In the Real Estate Development Course, cases frequently ask you to analyze a proposed investment. To do so, after developing a comprehensive picture of the project, you should generally follow this six step process (also shown in Exhibit 1) to determine value:
 

1.  Evaluate whether the construction/acquisition budget is reasonable.

Make sure that all major categories of cost have been included and that each cost item estimate is in line with other similar projects. The most common omissions are: Professional fees, interest during construction, "points" or other loan fees, contingencies and developer overheads. The phasing of the project is critical in determining interest costs, and delays can increase costs fast. Costs per square foot, particularly for finishes and fitting-out are also often underestimated. Your task is to take a tough-minded approach to assessing each of these costs.

2.  Evaluate whether the expected rental income will be realized.

Critical questions here include: Reasonableness of the projected average rent per square foot, floor to floor differences, charges for common areas, and especially the speed of rent-up. Most major projects do not achieve their potential occupancy in less than two to three years, so don't overstate the early income. Some modest allowance for vacancy is necessary even after several years. It is not reasonable to assume that large percentage increases in rents will occur every year -- forever. Competition, and the likely future cost of new space must be taken into account.

3.  Evaluate whether ongoing expense estimates are adequate and whether tenant payment of all expenses is likely.

Some expenses -- usually about half the total for a "standard" commercial property -- are fixed and will be incurred whether space is occupied or not. The other half generally vary with occupancy. Expenses should be compared to other similar properties. Full tenant payment of expenses will be dependent on whether tenants renting competitive space accept similar prices and terms.

4.  Determine what level and combination of debt and equity the property will support.

The "Free and Clear Cash Flow" of a property, after all expenses, but before debt service, is the primary determinant of the debt the property will support and the value of the remaining equity. If the cash flow is substantial and reliable, virtually all of it can be used to support debt. Over time, as the unpledged portion of the cash flow grows, it can be used to secure additional debt finance either as a secondary loan or by refinancing. The remainder -- including expected income growth -- can then be used to attract more equity. Your goal is, generally, to give away as little ownership as possible to raise the needed debt and equity.

5.  Determine disposition value and timing.

Trends in "free and clear cash flow" also determine whether and when dispositon -- sale -- is desirable. If cash flow is dependable and growing, the property may be sold at an attractive "multiple" of gross or net income. When growth in cash flow is expected to be rapid, it is generally best to defer sale, unless you have immediate needs for the sale proceeds. Increasing the mortgage may be a better way to take out cash -- on a tax-free basis.

6.  Review the above in light of competition.

Very often "the numbers look too good to be true" until a thorough review of the likelihood of short and long term competition has been considered. If yields look "too good to be true," probably they are, and they will soon attract new competitors.