Project Economics: The Value of Leasing Russell Banham, Savills - ICSC European Retail Property School
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ICSC European Retail Property School
Project Economics: The Value of Leasing
Russell Banham, Savills
(Investment, Development & Asset Management)
Introduction
Who I am Russell Banham • Over 30 years of experience • UK, Europe & Middle East • Major Developers / Entrepreneurs / Funds
One of my Current Projects
Learning Objectives for the session
1. Identify various ownership positions and expectations Section I
2. Explore financial impact of a single lease and its various components
Section II
3. Examine the economics of releasing, buy-outs, take-backs and relocations
4. Look at development appraisals and Leasing’s role in that process Section IIIKey Points to Remember • Value is driven by the quantum & perceived quality of income. • Cashflow is the receipt of income, not just the right to receive income. • Cost is cost – not VALUE! • Income is generated by leasing activity. • Good leasing in shopping centres is about the creation of high quality income - in the context of the ‘right’ tenant mix (adjacencies matter).
Section 1 – Financial Issues Ownership Positions & Financial Issues
Ownership Positions and Expectations
Different shopping centre owners have different requirements:
• Property Companies
• REITS - ‘accretive’ growth
• Quoted Companies - income growth and capital appreciation
• Trader Developers - development profit
• Funds
• Pension Funds
income growth and capital appreciation
• Investment Companies
• Sovereign Wealth Funds - ‘trophy’ assets
• Opportunity Funds - capital appreciation and income growthOwnership Positions and Expectations
• Mortgagees / Debt Providers
• Banks
• Insurance Companies - secure income to repay debt
• Pension Funds
• Asset Managers
• Asset Management Companies - fees (often minority equity investors)
• Retailers
• Large /small /established / start-ups - profitability, market coverage, total costWhat about REIT’s? • REIT’s are generally public equity; similar to traditional stocks but with differences • Seek ‘accretive’ growth via new development & acquisition • Funds from operations (FFO) and Net Asset Value (NAV) are the primary measures; Not NOI • Most are traded on public exchanges but private or “closely held” REIT’s do exist.
Shopping Centre Valuation What Drives the Value of Retail Real Estate? • Location, location, location • Tenant mix • Competitive environment • Market Demographics • Land costs & “hard” costs • Length of leases / lease terms • Supply & Demand (retailers/investments/finance) • The economy!
Shopping Centre Valuation They all play a part, but the fundamental driver of value for retail real estate is...... - the underlying sales productivity of the asset!!
Financial Terminology 1. Capitalisation Rates 2. Measuring Return 3. Amortisation 4. Depreciation 5. Discounted Cash Flow (DCF)
1. Capitalisation Rates
The Official ICSC Definition:
“The rate used to convert income into value”
ICSC’s Guide to Shopping Center Terms
So what does that mean?
“Capitalization is the process by which anticipated future income is converted into a lump
sum present Value.”
The Dictionary of Real Estate Terms
Why is it relevant? It is the basis of valuation!
Value = Income x Cap Rate eg €100,000pa at 6.0% is (100,000 x 16.66 = €1,666,000)1. Capitalisation Rates Factors affecting the Capitalisation Rate • Perceived Risk • Market Transactions • The Economy • Weight of Money
2. Measuring Return
Return on Investment (ROI):
“A performance measure used to evaluate the efficiency of an investment or to compare the
efficiency of a number of different investments. To calculate ROI, the benefit (return) of an
investment is divided by the cost of the investment; the result is expressed as a percentage or
a ratio.”
ROI = Return / Cost
e.g. €100,000 pa x 100% = 6.0% ROI
€1,666,000 paMeasures of Return Let’s look at a few basic measures of return: • Cash on Cash Return • Total Return • Internal Rate of Return • Developers Profit (see later) This is not a complete list, there are other measures.
Cash on Cash Return • The cash on cash return on investment is the Net Operating Income divided by the initial cash investment. The formula looks like this: Cash on cash ROI = NOI / Initial Cash Investment • The Net Operating Income (NOI) is simply the total income from the property minus the total annual expenses (in any year).
Total Return • The Total Return on Investment (TROI) provides a better and more complete measure of a property’s financial performance. This is because you can include other factors such as interest repayment and depreciation along with appreciation gained over time. Total ROI = (NOI (adjusted for interest and depreciation, as required) + Net Sales Proceeds (or Net Valuation) – Initial Cash Investment) / Initial Cash Investment • This is a key measure for the performance of Property Companies and Funds – and can be greatly affected by the state of the market. (Everyone wants to be in the top quartile!)
The Best Measure of Return? • Internal Rate of Return (IRR) Measures the percentage return on each € for the period of time it is invested in a given asset. The IRR of an investment is the discount rate at which the sum of the PV of future cash flows equals the initial capital investment. • Often used as the ‘hurdle rate’ whether to invest or not invest in a particular project.
IRR Proof
Take an initial investment of €10,000 at a 10% pa interest rate, which returns in income, €0,
€1000, €5000, and €7931 in subsequent years; the IRR is 10%.
YR € Invested Interest Invested & Cash Flow € € Invested
Incurred Interest
1 €10,000 €1,000 €11,000 €0 €11,000
2 €11,000 €1,100 €12,100 €1,000 €11,100
3 €11,100 €1,100 €12,210 €5,000 €7,210
4 €7,210 €721 €7,931 €7,931 €0
Total €3,931 €13,931T-Bar Method
CCIMTM T-Bar Method
N 10% Discount / Interest Rate
0 €(10,000) Initial Investment
1 €1,000 Interest Earned
€-
2 €1,100 Interest Earned
€1,000 Cash Flow (Out)
3 €1,110 Interest Earned
€5,000 Cash Flow (Out)
4 €721 Interest Earned
€7,931 Cash Flow (Out)
10% Internal Rate of Return3. Amortisation
“The gradual paying off of a debt by periodic instalment”
The Dictionary of Real Estate Terms
This is an actual cash transaction between a borrower and lender!
This is the basis of a repayment mortgage.A “Basic” Example
A €1,000 5-year self-amortising loan with annual payments and 10% Interest
Year Payment Interest on Principal Unpaid
Required Unpaid Repaid Balance
Balance
1 €263.80 €100 €163.80 €836.20
2 €263.80 €83.62 €180.18 €656.02
3 €263.80 €65.60 €198.20 €457.82
4 €263.80 €45.78 €218.02 €239.80
5 €263.80 €23.98 €239.80 €0.00
Total €1,319.00 €318.984. Depreciation
“The process of estimating and recording lost usefulness”
ICSC’s Guide to Shopping Center Terms
“Allocating the cost of an asset over its useful life”
Dictionary of Real Estate Terms
This is a “non-cash” accounting transaction that does not affect NOI5. Discounted Cash Flow (DCF)
• The process of Discounting a Future Cash Flow back to a Present Value (PV)
• To Calculate:
• Future Value, Net Cash Flow
• Discount Rate (Interest Rate)Valuation • Valuation is a tool used to evaluate the value of an asset at a given date using various combinations of variables. • In real estate those variables are often: Capitalisation Rate, Discount Rate (DCF), NOI/ NOI forecasts and ERV of unlet units.
Sensitivity Analysis
• Different scenarios are modelled to judge the sensitivity of the project to changes in the key
variables (eg rent, capitalisation rate, costs).
• Conservative, Most Likely, Best Case & Worst Case
• The goal is Accuracy not Fantasy
• The process is dynamic and needs constant reviewTenant Risk Factors What are some Risk Factors? • Credit Issues: Fiscal strength – can the Tenant fulfil all lease obligations? • Operations: Is it a proven concept? • Ownership: What about assignment, sub-letting, sale of business. • Rents: Ability to pay the rent/sustainability of the rent. • Incentives: Did the landlord make a fit-out contribution?
Tools to Address Risk Factors
• Credit: Rent deposits, guarantees, security deposit, letter of credit
• Operational: Shorter base terms, Options (Mutual), performance clauses
• Change of Ownership: What about unilateral right of approval, pre-set credit
requirements, % rent conversion clause.
• Rents: Varying rental levels by size, rent reductions, % Rents
• Incentives: Stage payments, repayment penaltiesReturn Vs Valuation
For those who may be less comfortable with these concepts, here is a summary:
• Cash on Cash, Total Return and Internal Rate of Return are measures of Return:
• Are measures of an Asset’s PERFORMANCE over a PERIOD OF TIME
• Future Value, Present Value and Net Present Value are measures of Value:
• Are measures of an Asset’s WORTH on a given DATESection II: Leases
The Value of a LeaseValue of a Lease • Impact of a single lease on financial performance of a shopping centre • Sensitivity analysis relative to assumed percentage rent • Financial effects of tenant allowances (TA), % turnover rents and service charge caps / exclusions • Premiums for tenant mix needs
Impact of a Single Lease on the Financial
Performance of a Shopping Centre
• Discounted Net Cash Flow Analysis
• Net Present Value over the term
• Does not tell us the impact upon value
• Comparative Process versus:
• Pro-forma budget
• Look at impact on valueMethodology
Base Rent T-Bars
Sq m:size 200 sqm TA (psqm) € 300.00 Sq m:size 200 sqm TA (psqm) € 300.00
Rent: 5 years at € 200 psqm Rent: € 160 sqm to € 240 psqm in steps
Proforma Budget Proposed Terms
n € € € n € € €
0 € 60,000 0 € 60,000
1 € 40,000 1 € 32,000
2 € 40,000 2 € 36,000
3 € 40,000 3 € 40,000
4 € 40,000 4 € 44,000
5 € 40,000 5 € 48,000
Total € 200,000 Total € 200,000
Int = 10.00% Int = 10.00%
NPV = € 83,301 NPV = € 80,684
IRR = 60.38% IRR = 54.30%Impact of % Turnover Rents
“The prospect of % Turnover Rent has no impact on value only actual % [Turnover] Rent
received...”
An Anonymous Auditor
• Should % turnover rent be in our forecasts?
• Pro: Adds value if accurately forecast
• Con: Difficult to forecast turnover & growth
• How to build % Turnover Rent into our forecast?
• Need estimated sales (corroborate with evidence from elsewhere).
• Sales growth rate estimates (based on time series data).
• How do you deal with a turnover only rent?Financial Effects of Tenant Allowances, % Turnover
Rents Top-ups & Service Charge Caps / Exclusions
• Simply put, cash out for tenants allowances is likely to decrease short term value
• In ‘Zero Year’ every € out reduces value but payment may be necessary.
• % turnover rent top-ups are less risky for the landlord.
• % turnover rent may or may not actually accrue!
• Service charge caps / exclusions
• Every € not recovered from tenant is value lost (multiplier effect of cap rate)Issues with Key Tenant Deals
• Higher tenant allowances (psqm)
• Lower base rent; lower % turnover rent.
• Hard cost control measures:
• Caps on extras/service charges
• Token marketing contribution; possibly none
• Co-tenancy requirements; anchor & key retailers
All of these have an impact on value!The Economics of Buyouts, Relocations
and Take-backs
• Buyout: A party seeks to ‘buy their way out’ of a current lease obligation. May be initiated
by either the landlord or tenant (usually the landlord)
• Relocation: A landlord seeks to move an existing tenant from one location to another prior
to expiration of term
• Take-backs: A landlord agrees to “take back” a portion of an existing tenant space. May
be initiated by either landlord or tenantConcerns of the Tenant
• To be Treated Fairly
• To know who is paying whom for:
• Tenant Improvements / Landlord Work
• Downtime, Moving & Storage
• Releasing, Legal Work, Commissions
• Occupancy cost ratio; the “all-in” cost
• All pertinent points need to be addressed in a binding legal documentTenant Buyouts
• Tenant Buyouts
• Cost is always the key issue
• Difference if tenant is doing well versus tenant doing badly
• Tenant relationship will be crucial – opportunities elsewhere in portfolioRelocation
• Relocation
• Leverage depends upon lease terms
• Cost of moving tenant A must be part of “zero year” expense to get tenant B
• Is landlord building new store for A? Capital cost (€) ?
• Unique expenses: moving & storage
• Who pays for what is a function of lease terms and how much landlord needs the spaceTake-backs
• Take-backs:
• Can be landlord needs the space to get tenant B, for an expansion, etc...
• Can be tenant wants to downsize.
• Unique expenses: re-demise of space
• Who pays for what often depends upon who initiated the discussionSection III: Appraisals & Leasing
Development Appraisals
&
the Role of LeasingWhat is a Development Appraisal?
• ‘Best guess’ of the outcome of an activity – but an informed guess!
• Based on market information, cost estimates, pre-lets/ERVs and perceived risks
Income x Capitalisation Rate = Value
Less (Development Costs) = Costs
= ProfitValue
Projected Rental Income
Less Non-Recoverable Outgoings
= Net Rental Income (€pa)
X Cap Rate
= Capital Value (€)
plus any Capital Receipts
= Total Capital Value (€)Capitalisation Rate • Yield (Pricing) • Based on transactions (Judgement) • Reflects perception of risk / value • Consider ‘long term yield’
Development Costs
• Land Costs
• Planning / Survey / Preparation Costs
• Construction Related Costs
• Construction Contract
• Fees & Expenses
• Leasing / Marketing Costs
• Financing CostsProfit
• Measures of Profit
• Capital Profit (Developers Profit)
• Percentage Profit
• IRR
• Development Yield‘Bottom Line’ • Combination of facts / estimates / ‘best guess’ and judgement • Does the answer look right?! • Sensitivity Analysis to assess risk • Know what is critical to the ‘bottom line’
The Role of Leasing in the Development
Appraisal Process
• The Leasing Team should be involved early & throughout the development process
• Will separate fantasy from reality (but be careful of the easy option)
• Constantly ask, “what if?”
• Get Leasing’s input on the rental projections:
• Does the appraisal drive Leasing Strategy or does Leasing Strategy drive the
appraisal?
• Be farsighted:
• See the opportunity
• Make leasing decisions accordingly
• Stick to the plan but constantly re-evaluateIncremental Income / Commercialisation
• The potential has never been greater:
• Utilities: Resale, Production, Controlled Environment
• Kiosks & RMU’s
• Sponsorships & Strategic Alliances
• Vendor Leasebacks
• Antennas, Storage, Others...?
• If you create income, you create valueRe - cap • Value is the right to receive income (current and future). • Value is driven by the quantum & perceived quality of the income. • Cashflow is the receipt of income, not just the right to receive income. • Cost is cost – not VALUE! • Income is generated by leasing activity! • Good leasing in shopping centres is about the creation of high quality income - in the context of the ‘right’ tenant mix (adjacencies matter).
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