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1、 1 ShowMeTheMoney:AStudyofRealEstateDevelopmentReturnsbyMatthewS.FlowersB.S.,Mathematics,2002UniversityofFloridaM.S.,Management,2004UniversityofFloridaMasterofBusinessAdministration,2005UniversityofFloridaSubmittedtotheDepartmentofUrbanStudiesandPlanninginPartialFulfillmentoftheRequirementsfortheDeg
2、reeofMasterofScienceinRealEstateDevelopmentattheMassachusettsInstituteofTechnologySeptember,20082008MatthewS.Flowers.Allrightsreserved.TheauthorherebygrantstoMITpermissiontoreproduceandtodistributepubliclypaperandelectroniccopiesofthisthesisdocumentinwholeorinpartinanymediumnowknownorhereaftercreate
3、d.SignatureofAuthor:_DepartmentofUrbanStudiesandPlanningJuly31,2008Certifiedby:_DavidM.GeltnerProfessorofRealEstateFinanceDepartmentofUrbanStudiesandPlanningThesisSupervisorAcceptedby:_BrianA.CiochettiChairman,InterdepartmentalDegreePrograminRealEstateDevelopment 2 ShowMeTheMoney:AStudyofRealEstateD
4、evelopmentReturnsbyMatthewS.FlowersSubmittedtotheDepartmentofUrbanStudiesandPlanningonJuly31,2008inPartialFulfillmentoftheRequirementsfortheDegreeofMasterofScienceinRealEstateDevelopmentABSTRACTThispaperintroducesthreenewtoolsfortheanalysisandreplicationofrealestatedevelopmentreturns.Inparticular,th
5、ispaperdiscussesadvancedsensitivityanalysis,realestatedevelopmentreturnindexesandsyntheticrealestatedevelopmentinvestments.Theadvancedsensitivityanalysisallowsustoproducesubjectiveexantereturndistributions.Thisanalysiswillallowdevelopersandinvestorsto“see”theshapeoftheirinvestmentsreturndistribution
6、.Thebenefitsofknowingtheshapeofthesubjectiveexantereturndistributionsisthatitmayhelpdevelopersandinvestorsmakebetterdecisionsandnegotiatespecifictermswitheachcontributorinthecapitalstructure.Theexpostanalysisallowsustoproducedevelopmentreturnindexesusefulinthebenchmarkingofrealestatedevelopmentperfo
7、rmanceandinthecreationofsyntheticdevelopmentinvestmentsbywayofthenewrealestatederivatives.ThedevelopmentreturnindexesarecreatedbytransformingMITsTransactionBasedIndex(TBI),whichtracksstabilizedpropertyreturns,intodevelopmentreturnindexesthroughtheuseofastylizedmathematicalmodel.ThesisSupervisor:Davi
8、dM.GeltnerTitle:ProfessorofRealEstateFinance 3 ACKNOWLEDGEMENTSIwouldliketothankmyadvisorDavidGeltnerforpushingmetodigdeeperandformakingthethesisprocessfun.Davidisagreatadvisorandprofessorbecauseheteachesstudentshowtothink,notjusthowtosolveproblems.IwouldalsoliketothankPeterRothforbeingpatientandhel
9、pingmeexploreseveralideasalongtheway.Also,IwouldliketothankLarryEllmanfortakingthetimetospeakwithmeandkeepingmeuptodateoncurrentbusinesspractices.Additionally,Iwouldliketothankmyfamilyforstickingbymeandputtingupwithmeforalloftheseyears.Finally,IwouldliketothankMonicaforgivingmetheconfidencetoapplyto
10、MITinthefirstplace,andforbeingmybestfriend(thisshouldcountfor10sappybirthday/anniversarycards).LoveyaFatty!4 TABLEOFCONTENTSABSTRACT.2ACKNOWLEDGEMENTS.3TABLEOFFIGURES.51INTRODUCTION.62REALESTATEDEVELOPMENTINVESTMENTS&RETURNS.72.1NetPresentValueofaRealEstateDevelopmentInvestment.72.2LeveragedForwardC
11、ommitment.82.3Leverage&LeverageRatios.82.31FinancialLeverage.82.32LeverageRatio(LR).92.33OperationalLeverage.102.4AMultitudeofDevelopmentReturnMetrics:.142.41UnleveredDevelopmentInternalRateofReturn(UDIRR),.152.42LeveredDevelopmentInternalRateofReturn(LDIRR).152.43EquityPartnersReturn(MPIRR&DPIRR).1
12、52.44CanonicalReturn(ErC).162.45WhatsthedifferencebetweentheCanonicalOCCandtheLDIRR?.183EXANTEANALYSISOFREALESTATEDEVELOPMENTRETURNS.213.1BasicExAnteAnalysisforRealEstateDevelopmentProjects.223.2AdvancedSensitivityAnalysis.233.3DealStructures.253.4ExaminingtheResults.283.41DownsideProtection&UpsideP
13、otential:.293.42RiskandReturn:.303.43Debtvs.EquityCharacteristics:.303.44InverseRelationshipbetweentheMPandtheDP:.313.45Build&Sellvs.Build&Hold:.314EXPOSTANALYSISOFREALESTATEDEVELOPMENTRETURNS.324.1DevelopmentReturnIndexes.334.2TransactionBasedIndex(TBI).344.3Methodology.364.4Results.394.5Benchmarki
14、ng.414.6CreatingSyntheticDevelopmentReturns.425CONCLUSION.46APPENDIX.48BIBLIOGRAPHY.69 5 TABLEOFFIGURES Figure1.12Figure2.13Figure3.14Figure4.24Figure5.26Figure6.28Figure7.43 6 1INTRODUCTIONThepurposeofthisthesisistointroducenewtoolsfortheanalysisandreplicationofrealestatedevelopmentinvestmentreturn
15、s.Themethodologiesdescribedinthispapermayhelprealestateprofessionalsmakebetterinvestmentdecisions,evaluatetheirpastinvestmentsand“create”developmentreturnsusingderivatives.Inparticular,wewillexaminefivedevelopmentreturnmetrics,eachofwhichhasitsownuniquemeaningandinterpretation.Wewillthenexaminethese
16、returnmetricsfromaforwardandbackwardlookingvantagepoint,andfinally,wewillseehowtocreatethesereturnssynthetically.Chapter2introducesthecharacteristicsofrealestatedevelopmentinvestmentsandtheirreturns.Inthischapterweintroducefivereturnmetrics,eachofwhichprovidesadditionalinformationandclarityastotheri
17、sksandfundamentalsofaspecificdevelopmentinvestment.Chapter3isdevotedtothetopicofadvancedsensitivityanalysiswhichprovidesawayto“visualize”thepotentialdistributionofarealestatedevelopmentinvestmentsreturn.Thisanalysisisimportantbecausethereturndistributiongivesusinsightintohowaspecificinvestmentmightp
18、erforminthefuture.Theforecastedreturndistributionsprovidevaluetoinvestorsanddevelopersbyallowingthemtocomparealternativesandsubjectivelyjudgetherisksinandacrosscompetinginvestments.Additionally,itgivesthedecisionmakertheabilitytobetternegotiatethecapitalstructuretermstobettermatchhisrisk/returnprefe
19、rences.Finally,Chapter4describesthemethodologiesforcreatinghistoricdevelopmentreturnindexesandsyntheticdevelopmentinvestments.Thedevelopmentreturnindexesareimportantbecausetheyprovideabenchmark,orawayofmeasuringtheperformanceofaspecificdevelopmentinvestment.Benchmarkinginvestoranddeveloperperformanc
20、eisimportantasitallowsforasystemtobeestablishedforthepaymentofbonusesorincentives.Theindexesmayalsoactasadiagnostictoolfordissectingactualdevelopmentinvestmentperformance.Theindexeshaveadditionalvaluebyprovidingaplatformtodevelopaninvestmentproductthatmimicsthereturnsearnedbyrealestatedevelopments.T
21、hese“synthetic”developmentinvestmentshavemanybenefitsthatdirectinvestmentinrealestatedevelopmentlack,suchasaquickmeansofexitandentryintoadiversepoolofassets,lowerfinancingandtransactioncostsandgivinginvestorstheabilitytoshortsellrealestatedevelopmentexposureforthefirsttime.7 2REALESTATEDEVELOPMENTIN
22、VESTMENTS&RETURNSThischapteroutlinesthefundamentalsofrealestatedevelopmentinvestments,leverageanddevelopmentreturns.Wewillbeginwithanexaminationofthespecificcharacteristicsofrealestatedevelopmentinvestments.Inparticular,therearetwocharacteristicsofdevelopmentsprojectsthatmakethemuniquefromstabilized
23、propertyinvestments.Thesecharacteristicsarethatdevelopmentprojectstaketimetobuildandthattheyhaveaphasedriskregime.11)Developmentprojectstaketimetobuild,andthereforethecashoutflowstopayforthelandandtheconstructioncostsdonotalloccuratthesametimeandtheydonotalloccurupfront.Thischaracteristiccausesdevel
24、opmentprojectstohave“operationalleverage”(thistopicwillbediscussedextensivelyinthenextsection).2)Thephasedriskregimemeansthattheopportunitycostofcapital(OCC)isnotstableduringthedevelopmentperiodorbetweenthedevelopmentandstabilizedphases.Thischaracteristicmakesitdifficulttovalueadevelopmentinvestment
25、inthetraditionalway,inwhichonediscountseverycashflowatthesameOCC.Instead,itiseasiertovaluetheconstructioncostcashflows,theleaseupcashflows,theterminalsalesvaluecashflowandthelandseparatelyandthentreatthedevelopmentinvestmentasaportfolioorseriesoftheseinvestments.Ofcourse,ifonewereabletoobserveasingl
26、ecorrectOCCforthedevelopmentinthemarketplace,whichisoftendifficult,thenthesevaluesshouldbeequal(Geltner,Miller).2Throughoutthischapterwewillcarefullyscrutinizehowthesecharacteristicsshapeandinfluencerealestatedevelopmentinvestmentsandreturns,andhowthesecharacteristicsmakedevelopmentinvestmentsdiffer
27、entfrominvestmentsinstabilizedassets.2.1NetPresentValueofaRealEstateDevelopmentInvestmentThroughoutthecourseofthispaperitwillbeassumedthatalldevelopmentinvestmentsaremadeatazeronetpresentvalue(NPV).ThisassumptionisconsistentwiththeviewthattheprivaterealestatemarketiscompetitiveandnonzeroNPVdealsarer
28、are.SinceweareassumingzeroNPVinvestmentsthepriceoflandwillbedeterminedbythefollowingformula.3(1)PVVPVK=Land 1Athirdcharacteristicisthattheuseofconstructionloansindevelopmentprojectsisalmostuniversal.2Wesay“should”herebecauseequilibriumshouldexistbetweenthemarketsforstabilizedassets,constructioncosts
29、andland;thereforethetwovaluationtechniquesshouldyieldthesameanswer.Theportfolioviewofrealestatedevelopmentinvestmentsisnormative,i.e.ittellsuswhatshouldoccur.3TheNPVofadevelopmentinvestmentisdefinedasNPV=PVVPVKLand,thisformulareiteratesthepointthatadevelopmentinvestmentislikeaportfolio,orseriesofinv
30、estmentsinastabilizedproperty,constructioncostsandland.8 WherethePVVisthepresentvalueoftheexpectedvalueoftheassettobeconstructedandthePVKisthepresentvalueoftheconstructioncosts.42.2LeveragedForwardCommitmentArealestatedevelopmentinvestmentisaleveredforwardpurchasecommitmentontheunderlyingstabilizedp
31、ropertytobebuilt.Inthisforwardpurchasecommitmenttheinvestorwilltypicallymaketwosetsofpayments.Thefirstpaymentwillbemadeupfront(time0)andwillcoverthepurchasetheland,aswellastopayforanyupfrontfeesofthedevelopment.Thecostofthelandwillbeatitscurrentfairmarketvalue,orequivalentlyitsopportunitycost(i.e.th
32、elandispurchasedforazeroNPV).5Thesecondsetofpaymentsoccursthroughouttheconstructionperiodandcoverstheconstructioncosts.Theconstructionlenderusuallyfunds100%oftheconstructioncosts.However,theuseofaconstructionloanoranyotherspecificfinancialarrangementisnotnecessarytocarryouttheinvestmentanalysisofade
33、velopmentproject.Uponcompletionofconstructiontheinvestorwillmakethefinalconstructionpaymentandreceivethecompletedasset(Fisher,Geltner).Tosumup,theinvestorpaysfortheland,upfrontfeesandtheconstructioncostsandreceivesastabilizedassetuponcompletion.This“portfolio”ofinvestmentsincludesalongpositionintheu
34、nderlyingrealestateasset(theforwardcommitment)andashortpositionintheconstructioncosts(theleverage).Thecombinationofshortandlongcashflowsisinherentlyleveredbecausethecashoutflowsdonotoccuratthesametimeandbecausetheconstructioncostsarenotperfectlyandpositivelycorrelatedwiththevalueoftheunderlyingasset
35、.Theinherentleveragethatexistsinrealestatedevelopmentinvestmentsisanimportantpointbecauseitexistsevenifnofinancialleverageisemployed.2.3Leverage&LeverageRatios2.31FinancialLeverageFinancialleverageiscreatedbytheuseoffixedpaymentsourcesofcapitalinthefinancialstructure.6Thefixedpaymentcapitalisusually
36、debt,butmezzaninedebtandpreferredequityalsoleversuptheresidualequitypositioninthesameway.Thereasonwhyfinancialleverageoccursisbecausedebtcapitalearnsafixedrateofreturnwhiletheunderlyingassetsreturnisvolatile.Bydefinition,theequityinvestorreceivesalloftheresidualcashflowsoftheassetafter 4Throughoutth
37、isanalysisitisassumedthatitistheoptimaltimetodevelop,thatis,thedevelopmentoptionisbeing“exercised”andholdingthelandvacantforspeculationwouldnolongerbe“highest&bestuse.”5Thehistoric,orbookvalue,ofthelandisirrelevantforthisparticularanalysis.6Actually,theuseoffinancialcapitalthatdoesnotearnafixedrates
38、ofreturnstilladdsleverageifthereturnisnotperfectlyandpositivelycorrelatedwiththeunderlyingasset.Additionally,ifacapitalprovidersreturnisfloatinghasnegativecorrelation,movesinversely,withtheunderlyingassetsreturnthentheamountofleverageincreasescomparedwithfixedratesourcesofcapital.9 thedebtholderrece
39、iveshisfixedsum.Therefore,anyfluctuationintheincomeearnedbythepropertyispassedthroughdirectlytotheequityholder.Therefore,onadollarbasisanychangeintheincomeatthepropertylevelismirroredattheequitylevel.Sincedebtisusedtofinanceaportionofthepurchasepricethenthepercentagechangeearnedattheequitylevelismag
40、nified,orlevered,whencomparedtothepropertylevel.Conversely,ifthecapitalusedwasnotfixedratebutinsteadvariedperfectlyandpositivelywiththecashflowoftheassetthentheequityreturnwouldnotbelevered,aswiththeuseofjointventureequitypartner.Tomakethisideamoreconcreteletsassumethataninvestorpurchasesabuildingfo
41、r$100byborrowing$75indebtandinvesting$25inequityandthisbuildingproducesconstantincomeinperpetuity.Ifthepropertyisexpectedtoproduce$8peryearandthedebtearns$4.50peryear,thentheequityinvestorcanexpecttoearn$3.50peryearforever.However,ifthepropertyactuallyearns$9peryearforever,thenthedebtholderstillrece
42、iveshis$4.50andtheentire$1extraflowsthroughtotheequityinvestor,whonowearns$4.50.Soonadollarbasis,anychangeintheincomeofthepropertyflowsthroughtotheequityinvestors.However,onapercentagebasisthereturntotheequityinvestorisleveredupbecausethedollarchangeincashflowsisearnedoverasmalleramountofcapital.For
43、example,inthepreviousexamplethedebtholderwillearn6%(calculatedas:$4.50/$75)regardlessofhowmuchthepropertyearns(ignoringtheprobabilityoffinancialdistress).Whenthepropertyearns$8,oran8%returntheequityholderearnsa14%return(calculatedas:$3.50/$25).However,whentheincomeincreasesby$1thepropertynowearns9%(
44、calculatedas:$9/$100)andtheequityreturnismagnifiedto18%(calculatedas:$4.50/$25),anincreaseof4%orfourtimesthe1%increaseatthepropertylevel.2.32LeverageRatio(LR)Tounderstandwhytheequitypositionearnedfourtimestheadditionalreturnthanthepropertyweneedtointroducetheconceptoftheleverageratio.Inthecontextofi
45、nvestmentinastabilizedpropertytheleverageratioisdefinedasthevalueofthepropertydividedbythevalueoftheequityusedtopurchasetheproperty.Inourexampletheinvestmenthasaleverageratioof4(calculatedas:$100/$25),thereforeanychangeinthereturnatthepropertylevelwouldbeexperiencedfourtimesgreaterattheequitylevel.T
46、heleverageratioconceptmaybeextendedfromstabilizedpropertyinvestmentstodevelopmentinvestmentsusingthefollowinganalogy:thepurchasepriceforthestabilizedpropertyisequivalenttothepresentvalueoftheexpectedassetvalueinthedevelopmentproject,andtheamountofequityinthestabilizedassetisequivalenttothevalueofthe
47、landinthedevelopmentcase(LR=PVV/Land)(Geltner,Miller).7 7Thedevelopmentleverageratiowillbediscussedingreaterdetaillaterinthischapter.10 2.33OperationalLeverageIneveryrealestatedevelopmentinvestmentleverageexistsregardlessofhowtheinvestmentisfinanced.Webrieflytoucheduponthispointwhenwementionedthatad
48、evelopmentinvestmentisaleveredforwardcommitmenttopurchasetheunderlyingasset.Theleveragethatisinherentinrealestatedevelopmentinvestmentsiscalledoperationalleverageanditexistsforthesamefundamentalmathematicalreasonsasfinancialleverage.Operationalleverageexistsbecausetheupfontcommitmentofthelandbuysane
49、tasset,specificallythedifferencebetweentheterminalassetvalueandtheconstructioncosts.Thisnetassetcanbeviewedasalongpositionintheunderlyingriskyassetandashortpositionintheuncorrelatedconstructioncosts;muchlikehowfinancialleverageisalongpositionintheunderlyingassetandashortpositioninfixedpaymentdebt.Th
50、ismeansthatthevolatilityandreturnoftheequity/landvalueisamagnification,orleveredderivativeoftheunderlyingasset.Operationalleverageexhibitsseveraltraits.Forinstance,operationalleverageincreasesthefurtheroutintimetheconstructioncostsoccur,themoreriskytheunderlyingassetandthelesscorrelatedtheconstructi