[Spencer Burton]

Good catch. I’d actually caught this near the end of the Watch Me Build video when I was reviewing my assumptions. I made the change to expense growth rates at time 58:40 of the video. The completed Excel file from the Watch Me Build lecture should reflect the correct expense growth rates.

[Spencer Burton]

Absolutely. You can make changes to your A.CRE account on the blog side of the website. All changes there should be reflected on the Accelerator side.

First, login to the main site here: https://www.adventuresincre.com/login. Then, click the ‘Edit Account’ link in the upper right-hand corner to change email address, password, name, and display name.

Let us know if that doesn’t work.

Thanks!

Spencer

[Spencer Burton]

Hi Kyle,

This is a great question. In my experience Actual/365 and Actual/Actual are distinct. Actual/365 assumes a 365 year always, whereas Actual/Actual takes into account leap years.

Spencer

[Spencer Burton]

Hi Matt – thanks for the question.

We do not directly cover after-tax analysis in the Accelerator. This is largely because analysis in real estate is done on a before-tax basis. But also because tax treatment varies from country to country, state to state, and property to property.

In terms of modeling the tax benefits of Opportunity Zone investments in the United States. We won’t be covering that in the Accelerator as Michael and I are far from experts on the subject. I should mention however that we are trying to put some content together for the blog side of the website on the subject, and have actually connected with someone who knows the ins and outs of OZ funds. But I can’t say what the final product will look like exactly, whether it will be a full model or just a discussion on the subject.

Spencer

[Spencer Burton]

Okay, now I understand what you’re referring to. Thanks for the clarification.

You are correct that the Gross Market Value and subsequent Net Market Value are negative (i.e. outflows) when calculating the returns. In this particular case, I intentionally leave the Net Market Value positive within the Investment Cash Flow section but make the Net Market Value negative when building the Net Unlevered Cash Flow line (see time 1:38 in last ‘Returns’ video at the very bottom of Lecture 2.8).

With that said, I understand the confusion and I think comes in both how I present the Investment Cash Flow section and in how the Selling Costs in the Investment Cash Flow calculation are uniquely handled in hold/sell analysis. Let me tackle both one by one.

First, why did I leave Gross Market Value and Net Market Value positive within the Investment Cash Flow section? I do this for visualization purposes; or in other words to make it easier to understand the calculation that’s going on. For example, when modeling development cash flows I always model them as positive values within the Investment Cash Flow section even though they’re negative cash flows at the Net Cash Flow line. In my opinion it’s just easier to work with positive values. In this particular case (the hold scenario analysis), the selling costs are actually adjustments to the Market Value rather than additions to it. So modeling the Market Value as positive values within the Investment Cash Flow section, and then setting them as negative when calculating the returns in my mind made it easier to understand.

The second piece, and I think the main element of confusion, is why the selling costs are an adjustment, rather than an addition to Market Value. In a typical acquisition, Investment Cash Flow is made up of the sum of Purchase Price, Acquisition Cost, and Closing Costs. The sum of those cash flows is Total Acquisition Cost which flows into the returns as a negative value. If this example were an acquisition, you’d be right that the calculation would look something like this:

Purchase Price: 25,000,000
+ Acquisition and Selling Costs: 1,250,000
Total Acquisition Cost: 26,250,000

However in the case of the hold scenario, the selling costs portion of the Investment Cash Flow calculation is actually an inflow. This is because in the hold scenario, the Investment Cash Flow represents the opportunity cost of not selling. Or what we would be missing out on if we didn’t sell the property. And how do we calculate that opportunity cost? We take what we could sell the property for (i.e. Gross Market Value) and we subtract any selling costs to arrive at a Net Market Value (i.e. the net proceeds from selling).

Gross Market Value: 25,000,000
– Selling Costs: 1,250,000
Net Market Value: 23,750,000

Then in the Hold scenario DCF, that Net Market Value flows to the Net Unlevered Cash Flow line (i.e. the returns) as one big negative cash flow in time zero.

Hope that clears up the confusion! Happy to answer any follow up questions you might have.

Spencer

[Spencer Burton]

It was a great question – thanks for it!

Spencer

[Spencer Burton]

Hi Josh,

Before elaborating further, I think it’s important to first distinguish between accounting (i.e. look back) and finance (look forward), and how capital reserves are thought of distinctly in each.

So from a backward looking accounting point of view, all Capital Expenditures are known and itemized; because they actually occurred. The Capital Reserve is not an expenditure in the P&L, because really it’s just a transfer of funds from one account to another. So in your example, from an accounting perspective the $50k per year that was reserved was not a Capital Expenditure in each year but a way to save for the $250k new elevator expenditure that actually occurred in year five. And by the way, the lender probably required that amount to be placed in savings (i.e. lender reserves).

In forward looking analysis like we’re doing here, we don’t necessarily know when capital expenditures will occur. But we need to account for the likelihood that there will be capital expenditures over the hold period. So early in our analysis we’ll hit our income statement with a Capital Reserve amount, either above or below NOI, that will impact returns. Or in other words, we assume some total amount will be spent over the entire hold period but because we don’t know when, we just make a straight-line estimate and we’re done.

Then, as a deal becomes more real, what many firms will do is hire a consultant (i.e. property condition consultant) who will actually forecast what capital expenditures will be needed over the hold period. So for instance, the consultant may predict that the elevator only has five years of life left, the roof has seven years of life, and the building will need to be painted twice over the ten year hold. And maybe the consultant estimates the cost of those capital expenditures will be $1,000,000.

With that information, some firms will adjust the Capital Reserve in their forward looking analysis to reflect the consultants estimate: $1,000,000 ÷ 10 or $100,000 per year. Other firms will then delete the Capital Reserve line all together and manually model the elevator, roof, and paint expenditures in the years that the consultant expects those expenditure to occur. Irrespective of how the timing of the expenditures are modeled, both firms will assume $1,000,000 in capital expenditures over the hold period.

Hope that helps.

Spencer

[Spencer Burton]

Hi AE,

Thanks for the comment. Unfortunately, I don’t quite understand the question.

When you say GMV, are you referring to Gross Reversion Value? And what do you mean by “should be a -ve number in the spreadsheet?”

Also, are you referring to the lecture 2.8 ‘From Theory to an Excel Workbook’? If so, what part of that lecture?

If you wouldn’t mind rephrasing the question that will help me get a good answer for you.

Thanks!

Spencer

[Spencer Burton]

Hi Francisco,

Downtime and Renewal Probability

Glad you brought this up. I think first it’s important to point out that there are various ways to handle downtime assumption and renewal probability. I taught you one method in this course. I use a different method in my All-in-One model. And there are others I’ve seen and used. One method isn’t necessarily better or worse than another, just different. What’s most important is that you understand why the method is being used. Allow me to explain my rationale in this instance.

What column R is solving for is when the 2nd generation lease begins. Remember, from a modeling perspective a tenant labeled “Vacant” is really no different than a tenant with a name. The only difference is we know the contract terms of the named tenant, whereas we’re making an educated guess (i.e. assumption) as to the terms of the “Vacant” tenant’s lease. But in both instances, column R is making an approximation of when the next lease (i.e. the 2nd generation lease) begins.

So take the example of the exercise from this course. In the case of both the Vacant and named tenants, the 2nd generation lease is expected to start 9 months following the end of the 1st generation lease. However, we also set a 70% renewal probability. Meaning, we give this instance a 70% probability that there will be 0 months between the 1st and 2nd generation lease and a 30% probability that there will be 9 months between the 1st and 2nd generation lease. Thus, we use a formula that calculates the weighted average downtime of these two scenarios (70% x 0 + 30% x 9 = 2.7 months). I then round up to the nearest month, 3 in this case. Thus, I assume that there will be 3 months of $0 income between each generation of lease for this tenant.

Again, that’s just one method. Another method, using a 70% renewal probability and 9 months downtime, is to assume no months of $0 income. But instead to assume income is only 70% of gross potential for that tenant during the 9 months between each lease generation. That is the method I use in the All-in-One.

Escalation Formula

Consider that rent bumps for contract leases occur at different times in the year, usually on the anniversary month of the lease start. So if a lease started in July, and has annual bumps, you’d expect future rent increases to occur in July.

The challenge is, every tenant has a different “lease start anniversary month”, so how do you model rent bumps in different months? The Escalation Month value (column V) is part of a module I created that does that calculation.

Essentially, the formula in cell V7: ‘=12-(ROUNDUP(R7/12,0)*12-R7)‘ finds which month of the year (i.e. Jan = 1, July = 7, Nov = 11) that tenant’s rent should increase. It’s a formula I developed myself, and it took some time create. If the lease starts between month 1 and 12 of the analysis, it’s simple. But when the lease starts beyond month 12, say in month 91, it becomes more difficult.

Take month 91 as an example. Which month of the year is month 91? Well month 91 is in year 8 of the analysis – we know this by doing the following calculation: ROUNDUP(91/12,0) = 8. Year 8 starts in month 85 (Jan = 1). Thus 86 = Feb (2), 87 = Mar (3), 88 = Apr (4), 89 = May (5), 90 = Jun (6), and 91 = Jul (7).

To do the above calculation, I developed the formula 12-(ROUNDUP(‘Lease Start Month’/12,0)*12-‘Lease Start Month’). Such that 12-(ROUND(91/12,0)*12-91) = 12-(8*12-91) = 12-(96-91) = 12-5 = Month 7.

Thanks again for the questions!

Spencer

[Spencer Burton]

Hi Josh,

Thanks for the great question. Let me see if I can answer it for you.

First, I think your definition of Capital Reserve (i.e. cash funding set aside for a rainy day) is spot on. The complication enters when you ask, what constitutes a “rainy day”. Some real estate professionals will reserve for leasing costs, usually because a lender requires it, while others will only reserve for property upkeep.

Personally, I prefer to limit my use of Capital Reserve to the cash necessary to maintain the market condition of the property. So a Capital Reserve would be reserving cash for major capital improvements such as replacing the roof, mechanicals, fixing the structure, etc. Such that at sale, there are no deferred maintenance items dragging on the value.

The reason you’ll sometimes see Capital Reserve above the line (i.e. factored into the Direct Cap value), as that many real estate professionals view Capital Reserve as necessary to maintaining the property’s value, and thus should be factored into the valuation calculation.

Now the Capital Expenditures vs. Capital Reserve question is a good one. First off, Capital Reserves are Capital Expenditures, where a Capital Expenditure refers to an amount spent on a tangible asset (e.g. new elevator) that will be used for more than one year in the operation of the property. From a modeling point of view, however, I put all of the unknown Capital Expenditures into the Capital Reserve line item while I place all of the known Capital Expenditures (e.g. leasing costs, known CapEx such as roof repair, capital improvement plan as part of value-add strategy, etc) into separate line items under the Capital Expenditure section.

Hope that helped! Happy to answer any follow up questions you may have.

Spencer

[Spencer Burton]

I wanted to give you an update on this. I spoke with Michael earlier today about this, and he’s working to roll out a fix shortly.

Thanks for giving us a heads up!

Spencer

[Spencer Burton]

Hi Matt,

Thanks for the question. It sounds like your questions will be fully answered in Michael’s development cash flow course and the construction interest portion of our course on Real Estate Debt.

With that said, allow me to quickly offer an answer to both questions.

I model construction debt timing somewhat independent of development cash flow timing. I first model budget cash flows (i.e. uses of capital) and then model debt and equity (i.e. sources of capital). In modeling sources of capital, I build a cumulative loan draw (i.e. construction loan balance) line from which I calculate monthly construction interest. Once construction ends, the construction loan balance only grows by interest and operating shortfall. At some point, operating income is sufficient to cover operating expenses and monthly interest (i.e. breakeven), at which point the loan balance becomes static (i.e. stops growing). Depending on the type of model, whether merchant build (i.e. sell at stabilization) or build to core (i.e. refinance at stabilization), I add an assumption for either a permanent debt funding month or property sell month. I use that assumed month to model a payoff of the construction loan.

In terms of if there is a resource where you can review options for not drawing in a straight line. Absolutely. Michael teaches this in in-depth his development cash flow modeling course. Additionally, here are resources directly from the blog side of the site:

S-Curve Forecasting in Real Estate Development (Updated Sep 2021)

Watch Me Build A Construction Draw Schedule (Updated Jan 2020)

Let me know if you have any other questions on this subject.

Thanks again!

Spencer

[Spencer Burton]

Kyle,

This is a great question. The short answer is, it depends on the credit risk of the tenant. You underwrite a B-rated tenant quite differently than you underwrite a AAA-rated tenant.

Of course in practice, every firms handles this credit risk issue a bit differently.

Some will just simply apply a ‘General Vacancy and Credit Loss’ factor to the tenant each year, depending on its credit risk.

Others will apply a rent payment limit, where the underwriter will say that a tenant will likely only pay rent a certain number of years depending on its rating (e.g. BB rating = max 5 years, AAA = max 30 years). At which point the tenant will vacate, irrespective of the actual lease term.

I’ve also seen some hybrid of the above, where the underwriter will initially assume no General Vacancy or Credit Loss but as the lease progresses, begin to add some credit loss factor each year.

And finally, some will just account for the credit loss in the reversion pro forma. So they won’t include any General Vacancy or Credit Loss throughout the hold period, but will include something in the reversion pro forma to account for a likely termination or lease default beyond the hold.

In the end, it’s dependent on the tenant’s credit, the length of the lease, and how sensitive the real estate professional wants to be to credit risk.

Thanks again!

Spencer

[Spencer Burton]

In the United States, yes it is common to see apartment operators billback common area utility expenses.

But that doesn’t mean the operator is able to recover 100% of utility expenses. This varies by market, but generally you find Apartment owners are able to recover 50% – 90% of actual utility expenses. It really comes down to what the market can bear. For mid-rise product, utility billback tends to max out at $40-$60/unit per month, whereas you might see that be $10-$20/month higher for high-rise.

[Spencer Burton]

Yes, the income statement we provided in this case hadn’t included a percentage rent line item. You did the right thing adding it manually. This is not uncommon by the way. You’ll often find line items in property income statements that are important enough to your analysis to change your income statement to include it.

For instance, cable income is becoming more and more common in multifamily underwriting but it’s not a common line item on a lot of standard MF income statements. But the cable income number can be substantial (up to $150/unit/mo!). So it makes sense to add the line to your analysis when you see it.

As you mentioned, in my Watch Me Build video here I lumped the Percentage Rent in with Other Income. While not wrong, if I were to do the Watch Me Build over again I’d probably add a separate line item for Percentage Rent given its importance to the analysis.

Thanks for the comment!

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