ESTIMATING RETURN ON TOTAL COSTS

Transcription

1 ESTIMATING RETURN ON TOTAL COSTS S P E C I A L S K I L L S

2 ESTIMATING RETURN ON TOTAL COSTS (RTC) The Overall Return on Total Costs (R TC ) (sometimes called Going-in Cap Rate) is defined as the Net Operating Income (I O ) divided by the sum of the Hard Costs (HC), Soft Costs SC) and Land Costs (LC): R TC = I O / (HC + SC + LC) The expected Overall Market Capitalization Rate (sometimes called the Disposition Cap Rate) is when the building is built, leased, and ready to be sold to the Building Operator. The Building Developer compares the Going In Cap Rate to the Disposition Cap Rate. Hopefully, the Building Developer will be able to sell the completed project at a higher price than it the cost to build it: Overall Market Value > Total Costs to Construct For this to occur the Return on Total Costs (R TC ) must be greater than the Overall Market Capitalization Rate (R 0 ) because of the inverse relationship between Cap Rates and Value: Return on Total Costs (R TC ) Overall Capitalization Rate (R O ) 2

3 ESTIMATING RETURN ON TOTAL COSTS (RTC): THE INTERNATIONAL PLAZA EXAMPLE Assume: Net Operating Income (I O ) = 4,554,680 Hard Costs (HC) = 36,810,953 Soft Costs (SC) = 13,780,816 Land Costs (LC) = 4,940,000 Calculations: R TC = I 0 / (HC + SC + LC) R TC = 4,554,680 / (36,810, ,780, ,940,000) =.0813 or 8.13% 3

4 ESTIMATING THE REQUIRED SPREAD SPECIAL SKILLS 4

5 ESTIMATING THE REQUIRED SPREAD The Spread or difference between the Market Overall Cap Rate and the Return on Total Cost indicates the profitability of the proposed Building Development. Building Developers usually use a required spread to evaluate projects. The riskier the project the higher the required spread. Building Developers subtract the Required Spread from the Return on Total Costs to determine the Required Disposition Cap Rate (RDCR) Required Disposition Cap Rate reflects the required spread and is compared to the Market Overall Capitalization Rate to see if the project is feasible, i.e. meets the required spread. 5

6 Assume: ESTIMATING THE REQUIRED SPREAD: INTERNATIONAL PLAZA EXAMPLE Required Spread is.0125 R TC is.0813 Calculate Required Disposition Cap Rate (RDCR): RDCR = R TC - Required Spread RDCR = =

7 ESTIMATING THE NET DISPOSITION CAP RATE: INTERNATIONAL PLAZA EXAMPLE Assume: Market Overall Capitalization Rate (R 0 ).0675 RDCR.0688 Calculate the Net Disposition Cap Rate (NDCR): NDCR = RDCR - R0 NDCR = =.0013 If Positive, GO If Negative, DON T GO When the RDCR.0688 is compared to the Market Overall Capitalization Rate.0675, the net cap rate is positive so the project would be considered feasible at this time. 7

8 ESTIMATING THE BUILDING DEVELOPER S JUSTIFIED LAND PRICE SPECIAL SKILLS 8

9 ESTIMATING THE BUILDING DEVELOPER S JUSTIFIED LAND PRICE The determination of the building Developer s Justified Land Price is a four-step process: 1. Step One: Estimate the Required Rate of Return on Total Costs 2. Step Two: Estimate the Building Income 3. Step Three: Estimate the Residual Land Income 4. Step Four: Divide the Residual Land Income by the Require Rate of Return on Total Costs to determine the Justified Land Price The Justified Land Price is the most that a Building Developer can pay for a parcel of land and still achieve his required Rate of Return on Total Costs 9

10 ESTIMATING THE BUILDING DEVELOPER S JUSTIFIED LAND PRICE: INTERNATIONAL PLAZA EXAMPLE Steps One and Two: Estimate the Required Building Income Overall Market Cap Rate Developer s Required Spread.0125 = Required Return on Total Costs.0800 X Total Hard & Soft Costs 50,591,769 = Required Building Income 4,047,342 10

11 ESTIMATING THE BUILDING DEVELOPER S JUSTIFIED LAND PRICE: INTERNATIONAL PLAZA EXAMPLE Step Three and Four: Estimate Justified Land Price Net Operating Income 4,554,680 - Required Building Income (4,047,342) = Residual Land Income 507,338 Required Return on Total Costs.08 = Justified Land Price 6,341,731 The Building Developer can pay up to the Justified Land Price and still achieve his Required Return. 11

12 ESTIMATING FEASIBILITY SPECIAL SKILLS 12

13 ESTIMATING FEASIBILITY 1. Know Thy Market I. Accurate Market Forecasts? a) Rental Rates b) Operating Expenses c) Vacancy Rates d) Capitalization Rates e) Absorption Rates 13

14 ESTIMATING FEASIBILITY 1. Know Thy Market 2. Know Thy Costs I. Accurate Cost Estimates? a) Land Acquisition Cost b) Hard Costs c) Soft Costs 14

15 ESTIMATING FEASIBILITY 1. Know Thy Market 2. Know Thy Cost 3. Know Thy Self I. Can I form a development team that can build the improvements and lease/sell the completed project on time and on budget and in process create value. 15

16 ESTIMATING FEASIBILITY 1. Know Thy Market 2. Know Thy Cost 3. Know Thy Self 4. Risk Analysis I. Most Likely Scenario II. Optimistic Scenario III. Pessimistic Scenario 16