Due Diligence.

Real estate evaluation is a pivotal process in the real estate industry. It involves a comprehensive assessment of a property’s physical attributes, operational costs, expected rental rates, and future market dynamics that could influence income and potential capital appreciation. This process becomes more intricate with investment structures and the construction and financing life cycle of a refurbished or newly developed property. For instance, a newly constructed commercial building in New York City would require a detailed evaluation of its physical attributes, such as the quality of construction, the layout, and the amenities provided. Operational costs such as maintenance, security, and utilities would also be assessed. The expected rental rates would be determined based on the prevailing market rates in the area, and future market dynamics such as potential changes in demand and supply would be considered.

The due diligence process for private real estate is multifaceted. It involves:

1. Market Review and Outlook

For income-producing properties, due diligence primarily focuses on current sale prices, lease rates, and trends. However, opportunistic property investors also consider comparable prices of undeveloped land or properties targeted for refurbishment, as well as construction costs. For instance, an investor looking at a rental apartment building in Chicago would consider the current sale prices and lease rates in the area, as well as the cost of refurbishing the building to increase its rental income.

Real Estate Cycle Dynamics

Forward projections of real estate cycle dynamics are crucial for estimating future income. In the case of value-add real estate renovation projects, improved local economic conditions may be necessary to generate higher rental and lease income following capital improvements. For example, a developer renovating a retail complex in a growing suburb would need to consider the potential increase in consumer spending due to population growth and increased employment.

Additional factors to consider in real estate evaluation include community engagement, the anticipated arrival or departure of major employers, similar development in the area, and changes to public infrastructure. For example, the planned arrival of a major tech company in a city could significantly increase demand for housing and office space, thereby affecting real estate values.

2. Property and Project Plan Review

Prior to making an investment decision, investors typically scrutinize several key documents and studies. These include property surveys, physical feasibility studies, engineering feasibility studies, and environmental feasibility studies. For instance, a property survey for a commercial building in New York would provide detailed information about the property’s boundaries, easements, and any potential encroachments. A physical feasibility study might assess the condition of an old warehouse in San Francisco, determining whether it could be feasibly converted into a residential loft space. An engineering feasibility study could evaluate the proposed solutions for a bridge construction project in London, while an environmental feasibility study might assess the potential impact of a new shopping mall in Sydney on local wildlife habitats. Each of these studies offers crucial insights about the property or project, such as its physical condition, the feasibility of the proposed engineering solutions, and the potential environmental impact.

Alongside these studies, investors also examine construction plans and details. These documents offer a comprehensive overview of the proposed construction process, including the materials to be used, the timeline for completion, and the estimated cost. For example, the construction plan for a new office building in Tokyo might specify the use of energy-efficient materials, a completion timeline of 18 months, and an estimated cost of $50 million.

The reputation and experience of the architecture and engineering (A&E) firm serving as a technical consultant is another crucial factor that investors consider. A reputable and experienced A&E firm, such as Foster + Partners or Zaha Hadid Architects, can provide valuable insights and advice, helping to ensure that the project is completed successfully.

Finally, the coordination and integration of the design and construction process are key factors affecting the timely completion of a project within the original budget. Effective coordination and integration, such as the use of Building Information Modeling (BIM) technology, can help to prevent delays and cost overruns, ensuring that the project is completed on time and within budget.

3. Developer, Contractor, and Supplier Review

The construction phase is critical, requiring collaboration among developers, general and specialty contractors, and suppliers.

An Architecture and Engineering (A&E) firm or a general contractor may deliver a project on a turnkey basis, meaning it is fully completed upon delivery, which concentrates execution risk with a single entity.

Projects can also be executed in stages, with progress payments made at key milestones, such as in the construction of a highway.

Key factors include the experience of contractors on similar projects, past partnerships between parties, and their financial strength.

Adherence to safety measures, alignment of incentives, and adequate liability insurance are crucial considerations for project success.

4. Lease Commitments and Cash Flow Projections

In real estate investment, understanding lease commitments and how they impact cash flow projections is crucial. The level and variability of property income can differ significantly based on the business strategy, type of property, and lease commitments in place upon completion. For instance, a commercial building in a prime location with long-term lease agreements might generate a steady stream of income, while a residential property in a less desirable area with short-term leases might have more variable income.

Lease commitments can range from a single commercial tenant with a pre-signed rental contract, one or two major retailers committed to leases in a multi-tenant shopping facility, or a property constructed on a speculative basis with no predevelopment leases in place. For example, a large shopping mall might have anchor tenants like Walmart or Target with long-term lease commitments, while a speculative office building might not have any tenants lined up at the time of construction.

Base-case assumptions supporting income and expense forecasts should be critically evaluated. This means scrutinizing the assumptions about rental income, operating expenses, and capital expenditures. For example, if a property is expected to generate $1 million in annual rental income, but the operating expenses are projected to be $1.2 million, the property would operate at a loss unless adjustments are made. Possible construction or lease delays or other adverse events should be taken into consideration while making these forecasts. For instance, if a property is under construction, potential delays due to weather, labor disputes, or supply chain issues should be factored into the cash flow projections.

5. Financing Plan Review

Investors play a significant role in the financial structure of a project. Their assessment of future cash flows can greatly influence the project’s success. For instance, a venture capitalist investing in a tech startup would assess the level and variability of future cash flows based on their position in the startup’s capital structure and life cycle timing. They would also view associated risks and considerations differently, depending on their investment strategy and risk tolerance.

Acquisition, Development, and Construction (ADLs) and Construction & Development (C&D) Loans

Investors in debt drawn during the land purchase, development, and construction phases focus on the nature of costs funded, expected financial leverage, and the commitment and timing of permanent debt financing. For example, a real estate developer might take on a C&D loan to finance the construction of a new apartment complex. The lender would focus on the costs of land acquisition, construction materials, and labor, as well as the developer’s commitment to securing permanent financing upon completion. Greater risk is present when drawdowns are for fees or project management costs as opposed to land and building materials expenses. The probability of default for such loans is greater for projects that rely more heavily on debt financing or that lack a firm mortgage commitment upon completion. Early-stage lenders pay particular attention to the financial condition of developers, loan covenants, and completion of project milestones over time.

Mortgage Loans

Permanent lenders evaluate the degree of upfront commitment, as well as the expected and actual debt coverage, leverage, and the profitability of the completed project. For instance, a bank providing a mortgage loan for a commercial property would evaluate the borrower’s upfront commitment, the expected and actual debt coverage ratios, and the profitability of the completed project. Firm loan commitments at rates or spreads fixed prior to project completion carry greater risk because they must rely on the value of the undeveloped land only. Standby commitments usually allow for adjusted market rates and other terms upon loan disbursal. Mortgage prepayment features give rise to reinvestment risk for lenders.

Equity

Equity plays a crucial role in the financial structure of a project. Prospective equity investors must balance the higher return of projects with greater leverage and financial flexibility with the risk-reducing benefits that financially sound debt providers able to meet debt drawdowns typically impose. For example, an angel investor considering an equity investment in a startup would need to balance the potential for high returns against the risks associated with the startup’s leverage and financial flexibility. Such benefits include leverage- and covenant-based constraints. Equity owners must understand the consequences of debt drawdowns not occurring or a loan not closing and be prepared to potentially inject additional equity to bridge the project or walk away and lose their existing equity investment.

6. Partnership Agreement, Legal, and Documentation Review

In private real estate investments, there are several key aspects that investors need to be aware of. These include the partnership agreement, legal and documentation review, financial disclosures, compensation arrangements, and the considerations for prospective Limited Partner (LP) investors.

Partnership Agreement

Private real estate investments often involve a partnership agreement. For instance, if you and a friend decide to invest in a rental property, you would likely create a partnership agreement to outline the terms of your investment.

This agreement governs shareholder rights, which may include voting rights or General Partner (GP) appointment rights. For example, in a real estate investment trust (REIT), shareholders may have the right to vote on major decisions or appoint the GP.

Financial Disclosures and Sale Restrictions

The partnership agreement also covers financial disclosures. This could include the requirement for annual financial statements or regular updates on the property’s performance.

It includes sale restrictions such as lockup provisions. A lockup provision, for example, might prevent you from selling your share of the investment for a certain period of time.

Compensation Arrangements

The review extends to compensation arrangements that aim to align the incentives of the manager and the investor. For instance, the manager might receive a performance-based bonus, encouraging them to maximize the return on the investment.

Prospective Limited Partner (LP) Investors

Prospective LP investors need to consider the potential risks of early involvement, concentration in larger investments, and/or longer lockup periods. For example, investing in a large commercial property might offer higher returns, but it also comes with greater risk and a longer commitment. These risks need to be weighed against the greater rewards offered by GPs for such positions. In other words, the potential for higher returns might justify the increased risk and commitment.

Legal and Tax Review

Similar to public investments, a legal and tax review of ownership history is necessary. This ensures that the property is free of any liens or tax obligations, protecting the new owner and secured lenders. For example, before purchasing a property, you would want to ensure that there are no outstanding property taxes or liens that could affect your ownership.

Private Real Estate Valuation Approaches

Private real estate valuation is a critical process that involves the estimation of the most probable price that a property should bring in a competitive and open market. This process involves the use of income, cost, and sales comparison approaches. These methods are not exclusive to private real estate but are also applicable in the valuation of public real estate and other private market assets. The valuation of private real estate is distinguished by factors such as property development life cycle dynamics, the future state of the real estate market, and the income and capital appreciation of a completed project. Real options are also considered, which relate to an investor’s ability to change a planned course of action in response to changing market conditions.

Private real estate investors often use more than one valuation approach to determine a price at which they may be willing to buy or sell a property over the development life cycle. The preferred method can vary based on an investor’s position and property characteristics.

Income Approach

The income approach to private real estate valuation focuses on the property’s ability to generate earnings, either currently or in the future. It’s particularly suitable for properties like commercial buildings, which have stable, long-term lease agreements with tenants. The fundamental concept behind this approach is that the value of the property is directly related to the income it can produce. This method is preferred when earnings are considered the primary source of value, based on the property’s current or anticipated economic use.

Direct Capitalization Method

The direct capitalization method, which uses the single-year Net Operating Income (NOI) in the numerator, assumes consistent future earnings. This method is used to gauge the post-completion value of a property based on future earnings under its new economic use. In the case of new development, the potential for development from which the raw land derives its value is considered, rather than current earnings. Here, a market price comparison to other nearby comparable properties available for development is more suitable than an income valuation approach.

Sales Comparison Approach

For properties such as vacant lots in rapidly developing areas, where the potential for development contributes more to the value than current earnings, the sales comparison approach is more appropriate. This method involves comparing the property to similar ones in the vicinity that have been recently sold. The value is determined based on market comparables, making it suitable for valuing properties with significant developmental prospects rather than existing income generation capabilities.

Cost Approach

The cost approach to real estate valuation considers the expenses associated with acquiring the land and constructing a new building that matches the economic use of the appraised property. This method is particularly useful for properties where replacement costs provide a solid basis for valuation, such as unique or specialized real estate. The valuation reflects the cost of replicating the property in its current state, thereby providing a baseline value derived from the property’s physical and functional characteristics.

Discounted Cash Flow (DCF) Method

The DCF method is a dynamic approach that is ideal for capturing cyclical or multiperiod trends in real estate valuation. It involves discounting a series of projected cash flows and a terminal value back to the present value. This method is applicable when there is enough information to estimate the property’s cash flows over several years, making it suitable for properties with predictable and stable income streams, such as those with long-term leases. The DCF analysis allows for a comprehensive understanding of a property’s value over time, considering the time value of money and expected future income.
$$\text{Property value} = \sum_{i=1}^{n} \frac{\text{NOI}_{t+i}}{(1+ r)^i} + \frac{\text{Terminal value}}{(1 + r)^n} $$

It helps to calculate the post-completion value of a property based on future earnings, factoring in the number of years (n), the NOI, the discount rate (r), and the specific time period (t). It is particularly useful for evaluating the potential of new developments, where the value is derived from the property’s developmental prospects rather than its current earnings. Terminal value helps in determining the future value of a property at the end of a specified period, based on its expected income. The terminal value can be calculated using the formula:

$$\text{Terminal value} = \frac{\text{NOI}_n}{r – (1+ \text{growth rate})}$$

Cash Flow Forecast Method

This approach is used for properties or companies with stable income sources that are not expected to fluctuate significantly over the forecast period. A property with a long-term lease, offering predictable rental income, exemplifies an ideal candidate for this method. The cash flow forecast method focuses on the direct projection of income and expenses to derive a property’s value, emphasizing the importance of stable and reliable income sources in real estate investment.

Scenario Analysis

Scenario analysis offers a way to evaluate a property’s potential value under different market conditions by considering multiple outcomes. This method is beneficial in situations with high uncertainty, such as development projects or volatile real estate markets. By analyzing a range of scenarios, from the most optimistic to the most pessimistic, this approach provides a weighted valuation based on the probability of each outcome. This enables a more nuanced understanding of the potential risks and rewards associated with a real estate investment.

Sensitivity Analysis

Used to assess the impact of changes in key variables on the investment’s return, sensitivity analysis is crucial for understanding the robustness of a property’s valuation against fluctuations in market conditions, such as interest rates or rental income changes. This method simplifies the valuation process by focusing on fewer scenarios and variables, making it an effective tool for investors to gauge the potential effects of different market dynamics on a property’s profitability. The property’s value is adjusted based on the probable outcomes, providing a more dynamic and responsive valuation technique.

$$\text{Property value} = \sum_{i=1}^{n} \text{Probability (i)} \times \text{Property value}_i $$

Where \(\text{Probability(i)}\) represents the likelihood of each scenario occurring, and \(\text{Property value}_i\) indicates the value of the property under scenario i, with the sum of all scenario probabilities equaling 1.

Example

Mia Wong at PacificStructures is evaluating a real estate development project in Chiang Mai, Thailand. The project involves constructing a residential complex with 600 units averaging 1,200 \(ft^2\) each, totaling 720,000 \(ft^2\). Wong has gathered data from four recent property transactions in Chiang Mai that are comparable to the PacificStructures project. She assessed each property’s key features, including location, age, and size, to establish an expected net difference in price per \(ft^2\).

Comparable Data and Adjustments: The data for the Chiang Mai project and the four comparables are as follows:

$$ \begin{array}{l|c|c|c|c|c}
\textbf{Description} & \textbf{Project} & \textbf{Comp 1} & \textbf{Comp 2} & \textbf{Comp 3} & \textbf{Comp 4} \\ \hline
\text{Gross Square} & {720,000} & {800,000} & {680,000} & {750,000} & {700,000} \\
\text{Feet} & \text{ ft}^2 & \text{ ft}^2 & \text{ ft}^2 & \text{ ft}^2 & \text{ ft}^2 \\ \hline
{\text{Price per ft}^2 } & – & {\text{THB} } & {\text{THB} } & {\text{THB} } & {\text{THB } } \\
\text{(Before} & & 48.50 & 52.00 & 47.00 & 49.50 \\
\text{Adjustments)} & & & & & \\ \hline
\text{Location} & – & +3\% & -5\% & +4\% & 0\% \\
\text{Adjustment} & & & & & \\ \hline
\text{Age} & – & 0\% & -3\% & +2\% & +1\% \\
\text{Adjustment} & & & & & \\ \hline
\text{Size} & – & -2\% & +1\% & 0\% & -1\% \\
\text{Adjustment} & & & & & \\
\end{array} $$

Project Details:

• Current Cost: THB 30,000,000
• Expected Development Completion: 2 years

Determine if the Chiang Mai project will exceed PacificStructures’ 12% hurdle rate.

Step 1: Calculate Adjusted Price per Square Foot for Each Comparable

• Comp 1:
  • Base Price: THB 48.50
  • Total Adjustment: \(+3\% + 0\% – 2\% = +1\%\)
  • Adjusted Price: \(48.50 \times (1 + 0.01) = \text{THB} 49.00\)
• Comp 2:
  • Base Price: THB 52.00
  • Total Adjustment: \(-5\% – 3\% + 1\% = -7\%\)
  • Adjusted Price: \(52.00 \times (1 – 0.07) = \text{THB} 48.36\)
• Comp 3:
  • Base Price: THB 47.00
  • Total Adjustment: \(+4\% + 2\% + 0\% = +6\%\)
  • Adjusted Price: \(47.00 \times (1 + 0.06) =\text{THB} 49.82\)
• Comp 4:
  • Base Price: THB 49.50
  • Total Adjustment: \(0\% + 1\% – 1\% = 0\%\)
  • Adjusted Price: \(49.50 \times (1 + 0) =\text{THB} 49.50\)

Step 2: Estimate Expected Price per Square Foot for the Project

The average adjusted price per square foot for the Chiang Mai project, based on the comparable properties, is \( \frac{\text{THB 48.36} + \text{THB 49.00} + \text{THB 49.82} + \text{THB 49.50}}{4} = \text{THB 49.17} \)

Step 3: Calculate Expected Total Value upon Completion

With the average adjusted price per square foot, the expected total value of the project upon its completion is \( 720,000 \times \text{THB 49.17} = \text{THB 35,402,400}\)

Step 4: Evaluate Against the Hurdle Rate

Using the expected total value and the initial cost, calculate the IRR to compare against the 12% hurdle rate.

The IRR is calculated using the initial cost and the expected total value upon completion to compare against the 12% hurdle rate. The formula for IRR, considering the project has only two cash flows (initial investment and return upon completion), is derived from the NPV formula set to zero:

$$0 = -\text{Initial Investment} + \frac{\text{Future Value}}{(1 + IRR)^n}$$

Where:

• \(n\) is the number of periods (2 years in this case).
• \(IRR\) is the internal rate of return.
• \(\text{Future Value}\) is the expected total value upon completion.

$$0 = -\text{30,000,000} + \frac{\text{35,402,400}}{(1 + IRR)^2}$$

$$IRR = \left( \frac{\text{35,402,400}}{\text{30,000,000}}\right)^{\frac{1}{2}} – 1 = 8.63\%$$ Under the given project details and assumptions, the Chiang Mai project would not exceed PacificStructures’ 12% hurdle rate, as the calculated IRR is below the specified threshold.

Forecast the project’s Net Operating Income

Mia Wong is utilizing a scenario analysis to augment her initial examination of the real estate development project in Chiang Mai. Three scenarios have been defined to assess the project’s performance in Year 3 of operation:

• Growth Scenario: This scenario assumes a 10% increase in rental rates due to a local shortage of rental housing, leading to lower vacancies and a decrease in operating costs. The expected Year 3 NOI under this scenario is THB 7,151,344.
• Base-Case Scenario: Based on current market trends without significant changes, this scenario projects a Year 3 NOI of THB 6,093,360, serving as the baseline for comparison.
• Oversupply Scenario: Reflecting a potential 10% decrease in rental rates caused by market oversupply, along with increased vacancies and a 2% rise in operating costs, this scenario results in a Year 3 NOI of THB 4,422,600.

Each scenario is assigned a probability, reflecting its likelihood of occurrence:

$$ \begin{array}{l|c|c}
\textbf{Scenario} & \textbf{Probability} & \textbf{Year 3 NOI (THB)} \\ \hline
\text{Growth Scenario} & 25\% & 7,151,344 \\ \hline
\text{Base-Case Scenario} & 45\% & 6,093,360 \\ \hline
\text{Oversupply Scenario} & 30\% & 4,422,600
\end{array} $$

The calculation of the expected NOI for the first full year of operation (Year 3) and the project value using a direct capitalization approach with a 10% cap rate can be calculated as follows. The scenario analysis provides three scenarios with associated probabilities and NOIs.

Step 1: Calculate Expected NOI

The expected NOI is calculated by weighting each scenario’s NOI by its probability and can be calculated as:

$$ \begin{align*} \text{Expected NOI} & = (\text{NOI}_{\text{Growth}} \times P_{\text{Growth}}) + (\text{NOI}_{\text{Base-Case}} \times P_{\text{Base-Case}}) \\ & + (\text{NOI}_{\text{Oversupply}} \times P_{\text{Oversupply}}) \end{align*} $$

Where:

• \(\text{NOI}_{\text{Growth}} = 7,151,344\) THB
• \(\text{NOI}_{\text{Base-Case}} = 6,093,360\) THB
• \(\text{NOI}_{\text{Oversupply}} = 4,422,600\) THB
• \(P_{\text{Growth}} = 25\% = 0.25\)
• \(P_{\text{Base-Case}} = 45\% = 0.45\)
• \(P_{\text{Oversupply}} = 30\% = 0.30\)

$$ \begin{align*} \text{Expected NOI} & = (7,151,344 \times 0.25) + (6,093,360 \times 0.45) \\ & + (4,422,600 \times 0.30) \\ & = 5,856,628 \end{align*} $$

Using the direct capitalization method with a 10% capitalization rate (cap rate), the project value (PV) is estimated as follows:

$$\text{PV} = \frac{\text{Expected NOI}}{\text{Cap Rate}}$$

Given a cap rate of 10% or 0.10, the formula becomes:

$$\text{PV} = \frac{\text{5,856,628}}{0.10} = 58,566,280$$

Real Options in Real Estate Investment

Real options in real estate investment refer to the strategic opportunities investors have to alter their course of action in response to market changes or new information. These options grant the right, though not the obligation, to take certain actions that can enhance a property’s value. Common real options include the delay option, which allows investors to postpone development or investment decisions; the sequencing option, which enables the phased development of a project; and the switching option, which offers the flexibility to change the intended use of a property based on evolving market demands.

Calculating Project NPV with Real Options

The inclusion of real options in the valuation of real estate investments provides a more nuanced view of a project’s potential value. The calculation for the net present value (NPV) of a project incorporating real options is given by the formula:

$$\text{Project NPV} = \text{NPV (without options)} – \text{Option cost} + \text{Option value}$$

This formula takes into account the base NPV of the project without considering the real options, subtracts the cost associated with acquiring and maintaining these options, and adds the value that these options could potentially bring to the project. This method acknowledges the flexibility and strategic value that real options provide to investors, allowing for a more dynamic approach to real estate valuation.

Valuation Methods Incorporating Real Options

Investors have several methods at their disposal to factor real options into the valuation of real estate investments. One common approach is conducting a Discounted Cash Flow (DCF) analysis without including options, to establish a baseline valuation. The Net Present Value (NPV) with real options is then calculated to understand the additional value that strategic investment decisions could bring. Decision tree analysis and option pricing models are also used to evaluate the potential outcomes and financial implications of exercising real options, offering a structured way to assess the strategic opportunities available to real estate investors.

These methods highlight the importance of flexibility in investment strategies and the potential for real options to significantly influence the value and feasibility of real estate projects. By incorporating real options into the valuation process, investors can make more informed decisions that account for the inherent uncertainties and dynamic nature of the real estate market. Investors may use different methods to factor these alternatives into valuation, such as conducting a Discounted Cash Flow (DCF) analysis without options, calculating Net Present Value (NPV) with real options, or using a decision tree or option pricing model.

Example Case Study

A manufacturing company is considering an investment in a new plant. The initial investment cost is USD 80,000,000, with an expected present value of returns of USD 100,000,000. The company also has the option to expand the plant in one year, which requires an additional USD 5,000,000 in upfront costs to make the initial plant expansion-ready. The expansion is expected to increase returns by 25% if market demand grows.

The company estimates a 60% probability of market demand growth and a 40% chance that the market will remain stable, with no additional returns from expansion. The required rate of return for the project is 15%.

Calculate NPV without Expansion Option

When considering the investment in a new manufacturing plant, we include the real option of expansion to capture the value of flexibility in response to future market conditions. We need to determine the net present value (NPV) of the project, both without and with the option to expand, under the given assumptions.

First, we calculate the NPV of the project without considering the expansion option. This step provides a baseline for comparison. The NPV is the difference between the expected present value of returns and the initial investment cost which can be calculated as .

$$ \begin{align*} \text{NPV}_{\text{initial}} &= \text{Expected Present Value of Returns} – \text{Initial Investment Cost} \\
\text{NPV}_{\text{initial}} &= \text{USD} 100,000,000 – \text{USD} 80,000,000 = \text{USD} 20,000,000 \end{align*} $$

Calculate Expected NPV with Expansion Option

Next, we consider the option to expand the plant, which requires an upfront cost to make the plant ready for potential expansion. This cost is incurred regardless of whether the expansion happens. The expected additional returns from expansion are calculated based on the probability of market demand growth.

$$ \begin{align*} & \text{Expected NPV}_{\text{with expansion}} \\ & = \left( \text{Probability of Growth} \times \left( \frac{\text{Additional Returns from Expansion}}{(1 + \text{Required Rate of Return})} \right) \right) \\ &- \text{Expansion Option Cost} + \text{NPV}_{\text{initial}} \end{align*} $$

The additional returns from expansion are 25% of the expected present value of returns if the market demand grows. We discount these additional returns to present value using the required rate of return of 15%.

$$ \begin{align*} \text{Additional Returns from Expansion} & ={ \text{USD } 100,000,000}\times 25\% \\ & = {\text{USD } 25,000,000} \\
\text{Discounted Additional Returns} & = \frac{ \text{USD 25,000,000}}{1 + 15\%} \\ & = {\text{USD }21,739,130} \\
\text{Expected NPV with Expansion} & = 60\% \times {\text{USD } 21,739,130} \\ & – {\text{USD } 5,000,000} + { \text{USD } 20,000,000} \\ &= {\text{USD }28,043,478} \end{align*} $$

Comparing the NPV without the expansion option (USD 20,000,000) and the expected NPV with the expansion option (approximately USD 28,043,478), we find that incorporating the option to expand adds significant value to the project. Therefore, the manufacturing company should proceed with the investment in the new plant, including the upfront cost for the expansion option, to capitalize on potential market growth and enhance the project’s value.

Practice Questions

Question 1: In the context of private real estate, the due diligence process is multi-dimensional and involves a thorough evaluation of various aspects of the property. This includes not only the physical attributes and operational costs but also the expected rental rates and future market dynamics. Additionally, the construction and financing life cycle of a refurbished or newly developed property is taken into account. Given this, which of the following is NOT typically considered in the due diligence process for private real estate?

1. The property’s physical attributes and operational costs.
2. The expected rental rates and future market dynamics.
3. The property’s historical significance and architectural style.

Answer: Choice C is correct.

The property’s historical significance and architectural style is typically not considered in the due diligence process for private real estate. While these factors may be of interest to certain buyers or investors, they are not typically part of the formal due diligence process. The due diligence process for private real estate is primarily focused on evaluating the financial and operational aspects of the property, as well as the potential for future returns. This includes a thorough evaluation of the property’s physical attributes and operational costs, the expected rental rates and future market dynamics, and the construction and financing life cycle of a refurbished or newly developed property. These factors are all crucial in determining the potential profitability of a real estate investment and are therefore key considerations in the due diligence process.

Choice A is incorrect. The property’s physical attributes and operational costs are indeed a crucial part of the due diligence process for private real estate. These factors can significantly impact the profitability of a real estate investment and are therefore thoroughly evaluated during the due diligence process.

Choice B is incorrect. The expected rental rates and future market dynamics are also a key part of the due diligence process for private real estate. These factors can significantly impact the potential returns on a real estate investment and are therefore thoroughly evaluated during the due diligence process.

Question 2: For income-producing properties, due diligence primarily focuses on current sale prices, lease rates, and trends. However, opportunistic property investors also consider other factors. Which of the following is NOT typically considered by opportunistic property investors when conducting due diligence for income-producing properties?

1. Comparable prices of undeveloped land or properties targeted for refurbishment.
2. Construction costs.
3. The property’s proximity to the investor’s residence.

Answer: Choice C is correct.

Opportunistic property investors typically do not consider the property’s proximity to their own residence when conducting due diligence for income-producing properties. The location of the investor’s residence is irrelevant to the potential income and return on investment that a property can generate. Instead, opportunistic investors focus on factors that can directly impact the property’s income potential and market value. These include the current sale prices, lease rates, market trends, comparable prices of undeveloped land or properties targeted for refurbishment, and construction costs. The investor’s personal convenience or preference does not play a role in the professional assessment of a property’s investment potential. Therefore, the property’s proximity to the investor’s residence is not a factor that is typically considered in the due diligence process for income-producing properties.

Choice A is incorrect. Comparable prices of undeveloped land or properties targeted for refurbishment are indeed considered by opportunistic property investors. These prices can provide valuable insights into the potential profitability of a property investment, especially for investors who are considering refurbishing or developing a property to increase its value.

Choice B is incorrect. Construction costs are also a key factor considered by opportunistic property investors. These costs can significantly impact the profitability of a property investment, particularly for investors who are planning to refurbish or develop a property. Understanding the construction costs can help investors to accurately estimate the total investment required and the potential return on investment.

Glossary:

• Turnkey: A type of project that is constructed so that it can be sold to any buyer as a completed product.
• Execution Risk: The risk that a project will not be completed on time, within budget, or meet performance specifications.
• Progress Payments: Payments made in stages as work on a project progresses.
• Liability Insurance: Insurance that provides the insured party with protection against claims resulting from injuries and damage to people and/or property.
• Real Estate Evaluation: The process of assessing a property’s physical attributes, operational costs, expected rental rates, and future market dynamics.
• Due Diligence: A comprehensive appraisal of a business or a property to establish its assets and liabilities and evaluate its commercial potential.
• Income-Producing Properties: Properties that generate income for the owner, typically through renting or leasing.
• Real Estate Cycle Dynamics: The cyclical nature of the real estate market, characterized by periods of growth, plateau, and decline.
• Property Survey: A detailed examination and report on the physical boundaries, easements, and potential encroachments of a property.
• Physical Feasibility Study: An assessment of the physical condition of a property or project, determining its suitability for a proposed use or development.
• Engineering Feasibility Study: An evaluation of the proposed engineering solutions for a project, assessing their practicality and potential effectiveness.
• Environmental Feasibility Study: An assessment of the potential environmental impact of a project, considering factors such as local wildlife habitats, water quality, and air pollution.
• Construction Plans: Detailed documents outlining the proposed construction process, including the materials to be used, the timeline for completion, and the estimated cost.
• Architecture and Engineering (A&E) Firm: A company that provides professional services in the fields of architecture and engineering, often serving as a technical consultant on construction projects.
• Building Information Modeling (BIM): A digital representation of physical and functional characteristics of a facility. A BIM is a shared knowledge resource for information about a facility forming a reliable basis for decisions during its life-cycle; defined as existing from earliest conception to demolition.
• Cash Flow Forecast: A detailed projection of a company’s cash inflow and outflow over multiple periods.
• Scenario Analysis: A method that combines a base case with alternative outcomes to incorporate more favorable or adverse scenarios in the valuation process.
• Sensitivity Analysis: A technique used to determine how different values of an independent variable impact a particular dependent variable.
• Real Options: The right but not the obligation to take future action that can affect a property’s value.
• Discounted Cash Flow (DCF): A valuation method used to estimate the value of an investment based on its future cash flows.
• Net Present Value (NPV): The difference between the present value of cash inflows and the present value of cash outflows over a period of time.
• Lease Commitments: Legal obligations to pay rent for the use of a property, typically outlined in a lease agreement.
• Property Income: The revenue generated from renting or leasing a property.
• Income and Expense Forecasts: Projections of the potential revenue and costs associated with a property, used to evaluate the profitability of a real estate investment.
• Base-case Assumptions: The expected scenario used as a starting point for making financial projections.
• Debt: An amount of money borrowed by one party from another.
• Equity: The ownership interest of investors in a business.
• Acquisition, Development, and Construction (ADLs) Loans: Loans used to purchase property, develop it, and construct buildings or other structures.
• Construction & Development (C&D) Loans: Loans used for the construction and development of real estate projects.
• Mortgage Loans: Loans secured by the collateral of specified real estate property that the borrower is obliged to pay back with a predetermined set of payments.
• Debt Coverage Ratio: A financial metric that measures the ability of a company to produce enough cash to cover its debt payments.
• Leverage: The use of borrowed money to increase the potential return of an investment.
• Covenant: A promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out.
• Partnership Agreement: A legal document that outlines the terms and conditions of a partnership.
• General Partner (GP): A partner who has unlimited liability for the debts of the partnership.
• Financial Disclosures: Information about a company’s financial position that is released to the public.
• Lockup Provision: A contractual clause preventing investors from selling their shares for a specified period.
• Limited Partner (LP): A partner whose liability is limited to the extent of their share of ownership.
• Liens: A right to keep possession of property belonging to another person until a debt owed by that person is discharged.

Private Markets Pathway Volume 2: Learning Module 6: Private Real Estate Investments; LOS 6(c): Discuss the due diligence and valuation processes for private real estate