million each after 3 and 9 months, and cash inflows of $3.5 million each after 6 and 12 months. These cash flows generate expected returns (IRRs) of 9.38% and 16.59% for AlreadyHere and NotYetBuilt, respectively. Now, suppose that the asset values turn out to be 10% less than expected. The effect on AlreadyHere’s realized return relative to the prior expectation (a way to quantify this downside investment risk) is illustrated below: Thus, IRR = −0.087%