Construction Funding: The Process of Real Estate Development, Appraisal, and Finance, Fourth Edition
معرفی کتاب «Construction Funding: The Process of Real Estate Development, Appraisal, and Finance, Fourth Edition» نوشتهٔ Nathan S. Collier, Courtland A. Collier, Don A. Halperin(auth.)، منتشرشده توسط نشر John Wiley & Sons در سال 2007. این کتاب در فرمت pdf، زبان انگلیسی ارائه شده است.
CHAPTER 1
Characteristics of Real Estate
REAL ESTATE'S TRADITIONAL, CYCLICAL NATURE
Real estate has traditionally been a cyclical business, and that characteristic has fundamentally shaped the industry. The basic real estate cycle, illustrated in Figure 1-1, proceeds as follows: economic expansion, robust construction, rising occupancy and increasing rents, good times, easy money, abundant financing at good rates, and boom times, resulting in overbuilding, oversupply, and a glut that may take years to absorb. A real estate recession results when new-construction starts come to a virtual halt but, because of long planning and construction time frames, completions continue to come on line. Occupancy as well as rents fall, particularly after adjusting for inflation, specials, incentives, and discounts. Eventually, as the overcapacity is worked off, occupancy and rents begin to rise again, and the final recovery phase begins. Boom followed by bust has long been a hallowed real estate tradition.
Many argue that increasing sophistication in the industry, more institutional ownership with accompanying oversight, increased accounting transparency, and greater financial discipline imposed by the involvement of Wall Street capital markets will dampen, if not eliminate, real estate cycles. Computerization and the Internet are revolutionizing the flow of information in the industry, and only time will tell the full impact of all these changes.
In addition to the basic real estate cycle, shown in Figure 1-1, we will look at three other cycle types that affect the real estate industry:
1. United States national economic cycle
2. Capital market cycles, including liquidity and interest-rate cycles
3. Property market (or occupancy) cycles
Within capital market cycles, we will look at both liquidity and interest-rate cycles. Within property market (or occupancy) cycles, we will look at how various real estate sectors move through the real estate cycle at different times and how, even within one real estate sector, different parts of the country will be in different phases of the real estate cycle at the same time. We will then look briefly at how the rental-rate growth cycle impacts occupancy.
UNITED STATES NATIONAL ECONOMIC CYCLE
It is important to remember that there are many types of business cycles. The most widely followed is the U.S. national economic cycle, traditionally marked by the quarterly reporting of the expansion (or contraction) of the GNP (gross national product), with a recession defined as two consecutive quarterly contractions of the GNP. There are also global economic cycles and regional economic cycles, all of which, through imports and exports, affect investor confidence and America's national economic cycle. Obviously, new projects are more likely to be undertaken during an upswing and at the top of an economic cycle than on a downswing.
Figure 1-2 depicts multifamily housing starts from 1988 to 2005. The impact of the real estate recession of the early 1990s is clearly shown in the multiyear decline in housing starts beginning in 1990 and continuing until 1994. The recovery phase occurs in 1995, and for the next ten years multifamily housing starts oscillate roughly between 340,000 to 350,000 per year.
The excessiveness of the robust 1988 and 1989 multifamily housing starts of 407,000 and 373,000, respectively, is highlighted by the fact that almost twenty years later multifamily housing starts are still significantly lower (345,000 in 2004 and 353,000 in 2005) in spite of a population growth of roughly 50 million people from 1990 to 2005.
CAPITAL CYCLES: LIQUIDITY AND INTEREST RATES
Compared with other sectors, real estate is a capital-intensive sector of the economy. Real estate requires a significantly greater investment of capital for every dollar of revenue generated than may be required for a less capital-intensive sector such as the service sector, hence, real estate's sensitivity to the capital markets. Capital cycles are affected by both liquidity and interest-rate cycles. Liquidity cycles reflect fluctuations in the availability of capital; whereas interest-rate cycles reflect fluctuations in the cost of capital. Although related, these concepts are very different. It is quite possible for interest rates to be favorable (when the cost of capital is affordable), but for one reason or another capital is not available—its availability is constrained. The opposite also is often true: When interest rates are high, money is often very available and the markets are liquid; but the cost of the money is so high that few projects will pencil out because the cost of the capital is higher than the intrinsic return of the project. Consequently, the use of debt capital would represent negative leverage.
A classic example of a liquidity crisis occurred in the conduit lending market in the fall of 1999 when Nomura (a very large Japanese bank with a major American real estate lending portfolio) abruptly shut down its real estate lending operations, shocking the commercial mortgage backed securities (CMBS)/conduit lending market (see Chapter 8) and virtually shutting the conduit lending door for many months.
At other times in the past, real estate has simply been out of favor as a sector of the economy, either because analysts or economists did not foresee favorable prospects or because a recent real estate downturn had left painful memories of loan losses in the minds of lenders.
Interest rates move in cycles that, although related to and with impact on national economic cycles, move somewhat independently, at times lagging and at times leading the national economic cycle. The Federal Reserve (the Fed) will tend to attempt to move interest rates higher if it thinks the economy is overheating and lower interest rates if it believes that the economy is in need of stimulation. However, the Federal Reserve can directly change only short-term interest rates. The Fed affects short-term rates by lowering the discount rate (the interest rate at which the Federal Reserve lends money to banks), but longer-term rates are set by investor expectations about inflation and the necessary return on capital.
Most ten-year term, commercial real estate loans are written at a spread (i.e., the additional amount of interest charged over a given index) over the matching 10-year U.S. Treasury note rate. Spreads are quoted in basis points or 100ths of a percentage point. Spreads over the Treasury note rate will typically be 75 to 250 basis points, or .75% to 2.5%. For instance, if the Treasury rate is 5.5%, the commercial real estate rate may vary from 6.25% to 8.0% (5.5% + 0.75% = 6.25% to 5.5% + 2.5% = 8%). The spread varies according to market conditions, the type and grade of real estate, and the amount of leverage (that is, the ratio of loan to value).
Loans to the U.S. government are generally defined as risk free, shorthand for noting that there is no risk of default (an inflation risk remains, though). Because default risk is the probability that the principal lent will not be repaid, defining loans to the U.S. government as risk free is either a vote of faith in the strength of the U.S. economy on which the taxes are levied to raise the money used to repay the loans or a tacit recognition that, if the need arose, one of the powers of a national sovereign is the ability to order that money be printed to pay its bills. Of course, printing money to pay national debts is only a temporary solution. When the supply of any good, including money, exceeds demand, the price drops. Inflation is what happens when the "price" (or value) of money drops. History has shown that rampant inflation is the inevitable result of expanding the money supply faster than the growth rate of the underlying economy. The Confederacy found this out during the Civil War in the 1860s, as did Germany during the Great Depression in the 1930s. The bitter joke in Germany at the time was that you used to be able to go shopping with your money in your purse and take your purchases home in your cart, but the hyperinflation was so bad that you had to use your cart to carry your money to market and you could take home your resulting purchases in your purse.
Because it is considered free of default risk but not free of inflation risk, the rate at which the marketplace is willing to lend money to the U.S. Treasury is considered the true cost of money plus a premium for anticipated inflation over the period of the loan. Economists have long debated the true cost of money (the rate the market would demand in the absence of risk or inflation), but it is generally considered to be about 2% to 3%.
The spread over the Treasury rate represents the risk premium the marketplace puts on commercial real estate loans. Fluctuations in interest rates charged to real estate borrowers are a result of variations in both the amount of spread over the 10-year Treasury rate demanded by the marketplace and variations in the underlying 10-year Treasury rate. This topic is covered in greater detail in Chapter 8 in relation to sources of financing.
PROPERTY MARKET CYCLES
Property market cycles, sometimes called occupancy cycles, refer to the balance of demand and supply of real estate itself. Yet, absent NASA making great strides in interplanetary exploration, because the supply of real estate is fixed, property market cycles refer to the balance of supply and demand of the buildings that sit on the real estate. Property cycles occur both in various real estate sectors and geographically within any one sector; that is, at the same time, different regions of the country will be in various stages of the cycle. In all cases, they are impacted by the rental-growth rate cycle.
Real Estate Sectors
Real estate is a vibrant, fragmented, and evolving economic sector that at times defies easy analysis. Real estate can be divided into Institutional (governmental or nonprofit: schools, museums, city halls, police stations, public hospitals, etc.), Private (owner-occupied homes), and Commercial sectors. Commercial real estate can be further divided into different sectors and subsectors. Office, Retail, Industrial and Warehouse, and Multifamily constitute a common division. The Office sector is often subdivided into suburban and central-city business districts. Retail can be divided many ways, but it is commonly divided into Regional Malls, first and second tier; Strip Malls; Factory Outlets; and Power Centers (sometimes called "big boxes" because a power center is a retailer strong enough to draw customers to a stand-alone location, to just one big box). Other types of real estate that are not as large but defy easy categorization in one of the major sectors include Senior Housing (with subsectors for active retirees, assisted living, and full service) and Hotels (full service, extended stay, limited service, and resort are potential categories), as well as specialty retail such as outlet malls and multiuse mixes of retail and entertainment. Sometimes new subsectors emerge. The trend toward miniwarehouses is an example of a sector that took off in the 1990s. "Telco hotels," that is, large equipment farms, buildings, or parts of buildings that house the transmission gear for phone, data, and Internet companies, emerged in the mid to late nineties. More recently, the residential condominium sector exploded (both new construction and conversions of existing projects; see Chapter 12) and then contracted within roughly a five-year period.
Obviously, all of these sectors and subsectors are very different and respond differently to various economic stimuli; thus, they are at any given time at different phases in the real estate cycle. Figure 1-3 illustrates a typical national real estate cycle by various types of property.
Geographic Variations Within a Property Type
Remember that although there are national cycles, by the very nature of real estate, product and occupancy cycles are local or regional in nature. Capital can flow across borders and from region to region to find the highest return; real estate, however, is immobile. If a particular region becomes overbuilt (i.e., oversupplied), it is not possible to pick up a building and ship it to a region where there is an undersupply. To a certain extent, even though the buildings do not move, it is possible for the people who occupy and use those buildings to move. However, this can be a slow, costly, and disruptive solution. Figure 1-4 shows a typical distribution of where various cities may be in a multifamily (apartment) cycle.
Typically, rental-growth rate cycles are a primary driver of occupancy cycles. Figure 1-5 illustrates a rental-growth rate cycle as stagnant to negative rent growth, characterized by the recession portion of the cycle, giving way to modest rent growth during the recovery, followed by strong rent growth during the expansion phase that justifies new construction. Equilibrium occurs at the top of the cycle but is generally recognized only in retrospect. The oversupply phase of the real estate cycle features declining but still positive rent growth.
Although analysts attempt to define what the long-term average occupancy rate is for a given sector, the vagaries of the marketplace defy easy categorization, as illustrated by Figures 1-6 and 1-7. Figure 1-6 shows nationwide industrial vacancy (availability) rates ranging from 5.5% to more than 10.5% for the period 1981 to 2004, illustrating how difficult it is to determine a long-term average occupancy rate for a sector. Was the peak in vacancies that occurred during the recessionary years of the early 1990s an aberration to be discounted or part of a normally occurring cycle for which one must plan? What about the vacancy peak in 2002 to 2004? Is there a long-term upward trend in vacancy? Or are recent trends an aberration? And can a reversion to the long-term mean be forecasted? How can one tell the difference among random fluctuations, "normal" cycles, and long-term structural changes in the marketplace? No easy answers exist and opinions among intelligent professionals differ, which, in turn, is what creates markets.
Figure 1-7 shows the ten highest and lowest Central Business District (CBD) office rents for North America as of 2001. These numbers probably represent close to the peak of CBD rents during the great Internet run-up of the stock market. Markets softened after the tech bubble burst, and it took roughly five years for the office market to completely recover, that is, for 2006 rents to approximate 2001 rents.
It is important to note that these numbers, like many numbers in real estate, are only approximations. Rent numbers are generally gathered from brokers who specialize in office leases, and since there is generally no legal requirement to report such numbers nor penalty for inflating or providing selective disclosures, all numbers must be taken with a grain of salt. It is not unusual to see different sources reporting significantly different numbers at the same time for supposedly the same market, with variations arising from the source of their data, their definition of the market, and their chosen methodology.
Furthermore, there are many submarkets within any given market, and rents may vary greatly even within a submarket, depending on building quality and the desirability of the location. For instance, even in Manhattan (which is a submarket of New York City itself), there is substantial variation between office rents downtown (Wall Street) and midtown (Rockefeller Center). In addition, office locations exist on the Upper West Side, Harlem (the location of former U.S. President William J. Clinton's official office), the Upper East Side, and on and on.
Even the ranges within the top ten and bottom ten rents are great. The range on the high side is $69 to $30 per square foot and on the low side, $12 to $20 per square foot. Applying national averages to local markets can be a recipe for disaster.
The problem of real estate cycles is exacerbated by the long lead times necessary for development, which are being further lengthened by an increasingly complex regulatory environment. A New York City rezoning can easily take five years or more; the CEO of a major apartment REIT (Real Estate Investment Trust) that specializes in infill development and redevelopment said several years ago that the company faces court battles in approximately 30% of its projects, and that percentage is no doubt higher today. At the time of the original conception of a development, market conditions may be favorable. By the time the land has been tied up, approvals secured, and a great deal of time and capital invested, the outlook may not be so rosy. By this time, the project has tremendous momentum, and many firms and people (and their egos and pocketbooks) are committed to it. These enterprises are rarely cut and dried. Signs of downturn are often hard to read, and although hindsight is usually 20/20, the crystal ball is often murky when one tries to look ahead. Moreover, there is a strong tendency to believe that "this project" is different because of "the unique site," "our extraordinary architecture," "the strength of our development team," "the wonderful marketing plan," "the financial strength of our backers," or some other factor.
(Continues...) Excerpted from Construction Funding by Nathan S. Collier, Courtland A. Collier, Don A. Halperin. Copyright © 2008 John Wiley & Sons, Ltd. Excerpted by permission of John Wiley & Sons.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site. Preface -- Foreword -- Background -- Characteristics Of Real Estate -- Different Types Of Business Organizations -- Negotiation -- The Development Process Start To Finish -- The Development Process: An Overview -- Market Studies, Site Feasibility Analysis, And Selection -- Creating The Project Pro Forma -- The Appraisal -- Sources Of Financing, The Loan Application Process, And Term Sheets -- The Commitment -- Closing The Loan: The Note, Mortgage, Construction Loan Agreement, And Unconditional Guaranty -- Evolution Of The Development Process -- Joint Ventures -- Condominiums And Condominium Conversions -- Cash Forecasts And The Time Value Of Money -- How To Forecast Cash Needs During Construction -- Basic How-to-do-it Time Value Of Money Calculations -- Appendix A -- Exhibit A-1 Real Estate Promissory Note -- Exhibit A-2 Mortgage And Security Agreement -- Exhibit A-3 Construction Loan Agreement -- Exhibit A-4 Real Estate Unconditional Guaranty -- Exhibit A-5 September 2000 Market Reports, Orlando And San Jose -- Appendix B -- Exhibit B-1 Hidden Lake -- Exhibit B-2 Apartment Complex Put On Hold -- Exhibit B-3 Hidden Lake Gets Approval -- Appendix C -- Exhibit C-1 Letter Of Intent -- Exhibit C-2 Letter Of Intent -- Exhibit C-3 Letter Of Intent -- Exhibit C-4 Letter Of Intent -- Exhibit C-5 Letter Of Intent -- Exhibit C-6 Letter Of Intent -- Exhibit C-7 Letter Of Intent -- Exhibit C-8 Letter Of Intent -- Exhibit C-9 Letter Of Intent -- Exhibit C-10 Converted Condos Offer Additional Space, Storage Areas -- Appendix D Interest Tables -- Appendix E End-of-chapter Answers To Questions -- Index. Nathan S. Collier, Courtland A. Collier, Don A. Halperin. Includes Index. Preface Foreword I background Characteristics of real estate Different types of business organizations Negotiation The development process start to finish The development process: an overview Market studies, site feasibility analysis, and selection Creating the project pro forma The appraisal Sources of financing, the loan application process, and term sheets The commitment Closing the loan: the note, mortgage, construction loan agreement, and unconditional guaranty Note to wiley: need title Joint ventures Condominiums and condominium conversions Cash forecasts and the time value of money How to forecast cash needs during construction Basic how-to-do-it time value of money calculations Appendix a Exhibit a-1 real estate promissory note Exhibit a-2 mortgage and security agreement Exhibit a-3 construction loan agreement Exhibit a-4 real estate unconditional guaranty Exhibit a-5 september 2000 market reports, orlando and san jose Appendix b Exhibit b-1 the gainesville sun Exhibit b-2 apartment complex put on hold Exhibit b-3 hidden lake gets approval Appendix c Exhibit c-1 letter of intent Exhibit c-2 letter of intent Exhibit c-3 letter of intent Exhibit c-4 letter of intent Exhibit c-5 letter of intent Exhibit c-6 letter of intent Exhibit c-7 letter of intent Exhibit c-8 letter of intent Exhibit c-9 letter of intent Exhibit c-10 converted condos offer additional space, storage areas Appendix d interest tables Index.