A FINANCIAL ANALYSIS OF RETURNS FROM COMMERCIAL REAL ESTATE

PROPERTIES IN THE UNITED STATES

Done for

Project report submitted in partial fulfillment of the requirement of Pondicherry University for the
award of the degree of

MASTER OF BUSINESS ADMINISTRATION

Submitted By

KARTHIGA. D
(Reg No.1095526)
Under the guidance of

INTERNAL GUIDE: EXTERNAL GUIDE:

Dr. B. CHARUMATHI, Mr. MOHAMED ALI. A. S
Associate Professor Senior Analyst
Department of Management Studies Zenta Knowledge Services Pvt Ltd
School of Management Chennai.
Pondicherry University

DEPARTMENT OF MANAGEMENT STUDIES

SCHOOL OF MANAGEMENT
PONDICHERRY UNIVERSITY
PUDUCHERRY- 605 014

MARCH- APRIL 2011

DEPARTMENT OF MANAGEMENT STUDIES
SCHOOL OF MANAGEMENT

1
 PONDICHERRY UNIVERSITY
PUDUCHERRY-605014

CERTIFICATE

This is to certify that this project entitled “A FINANCIAL ANALYSIS OF RETURNS FROM
COMMERCIAL REAL ESTATE PROPERTIES IN THE UNITED STATES.” done for
ZENTA KNOWLEDGE SERVICES PVT LTD, CHENNAI, is submitted by KARTHIGA.D, II
year MBA (Reg NO. 1095526) to the Department of Management Studies, School of
Management, Pondicherry University in partial fulfillment of the degree requirement for the
award of degree Master of Business Administration and is certified to be an original and
bonafide work.

DR.R.P.RAYA DR.B.CHARUMATHI
Professor & Head of the Department

Place: Puducherry
Date:

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 DECLARATION

I, KARTHIGA. D, Student of Department of Management Studies, Pondicherry

University, hereby declare that this project report titled “A FINANCIAL
ANALYSIS OF RETURNS FROM COMMERCIAL REAL ESTATE
PROPERTIES IN THE UNITED STATES” is an original work done by me and
submitted to the Department of Management Studies, for the award of Master
Degree in Business Administration. I further declare that any part this project itself
has not been submitted elsewhere for award of any degree.

PLACE:

DATE: Signature of the candidate

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 ACKNOWLEDGEMENT

I am indebted to the powerful Almighty God for the blessings he showered on me and for
being with me throughout the study.

I place on record my sincere gratitude and appreciation to my project guide Dr.B.CHARUMATHI,

Reader, Faculty Advisor – Corporate Relations and Placements, Department of Management Studies,
for her kind co-operation and guidance which enabled me to complete this project.

I express my sincere thanks to Dr. R. P. RAYA, HOD, Department of Management Studies, School of
Management, Pondicherry University, who provided me an opportunity to do this project.

I am deeply obliged to Mr. MOHAMMED ALI, Senior Analyst,Zenta Knowledge Services Pvt Ltd,
Chennai, for his exemplary guidance and support for this project. I would also like to extend my
thanks to Ms. PRAVINA RAVINDRA, Senior Manager, Zenta Knowledge Services Pvt Ltd, Chennai,
for her support.

I take this opportunity to dedicate this project to my parents who were a constant source of motivation
and I express my deep gratitude for their never ending support and encouragement during this project.

Finally I thank each and everyone who helped me to complete this project.

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 EXECUTIVE SUMMARY

Real Estate in India is investment, but Real Estate in US is business. It is like any stocks, bonds or any
other security. The market for real estate in US is booming over a period of time. The investment
done in US real estate is basically long term and the return is also high. Real estate finance and
Securitization has emerged the driving forces of Real Estate Industry.

The study emphasizes on valuation of US Real Estate, as the industry is highly organized and
structured, large holdings and that there is a distinct difference between residential and commercial
markets. The trend is also increasing in Indian market. But the importance given in the Indian market
is not as high as compared to the US market. The level of transparency is high in the US market.

This study is done to analyze the returns and estimate the value of a commercial property from
borrowers and lenders perspective. This valuation is triggered by various factors and the study
considers their influence on valuation.

The major factors influencing the valuation are the property characteristics, the markets and
submarkets, the base rental income, the escalations, the retails sales, Capitalization rate and the Market
leasing assumptions. These factors are considered as most important with regard to the Real Estate
Valuation.

The study is therefore useful for the lenders to determine the value of a property and calculate the LTV
(Loan to Value) and the borrowers to value their property to approach the Real Estate Financiers.

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 TABLE OF CONTENTS
CHAPTER DESCRIPTION PAGE NO.

1 INTRODUCTION
1.1Introduction to the topic
1.2 Statement of problem
1.3 Objective of the study
1.4 Period of the study
1.5 Research methodology
1.6 Limitations of the study
1.7 Chapterization
2 PROFILES
2.1 Profile of US Real Estate Industry
2.2 Profile of Zenta
3 INVESTMENT IN REAL ESTATE &
FUNCTIONING OF RE INDUSTRY
4 ANALYSIS & INTERPRETATION
SUMMARY OF FINDINGS,
5 RECOMMENDATIONS &
CONCLUSIONS
5.1 General findings
5.2 Special findings
5.3 Recommendations
5.4 Conclusion
6 BIBLIOGRAPHY

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LIST OF TABLES

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 INTRODUCTION

1.1 INTRODUCTION TO THE TOPIC:

Real estate is a legal term that encompasses land along with improvements to the land, such as
buildings, fences, wells and other site improvements that are fixed in location -- immovable. Real
estate law is the body of regulations and legal codes which pertain to such matters under a particular
jurisdiction and include things such as commercial and residential real property transactions. Real
estate is often considered synonymous with real property, in contrast with personal property.
The real estate industry in the United States mainly deals with three types of properties namely
commercial real estate, residential real estate, and industrial real estate.
This project titled, “A financial Analysis of Returns from Commercial Properties in the United
States” aims to study the factors influencing the US real estate value and the relationship between
those factors and analyzes the various valuation approach that gives the maximum yield through which
the income generation capability of a property can be determined. There are several factors which
determine the value of a property viz., rent, reimbursement, capital expenditure, probability, inflation,
occupancy, location, cost of capital etc.

1.2 STATEMENT OF PROBLEM

There has been a slowdown in the US real estate market over the last couple of years. The
process of slowdown came into prominence between the late summer of the year 2005 and summer
2006. The real estate dealers suffered from huge financial loss due to decrease in sales volume and
declining real estate prices. Any collapse of the U.S. Housing Bubble has a direct impact not only on
home valuations, but the nation's mortgage markets, home builders, real estate, home supply retail
outlets, Wall Street hedge funds held by large institutional investors, and foreign banks, increasing the
risk of a nationwide recession. The housing bubble has been the result of significant increase in
valuations of real estates. In this current scenario, this project aims to determine returns from
commercial properties and estimate the value of properties in the US. The purpose of this study is to
facilitate the investment decision of a client through a risk-return analysis of the income streams of
different Retail properties in the US Real Estate.

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1.3 OBJECTIVES OF THE STUDY
• To analyze the returns from various commercial real estate properties to facilitate the lending
decision.
• To arrive at estimates of value of the properties based on the DCF approach.
• To analyze the risk associated with the loan from the lender’s perspective.
• To analyze the credit worthiness of tenants.

1.4 SCOPE
The Scope of the Study is confined to US Retail Properties.

1.5 LIMITATION OF THE STUDY

The major limitations of this research are
 Only secondary data of last 5 years data for US is used for analysis.
 Projections are made only for a period of 5 years.
 This study is confined only to US Real Estate Industry. It gives suggestion only for
investor of the real property in the major cities and markets and not for the buyers
whose ultimate aim is to buy for living purpose and also not for brokers of real estate.
 Details such as the client’s name, the property name and address are not revealed, as it
would amount to breach of the confidentiality agreement between the company and its
client.
 Only commercial properties have been focused upon.

1.6 RESEARCH METHODOLOGY

This is a descriptive research which aims at evaluating the returns from a set of properties.

TOOLS USED
- Loan To Value
- Debt Service Coverage Ratio
- Number of Credit Tenants

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 - Rollover Risk

1.7 Chapterization:
• The introductory chapter deals with a crisp introduction of US Real Estate Industry, statement
of problem, objectives of study, research methodology and limitations.

• Chapter 2 portrays the profiles of the US Real Estate Industry and Zenta Knowledge Services
Pvt. Ltd.,

• Investments in Real Estate & functioning of the industry are reviewed in chapter 3

• The data collected were compiled and analyzed in chapter 4.

• Suggestions based on findings emanated from the study were presented in the concluding
chapter 5.

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2.2 PROFILE OF ZENTA KNOWLEDGE SERVICES PVT. LTD.,

About Zenta

Founded in 2001, Zenta is a world-class knowledge process

outsourcing (KPO) and business process outsourcing (BPO)
Overview
and Company, offering a full range of back-office, voice and
on-site support solutions such as Credit Card Servicing,
Consumer Lending Servicing, Accounts Receivable
Management, Mortgage Servicing and Real Estate Capital
Market Analytics. The Company serves the following
verticals: Consumer Credit, Insurance and Financial Services,
and Commercial and Residential Real Estate.

With 4,500+ employees worldwide, Zenta has operations in six

locations across three continents. Zenta is a preferred
employer in India.
For further information visit www.zenta.com
Year Founded 2001
Executive Chairman Henry Hortenstien
Country Head Jaswinder Ghumman
Number of Employees 4500+
Global Headquarters New York City
Number of Facilities India: 4 operating centers
• 2 in Mumbai, and
• 2 in Chennai
USA Service delivery centers:
• Philadelphia, PA
• Charlotte, NC
• Dallas, TX and

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 • Los Angeles, CA
Rank 6th in the 2004 NASSCOM Indian BPO survey
Notable Customers Fortune 1000 clients
Financial Services:
• 10 in the Fortune 500
• 7 in the Fortune 100
• 3 of the top 5 US banks
• 5 of the top 10 US banks
• 4 of the top 6 US credit card issuers
Healthcare
• Top three US healthcare system
Vertical Practices • Real Estate
• Financial Services
• Healthcare
Services • Credit Card Servicing
• Commercial Realty
• Residential Realty
• Account Receivables Management, and
• Healthcare Revenue Cycle Management
• ISO 9001:2000 certified
Quality Certification
• CMM Level 3 assessed
• SAS70 (2006) assessed

Vision & Mission

The May 2007 realignment of the Company’s services under the Zenta brand reflects the new
corporate vision of building a world-class Knowledge and Business Process Outsourcing Company
focused on the real estate and financial services industries. As a fully integrated global enterprise,

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Zenta now offers real estate and financial services customers a broad array of services from its centers
of excellence around the globe.

INDUSTRY AND SERVICES

Commercial Real Estate Services

Zenta's focused approach and industry expertise is unique among business process outsourcing
firms. Our senior management team averages over 20 years of real estate and financial services
experience with major balance sheet lenders, institutional investment firms, securitization programs
and loan servicers. Since its founding, our company has conducted analysis on more than 45,000
properties in over $1 trillion of commercial real estate transactions, provides servicing support on over
16,000 commercial loans each month and provides comprehensive research and information
management services for real estate lenders and investors.

Commercial Real Estate Services include

• Buy & Sell Due Diligence
• Lendor/Investor Services
• Commercial Mortgage Underwriting
• Finance and Accounting
• Lease Administration

Residential Mortgage Services

Zenta's Residential Services Group provides processing, servicing and operational support for
a variety of residential real estate services. Zenta’s team of residential mortgage professionals has the
operational experience to implement a program specific to your needs and processes. Examples of our
residential real estate capabilities include:

• Residential Master Servicing

• Broker Services
• Loan Origination and Underwriting

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 • Loan Administration
• Default Services
• Repeatable Results
• Representative Clients
Technology Services

IT Services
Zenta provides a comprehensive range of IT services that are backed by years of experience in
complex, integrated BPO management and a thorough understanding of the industry verticals in which
we operate. Zenta's IT professionals are also extensively trained in client-specific implementation
methodologies creating a dedicated IT team, which you can allocate where needed.

With Zenta's ISO 9001 registration and a CMM Level 3 rating, you can be assured of
consistent, high quality solutions. In addition, Zenta's IT division is housed in a facility that features
high service availability and redundancy to ensure secure, dependable operations. Leading edge
technology platforms deliver fast, effective transaction processing.
In addition, Zenta's IT Services increase overall productivity through better quality SLAs and the use
of 24-hour production.

Zenta offers three-tiered IT solutions viz., Preferred Partner Program & Application Integration
and Solution Architecture

Informative Services
Zenta develops real estate information management & technology solutions to assist in client
assignments and portfolio monitoring. Applying customized research services & tailored web-based
applications, we deliver proprietary portfolio & third party data in a centralized format.
Our information service capabilities deliver relevant and timely information with unprecedented
speed, scale & savings to our clients.
Zenta information services team provides:
• Web-Based Information Management Applications
• Data Sourcing & Extraction Services

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 • Customized Research Services

Health Care Services

Customer Lending Services
Group Focus - Consumer lending lifecycle services.
Representative Clients - Commercial/Investment Banks, Credit Grantors, Specialty Finance
Companies.

Products/Services
• Lead Generation
• Contact Strategy
• Outbound for Home Warranty, Checking Accounts, Home Equity Loans, Credit Insurance,
etc.
• Customer Service and Relationship Management
• Collections
• Custom Analytics
• Notice of Repossession / Foreclosure
• Adaptive Control
• Post-charge-off services

Revenue Care Services

In combination, Zenta and its partners provide the most highly trained, certified and qualified
professionals in the industry today, providing a comprehensive suite of revenue cycle services, along
with HIS and bolt-on technology expertise, including:
• Third party follow-up, all payers
• Self-pay follow-up including day-one
• Early-out receivables outsourcing
• Computer conversion projects with A/R protection
• Full business office, medical records & patient access outsourcing

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 • Medical records transcription and coding
• Embedded process reengineering with each engagement
Among the key Zenta advantages are:
• Extensive Industry Expertise
• Sophisticated Networking Access
• In-depth Understanding of HIPAA and Regulatory
• On-site Presence

THE US REAL ESTATE INDUSTRY

Real estate plays a vital role in the US economy. Following are some of the facts and figures that
show the importance of the real estate sector to the overall US economy, according to a report as of
February 2005 prepared by Economic Intelligence Company:

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  In 2002, the real estate industry employed 1.56 million people in its various segments.
 Over the past two decades employment in real estate has grown more rapidly than the general
economy. Since1982, employment in the real estate industry has increased more than 60%, far
more than the 46% increase in total employment.
 In 2001, the real estate industry generated more than $66 billion in compensation for its
employees. That makes it one of the largest income producing industries in the country.
 The total value of commercial real estate in the US as estimated by the Department of
Commerce is $3.54 trillion dollars.
 Since 1992, the value of commercial real estate has increased by 67.5%, while GDP has
increased by only 59.6%
 The value of all real estate in the US is larger than the total GDP of every country in the world
except Japan. In fact, the total value of commercial real estate in the US is roughly equal to the
annual output of Germany, France, Sweden and Switzerland combined.
 In 2001, the real estate industry generated $326.6 billion in output, accounting for 3.24% of the
total output of goods and services in the US economy.
 The commercial real estate industry contributes more to the US economy than many other
large industries. In 2005, real estate’s contribution to GDP was almost three times as large as
the motor vehicle industry, twice as large as the chemicals industry and larger than the
communication or transportation sectors.

Real Estate Property Types:

The two major types of real estate property are:
 Residential Properties
 Commercial Properties

Residential Properties:
idential properties include single family houses and multifamily properties such as apartments.
Condominiums and co-ops are also included as residential property. In general, residential properties
are properties that provide residences for individuals or families.

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Single family houses are usually individual, detached units. Multifamily housing is differentiated by
location (urban or suburban) and size of structure (high rise, low rise, or garden apartments. High rise
apartments are usually found near or close to the central business district of cities because land costs
are greater than suburban areas.

Commercial Properties:
Commercial properties are typically broken down into five major subcategories:
 office,
 retail,
 industrial,
 hotel/ motel,
 recreational and
 institutional.

Office buildings range from major multi-tenant buildings found in the central business district of most
large cities to single tenant buildings, often built with the needs of a specific tenant or tenants in mind.

Retail properties vary from large regional shopping containing over million square feet of space to
small stores with single tenants.

Industrial real estate includes property used for light or heavy manufacturing as well as associated
warehouse space. This category includes special – purpose buildings designed specifically for
industrial use that would be difficult to convert to another use, buildings used by wholesale
distributors, and combinations of warehouse/ showroom and office facilities. Older buildings that were
initially used as office space often become warehouse or light industrial space.

Hotels and motels vary considerably in size and facilities available. Motels and smaller hotels are
used primarily as a place of business travelers and families to spend a night. These properties may
have limited amenities, such as swimming pools, dining facilities, or meeting space. The property will
often be located very close to a minor highway. Hotels designed for tourists who plan to stay longer

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will usually provide dining, a swimming pool, and other amenities. They are also typically located
near other attractions that tourists visit. Hotels at destination resorts provide the greatest amount of
amenities. Hotels are of various types such as discount or budget, extended stay, mid-price, full
service, limited service, suites, luxury.

Recreational real estate includes uses such as country clubs, marinas, sports complexes, and so on.
These are very special uses, usually associated with retail space that compliments the recreational
activity. Dining facilities and hotel facilities may also be present.

Institutional real estate is a general category of property that is used by a special institution such as a
government agency, a hospital or a university. The physical structure could be similar to other
properties; government office space for example, would be similar to other offices, and could in fact
be in the same building. However, space used by institutions such as universities and hospitals is
usually designed for a specific purpose and are not easily adaptable for other uses.

INCOME STREAMS FROM COMMERCIAL PROPERTY TYPES

COMMERCIAL OFFICE
Revenues:
The primary source of revenue for a commercial office building is rent. However all things being
equal desirability or the demand for a particular office building governs the rents it can command
within a class. Desirability is primarily a function of location. Other sources of revenue for an office
building include reimbursement of operating costs. These are subject to annual adjustments. Office
building owners receive other forms of income such as building services income and even percentage
rents from other retail tenants.

Expenses:
Expenses are incurred to operate and maintain a building occupied by tenants. Major office building
costs include –

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Cleaning and custodial supplies
Repairs and maintenance costs
General and administrative expenses
Management fees and leasing commissions
Utilities
Property taxes
Insurance
Such costs are referred to as Operating expenses

RETAIL:
Revenues:
The rental income of a shopping center comes from base rent and percentage rent. One of the primary
sources of other income for a retail center is income related to the pass through of Common Area
Maintenance (CAM). CAMs are those that relate to the center as a whole and therefore relate to each
retail tenant.

Expenses:
Operating costs of a shopping center are much smaller, in terms of magnitude, than those incurred by a
commercial office building. This occurs because the tenants in a retail center pay many of the
operating costs, including utilities for which they are usually separately metered. Management fees
are generally low for a retail property since less work is involved from an administrative and
management standpoint.

MULTIFAMILY:
Revenues:
The income from apartments is generally rent. Depending on the facilities, there may be some
ancillary income from laundry, parking, vending, interest and the rental of special facilities-
recreational facilities or club houses. Apartments do not charge the common area maintenance pass
throughs that one finds in retail. There is no need for such pass throughs, since the leases are short
term and are subject to constant adjustment as leases roll over.

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Apartments differ from most forms of real estate ownership in the requirement for security deposits.

Expenses:
Expenses run into same broad categories found in any commercial property including repairs and
maintenance, taxes and utilities, insurance, management fees and administrative charges. Certain
repair and maintenance charges relate to items that are funded from a reserve and are therefore not
considered as ordinary operating expenses.
Management fees run from 2.5% to 5% depending on market conditions and the owners of the
property

INDUSTRIAL:
Revenues:
The basic revenue of an industrial project is rent. Again, product type, construction, area
demographics, amenities, location and market perception drive industrial rental revenues. Since many
industrial buildings or parks serve as distribution or warehouse facilities, building or park accessibility
to various forms of transportation may also impact the rent charged. There may be some pass through
of expenses.

Expenses:
The expenses of an industrial warehouse project fall into some major categories found in the other
commercial property types- insurance, taxes and operating costs. Operating costs of such facilities are
fairly low and the tenants often bear a great deal of the operating costs since the operations contained
within the industrial space belong to the tenant and not the landlord. The landlord incurs taxes, subject
to pass through. The landlord also incurs casualty insurance costs for the building and general liability
insurance.

HOTELS:
Income:
Hotels earn revenues from the range of services that they offer. Depending on the hotel’s services,
revenues could include catering, meetings conventions, office services, gambling or golf revenues.

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Expenses:
The expenses other than those in the cost of sales category are generally the same found with any real
estate project. Since many hotels are franchises, a franchise fee may also be paid to the franchisor.

Major Participants In The Real Estate Industry

Developers:
Development is an idea that comes to fruition when consumers – tenants or owner – occupants acquire
and use the space put in place by the development team. Land, labor, capital management and
entrepreneurship are needed to transform an idea into reality. Developers balance the needs of diverse
providers and consumers of the real estate product. The developers have to demonstrate the project’s
feasibility to the capital markets and pay interest or assign Equity positions in return for funding.

Appraisers:
Appraisers can be a part of every stage of the property development process. Appraisers are primarily
responsible for valuation of the project. They estimate the market value of the property and typically
prepare a formal document called appraisal. Appraisals may be necessary when a developer transfers
ownership, seeks financing and credit, resolves tax matters, and establishes just compensation in
condemnation in condemnation proceedings. Appraisers can also evaluate a project as input to market
studies and feasibility studies.

The total number of appraisers registered with the National Appraisal Institute, USA is approximately
100,000 as of September 2002. Some of the familiar names in the US Real Estate markets include CB
Richard Ellis, Cushman and Wakefield and Grubb and Ellis.

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Property managers:
Property mangers focus on the day to day operation of the asset. Property managers carry
responsibility for all respects of the physical space in accordance with the asset manager’s plan. The
responsibilities of a property manager include:

• Marketing and leasing

• Maintenance and repair
• Tenant relations including rent collection
• Insurance
• Accounting
• Human resource Management
• Providing timely information to the asset manager about events affecting the property.

Some of the major property managers include Trammel Crow Company and Grubb and Ellis
Company.

Brokers/ Leasing Agents:

Real Estate brokers and leasing agents are hired to act in the name of the developer in leasing and
selling space to prospective tenants or buyers. Their function, particularly in leasing large industrial
and commercial spaces is to carry out one of the most complex financial negotiations in the
development process. Leasing agents must balance all the various users’ individual needs against the
developer’s financial model.

Lenders:
Construction Lenders are usually commercial banks which are responsible for financing during
project construction and for seeing that the developer completes the project within the budget and
according to the specifications. Construction lenders faced the risk that construction costs will exceed
the construction loan that they have agreed to provide, requiring the developer to cover the difference.

Permanent lenders seek to originate safe loans generating the maximum possible return. The market
value of the completed project is very critical in that it serves as the primary collateral for the loan.

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REITs (Real Estate Investment Trusts) are an efficient way for many investors to invest in
commercial and residential real estate businesses. REITs own and in many cases operate income
producing real estate such as apartments, shopping centers, offices, hotels and warehouses. REITs
were created in 1960 to make investments in large scale income producing real estate accessible to
small investors. A company to qualify as a REIT must comply with certain provisions within the
Internal Revenue Code. There are about 300 REITs operating in the United States. In addition there
are several REITs that are not traded on a stock exchange. REITs can be classified as Equity REITs,
Mortgage REITs and Hybrid REITs. REITs are managed like other publicly managed companies.

At the end of 2002, the market capitalization of all REITs in the US reached a record high of $161.9
billion. At the end of 2002 there were 176 REITs operating in the US

Portfolio Managers:
Portfolio Managers view assets in a larger context than only one asset. For Real Estate investments,
managers are concerned about the return and risk of single property investment opportunities and how
they affect the performance of both the entire mixed-asset portfolio and the component real asset
portfolio.
Boundaries Of The Market:
The US Real Estate market extends across the fifty states which are grouped into six Census regions.

Direct Capitalization Model:

This technique is a very simple approach to the valuation of income-producing property. It is based on
the idea that any given point in time the current NOI produced by a property is related to its current
market value. Symbolically,

NOI1
R = -------
V
Where NOI1 is net operating income in the first year of the holding, as developed from the operating
statement, V is the property value and R is the capitalization rate.

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Calculation of the direct cap rate:
Example:
Comparable Sale Sale Price NOI
1. $1,400,000 $145,000
2. $1,350,000 $150,000

The capitalization rate on the first sale is $145,000 / $1,400,000 = 0.104 and on the second sale is
$150,000 / $1,350,000 = .111. The weighted average of the two cap rates is about 0.1075. Assuming
that the above two properties are similar to one another and to the subject property, this average can be
used as the direct cap rate to find out the value of the subject property.

Discounted Cash flow model: n

The present value method involves projecting the NOI for the property over a typical investment
holding period. When projecting over a holding period, the resale value of the property at the end of
the holding period must also be estimated. The discount rate must reflect a competitive investment
yield for the type of property being valued. That is, it should be a rate that the typical investor would
normally require as a minimum return over the life of the investment to be willing to purchase the
property. One guide for the discount rate would be the interest rate on a mortgage for the same
property plus a risk premium for ownership (equity).

The present value of an income stream that is increasing at a compound growth rate ‘g’ as a perpetuity
is found as follows:

V = NOI1 / (r-g)

where,
V = Present value of the income stream
NOI1 = the first year income (NOI)
g = annual growth in income
r = discount rate for present value

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Holding period: Investors typically hold assets for a period that is lesser than the entire economic life
of the asset. The property obviously must be sold at the end of the holding period subject to any leases
that extend beyond the holding period. In such a situation, the value at which the property would be
sold at the end of the holding period should be determined.

Reversionary value:
The reversionary value of the property is calculated by applying the terminal cap rate over the income
projected for the year following the holding period.
Example:

V10 = NOI11 / Terminal Cap Rate

Where,
Holding period = 10 years
V10 = Value at the end of the tenth year
NOI11 = NOI of the eleventh year
Calculation of the property value:
The reversionary value along with the income streams expected during the holding period are
discounted to find the present value of all the cash flows expected during the holding period.

In theory, the estimated value of the property under all the three approaches should be equal. But, in
practice, there is always a discrepancy between the values estimated under different approaches. So it
is left to the judgment of the appraiser to conclude the final value of the property by assigning
appropriate weights to the values calculated under the different approaches. For instance, according to
the FHA guidelines, the sales comparison approach has the most weight when determining the market
value of a home that is to be insured by an FHA loan.

Another viewpoint is that when the estimates of value under the direct cap approach and DCF
approach diverge, it is better to rely on the results of the DCF analysis for two reasons. First, DCF
models force the analyst to make explicit assumptions about the future income streams and the sales
price assumptions that finally generates the present value of the property. Second, the use of a direct

26
cap rate assumes that the properties from which the cap rate was extracted were very similar to the one
being valued.
Measures Of Investment Performance Based On Cash Flow Projections:

Net Present Value (NPV):

To find the NPV, first the present value (PV) of all the estimated future cash flows. Then the initial
cash outlay invested to acquire this investment is subtracted from this present value to obtain the net
present value.

NPV = Present Value of cash inflows - Present Value of cash outflows

Thus, NPV measures the extent, if any, that the present value of cash flows to be received from the
investment exceeds the equity invested in the property. A positive NPV indicates that the value of the
investment in present value terms exceeds the equity investment. The NPV obviously depends on the
discount rate used to calculate the present value of cash inflows. This discount rate should reflect the
minimum rate of return that the investor requires to make the investment, considering the risk of the
investment. NPV is an opportunity cost concept in that the return required for the investment being
analyzed should be at least as good as the return available on comparable investments. By investing in
the properties being analyzed, the investor must forgo the return that could have been earned on
alternative investment opportunities.

Internal Rate of Return:

The investment yield or IRR is the discount rate that equates the present value of the future cash
inflows with the initial cash outflow.

3.2 EVALUATION PARAMETERS

A. Loan To Value
B. Debt Service Coverage Ratio
C. Credit Tenants
D. Lease Rollover Risk
E. Location

27
A. Loan To Value

One of the factors lenders consider before they approve a mortgage is the loan-to-value ratio
(LTV). The LTV is the loan amount expressed as a percent of either the purchase price or the
appraised value of the property. So, if you make a 20 percent cash down payment on a property you're
buying, the LTV is 80 percent. Or, if you're buying a property for $25 0,000 and the mortgage amount
is $200,000, the LTV is 80 percent (the $200,000 loan amount divided by the $250,000 purchase
price).

A mortgage with a high LTV is one where the mortgage amount is high relative to the
borrower's cash down payment or to the equity in the property. For example, if the LTV is 95 percent,
the mortgage amount is equal to 95 percent of the purchase price and the buyer's cash down payment
is equal to only 5 percent of the price. From a lender's perspective, a high LTV mortgage is more risky
than one where the LTV is low. When borrowers make a large cash down payment, or have a large
equity in a property, they are less likely to default on the mortgage. Borrowers with less equity in a
property have less to lose which puts lenders more at risk.

B. Debt Service Coverage Ratio

The debt service coverage ratio (DSCR) is the NOI divided by debt service.

DSCR = NOI
----------------
Debt Service
The DSCR is indicative of the ability of the property’s income stream to service the loan. The lender
fixes a minimum required DSCR that is expected from a property which is to be financed. The DSCR
projections over the loan period are compared against this benchmark and the risk associated with the
property’s income streams is assessed.

C. Credit Tenants

28
Credit Tenants are those tenants whose creditworthiness is high and default risk is almost nil. Credit
tenants play a major role in retail properties. They also play the role of anchor tenants who attract
more customers than an ordinary tenant. These tenants are usually rated by Credit Rating Agencies
like Standards & Poor’s and Moody’s .The concept of credit tenants plays an important role in risk –
return analysis and in valuation. Therefore the number of credit tenants in retail properties and their
contribution to the revenue helps us in determining the profitability of the proposal. The more the
credit tenants and the area occupied by them the lesser the risk.

Table 3.1 Credit Rating Table

General Credit Quality Standard & Poors Moody's

AAA AAA
AA+ AA1
AA AA2
AA- AA3
A+ A1
A A2
A- A3
INVESTMENTGRADE
BBB+ Baa1
BBB Baa2
BBB- Baa3
BB+ Baa1
BB Baa2
BB- Baa3

B+ Ba1
B Ba2
NON-INVESTMENT GRADE B- Ba3

D. Lease Rollover risk

Rollover is the probability that an existing tenant might continue to occupy the space. It is a risk to the
owners of the building and to the lenders. Incase of a rollover, the landlord has to take some efforts to

29
bring in new tenants to the building. The occupancy of the building depends on various factors like
location, market rent, anchor tenants existing in the building and the various demand & supply factors.
This is a risk. If the landlord is unable to bring in a tenant within the stipulated time, it might result in
downtime leading to vacancy in the building. This would affect the Debt Service of the borrower in
turn affecting the lender. Thus the rollover risk has to be considered before evaluating the proposals
for retail properties. The longer the rollover, lesser is the risk.

30
 CHAPTER V - DATA ANALYSIS AND INTERPRETATION

PROPERTY #1

Name : Altamont Avenue

Type : Retail
Net Rentable Area : 60,802 SF
Value : $ 10,197,191

31
Table 5.1

CASH FLOWS
For the Years Ending
POTENTIAL GROSS REVENUE
Base Rental Revenue
32
CASH FLOWS
For the Years Ending
POTENTIAL GROSS REVENUE
Base Rental Revenue
Absorption & Turnover Vacancy
Base Rent Abatements
Table 5.2 Terminal Value Calculation

Scheduled Base Rental Reven 33

Terminal Value Calculation
Valuation Term 10 Years
Year 11 NOI $1,248,948
Terminal Cap Rate 8.00%
Gross Sale Proceeds $15,611,850
Net Sale Proceeds $15,611,850

Table 5.3 Present Value Summary

Present Value Summary
Total PSF %
PV of Residual @ 10.0% $6,019,044 $98.99 59.0%
PV of Cash Flow @ 10.0% 4,178,147 68.72 41.0%
Total Present Value $10,197,000 $167.71 100.0%

Interpretation:
Here we have assumed a 10 year holding period irrespective of the useful life of the asset. At the end of the 10th year, the
property is assumed to be sold. So, the 11th year NOI is capitalized to get the Net Sale Proceeds. The capitalized value is
then discounted to get the present value. This value is added to the present value of the 10 year cash flows to get the
value of the property.

Table 5.4 NPV Sensitivity Table

34
 Discount Rate
9.50% 9.75% 10.00% 10.25% 10.50%
7.50% $11,009 $10,801 $10,598 $10,400 $10,206
(181.06) (177.65) (174.31) (171.05) (167.86)
Terminal Cap Rate
7.75% $10,792 $10,590 $10,391 $10,198 $10,009
(177.50) (174.16) (170.90) (167.72) (164.61)
8.00% $10,589 $10,391 $10,197 $10,008 $9,823
(174.16) (170.90) (167.71) (164.60) (161.56)
8.25% $10,398 $10,204 $10,015 $9,830 $9,649
(171.02) (167.83) (164.71) (161.67) (158.69)
8.50% $10,219 $10,029 $9,843 $9,662 $9,485
(168.06) (164.94) (161.89) (158.91) (155.99)

Interpretation:
The above table shows the resulting Net Present Value of the property in response to the fluctuations in Cap rate and
Discount rate due to changes in market conditions.

Table 5.5 Sensitivity Of DSCR And LTV To Changes In Interest Rates And Cap Rates

Debt Service Coverage Matrix Loan To Value Matrix

Interest Rate Debt Service DSCR Direct Cap. Rate Value LTV
5.75% $566,196 1.20 7.00% $9,746,000 82.1%
6.25% $593,702 1.15 7.50% $9,096,000 88.0%
6.75% $621,820 1.10 8.00% $8,528,000 93.8%
7.25% $650,526 1.05 8.50% $8,026,000 99.7%
7.75% $679,796 1.00 9.00% $7,580,000 105.5%

The above tables show the corresponding changes in Debt Service Coverage Ratio to the changing Interest rates and the
changes in the Loan To Value corresponding changes in Cap Rates. Clients generally require this table for their decision
making.

35
Table 5.6 Lease Expiration

For the Years Ending Jun-2006Jun-2007Jun-2008Jun-2009Jun-2010Jun-2011Jun-2012Jun-2013Jun-2014Jun-2015

TENANT SUITE
MA DISON LINEN 401 480
HEBRON Y ESHIV A 406 536
MERCHA NT RENA ISSA NCE 503 712
BUREKHOV ICH TRA V EL 504 1,575
INNO FUND CORP. 505 1,100
SA LOMON ENGINEERING 803 1,125
GLA MOUR (USA ), INC. 407 776
SA MUEL SA NG HY ON 502 2,081
SENECA TRA DING, INC. 610 752
PRIMA RY RESOURCE 901 2,000
KA M CONSULTING SERV ICE 410 650
WELLINK PRODUCTS 603 1,210
BEST STY LES, INC. 0604A 2,145
URBA N OUTDOOR 701 400
MA RKETING GRA PHICS, INC 707 636
C & M INTERNA TIONA L 708 600
J & J CORP. 201 1,215
BEST SILV ER, INC. 0205A 4,130
TIME CENTER, INC. STOR3 315
J & J CORP. STOR5 682
KI KI JEWELRY CORP 605 1,000
WENCY LLC 408 1,460
HERITA GE, INC. 810 1,275
HOWA RD NOWES 405 640
K. Y OUNG A SSESSA RIES 508 1,800
A FRICA N A NGELS STOR4 445
STA TE TO STA TE RISK 802 553
CIRCLEX CORPORA TION 601 1,782
BEST STY LES, INC. 0610A 460
36
EMPORIO PLUS, INC. 0703A 365
SECURE TRA DING EST. 801 410
V ERMA NI PERFUMES STOR7
For the Years Ending Jun-2006Jun-2007Jun-2008Jun-2009Jun-2010Jun-2011Jun-2012Jun-2013Jun-2014Jun-2015
TENANT SUITE
MA DISON LINEN 401 480
HEBRON Y ESHIV A 406 536
MERCHA NT RENA ISSA NCE 503 712
BUREKHOV ICH TRA V EL 504 1,575
INNO FUND CORP. 505 1,100
SA LOMON ENGINEERING 803 1,125
GLA MOUR (USA ), INC. 407 776
SA MUEL SA NG HY ON 502 2,081
SENECA TRA DING, INC. 610 752
PRIMA RY RESOURCE 901 2,000
KA M CONSULTING SERV ICE 410 650
WELLINK PRODUCTS 603 1,210
BEST STY LES, INC. 0604A 2,145
URBA N OUTDOOR 701 400
MA RKETING GRA PHICS, INC 707 636
C & M INTERNA TIONA L 708 600
J & J CORP. 201 1,215
BEST SILV ER, INC. 0205A 4,130
TIME CENTER, INC. STOR3 315
J & J CORP. STOR5 682
KI KI JEWELRY CORP 605 1,000
WENCY LLC 408 1,460
HERITA GE, INC. 810 1,275
HOWA RD NOWES 405 640
K. Y OUNG A SSESSA RIES 508 1,800
A FRICA N A NGELS STOR4 445
STA TE TO STA TE RISK 802 553
CIRCLEX CORPORA TION 601 1,782
BEST STY LES, INC. 0610A 460
EMPORIO PLUS, INC. 0703A 365
SECURE TRA DING EST. 801 410
V ERMA NI PERFUMES STOR7
BEST STY LES INC. 400 1,800
A A & TC, INC. 706 1,400
HIND FA SHION, INC. 800 1,037
EA RTH MECHA NICA L CORP 806 1,044
UNICOM CRA FTS, INC. 809 1,063
GENESIS INTERNA TIONA L STOR2 689
LUCKY SILV ER INC. 404 1,000
LUCKY GEM, INC. 300 630
LUCKY GEM, INC. 301 1,295
A BLE JEWELRY CREA TION 305 530
LUCKY GEM, INC. 308 5,107
TOP SA LE TRA DE USA 807 1,700
HA N SOL USA GROUP, INC. 704 600
BA RA TO TRA DING STOR6 1,000
SILV ER GA LORE, INC. STOR8 881
GURU IMPORTS, INC. 202 625
DECENT TRA DING, INC. STOR1 2,000
TOTAL 30,337 23,842 4,506 0 0 0 0 0 0 0
% of Total SF Expir ing 49.89% 39.21% 7.41% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Cu lm ulative Expir ation 49.89% 89.1% 96.5% 96.5% 96.5% 96.5% 96.5% 96.5% 96.5% 96.5%

37
Fig 5.1 Lease Expiration Chart

Year % of NRA Expiring

% of NRAAnnually
Expiring Cumulative
Jun-2006 2006 2006 49.9% 49.9%
Jun-2007 2007 2007 39.2% 89.1%
Jun-2008 2008 2008 7.4% 96.5%
Jun-2009 2009 2009 0.0% 96.5%
Jun-2010 2010 2010 0.0% 96.5%
Jun-2011 2011 2011 0.0% 96.5%
Jun-2012 2012 2012 0.0% 96.5%
Jun-2013 2013 2013 0.0% 96.5%
Jun-2014 2014 2014 0.0% 96.5%
Jun-2015 2015 2015 0.0% 96.5%

Interpretation
The above chart depicts the percentage of Net Rentable Area completing the first lease
rollover. Table 6 shows the total square foot of first rollover of each tenant.
The information was obtained from the lease agreements. Whenever there is a lease
rollover, there is a probability of either the tenant renewing the lease or vacating. This risk is
shown above. Here 96.5 % gets rolled over within 3 years, hence the risk is high.

38
Table 5.7 Rent Roll
Tenant Suite No. SF % of Total Rent/SF Annual % of Annual
SF Income Incom e
Credit Tenants
J & J CORP. STOR5 682 1.1% $138.56 $94,501 4.5%
J & J CORP. 0201 1,215 2.0% $13.00 $15,790 0.7%
Credit Tenants Total/Average 1,897 3.1% $58.14 $110,291 5.2%

Non-Credit Tenants
DECENT TRADING, INC. STOR1 1,487 2.4% $196.98 $292,903 13.9%
GENESIS INTERNATIONAL STOR2 1,000 1.6% 156.60 156,600 7.4%
TIME CENTER, INC. STOR3 315 0.5% 197.78 62,300 2.9%
AFRICAN ANGELS STOR4 445 0.7% 321.35 143,002 6.8%
BARATO TRADING STOR6 881 1.4% 194.10 170,998 8.1%
VERMANI PERFUMES STOR7 1,800 3.0% 53.17 95,706 4.5%
SILVER GALORE, INC. STOR8 625 1.0% 115.20 72,000 3.4%
GURU IMPORTS, INC. 0202 2,000 3.3% 24.90 49,800 2.4%
BEST SILVER, INC. 0205A 4,130 6.8% 11.14 45,998 2.2%
LUCKY GEM, INC. 0300 1,295 2.1% 24.68 31,961 1.5%
LUCKY GEM, INC. 0301 530 0.9% 24.68 13,080 0.6%
ABLE JEWELRY CREATION 0305 5,107 8.4% 24.08 122,977 5.8%
LUCKY GEM, INC. 0308 1,700 2.8% 24.68 41,956 2.0%
BEST STYLES INC. 0400 1,400 2.3% 24.86 34,804 1.6%
MADISON LINEN 0401 480 0.8% 12.71 6,100 0.3%
GLAMOUR LINE INC. 0402 500 0.8% 25.20 12,600 0.6%
DYNAMIC AIRCONDITIONING 0403 400 0.7% 29.63 11,850 0.6%
LUCKY SILVER INC. 0404 630 1.0% 28.57 17,999 0.9%
HOWARD NOWES 0405 640 1.1% 23.46 15,013 0.7%
HEBRON YESHIVA 0406 536 0.9% 11.63 6,231 0.3%
GLAMOUR (USA), INC. 0407 776 1.3% 12.23 9,490 0.4%
WENCY LLC 0408 1,460 2.4% 18.08 26,397 1.2%
KAM CONSULTING SERVICE 0410 650 1.1% 11.51 7,479 0.4%
SAMUEL SANG HYON 0502 2,081 3.4% 12.58 26,186 1.2%
MERCHANT RENAISSANCE 0503 712 1.2% 12.80 9,114 0.4%
BUREKHOVICH TRAVEL 0504 1,575 2.6% 12.42 19,555 0.9%
INNO FUND CORP. 0505 1,100 1.8% 13.02 14,317 0.7%
K. YOUNG ASSESSARIES 0508 1,800 3.0% 19.86 35,756 1.7%
CIRCLEX CORPORATION 0601 1,782 2.9% 25.59 45,595 2.2%
WELLINK PRODUCTS 0603 1,210 2.0% 14.91 18,045 0.9%
BEST STYLES, INC. 0604A 2,145 3.5% 11.67 25,032 1.2%
KI KI JEWELRY CORP 0605 1,000 1.6% 13.65 13,650 0.6%
SENECA TRADING, INC. 0610 752 1.2% 12.65 9,510 0.5%
BEST STYLES, INC. 0610A 460 0.8% 27.18 12,502 0.6%

39
P.O.M. PLANNING SERVICE 0700 1,042 1.7% 19.58 20,402 1.0%
URBAN OUTDOOR 0701 400 0.7% 13.08 5,233 0.2%
METRO OFFICE FURNITURE 0702 630 1.0% 20.95 13,199 0.6%
EMPORIO PLUS, INC. 0703A 365 0.6% 29.59 10,800 0.5%
HAN SOL USA GROUP, INC. 0704 1,000 1.6% 28.60 28,600 1.4%
AA & TC, INC. 0706 1,037 1.7% 26.04 27,003 1.3%
MARKETING GRAPHICS, INC 0707 636 1.0% 12.92 8,215 0.4%
C & M INTERNATIONAL 0708 600 1.0% 12.92 7,750 0.4%
HIND FASHION, INC. 0800 1,044 1.7% 23.18 24,202 1.1%
SECURE TRADING EST. 0801 410 0.7% 26.95 11,049 0.5%
1220 BROADWAY BUSINESS 0801A 1,032 1.7% 27.91 28,803 1.4%
STATE TO STATE RISK 0802 553 0.9% 25.50 14,102 0.7%
SALOMON ENGINEERING 0803 1,125 1.9% 13.01 14,637 0.7%
EARTH MECHANICAL CORP 0806 1,063 1.7% 29.54 31,399 1.5%
TOP SALE TRADE USA 0807 600 1.0% 23.00 13,800 0.7%
UNICOM CRAFTS, INC. 0809 689 1.1% 26.27 18,098 0.9%
HERITAGE, INC. 0810 1,275 2.1% 22.74 28,996 1.4%
PRIMARY RESOURCE 0901 2,000 3.3% 9.93 19,867 0.9%
Non-Credit Total/Average 58,905 96.9% $34.00 $2,002,661 94.8%

Total/Average 60,802 100.0% $34.75 $2,112,952 100.0%

Interpretation:
The above table shows whether the tenants are credit tenants or not. This information was
searched from websites such as Standard & Poors, Moodys and Fitch to find out the credit
rating of each tenant. Then they are rated as credit and non-credit based on the credit rating
table. A credit tenant generally is an anchor tenant who attracts customers to the property.
His lease lasts long and he is a credit worthy tenant. The area occupied by the tenant and
the income generated by them is also shown in the table.

40
PROPERTY #2

Name : Orchards
Type : Retail
Net Rentable Area : 39,514 SF
Value : $ 10,195,446

41
Table 5.8 Cash Flows
For the Years Ending Jun-2006 Jun-2007 Jun-2008 Jun-2009 Jun-2010 Jun-2011 Jun-2012 Jun-2013 Jun-2014 Jun-2015 Jun-2016

POTENTIAL GROSS REVENUE

Base Rental Revenue $747,767 $780,567 $804,824 $828,481 $833,249 $857,447 $903,593 $919,405 $958,492 $1,003,625 $1,060,211
Absorption & Turnover Vacancy 0 0 (3,278) 0 0 (13,842) 0 (3,800) (8,313) (5,258) (25,792)
Scheduled Base Rental Revenue 747,767 780,567 801,546 828,481 833,249 843,605 903,593 915,605 950,179 998,367 1,034,419
Expense Reimbursement Revenue 356,876 366,479 374,715 386,121 396,235 400,557 418,137 427,917 438,787 452,442 458,089

TOTAL POTENTIAL GROSS REVENUE $1,104,643 $1,147,046 $1,176,261 $1,214,602 $1,229,484 $1,244,162 $1,321,730 $1,343,522 $1,388,966 $1,450,809 $1,492,508
General Vacancy (33,139) (34,411) (32,108) (36,438) (36,885) (23,898) (39,652) (36,620) (33,605) (38,424) (19,757)
Collection Loss (22,093) (22,941) (23,525) (24,292) (24,590) (24,883) (26,435) (26,870) (27,779) (29,016) (29,850)
EFFECTIVE GROSS REVENUE $1,049,411 $1,089,694 $1,120,628 $1,153,872 $1,168,009 $1,195,381 $1,255,643 $1,280,032 $1,327,582 $1,383,369 $1,442,901

OPERATING EXPENSES
Grease Trap Pumping $1,250 $1,288 $1,326 $1,366 $1,407 $1,449 $1,493 $1,537 $1,583 $1,631 $1,680
Alarm Monitoring 300 309 318 328 338 348 358 369 380 391 403
Elevator 1,200 1,236 1,273 1,311 1,351 1,391 1,433 1,476 1,520 1,566 1,613
Management Fee 31,482 32,691 33,619 34,616 35,040 35,861 37,669 38,401 39,827 41,501 43,287
Liability Expense 27,000 27,810 28,644 29,504 30,389 31,300 32,239 33,207 34,203 35,229 36,286
Administration Charges 1,000 1,030 1,061 1,093 1,126 1,159 1,194 1,230 1,267 1,305 1,344
Other CAM 115,294 118,753 122,315 125,985 129,764 133,657 137,667 141,797 146,051 150,433 154,945
Real Estate Taxes 102,000 106,080 110,323 114,736 119,326 124,099 129,063 134,225 139,594 145,178 150,985
TOTAL OPERATING EXPENSES $279,526 $289,197 $298,879 $308,939 $318,741 $329,264 $341,116 $352,242 $364,425 $377,234 $390,543

NET OPERATING INCOME $769,885 $800,497 $821,749 $844,933 $849,268 $866,117 $914,527 $927,790 $963,157 $1,006,135 $1,052,358

LEASING & CAPITAL COSTS

Tenant Improvements $0 $0 $12,293 $0 $0 $26,373 $26,299 $14,251 $4,988 $19,718 $41,158
Leasing Commissions 0 0 9,835 0 0 21,099 21,039 11,401 24,940 15,775 79,829
Capital Reserve 5,927 6,105 6,288 6,477 6,671 6,871 7,077 7,290 7,508 7,734 7,966
TOTAL LEASING & CAPITAL COSTS $5,927 $6,105 $28,416 $6,477 $6,671 $54,343 $54,415 $32,942 $37,436 $43,227 $128,953
CASH FLOW BEFORE DEBT SERVICE $763,958 $794,392 $793,333 $838,456 $842,597 $811,774 $860,112 $894,848 $925,721 $962,908 $923,405
& TAXES

42
43