Second Period

Alec J. Pacella

Last month, we went back to school and discussed some useful financial calculations incorporated within Microsoft Excel formulas. This month, we are going to continue the school day and, along the way, weave in the theme of renovation being covered throughout this issue of Properties. Both fit perfectly for me; I teach a course at the University of Denver and just finished writing a question for the midterm exam, as follows:

An investor is contemplating installing an automated ticketing system in their parking garage. If continued to be operated with a manned attendant, the garage is expected to produce $100,000 next year and anticipated to grow $2,500 annually in subsequent years as a result of planned increases in the parking rate. The reversion value at the end of five years is expected to be $1,200,000.

The automated system is anticipated to cost $250,000 but income will increase to $125,000 in the first year, as a result of no longer needing an attendant and thus realizing lower expenses. Annual increases are projected to remain the same, $2,500 per year, and the reversion value at the end of five years is expected to be $1,500,000, based on the higher income level.

Using a discount rate of 10%, which alternative should the investor choose?

This is a classic renovation analysis – should the investor keep on keeping on, as-is, and not incur the upfront expense which will result in lower annual cash flows and lower reversion. Or should the renovation be completed, which will result in a significant upfront expense but higher annual cash flow and higher reversion. Who’s ready to go back to school?

We are going to use a three-step approach to solve this problem, dragging in our old friend the CCIM T-bar to help. The first step is to model the cash flows associated with doing nothing. The present value (PV) component would be zero, as no initial money is being spent. The payment (PMT) component would start at $100,000 in the first year and increase $2,500 each subsequent year of the holding period. And the future value (FV) would be $1,200,000. Figure 1 represents the T-bar for these cash flows. The second step is to model the cash flows associated with making the renovation. The PV component would be ($250,000), reflecting the cost of installing the automation system. The PMT component would start at $125,000 in the first year and increase $2,500 each subsequent year of the holding period.

And the FV would be $1,500,000, which is the anticipated value of the garage at the end of the holding period. Figure 2 represents the T-bar for these cash flows.

The third step is to calculate the net present value (NPV) of each T-bar, using the 10% target rate. You’ll need a financial calculator to perform this function (unless you were paying attention to last month’s column). Once completed, you will discover the “as-is” scenario has a NPV of $1,141,339 while the “renovate” scenario has a NPV of $1,172,385. At this point, the decision is simple; based on the assumptions provided, it is worth it to pursue the renovation.

We are not done yet – the university students also have a related bonus question, so why shouldn’t you? We can take this analysis one step further by using a concept known as “IRR of the differential.” Calculating it is straightforward and is the IRR of the difference between the renovated series of cash flows less the as-is series of cash flows. As you can see in Figure 3, the PV of ($250,000) is found by subtracting the PV of the renovated T-bar (Figure 2) minus the as-is T-bar (Figure 1). The PMT in year one in Figure 3 is found by subtracting the year one PMT of the renovated T-bar minus the as-is T-bar. Lather, rinse, repeat for the cash flows in years two through five and the reversions. Plug these into a financial calculator (unless, again, you were paying attention to last month’s column) and we come up with an IRR of the differential of 13.08%.

But the bonus question on this insidious mid-term exam doesn’t ask for the IRR of the differential. C’mon, these are graduate students! It asks what this concept means – because to me, this is the most important number on the board. And I’ll save you the grief. From a purely mathematical perspective, 13.08% is the exact rate at which the NPV of the as-is scenario and the NPV of the renovate $1,500,000, which is the anticipated value of the garage at the end of the holding period. Figure 2 represents the T-bar for these cash flows.

scenario are equal. You are welcome to try it but, trust me, you will come up with an NPV of $1,015,465-ish for either scenario if you use a discount rate of 13.08%. But mathematics doesn’t pay the bills, understanding the practical application is what’s important. The 13.08% discount rate is considered the point of indifference or cross-over point. At that exact rate, there is no difference between the as-is and the renovate scenario. They are equivalent decisions. But at any rate less than 13.08%, the decision swings to the renovate scenario and the lower the rate, the more pronounced the renovate decision becomes. Conversely, at any discount rate greater than 13.08%, the decision swings to the as-is scenario and the higher the rate, the more pronounced the as-is decision becomes.

Gang, our business is all about under- standing and quantifying risk, and the concept of IRR of the differential is a hallmark example. The break-even risk versus return for this proposed renovation is 13.08%. If you believe the risk associated with this proposed renovation demands a return greater than this point of indifference, you are better off to not spend the money and keep on keeping on. But if you perceive a low degree of risk associated with the renovation, and are good earning a return at some rate less than this break-even rate, you are better off to spend the money. And if you liked second period, just wait to see what we have in store for third period!

by Alec Pacella for Properties Magazine, November 2022

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Stabilizing employment rates good news for commercial real estate?

Employment numbers are up according to a recent news release from the Bureau of Labor Statistics (BLS). In their analysis, BLS announced that the unemployment rate had dropped to 3.5%, with 528,000 new jobs added over the course of the month.

These figures mean that, for the first time, unemployment measures have returned to their February 2020, pre-pandemic levels. BLS also noted that the gains were led by the leisure and hospitality industry.

Strong recovery in hospitality

Reporting on the figures, Real Deal pointed out that hiring at hotels, restaurants and bars was responsible for a large percentage of the 528 000 jobs created in July. Together with construction and healthcare, these sectors accounted for 43% of the overall job gains posted. Quoted in the article, Mortgage Bankers Association Chief Economist, Mike Fratantoni added: “This is not a picture of an economy in recession.”

Mixed results for other sectors

Though the construction industry was a strong performer, with an additional 32,000 employees hired, it’s worth noting that this figure would likely have been much higher if there were more workers available. The sector is still deep in the grips of a labor shortage that has put pressure on projects across the US, and led to a slow-down in new developments.

Meanwhile, the office sector also faced constraints, with the percentage of workers staying remote due to the pandemic remaining at 7.1%, exactly the same as in June.  As one of our NAI Offices recently reported, the future of offices has generated some strong dissenting opinions among those in the know, and exactly how the situation is going to pan out remains unclear.

Shifting sands

Though some of these figures certainly seem to indicate an upturn, it’s worth bearing in mind that there are still many indicators of a possible recession. As recently as a month before these figures were posted, there were announcements of cutbacks in the residential sector, and some experts were predicting a drop-off in employment rates.

For other experts, the picture is more nuanced. Lawrence Yun, Chief Economist at the National Association of Realtors (NAR) puts it like this:

“It would be one of the most unusual recessions — if it [the economy] does technically reach it — in that there are worker shortages. Some industries will lay off workers, but there could still be more job openings than the number unemployed throughout the recession.”

Long-term prospects

How the current job situation plays out, and how this affects Commercial Real Estate professionals, remains to be seen. We do know that the employment numbers we are seeing now exceed predictions that were made just a few months ago. If the positive trend in hospitality and construction continues, there could be a lot of new projects, and prospects, on the cards.

SOCIAL: How have hiring trends impacted commercial rentals and development projects in your area?

Multifamily debt data reaches new record at end 2021

Recent data from the Mortgage Bankers Association’s (MBA) latest Commercial/Multifamily Mortgage Debt Outstanding report shows that the level of outstanding debt on commercial/multifamily mortgages – during the final three months of 2021 – was $287 billion (7.4 percent) higher than the level seen at the end of 2020.

Report frequency

The MBA releases this data on a quarterly basis and this provides a snapshot of debt and market health at the time. Released at the end of March 2022, this report focuses on the last quarter of 2021 – and compares figures to the preceding quarter and the corresponding quarter of the previous year.

For the purposes of this research, the four major investor groups considered include: “bank and thrift; commercial mortgage-backed securities (CMBS), collateralized debt obligation (CDO) and other asset-backed securities (ABS) issues; federal agency and government-sponsored enterprise (GSE) portfolios and mortgage-backed securities (MBS); and life insurance companies”.

Their data shows that “total mortgage debt outstanding rose by 2.9 percent ($116.0 billion) in fourth-quarter 2021” and specifically that “multifamily mortgage debt grew by $42.1 billion (2.4 percent) to $1.81 trillion during the fourth quarter, and by $121.9 billion (7.2 percent) for the entire year”.

Understanding the data

MBA’s Vice President of Commercial Real Estate Research Jamie Woodwell commented: “Strong borrowing and lending backed by commercial and multifamily properties drove the level of mortgage debt outstanding to a new high at the end of 2021.”

This was evident in every major capital source, he said, adding: “The 7.4 percent annual increase in outstanding debt compares to a 19.5 percent increase in underlying property values.”  

As Yield Pro points out in their analysis, government-sponsored enterprises (GSE) “continued to have the largest share of multifamily mortgages outstanding”.

In related material, MBA confirmed that commercial and multifamily mortgage delinquencies in the US also declined in Q4 2021, characterizing the rates as “down or flat for every major investor group”.

Work smarter not harder: The impact of blockchain on CRE

So far in this blog series, we’ve looked at some of the most cutting-edge emerging technologies: The Internet of Things (IoT), robotics, and virtual reality. We’ve discussed the potential these developments have to revolutionize the way we do business and work in the real estate space. 

While each of those has its applications, none hold quite the same promise for changing the fundamental aspects of how we make, and document, commercial real estate (CRE) deals as blockchain. In this fourth entry in the emerging tech series, we have a look at the implications of this pivotal technology.

Blockchain basics

Nowadays, blockchain is a term everyone’s hearing with increasing regularity. To start, it’s worth having a brief recap of exactly what the tech is. At its simplest, a blockchain is a ledger – a record of information. Not all that different from the databases you’re already using to record details of properties, clients, or transactions. 

The feature that makes blockchain unique is the way that information is recorded. Each “block” can hold a certain amount of data. Once a block is full, a new block is started and the previous block forms part of an immutable chain – essentially a timeline extending outwards from the first block to the current one. 

Information on the blockchain is public and distributed across a network of computer systems – meaning that it’s very, very difficult for one person to hack or alter the information stored in the chain. 

Streamlined data

The opportunity blockchain presents for the CRE space, is the ability to streamline a lot of time-consuming tasks. Imagine having all of the paperwork for a given property digitized, accessible to everyone involved in the deal, and confirmed as accurate by multiple parties. 

Steve Weikal, MIT’s Head of Industry Relations at the Center for Real Estate, describes it like this:

“There are two areas where I think the blockchain is. There’s going to be the intersection with legal tech, so that’s land registry and recording and ownership, and all of that paperwork that exists in the system… the other is the intersection with fintech.”

Of course, an issue that comes up here is how this system can be used with potentially sensitive information – client details that shouldn’t be a matter of public record. For business networks, private blockchains can be set up to only allow access to specified parties. In this case, the identity of participants is verified in the network as well, unlike public blockchain where users can remain anonymous. Private blockchains function more like a traditional database in this sense, trading off some of the immutability of their data for privileged access. 

Sealing the smart deal

Maybe the most promising application of blockchain for CRE deals is being able to deploy “Smart Contracts” for things like tenancy agreements. Smart contracts hard code the details of an agreement on the blockchain, and are uniquely suited to real estate deals, because they can handle conditional clauses. 

As an example, startups like UK-based Midasium are already providing a prototype platform that replaces traditional landlord-tenant agreements. Using smart tenancy contracts, clauses of the agreement are automatically enforced when certain conditions are met. This can include paying rent, returning a security deposit, and directly deducting maintenance costs from the rental amount paid across to the landlord. 

It’s a system designed for transparency and rapid settlement, and the concept is gaining traction in other parts of the world. An added bonus of using smart contracts for tenancy is the possibility of building up a database of real-time data for rental prices and trends in the rental market.

A growing sector

Overall, enterprise reliance on blockchain is set for rapid acceleration. Forbes, quoting an International Data Corporation (IDC) report notes that:

“Investment in blockchain technology by businesses is forecast to reach almost $16 billion by 2023. By comparison, spending was said to be around $2.7 billion in 2019, and we will see this acceleration ramping up over the coming year.”

Blockchain adoption in CRE, however, is still in the early stages. The tech still needs to overcome a few growing pains – in terms of privacy concerns, operational complexity, and a lack of standardized processes – before we’ll necessarily see it forming the backbone of CRE transactions.

That said, it’s a space well worth keeping an eye on. There’s been growing interest, for example, in CRE tokenization –  splitting the value of a given asset into separately buyable blockchain-based tokens. What this means in practice is that instead of looking for one buyer for an expensive asset the value gets subdivided and opened to a much broader market. Which in turn may actually boost the value of the underlying asset.

There’s a lot of potential and little doubt that blockchain will make its way into CRE one way or another. But, like many things in the cryptocurrency and blockchain space, the real challenge will be separating the wheat from the chaff, the fact from the hype, and identifying functional applications of the tech rather than purely fanciful ones. 

Adaptive reuse is CRE’s sustainable darling

Your new build might pack the best-of-breed technologies and energy solutions – but did you know that it would take roughly 65 years for an energy-efficient new development (with as much as 40% recycled input materials) to save or recover the equivalent energy lost through demolishing? This is according to the United States Environmental Protection Agency

Viewed through that lens, our approach to green buildings and energy efficiency may need a serious rethink. There is another approach to take, of course, and that is adaptive reuse. A strategy that although not strictly new, is quickly becoming a conversation starter and “darling” of sustainable commercial real estate (CRE) circles.

On-site savings

Adaptive reuse is not just about redesigning or redeveloping, it can be viewed as breathing new life into buildings, updating their use case as much as their construction, and a smart green step to take. They can also be beautiful, and  simply “cool” – as this article in Architectural Digest details in its review on Cool Is Everywhere: New and Adaptive Design Across America, by photographer Michel Arnaud.

Starting green

With adaptive reuse, developers and architects are starting on a green foot – using an existing building shell, rather than having to construct right from scratch. That means less material use, often less waste, and can reduce the number of shipments of materials needed, which contributes significantly to a building’s carbon footprint.

Use cases

Adaptive reuse can also contribute to a neighborhood – in feel and in service provision – and is a popular way of making space for more offices and workplaces in an area with a declining manufacturing industry, or unlocking dining and entertainment offerings as the demographics in a neighborhood change. Urban Stack, for example, is the oldest standing building in Chattanooga. It was previously the Southern Railway Baggage Depot.

The old drill hall in Guelph, Ontario, Canada, is another such example. The local press describes it as “a building without a purpose – at least not a contemporary one”, in this report on the City’s plans to repurpose the building which has stood empty for over a decade.

And on campuses, like that of Boston University, adaptive reuse enables a strategy of densification and reuse, rather than trying to expand in this already bustling and developed city.

Inspiration here

Seeking inspiration? This list of 20 creative adaptive reuse projects from around the world is a great showcase of the possibilities this tactic can unlock.