EVALUATING INVESTMENT
IN REAL ESTATE PROJECTS

By

Mohammed Ghane
B. Sc. Arch., University ofTechnology, 1985

Thesis Submitted In Partial Fulfillment of
The Requirements for the Degree Of
Master of Business Administration

THE UNIVERSITY OF NORTHERN BRITISH COLUMBIA
April2010

© Mohammed Ghane, 2010

UNIVERSilY of NORTHERN
BRlTISH COLUMBIA
LIBRARY
Prince George, B.C.

ABSTRACT
This study demonstrates the application of a financial model to evaluate the expected return
from investing in real estate projects. Based on the analytical framework which is widely adopted in
the market, the study examines the dynamics of supply and demand in the space and asset markets
and its impact on valuation of real assets in Canada. The study presents a financial and market
analysis for a hypothetical project using actual data of real estate properties close to Vancouver in
British Columbia. The valuation is based on the fact that real estate provides potential future cash
flow for investors, similar to any other asset in the capital market. The study also links the empirical
results of this valuation with the supply and demand theory in order to understand the boom and bust
that happened in real estate during the last few years. The analysis shows that the high increase in
property prices in 2003-2007 has led to a sharp reduction in cap rates which has a great impact on
lowering investor returns from real estate properties. The study concludes that the current rent level is
below the long-term equilibrium and, therefore, holding a property for rent does not meet the
expected return criteria.

ii

TABLE OF CONTENTS
ABSTRACT ...................... .. ................... .... ... ... .. ... ...... ...... ..... ..... ........ .... ... ........... ....... .................... ii
TABLE OF CONTENTS .......... ........................ ...... .... ........ ...... ........ .. ....... ............. .............. ........... iii
LIST OF TABLES ................................................................................................................... ......... v
LIST OF FIGURES ......................................................................................................................... vi
ACKNOWLEDGEMENT ........................................................................................................ ....... vii
INTRODUCTION .................. ...... ................ .................................................. .................... .............. 1
Chapter 2 ...... ...... ................. .. ................. ... ......... .... .. ......... ....... ................... ............ ...... ... ........... ..... 4
THE ANALYTICAL FRAMEWORK ........................................................... ..................... .. ............ 4
Space Market ........ .................. .. ...................... .... ...... ................... .. .. ... .. ................. ......... ... 4

2.1
2.1.1

Segmentation of Space Market ................................ .................... .................... ........... 4

2.1.2

Supply and Demand in the Space Market ........ ...................... ...................... .............. . 5

2.1.3

Supply, Development Cost and Rent .......................................................................... 8

2.1.4

Direction of Rent .......... ....... ..... .... .... .. .. ........ ... .............. .. ..... .. .......... .. .. ..... .. .............. 9
Asset Market ..... .............................................................. .. .. .... ...... ......... .................... .... . 10

2.2
2.2.1

Real Estate Asset Pricing ...... .. .................................... ...... .. .......... ...................... ..... 10

2.2.2

Factors Determining Cap Rate .... .............................. ...................... .................. ........ ll

2.3

Development Industry .... ........ .............. ....... ....................... .......... ....................... .. ........... 12

2.4

The Real Estate System .............................................. ................ ...... ....... ..... ............ ....... 13

2.5

Four-Quadrant Model ...................................................................................................... 15

2.6

Boom and Bust in Real Estate Market.. .. .. .. ...... .... .. ........................ .................... .... .......... 18

Chapter Summary ................................................................................................................... 23
Chapter 3 ................................................. ...... ...... ....... ....... ... .. .......... .. .. ..... .................... ................. 24
DATA SOURCE AND METHODOLOGY ............... ........ ..... ... ............. ....... ........... ................... .... 24
3.1

Site Description ............................................................................................................... 25

3.2

Development Proposal ..................................................................................................... 25

3.3

Market Study .... ....................... .. .................. .. ..... .... ... ............ .. ... .... ............... ......... ......... 26

3.4

Proforma ......................................................................................................................... 28

3.4.1

Option 1................................................................................................................... 30

3.4.2

Option 2 ..... ...... ....... ... ....... .. ... .... ........ .... ............................... ........ ................ .......... . 31

3.5

Cost of Capital. ....................................... .......... ....... ................... .... .. .... ...... ... .... ............. . 33
iii

3.5.1

Cost ofEquity .. ..... .... .... ....... ......... ........... ... ... .... ...... ... ................ ... .... ...................... 33

3.5.2

Cost ofDebt ............................................................................................................. 35

3.5.3

Market Value ............................................. .............................................................. 35

3.5.4

Weighted Average Cost of Capital (WACC) ............................................................ 35

Chapter 4 .......................................................................... .............................................................. 36
EMPIRICAL RESULTS- SCENARIO'S ....................................................................................... 36
4.1

Financial Analysis ................ ..... .... ............. .... ... .............................................................. 36

4.2

Market Analysis .... ................ .... .......... .............. .................. ................ ........................ .... 38

Chapter 5 ...... ..................... .. ......................................................................................................... .. 39
CONCLUSIONS ......... ....... ... .................. .... ................ .... ... .......... .... ..................................... ....... .. 39
BIBLIOGRAPHY ............................................................. .............................................................. 42
APPENDIX A .................... .... ...................... ...... ... ......... .. ............. ............................... .... .............. 45

iv

LIST OF TABLES
Table 1: Site Information of Project A ............. ...... ...... ..... ... ..... ........................................... 46
Table 2: Unit Breakdown .................................................................................................... 46
Table 3: Site Acquisition Cost ............ ................... ...................... .... ............. ................. ..... .46
Table 4: Development Cost and Total Project Cost (Site Acquisition+ Development Cost) 46
Table 5: Weighted Average Vacancy Rate ................................... ....... ... .... ........................ .47
Table 6: Capital Structure and Loan Conditions ......................... ........................................ .47
Table 7: Debt Service and Outstanding Balance for option 1 .............................................. .47
Table 8: Rent Revenue for option 1 .......... ............. .... ......... ............. .. ............. .... ........ ........ .48
Table 9: Cap rate and Reversion Cash Flow Estimation for option 1 ........... .. ..... ... .............. .48
Table 10: Proforma of Option 1.......... ... ............................ .... ... ...... ..... ............. .... .............. .49
Table 11: Debt Service and Outstanding Balance for option 2 .................................. ...... ..... 50
Table 12: Rent Revenue for Option 2 .................................................................................. 50
Table 13: Unit Sales Revenue on Year 3 for Option 2 .... ............. .......... .............. ................ 50
Table 14: Reversion Revenue on Year 10 for Option 2 ................. .... ..... .............................. 50
Table 15: Proforma of Option 2 ............ ........... ... ....................................................... ... ...... . 51
Table 16: Levered and Unlevered Beta ofthe Three Comparable Companies ............... ....... 52
Table 17: Weighted Average ofUnlevered Beta ............... ... ....... ........................ ..... ..... .... ... 52
Table 18: Project Beta ......................................................................................................... 52
Table 19: Risk Premium ...... ............................................. ....... .. ........ .................... ............ .. 52
Table 20: Cost ofEquity ....................... ........... ........... .... ........... ..... ......... ................... ........ 52
Table 21: Weighted Average Cost of Capital (WACC) .... .. ......... ............... ......... ..... ............ 53

v

LIST OF FIGURES
Figure 1: Office Demand as a Function of Employment ...... .............. ... ... ... .. .......... ............... 6
Figure 2: Real Estate Space Market Supply Function ... ........ ... .. ... .......... ... ............ .... .... ........ ?
Figure 3: Change in supply and Demand and Rent over Time .................... ......... .... ............ 10
Figure 4: The Real Estate System ... ............................................ ..... .. ............ ....... .... ........... 14
Figure 5: The DiPasquale-Wheaton Four-Quadrant Diagram ................. ...... ........................ 16
Figure 6: Effect ofDemand Growth in Space Market .. .. ..................... ........ ... ........... ......... .. 19
Figure 7: Effect ofDemand Growth in Asset Market.. ........ ..................... ........ ....... ....... ...... 21
Figure 8: Design Concept of Project A .......................................... ....... ...... ... ................... ...45

vi

ACKNOWLEDGEMENT
I would like to show my gratitude to my supervisor, Ajit Dayanandan, whose
encouragement, guidance and support from the initial to the fmal level enabled me to
develop an understanding of the subject. I would also like to thank my wife, Shatha, for her
support and patience through the entire duration of the MBA program.
Lastly, I am grateful to all of those who supported me in any respect during the
completion of the project.
Mohammed Ghane

vii

INTRODUCTION
In recent times, real estate and its contribution to recent fmancial crisis have been in
focus. In most of the countries, the savings of the society is embedded in real estate values
and fluctuations in its prices contribute to economic crisis and distress at the household level.
Thus real estate economics has direct implications at the macro and micro levels. On the
individual level, home ownership is the major investment that most people make though their
entire life's. Real estate is a store of wealth in the form of assets that can be used by its
owners. The term real estate embodies both the housing and commercial property market.
Individuals/households can use this wealth to set up a small business, pay school and
university fees for their children or enjoy their retirement. Therefore, the wealth of home
ownership plays an important role in the financial wellbeing of homeowners. (King, 2009).
The second implication of real estate is its influence on the whole economy. Real
estate contributes a significant amount of any economy's output and is the sector with the
largest linkages - forward and backward. A decline in real estate values has amplified impact
on wealth and economy. Since the economy in many developed countries is largely driven by
consumption, a reduction in consumer spending (arising out of shocks to real estate prices)

could contribute to a downward spiral in the economy. Therefore, real estate prices are the
focus of public policy as well. Governments take many measures to stabilize the economy
through housing regulations and real estate laws. These regulations may include setting the
interest rates that affect mortgages in addition to controlling the rent standards. (Amadeo,
2010).
The literature on real estate analysis is dominated with hedonic models which explain
real estate prices in terms of their characteristics (like size of dwelling, number of bedrooms,
1

location, number of bathrooms etc). But within the real estate economics there are two
branches which are relatively less researched or studied, viz., urban economics and financial
economics. Urban economics is the branch that studies cities, including the spatial and social
relations that affect real estate. It studies the theories of how cities form, grow, and decline. It
also focuses on the factors determining land rent and land value at different locations within
the city in addition to the dynamics of supply and demand in the space and asset markets.
(Geitner et al. , 2001 ). On the other hand, financial economics in real estate is the branch that
studies the property as a capital asset and evaluates the return from investment in real estate.
Just like evaluating return from any other asset in the capital market, the fundamental
element in this evaluation is the potential cash flow that the real estate asset can generate in
the future. The nature of this cash flow, its magnitude, timing and risk is mainly determined
in the rental market, which is where urban economics interacts with financial economics.
(Geitner et al., 2001 ). The main aim of this study is to contribute to this literature by
examining dynamics of supply and demand for the space market and its impact on
development cost and rent, the dynamic links between space, asset and development markets.
The main objective of this study is to demonstrate the application of a fmancial model
to evaluate the expected return from investing in real estate projects using actual data on real
estate variables from an active real estate property close to Vancouver in British Columbia.
The study will focus more on the fmancial economics side, viz., the valuation of real estate
as a potential future cash flow for investors.
To achieve these objectives, the study progresses from the basic principles of urban
economics to more specific application of financial economics. More specifically, chapter 2
begins with a literature review of the analytical framework. This includes identification of

2

the three elements of real estate: space market, asset market and the development industry. It
also examines the mechanism of supply and demand for space and asset markets through the
4-quadrant model and its application on the cyclicality of real estate. Chapter 3 introduces
the data source and methodology through a financial and market study of a hypothetical real
estate project that includes two investment options. The method used in this study is the base
for evaluating the expected return from real estate investment. Chapter 4 examines the
empirical results - scenario's - obtained from the financial and market study based on the
required investment criteria. It also links the results of the two investment options with the
theoretical framework. Finally, chapter 5 gives the conclusion of the whole financial and
market study and presents the best investment option that includes the best return for the
investor.

3

Chapter 2
THE ANALYTICAL FRAMEWORK
Real estate could be studied academically from several different perspectives that
illustrate the various disciplines involved in this sector. As indicated earlier, two major
branches of economics are involved in the analysis of investment in real estate - urban
economics and financial economics. The analytical framework on real estate evaluation is
well documented in the writings of Geitner, Miller, Clayton and Eichholtz (2001)
"Commercial Real Estate Analysis & Investment". This chapter provides an analytical
overview, based on this book, by introducing the main three component of the real estate
system. These three components are the space market (section 2.1), the asset market (section
2.2) and the development industry (section 2.3). This chapter also focus (in sections 1.4, 1.5
and 1.6) on the relation between these elements and the way this relation affects the supply
and demand in the space and asset markets.

2.1

Space Market
The space market could be defmed as the market for usage or rent of real property. It

is also referred to as the usage market or rental market. The price of the right to use space
(rent) could be quoted in annual terms, per square foot (SF) (like the rent of an office space)
or in monthly terms, per unit (like the rent of an apartment). The rental price of a certain
space gives an indication of the value of the built space and the current balance of supply and
demand for that space (Geitner et al., 2001).

2.1.1

Segmentation of Space Market

As indicated by Geitner et al. (2001), the demand side ofthe space market is highly
dominated by the type ofbuilt space and location. Users in the space market normally require
4

specific type of space in a specific location. For example an engineering firm, that requires
an office space, is not willing to rent a space specified for a retail shop or a warehouse. This
firm may also need this office to be located in downtown Vancouver. Therefore, an office
space in downtown Price George or even in downtown Burnaby will not be suitable.
On the other hand, the supply side of the space market is also dominated by the type
and location due to the fact that buildings cannot be moved. Therefore, the vacant office
building in downtown Price George may be the perfect fit for the Vancouver engineering
firm but it is not where the firm wants to be. Also, converting the type of the building from
one usage to another is not easy. Although some attempts to change the usage of buildings
(i.e. a warehouse to an apartment building) were successful, this approach is generally rare
and associated with high cost.
Because both supply and demand are dominated by the type of built space and
location, the real estate space market is highly segmented. This attribute gives space market a
local function and makes it specialized around certain building usage. This is in contrast to
any other commodity market, like the one for oil, lumber or fmancial capital where the
commodities are homogeneous and could be moved from one place to another. High
segmentation in space market has also an important implication on the rental prices. Same
type of built spaces may have different rents based on their locations and built spaces in the
same location may have different rents based on their type ofusage (Geitner et al., 2001).
2.1.2

Supply and Demand in the Space Market

In order to understand the mechanism of supply and demand and market equilibrium
in the space market, Geitner et al. (2001) assume the market for class A office space in
downtown City X during a period of20 years (1970- 1990).

5

Due to the increasing numbers of office jobs, there was a significant growth in office
usage demand. The number of office workers in class A office buildings has significantly
increased from 24,000 in 1970 to 30,000 by the mid-1980s. These 30,000 workers were
occupying some 5 million square feet (SF) of space in several office towers with an average
rent of$16/SF (per year). The growth in demand is illustrated in Figure 1. Notice that ifthe
growth continues to 36,000 workers, the demand in the market will increase to 6 million SF
at the same $16 rent. The demand function shown in Figure 1 is similar to the classical
demand functions of economic theory.

$25

GROWTH IN DEMAND
OVER TIME

$20

N~~D::::J6ooo
------~~w_____oRK~Rs

1-

z

w
a::
$15
_J .

<{

w

a::
$10

$5

3.5

4

4.5

5

5.5

QUANTITY OF SPACE (Mil. SF)

6

6.5

Figure 1: Office Demand as a Function ofEmployment
(Geitner, Miller, Clayton, Eichholtz. 2001. P. 6)
The supply side, however, is not similar to the upward-sloping continuous line
depicted in the classical supply/demand diagram. Instead, the supply function as shown in
Figure 2 is kinked or has a corner. This supply function starts as strait vertical line at the
current quantity of space available in the market (5 million) which reflects the fact that the
supply in the space market is inelastic. This is due to the long life ofbuilt space which makes
6

....---

it different than any other product. In fact, many buildings last for 50 years or more. This
attribute implies that if the demand for built space falls, the supply cannot be reduced. It is
unlikely for any building to be torn down with less than 20-30 year from the date of
construction (Geitner et al. , 2001).

$25
REAL ESTATE SUPPLY CURVE

$20 f-

KINK

z

LLJ

0::: $15
...J
<l:
LLJ
0:::

EXISTING

$10
$5

~

N
3.5

4

~
4.5

5

5.5

QUANTITY OF SPACE (Mil SF)

6

6.5

Figure 2: Real Estate Space Market Supply Function
(Geitner, Miller, Clayton, Eichholtz. 2001. P. 7)
The kink or comer in the supply function occurs at the level of rent that corresponds
to the long-run marginal cost of supplying additional space to the market. This marginal cost
is the cost of developing new buildings which account for the site acquisition cost, the
construction cost and the developer's profit.
"The level of rent that is just sufficient to stimulate profitable new development in the
market is called the replacement cost level of rent, and this tends to be the long-run
equilibrium rent in the market" (Geitner, et al. , 2001). Therefore, ifthe rent level is below the
replacement cost, constructing new built space is unprofitable for developers. As soon as the

7

rent rise above the replacement cost, developers start undertaking new developments which
force rents down to the long-run equilibrium level within few years.

2.1.3

Supply, Development Cost and Rent
Getting back to the Class A office building example, Assuming that in the mid-1980s

it would have cost $200/SF to develop a new class A office building including all the
associated costs in addition to the developer's profit. Then, the marginal cost for adding new
office space to the market is $200/SF.
Geitner et al. (200 1) explains that if any developer can sell the new office building for
$200/SF then adding new buildings would be feasible. But the price investors are willing to
pay for a building depends on how much return the building is expected to generate in the
future and how much the investors are willing to pay for each dollar of this return. If we
assume that investors are willing to pay $12.50 for every dollar on annual net rent and that
the annual building rent is $16/SF then the building value is $200/SF (16 X 12.5 = 200). In
real estate terminology, the building is selling at 8% cap rate (16 I 200 = 8%). In this case,
$16/SF is the rent level that corresponds to the marginal value of adding new supply and,
therefore, it is the replacement cost rent level.
The second part of the supply function is the line moving out to the right after the
kink or the comer. There are three possibilities for this line, rising, level or falling. If the cost
of developing the next building is higher than the current cost, then the supply line should be
rising. If the cost is less, then the supply line should be falling. If the cost is the same, then
the function is level (Geitner et al., 2001).

8

2.1.4

Direction of Rent

The direction of future rent in the market is an important aspect that any developer
should have the ability to predict. The level of real rent is largely determined by the shape of
the supply function. The kink in the supply function implies that if the growth in demand is
maintained, it is unlikely to have any change in the rent level.
However, the kink also implies that if the demand for space falls, there will be a
severe decline in market rent due to the inelasticity of supply reduction. Geitner et al. (200 1)
argues that the kink in the supply function is one of the reasons for the cyclicality trend in the
space market where a period of excess supply is followed by a period of tight market. This
idea could be applied to the office market in City X. After a ten-year period of continuous
growth, developers may anticipate that the same trend of demand will continue for the next
ten years. Therefore, they may continue adding more office space by building an extra 1
million SF which expands the supply from 5 million to 6 million SF. This change in supply
is shown of Figure 3 by the movement of the supply function from S 1 to S2• If the demand
continues to grow from D 1 to D2, this increase in supply would be justified and the rent level
would remain in the long-run equilibrium level of$16/SF. However, if the growth in demand
does not happen and the market continues on D 1 level, there will be a decline in market rent
to a level of around $13/SF. Furthermore, a third scenario could happen if a recession
happens in the next period and the demand falls to Do level. In this case the market rent will
sharply decline to a level of$10/SF.
With a demand of D 1 or Do and a supply of S2 the market rent is below the long-run
equilibrium. This implies that the rent level does not motivate developers to add new office
space to the market. In this situation, any increase in demand will be in the favour of

9

landlords as it increases the market rent significantly until it rises back to the long-run
equilibrium where new developments starts to take place (Geitner et al., 2001).

REAL RENT
$25 -

$20

-------------------

------------

-----

02--------

01---------

$15

DO

.

-

------

-----

------ ----------..._
-------

16 .................... -., ................................... -

LRMC

.

13 ............................................................... ............................ ~

$10
S1
$5

S2
1

3.5

4

4.5
5
5.5
QUANTITY OF SPACE <Mil

6

6.5

Figure 3: Change in supply and Demand and Rent over Time
(Geitner, Miller, Clayton, Eichholtz. 2001. P. 9)

2.2

Asset Market
The asset market is the market for ownership of real estate assets which could also

referred to as property market. This market includes trading of assets that have claims to
future cash flows (rent) and therefore could be compared to other products in the capital
market like stocks and bonds. Therefore, the real estate asset market must be viewed as part
ofthe larger capital market (Geitner et al. , 2001).
2.2.1

Real Estate Asset Pricing

The supply side of the asset market includes property owners who want to sell their
properties while the demand side includes investors who want to buy or increase their
holdings of real estate assets. The real estate asset values are determined by the level of
supply and demand compared to other capital assets. Within this context, the value of any
10

property or building is determined by the potential cash flow that this property can generate
in the future with the level of risk involved in this cash flow.
Since properties have wide range of characteristics that can determine their prices
(i.e. size, location, etc.), it is quite common to relate property value to the dollar amount of
current net rent or income. With this approach, the comparison between different properties
would be easier and more practical. As explained by Geitner et al. (2001), the measure used
in this approach is called the capitalization rate or cap rate which is simply the property
operating earnings divided by the property asset price or value. Therefore, property value
could be calculated by dividing earnings (net rent) by the cap rate.

2.2.2

Factors Determining Cap Rate
Supply and demand of capital investment is the main determinant of cap rate which is

largely based on three major factors (Geitner et al., 2001). These factors are:
1. Opportunity Cost of Capital: The prevailing return from other types of investments in
the capital market (e.g., stocks, bonds, money market investment) are a major
determinant of how much investors are willing to pay for each dollar of income from
any property. As indicated earlier, real estate assets are part ofthe capital market and
they tend to compete with all other types of assets for investors dollars. If the interest
rate and yields on bonds and stocks are low, investors will tend to invest more on real
estate. This will raise the property price and reduce the cap rate.
2. Growth Expectation: Investors are forward looking. They don't look only at the
current return from the property, but rather on the long-run growth in the cash flow
(net rent) that the property can generate in the future. Since the growth in net rent is
mainly determined by the supply and demand in the space market, investors must

11

forecast the future space market in which the property is located. The greater the
growth in the future net rent, the more investors are willing to pay for each dollar of
the current net rent which will also reduce the cap rate. As indicated earlier,
forecasting the future net rent may include comparing the current rent with the long
run equilibrium, forecasting the future demand function and the long-run supply
function in the market. Furthermore, investors should investigate if there are any
unique attributes relates to the specific property they are intending to buy such as
existing lease or required capital improvement.
3. Risk: Investors are risk aversion. If they perceive the potential net income from the
property as less risky then they will be willing to pay more for each dollar of income
from this property. In general, cash flows from real estate assets are perceived as
more certain than any other investment due to the fact that space market is relatively
stable and easy to forecast. The more the investors like the level of risk that property
income provides, the more they will pay for it and the lower the cap rate will be.

2.3

Development Industry
Geitner et al. (200 1) shows that in addition to the short-run relationship between the

space market and the asset market translated by the conversion of potential cash flow into
asset value, these two markets are connected on the medium to the long run through the real
estate development industry. This industry is the main source for supply to the space market
as it applies fmancial resources to construct new built space. Development is a complex and
creative function that includes considerable risk-taking by the developer. It also requires
intense interaction and coordination between government officials in the public sector and
sources of capital in the private sector.
12

Although thousand of firms are involved in the real estate development industry,
large scale commercial developments are dominated by a few national firms and a number of
local firms. Generally, most development firms are private companies which have
specialized expertise in local space markets. Joint ventures are common in the development
industry, especially for large projects, connecting the market knowledge and expertise of
development companies with those of financial institutions or local expertise with those of
large national firms.
Since the built space is an extremely long-lived commodity, addition of new built
space is only required by economic growth or by structural changes in the economy. It is
only the demand for new built space that supports the development industry. Therefore,
development is the most cyclical of all sectors ofthe economy.

2.4

The Real Estate System
The space market, the asset market and the development industry are the three main

components of the real estate system. Figure 4 present a diagram ofthis system including the
major elements and linkages among these three elements. It also shows the relation of this
system with the national and local macroeconomics and the capital market.
The three large boxes represent the three main elements of the real estate system: the
space market, the asset market and the development industry. Within the space market, the
interaction of space demand with the existing physical supply determines the level of rent in
the space market. The demand side is connected with the local and national economies which
have a significant influence on the demand for space. The supply side is connected with the
past and current activities of the development industry.

13

SPACE MARKET
SUPPLY
(Landlords)

IADDS
I
NEW I

1

RENTS
&
OCCUPANCY

DEVELO PMENT
INDUSTRY

I YES
IF

r.................i.s... . . . . . . . . 1

:~~:~~
CONSTR
COST

INCLU
LAND

•··-

__.. .......--- .- - -·

1

•
'
''

~~ ~~~
.... .--- -

•

t

...................

1-----"

PROPERTY
MARKET
VALUE

...

. .,

!...... ....................................
'
'

i
''

ASSET MARKET

"'-,

.....

r---

LOCAL
&
NATIONAL
ECONOMY

.....•.. --·-··· ·'" ... ---- ··

CASH
FLO W

~

-

DEMAND
(Tenants)

I
MKT
REQ'D
CAP
RATE

SUPPLY
(Owners
Selling)

~

•
i

~

CAP I
TAL
MKTS

DEMAND ~
(Investors
Buying)

= Causal flows.
•

= Information gathering & use.

Figure 4: The Real Estate System
(Geitner, Miller, Clayton, Eichholtz. 2001. P. 23)

The space market is connected with the asset market by determining the cash flow
produced by the real estate assets. This cash flow interacts with cap rate required by investors
to determine the market value of properties. The supply and demand in the asset market
consists of investors who want to sell or buy assets. These investors compare the risk and
return of real estate assets with other type of investments in the capital market to determine
the required cap rate on real estate assets. Investors also forecast the future demand and
supply of the space market to predict the future rent level. Therefore, the interaction between
the space market and the asset market produces the values of the real estate assets. These

14

values represent a key signal to the development industry, the third component in the real
estate system.
The development industry makes a comparison between the development cost, land
cost and construction cost in addition to developer's profit, and the asset values. If assets
values equal or exceed development cost then the developer starts with adding new space to
the current space market. Since the development process needs time, the developer should be
forward-looking as the success of any development only happens if the newly completed
built space value exceeds the development cost at the time when the project is completed.
The most important implication within the real estate system, as explained by Geitner
et al. (2001), is the negative feedback loops. This is the mechanism that keeps the whole
system self-regulating. If either supply or demand goes out of balance in the space market,
the result will be reflected in the property cash flow which gives a certain response in the
asset market. For example if a potential new development is perceived to increase the supply
significantly, investors will predict lower future rent which will consequently reduce the
current asset value. This reduction will make the new development unprofitable. On the
contrary, if demand for space grows without new addition to supply, current rent will rise
and push assets values up. This will give a signal to the development industry to start with
new space supply which will reduce the rent to the long-run equilibrium level.

2.5

Four-Quadrant Model
The four-quadrant (4Q) model was developed by DiPasquale and Wheaton in order to

perform a basic analysis of the real estate system. As shown on figure 5, this model consists
of four quadrants that explain the relationship between the space market, the asset market
and the development industry (Geitner et al., 2001).
15

Rent$
Asset Market:
Valuation

0

Space Market:
Rent Determination

0

Price$

Stock (SF)

P*

Q*

Space Market:
Stock Adjustment

Asset Market:
Construction

Construction (SF)

Figure 5: The DiPasquale-Wheaton Four-Quadrant Diagram
(Geitner, Miller, Clayton, Eichholtz. 2001. P. 26)
The concept of long-run equilibrium in real estate involves allowing sufficient time
for the new supply of built space to adjust for the demand. The doted rectangle represents
this long-run equilibrium which intersects with the 4 axes that represent the stock of built
space, Rent, asset Price and the rate of new construction. The four intersection points
between the rectangle and each ofthe axis, Q*, R* , P* and C*, are the long-run equilibrium
levels of prices and quantities. The northeast quadrant represents the space market which is
similar to the classical price/quantity diagram. The horizontal axis is the existing built space
in the market, the vertical axis is the rent and the downward-slopping line DD is the demand
function. If a vertical line is drawn from the point of the existing quantity of space (Q*), the
16

point where this line intersects with the demand function can give us the current equilibrium
rent. Point (R *) is the equilibrium rent for the (Q*) amount of space.
The northwest quadrant represents the asset market valuation which relates the
equilibrium rent (on the vertical axis) to the asset price (on the horizontal axis). The inclined
line in this quadrant is the cap rate which has a slope that corresponding to the division of
rent by the price. If the horizontal line from the rent point (R *) is continued to the cap rate
line and then a vertical line from the intersection point is drawn to the price axis, the asset
price can be determined. Point (P*) is the property price that correspond to the rent level
(R *). The two northern quadrants show the short-run interaction between the space market
and the asset market.
The two southern quadrants show the long-run effect of the real estate development
industry on the rent and asset price resulted from adding new built space to the market. The
southwest quadrant represents the relation between the asset prices (horizontal axis) with the
annual amount of construction activities (vertical axis). The slopped line in this quadrant is
the construction function line which indicates that higher property prices stimulate greater
amount of new construction. This is due to the fact that higher prices enable more costly sites
to be developed. The construction function line intersects the asset price axis at a positive
certain point rather than the origin because when property prices are below a certain
threshold, no developer starts any construction. Therefore, if a vertical line is drawn from the
current asset price (P*) to the construction function line and then a horizontal line is drawn
from this intersection to the construction axis, we can determine the amount of new
construction in the market per year (point C*).

17

The southeast quadrant indicates the relation between the rate of annual new
construction to the total available built space. The slopped line in this quadrant represents the
relation between the average annual space constructions to the total stock of space that can
be indefinitely maintained in the market. The concept in the southeast quadrant is that, in the
long run, there is a certain amount of buildings that needs to be removed from the market
because they become old and no more suitable to be used. Therefore, a certain amount of
new construction per year is necessary just to maintain the existing stock of built space in the
market. The sloped line in the southeast quadrant links the C* level of construction with the
Q* amount of stock available in the market (Geitner et al., 2001).

2.6

Boom and Bust in Real Estate Market
The real estate space and assets markets have historically experienced boom and bust

periods. Per Geitner et al., (2001), the length of each real estate market cycle in many
commercial markets has been approximated to be between 10 and 20 years which is longer
than the modern macroeconomic business cycle. The four-quadrant model (4Q) indicated in
the previous section can help in understanding the famous boom and bust that occurs
continuously in real estate.
The modern economic and demographic changes in any urban area imply a trend for
natural growth in usage demand for space and real estate assets. While it is clearly
understood that this increasing demand would stimulate new construction of space, the
question is whether this increase causes not only the rise but also the subsequent fall in the
real estate market. Geitner et al. (200 1) uses the 4Q diagram in an extended way to answer
this question. The analysis first considers the effect of growth in usage demand, holding the
capital market constant. Then it considers the effect of a growth in investor demand for real
18

estate assets, holding space usage demand constant. Finally, the analysis exammes the
situation when both phenomena happen together.
Rent$
Space Market :

Asset Market:

Stock {SF)

Price$

Asset Market
Construction

C* *
Space Market:
Stock Adjustment
Construction {SF)

Figure 6: Effect ofDemand Growth in Space Market
(Geitner, Miller, Clayton, Eichholtz. 2001. P. 30)
Figure 6 shows the first situation where the demand function m the northeast
quadrant moves out to the right from Do to DJ. In the short run (one to two years) the time
frame is not enough to build new space to respond to an unanticipated increase in usage
demand. Therefore, rent will initially rise to levels that cannot be supported in the long run
equilibrium. This level of rent is indicated in figure 6 by the increase of rent from the original
point R * to a temporary high level ofR 1 which was determined by the original stock of space
Q* to the new demand function D 1• By relating this level of rent to the asset market on the
19

northwest quadrant, the asset prices will also temporally increase from the original P* level
to P 1 level. Note that as soon as the asset prices start to increase from P*, it will give a signal
to the development industry to increase construction which will result in a new stock of
space in the market at the level ofQ**.
The new long-run equilibrium based on the new D 1 demand function and new stock
space Q** is indicated by the rectangle in the thick dashed lines, which lies outside the old
4Q rectangle. Although the new equilibrium rent (R**) and the asset prices (P**) exceed the
old equilibrium rent (R *) and asset price (P*), they are less than the temporary rent (R 1) and
temporary price (P 1). This implies the fact that any unpredicted increase in demand for space
will increase the rent and the asset price to certain levels but these levels will eventually fall
as soon as the new equilibrium stock of space get to the market. The analysis also implies
that the new equilibrium rectangle will always lie outside the old one as a result of growth in
usage demand (holding the capital market in the northwest quadrant constant).
This analysis is based on the assumption that the long-run-marginal-cost function is
upward-sloping (increasing real development costs). As noted earlier, if development costs
are constant (completely vertical construction function), the rent will remain constant even
with growing demand.
The second situation includes an increase of demand in real estate investment assets
among investors in the capital market. This happens when investors start to perceive real
estate to be less risky than other investment that they are willing to pay higher price/earnings
multiples for real estate assets.
This type of change in capital market is shown in figure 7 by the downward
movement (to a shallower slope) ofthe valuation line (cap rate) in the northwest quadrant.

20

When investors pay more for assets that have certain income (rent), then the cap rate will
drop. If the prevailing cap rates, for example, have moved from 11% to 8% then there will be
a substantial increase in property prices for some 37.5% if rents remained constant (from
1/0.11 to 1/0.08 per dollar of rent). Therefore, if investors continue with this trend, property
prices could rise temporarily to a level above what is sustainable in the long run and would
significantly stimulate the construction of new built space. This is shown by the short-run
price movement from the original P* level to P, level.
Rent$

...,___,

:,.

Price$

Asset Market:
Valuation
11% Cap Rate

Space Market:
Rent Determination

SR

Q**

p**

Stock (SF)

Asset Market:
Construction

C* *
Space Market:
Stock adjustment
Construction (SF)

Figure 7: Effect ofDemand Growth in Asset Market
(Geitner, Miller, Clayton, Eichholtz. 2001. P. 32)
The new long-run equilibrium is found by the new rectangle (in thick dashed lines)
connecting the four quadrants based on the new 8% cap rate in the northwest quadrant. The
new equilibrium involves a large increase in the amount of built space, which reflects the
21

effect of a real estate development boom that brought the stock of space up to the new Q**
level. This is the result of the flow of financial capital to the real estate asset market when
investor preferences shift toward real estate assets.
Based on the new stock of space quantity (Q**) and the same original usage demand,
the new equilibrium rent (R **) is less than the original rent (R*). The lower rents will reduce
the property prices to a lower level (P**) than the temporary price (P,) but higher than the
original price (P*).
This implies that an increase in investor demand for real estate assets will always
result in a temporary increase in asset prices to a certain level but the new quantity of added
built space will cause a fall in prices to a new level that is lower than the temporary prices
but higher than the original. Also, the increase in investor demand will always result in a
lower space rent than the original level of rent.
Now that we have seen how each of these situations can individually cause an
increase and fall of asset prices, the simultaneous occurrence of both situations would double
the effect of asset overpricing. This would be the answer to the question on whether a boom
contains the seeds of a subsequent bust. The increase of demand in space and asset market
would cause real estate prices to rise at first and then fall back, even without the subsequent
reduction in demand for either space usage or real estate investment. Ifthe fall back in prices
was combined with a reduction in demand due to an economic recession, this fall will be
much deeper. Cycles can be reduced by the ability of the asset market to respond quickly to
the relevant new information. However, the 4Q model allows us to see how cycles in real
estate can happen (Geitner et al., 2001).

22

Chapter Summary

Understanding real estate economics requires a basic perception to the three main
elements that forms this discipline. These elements are the (a) space market, (b) the asset
market and (c) the development industry. There is a continuous relation between these
elements which affects the supply and demand in the space and asset markets.
The space market could be defmed as the market for usage or rent of real property.
This market is attributed as highly segmented due to the immobility of real estate. The asset
market is the market for ownership of real estate assets. This market includes trading of
assets that have claims to future cash flows (rent) and therefore could be compared to other
products in the capital market like stocks and bonds. In addition to the short-run relationship
between the space market and the asset market translated by the conversion of potential cash
flow into asset value, these two markets are connected on the medium to the long run
through the real estate development industry. This industry is the main source for supply to
the space market as it applies financial resources to construct new built space.
This chapter explore the relationship between these three components of the real
estate system including the dynamics of how each component affects others. One of the
methods that could be used to illustrate this relation is the "Four-quadrant Model" which is
also used to understand the boom and bust in the real estate market. Furthermore, this model
explains the cyclical nature of the real estate in addition to the long-run equilibrium.

23

Chapter 3
DATA SOURCE AND METHODOLOGY
Based on the theoretical framework outlined in chapter 2, we now introduce the
financial economics branch as a methodology to build a financial model that can correspond
to the theory. Financial economics is the branch of economics that deals with the capital
market where capital assets are traded. Since real estate assets are claims for future cash
flows, they could be treated as capital assets. The substance of financial economics is the
systematic study for how markets for capital assets function and thereby determine the prices
of capital assets. The financial economics is the method of calculating the timing, risk and
other attributes of the potential cash flows from these real estate assets in order to determine
the expected return from these assets and how much they are worth in the capital market
today (Geitner et al. , 2001).
In order to illustrate this concept, this chapter will present a detailed analysis for a
real estate development project in the Lower Mainland which includes two fmancial options.
The analysis will determine the best option from the perspective of a developer by using
financial economic techniques. The evaluation will include the site characteristics,
development proposal, market analysis and financial analysis. The project is a hypothetical
multi-family residential development which does not have any resemblance to any actual
property. It has the characteristics ofBurnaby in terms of pricing and rent levels but may not
necessarily comply with the zoning bylaw or other jurisdiction requirements . The fmancial
analysis method will include projecting the cash flow from the development in order to
estimated the expected returns (IRR)

24

3.1

Site Description
The site of the project is located in Burnaby at the intersection of "X" street and "Y"

street. The neighbourhood is characterised as a high density residential area with many
commercial facilities that provide services to the entire community. "X" street boarders the
site to the west and forms a major transportation route to Vancouver with a busy traffic
during the rush hours. Many high rise developments lie along this street where major
department stores are located. The south side of the site is bordered by "Y" street which is
less busy and have the features of a residential neighbourhood. A 16-storey high rise
residential development is located at the north of the site and a 4-story wood frame condo
building is neighbouring the site on the east.
The site is rectangular in shape and has dimensions of (200 ft. X 300 ft) with a total
area of 60,000 sq.ft .
The subject property lies in the Comprehensive Development (CD) zone of the
district with a Floor Area Ratio (F.A.R.) of 3. Based on the total site area, this ratio allows
180,000 sq.ft. of buildable area. Table 1 in Appendix A provides the basic site information.

3.2

Development Proposal
The proposed development comprises of a 22-storey residential building with two

levels of underground parking. The first two levels consist of an L-shape residential building
along "X" street and "Y" street (row of Townhomes on level 1 and multiple size residential
units on level 2). A 20-storey tower is located above the L-shape building with 8 different
sizes of units in each floor. Figure 8 in Appendix A provide the design concept of the
proposed development. There is a total of200 units in the whole development which include
4 types: two bedroom Townhouse units on level 1 (Type A), one bedroom units (Type B),
25

one bedroom and a den units (Type C) and two bedroom units (Type D). Table 2 m
Appendix A Provides unit mix and breakdown of the units.
The new development will integrate perfectly with the type and size of the buildings
along "X" street as it provide the same level of density and architectural features of the
adjacent buildings. There will be a specious green area located behind the L-shape building
which provides some outdoor facilities for the residents of the building in addition to a
children playground. The building also includes an exercise room and amenity room on level
1 and media room on level 2. The parkade entrance is located on "Y" street as it has lower

traffic which gives the required safety. In order to provide marketable and affordable prices,
the units will include a medium level fmishes.

3.3

Market Study
Burnaby is situated in the central area of Metro Vancouver. As an established

municipality, few lots of undeveloped land remain for new residential development. Recent
population growth has mainly occurred in areas which have undergone residential
intensification.
Over the last twenty-five years, Burnaby's population has grown by 49%, from
136,494 in 1981 to 202,799 in 2006. The aging trend is most noticeable in the baby boom
generation. Those aged 40 to 59 (the age of the baby boomers in 2006) represented 30% of
the population in 2006 compared to 23% of the population in 1986. Of Burnaby's 56,035
families in 2006, 34% had no children living at home, 32% had one child at home, 25% had
two or more children at home and 9% had three or more children (City of Burnaby, 2009).
There has been a notable change in the type of dwellings occupied by Burnaby
residents over the last 25 years. In 1981, single family houses represented over half (52%) of
26

the city's housing stock compared to only 28% in 2006. In contrast, apartments in buildings
with 5 or more floors increased from 10% ofthe city's housing stock in 1981 to 19% in 2006
(City of Burnaby, 2009) .
Since 1985, the percentage of Burnaby renters paying 30% or more of their total
monthly household income on rent has increased from 40% in 1986 to 43% in 2006. For
owners, the percentage has increased significantly from 14% in 1986 to 27% in 2006. This
indicates a relatively higher trend toward ownership compared to rent (City of Burnaby,
2009).
Home values in Burnaby continued to edge upward in the fourth quarter of 2009 as
demand in the whole Greater Vancouver housing market increases as a result of the
economic recovery from the 2008 and 2009 recession. Over the last 12 months, the MLS
Housing Price Index (HPI) for apartments in Burnaby increased 9.4% per cent to 255 from
233 in November 2008. Increasing sales and lower listing inventories are evidence of
demand returning. Meanwhile, the number of new homes under construction is at its lowest
point in four years and strong absorptions have kept the inventory of completed and
unabsorbed new homes flat since the beginning of the year. Demand for new homes in 2010
will be supported by steady migration to the region, improvement in the economy and job
market and mortgage rates that are expected to remain low until mid-year (Real Estate Bard of
Greater Vancouver, Nov. 2009).
On the other hand, the rental market is still suffering from the economic downturn.
The rental apartment vacancy rate in Burnaby increased significantly to 2.4 per cent,
following several years of vacancies below one per cent. Same sample apartment rents
increased, but at a slower pace than last year. The stock of purpose-built rental apartments

27

and Townhomes grew by more than one thousand units (Canada Mortgage and Housing
Corporation, 2009).

3.4

Proforma
Two project Proforrnas have been prepared to show the potential expected return

from the project. The Proforma is a projection of the cash flow that includes site acquisition,
development cost, operating revenue and reversion revenue. These Proforrnas were based on
the following assumptions:
1. Due to the fact that the project is hypothetical, the site acquisition pnce was
approximated at $150 /sq.ft. based on the reasonable market value of the square
footage of land obtained from the Multiple Listing Service (MLS). There is a wide
range of land prices in Burnaby depending on the location and the potential type of
development allowed on the site which makes the average price unrealistic in
reflecting the value of this type of development sites. Table 3 in appendix A shows
the total acquisition cost after adding the property purchase tax.
2. Two years (24 months) was estimated for the construction period.
3. Construction cost was estimated at $220 I sq.ft. based on the BDC cost index for
concrete structure above underground parking in Burnaby. Table A-4 in appendix A
calculates the development cost and the total project cost.
4. The following vacancy rates was considered in calculating the weighted average
vacancy rate for the whole project based on the "Rental market Statistics- Fal12009"
issued by Canada Mortgage Housing Corporation.
a. 2.6% for type A units (2 Bedroom Townhome)
b. 2.1% for type B units (1 Bedroom)
28

c. 2.3% for type C units (1 Bedroom+ Den)
d. 2.6% for typeD units (2 Bedroom)
Table 5 in Appendix A shows the weighted average vacancy rate.
5. The capital structure was based on the assumption that 20% ofthe cost is required as
equity while the other 80% will be obtained through a bank loan with a simple
interest rate of 4.25% (2% above current prime rate). This interest rate was assumed
to be fixed over the 10 years life of the project. The developer is also required to
make an annual principal payment of $25,000. Table 6 in Appendix A shows the
capital structure and the loan conditions.
6. The average rent obtained from "Rental market Statistics - Fall 2009, Canada
Mortgage Housing Corporation" was adjusted to reflect the market rent of the project
units in the next 10 year. The adjustment includes multiplying the average rent by
1.5. This adjustment was due to the fact that the average rent was based on the rent of
properties in different part of Greater Vancouver area with different unit age. The
adjustment is reasonable because the project is in a premium location (Burnaby) and
includes brand new units (Kiel and Zabel, 2007).
7. The market rent was projected to grow at a constant rate of 1% per year. This
projection was based on the assumption that the expected inflation rate is 2% per year
and the market rent depreciation for the building is 1% per year. This results in a net
1% per year expected growth rate.
8. Operating expenses was estimated at 8% of the annual rent revenue and projected to
grow at the same rent growth rate (1% per year). A $500,000 capital expenditure was
assigned to take place in year 6 and year 9.

29

In order to maximize the profit and to examine the effect of the cap rate on the expected
return of the project, two Proforma options were considered in the fmancial analysis.
3.4.1

Option 1

The first Proforma includes holding the whole project for 8 years (rent start in year
three immediately after construction completion) and then the units are sold in year I 0. In
this option, the developer needs to pay the annual debt service which includes the interest
amount of the outstanding loan in addition to the $25,000 annual principal payment. The
total amount of the outstanding balance will be paid off by the end of year I 0 after all the
units are sold. Table 7 shows the debt service and the outstanding balance each year. Note
that the developer will borrow half the loan in year one and the other half in year two.
The rent revenue of the whole 200 units is calculated in table 8 and adjusted to reflect
the market rent of the project as indicated earlier.
In order to calculate the reversion cash flow from selling all the units in year 10, the
terminal cap rate needs to be estimated. This could be done by dividing the current rent (year
3 rent) by the market value of the project (we assume the market value ofthe project is 25%
higher than the project cost to the developer). The resulted cap rate then could be used as the
terminal cap rate to calculate the reversion cash. This includes dividing the expected rent of
year 11 by the terminal cap rate. Table 9 shows the estimation of the terminal cap rate and
the reversion cash flow.
Finally, table I 0 include the Proforma of option 1 which shows the cash flow
projection for the 10 years life of the project in addition to the unlevered and levered IRR.
Note that the development cost has been divided between the first two years to reflect the
cash outflow during the construction period. The same arrangement was done for the loan

30

because the developer does not need the whole amount in the first year. A summary of key
fmancial measure of option 1 is shown below.
Financial Summary of Scenario 1 (100%
Rent)
IRR (Unlevered)
IRR (Levered)
Site Acquisition Cost
Development Cost
Equity to Cost
Loan to Cost
Total Equity Required
Total Amount of Loan
Rental Revenue (year 3)
Sale Revenue (year 10)
3.4.2

7.30%
13.19%
9,180,000
44,748,000
20%
80%
10,785,600
43,142,400
3,809,628
63,360,846

Option 2

The second Proforma option includes selling approximately 50% of the units and
holding the other 50% till the end of year 10. In this scenario, the developer's target is to sell
the upper 12 floors of the tower which includes 96 units before the end of year 3. The
presales can start as soon as the development permit is obtained and even before the
construction commencement. In order to reduce risk, half of the loan amount is required to
be paid off by the end of year 3 (as soon as the 96 units are sold) in addition to the debt
service which includes the interest of the outstanding balance and the $25,000 annual
principal payment. The remaining outstanding balance will be paid off in year 10. Table 11
shows the debt service and the outstanding balance for each year. Like option one, the
developer will borrow half the loan amount in year one and the other half in year two.
The rent revenue of the 104 unit holding is calculated in Table 12 and adjusted to
reflect the market rent of the project as indicated earlier.

31

In this option, there are two sale revenues that need to be estimated, the sale of 96
units by the end of year 3 and the reversion of the remaining 104 units by the end of year 10.
In order to calculate the frrst sales revenue, the current market price per sq.ft. was
approximated based on the current MLS listing. These market prices and the total amount of
the 96 unit sales are shown on Table 13.
For the second sales revenue, estimating what the market price (per sq.ft.) would be
after 10 years is very difficult. Therefore, we will use the same terminal cap rate calculated in
option one (5.65%) to estimate the reversion revenue for the remaining 104 units. The
method is to divide the project net operating income (NOI) of year 11 by the cap rate as
shown on Table 14.
Table 15 shows the Proforma for option 2 with all the cash flow projections for the 10
year life of the project. Table 15 also shows the unlevered and levered IRR for this option.
Just like option one, the development cost has been divided between the frrst two years to
reflect the cash outflow during the construction period. The same arrangement was done for
the loan because the developer does not need the whole amount in the frrst year. A summary
of key fmancial measure of option 2 is shown below.
Financial Summary of Option 2 (50% Sale + 50%
Rent)
IRR (Unlevered)
12.58%
IRR (Levered)
32.67%
Site Acquisition Cost
9,180,000
44,748 ,000
Development Cost
Equity to Cost
20%
80%
Loan to Cost
10,785,600
Total Equity Required
Total Amount of Loan
43 ,142,400
2,059,596
Rental Revenue (year 3)
Sale Revenue (year 3)
40,257,360
34,557,860
Sale Revenue (year 10)
32

3.5

Cost of Capital
The cost of capital is the return that the developer or any other investor typically

expects to earn in other investments of similar risk to the subject investment. It is very
important for any investor to estimate the cost of capital which should be used as a hurdle
rate to examine the return of any project. If the return of the project exceed the hurdle rate
then the project is profitable to the investor (Damodaran, 2001 ). This analysis will estimate
the weighted average cost of capital (WACC) for the Burnaby project based on the cost of
equity, cost of debt and the market value of equity and debt.
3.5.1

Cost of Equity

The cost of equity is the rate of return that investors require on an equity investment
in any firm. Based on the capital asset pricing model CAPM explained by Damodaran
(200 1), there are three elements that need to be measured in order to estimate the cost of
equity: the riskless rate, Beta and risk premium. These three inputs are used to arrive at the
expected return on equity based on the equation:

Expected Return= Riskless rate+ Beta (Risk Premium)
The riskless rate that should be used to calculate the return should be a government
bond where there is no risk of default. As long as the objective is to calculate the cost of
equity for a project, then the time horizon of the government bond should match the time
horizon of the project (10 years). For this purpose, the bank of Canada 10-years bond rate
(4.08%) will be used (Google Finance).
The beta will be calculated based on the "Bottom-Up" method which includes the
following steps.

33

•

First, we identify the comparable compames that have a similar business of the
targeted project. For this purpose, three publicly traded residential real estate
companies have been chosen. These companies are: Equity Residential, Canadian
Apartment Properties REIT and Cartwell Senior Housing REIT (Google Finance).

•

Second, the historical beta on the public domain (Google Finance) is adjusted to
calculate the beta. This should be done by using the formula: [Beta= 0.33 +
0.67(Historical Beta)].

•

Third, we estimate the unlevered beta for each of the three companies by using the
formula : [Unlevered Beta= Current Beta/(1 + (1- tax rate)(debtfequity)] .
Exhibit 16 shows the calculations of the levered and the unlevered betas. The tax rate
is estimated at 35%.

•

Forth, the weighted average of the unlevered beta is estimated. This has been done
using the total revenue obtained from the public domain (Google Finance) as the
weight as shown on table 17.

•

Finally, we use the project debt to equity values to calculate the debt/equity ratio.
This ratio will then be used to estimate the levered beta by applying the equation:
[Levered Beta= Unlevered Beta X (1 + (1- tax rate)(debtjequity)].

Based

on this method, the project Beta is 1.67 as shown oftable 18.
The risk premium is estimated as the difference between the historical return on
stocks and the risk free rate. The historical return on stocks (1970-2003) is 12.72% (Geitner
et al. -Exhibit 11-4, P252) and the risk free rate is 4.08% (10-year bond; Google Finance) .
Therefore, the risk premium is 8.64% as shown on table 19.

34

Applying the above inputs (4.08% risk fre e rate, 1.67 beta and 8.64% risk premium)
to the CAPM equation result in 18.47% cost of equity (table 20).
3.5.2

Cost of Debt

The cost of debt measures the current cost to the firm of borrowing funds to fmance
projects (Damodaran, 2001 ). Therefore, the interest rate of the project loan (4.25%) will be
considered as the cost of debt. Since the project cash flow and IRR was estimated before-tax,
then the tax advantage of debt will not be used to reduce the cost of debt. Before-tax cost of
debt will be used in the calculation of the cost of capital.
3.5.3

Market Value

The total amount of equity required for the project ($1 0,785,600) is considered as the
market value of equity and the total amount of the project loan ($43 ,142,400) is assumed to
be the market value of debt.
3.5.4

Weighted Average Cost of Capital (WACC)

Since Burnaby project raises its money from two sources, equity and debt, the cost of
capital could be calculated by fmding the weighted average of each of these costs. By
applying 18.47% as a cost of equity, 4.25% as a cost of debt and $10,785,600 and
$43,142,400 as the market value of equity and debt to the following equation, we can
estimate the weighted average cost of capital (Damodaran 2001 ).
WACC = Cost of Equity ( E

Equity
)
(
Debt
)
.
D b + Cost of Debt E .
D b
qwty + e t
qwty + e t

The weighted average cost of capital (WACC) obtained from this equation is 7.09%
as summarized on table 21.

35

Chapter 4
EMPIRICAL RESULTS- SCENARIO'S
In order to conduct an analysis on the two development options ( 100% rent against
the 50% rent and 50% sell), we need to look at the criteria of each option from the fmancial
and marketing aspects.

4.1

Financial Analysis
The levered IRR for both option 1 and 2 are higher than the unlevered IRR for the

two options. This is due to the effect of debt financing where the return is amplified due to
leverage. Yet, the equity return (levered IRR) for option one ( 13.19%) is not greatly above
the unlevered return (7.30%) because there is not a great deal of positive leverage as the loan
faces 4.25% interest rate and the property return is hardly 1.4% above that at 5.65% (cap
rate). Considering that the cap rate equals the net operating income (NOI) divided by the
property price, low cap rate means that the return form rent (NOI) is lower than the return
from appreciation of the property. Although the whole property in option one will eventually
be sold with the same low cap rate, the reversion will happen in year 10 where the impact of
the high price on the IRR is minimized by the 10 years period (time value of money).
This indicates that the relatively low rent levels and high property prices have a great
impact on lowering investor returns from real estate properties (rent investments). Despite
the current economic downturn, property prices have increased significantly in the last few
years (2001-2008) while the rent levels have been declining. This was partially due to low
mortgage rates where home ownership became affordable and more appreciated than rent
(CMHC, Sprig 2009) (Somerville and Swann, 2008) (Tsounta 2009). This result exactly
reflects the implication of the analytical framework. If you recall the four-quadrant analysis
36

of boom and bust, an increase in demand for real estate assets will always result in a lower
space rent.
On the other hand, the difference between the levered IRR (32.67%) of option two
and the unlevered IRR (12.58%) is much higher because the effect of the low cap rate was
reduced by holding only 50% of the property for rent until year 10. Furthermore, both
levered and unlevered IRR's are higher in option two due to the revenue from the sale of
50% of the property in year 3. Advancing reversion revenue from year 10 to year 3 has a
great impact on the IRR (time value of money).
Although the property returns (unlevered IRR) of option one is slightly higher than
the cost of capital (7.30% unlevered IRR against 7.09% for WACC), the equity return
(levered IRR), however, is much lower than the cost of equity ( 13.19% levered IRR against
18.47% cost of equity). This implies that option one does not meet the investment
requirement and should be rejected. On the other hand, both levered and unlevered IRRs of
option two are much higher than the cost of capital and the cost of equity (12.58% unlevered
IRR against 7.09% WACC and 32.67% levered IRR against 18.47% cost of equity).
Therefore, option two is acceptable as an investment alternative.
The above analysis shows that selling the whole property immediately after
development is more profitable than holding it for rent. This could be the perfect option in a
high demand market. But with the current slow recovery from the recession and moderate
demand of housing market, selling 200 units may take much longer than the end of year-3
limit. Therefore selling 50% of the units could be a reasonable target to meet the investment
and market constraints.

37

4.2

Market Analysis
The market study shows that there is strong trend toward ownership compared to rent

in Burnaby (City of Burnaby, 2009). Currently, there is a stronger demand for housing than
last year implied by relatively higher prices (Real Estate Bard of Greater Vancouver, Nov. 2009).
On the other hand, the rental market is still suffering from the recession and the vacancy rate
has increased (Canada Mortgage and Housing Corporation, 2009). All these facts support the
criteria of option two which includes the sale of 50% of the units after development rather
than holding the whole property for the 10 years life of the investment.
The aging trend of the population where those above the age of 40 account for high
percentage of population implies that the targeted market segment should be the working
professionals and empty nesters. These two market segments have the fmancial resources to
bear the high unit prices of this development.
Since the majority of families in Burnaby have either on children or one child living
at home, the size of the units should be small in order to reduce the unit price and makes it
affordable to a higher percentage of home buyers. The one bedroom, one bedroom and den
and two bedroom units are the most appropriate unit mix. Conversely, the studio or the three
bedroom units are not preferable for the above two market segments.
The change in the type of dwelling in Burnaby from the single family houses to
apartments in multi-level building implies that there is a shortage in the open green areas.
The new development should provide enough outdoor facilities to meet the requirement of
the residents.

38

Chapter 5
CONCLUSIONS
The financial analysis shows that the 100% rent option (option one) does not meet the
investment criteria as it has a levered IRR of 13.19% which is lower than the 18.47% cost of
equity. This was due to the low cap rate reflected by the current low level of rent.
During 2008 and 2009, the rent level was below the replacement cost rent that
stimulates new development in the market. The high demand for real estate assets in (200 12008) has increased the supply in the space market and eventually led the rent level to fall
below the long-run equilibrium. The effect of excess supply, in fact, was doubled by the
sharp fall of demand for space during to the recession that stared in late 2007. As indicated in
the analytical framework, low rent levels do not motivate developers to start new
construction which was clearly illustrated in the fmancial analysis of option one. (CMHC,
Sprig 2009) (Somerville and Swann, 2008) (Tsounta 2009)
On the other hand, the financial analysis indicates that option two (50% rent - 50%
sell) has an acceptable investment potential. The total property return (unlevered IRR) of
12.58% exceeds the 7.09% cost of capital in addition to the significantly high return on
equity (levered IRR) of 32.67% compared with the 18.47% cost of equity. This was due to
limiting the negative impact of the low cap rate on the return by holding only 50% of the
total number of units for rent. It also shows the effect of current high asset prices on the total
return when 50% of the property is sold immediately after development.
The asset market during the last quarter of 2009 moderately rose after a marginal
decline at the end of 2008 and beginning of 2009 (Real Estate Board of Greater Vancouver,
Nov. 2009). Although the return from real estate investment (rent investment) does not
39

exceed the cost of capital, as shown in option one, investors are expecting significant growth
in the future return. This growth expectation has led to higher asset prices during the last few
months of2009. Furthermore, the sharp fall ofthe stock market in late 2008 and early 2009
had a major impact on perceiving real estate assets as less risky than any other assets. This
perception made a gradual shift of investors' preference toward real estate assets. All the
above reasons combined with the historically low mortgage rates had led to the recent
increase in real estate asset prices (Goodman and Goodman, 2007).
The market analysis also support the criteria of option two where the trend for
ownership is stronger than rent. The asset prices have gradually began to improve during the
last few months while the rent level is still suffering from the recession. The current vacancy
rate is at its highest level of many years which will create a negative impact on the operating
income of option one.
The demographics of Burnaby population support the development proposal where
small units are required for market feasibility. Furthermore, the proposed unit mix (1
bedroom, 1 bedroom + den, and 2 bedroom units) are the most appropriate product for the
market segment targets.
Since the working professionals and empty nesters are the most important market
segments, the strategy of the developer should include providing three important elements.
1. Contemporary unit features which is the main focus of all home buyers especially in
the urban environment where professionals seek the best life style.
2. Sufficient outdoor green areas which is an important interest ofthe market segments
that corresponds to the modern trend of practicing outdoor activities.

40

3. Affordable unit price is also the mam interest for any buyer as home pnces are
escalating to a very high level.
These three elements are normally the main interest of the target marketing consumer
of working professionals and empty nesters which correspond to their lifestyle and
purchasing behaviour. This strategy concept is drawn from personal experience based on
many years of employment in the development industry.

41

BIBLIOGRAPHY
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Guide to US Economy. Accessed in Feb. 8, 2010
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Ground Parking, Over 1000 sq.ft. Cost Index British Columbia. Accessed in Dec. 14, 2010

http://www.bdconsultants.com/cost.asp

Ben-Shahar, Danny; Deng, Yongheng and Sulganik, Eyal. (2009). Property appraisal in
high-rises: A cooperative game theory approach. Journal of Housing Economics. 18
(2009): 25-33
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2009.
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Canada Mortgage and Housing Corporation. (Fall2009). Rental Market Statistics, British
Columbia Highlights. Housing Market Iriformation. Date Released: Fall, 2009
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17431 f7f&fr= 1266538725221
Chen, Hong Long. (2008). Using financial and Macroeconomic Indicators to Forecast Sales
of Large Development and Construction Firms. . Journal of Real Estate Finance and
Economics. (forthcoming). DOl 10.1007/slll46-008-9158-7.
City of Burnaby. (Oct. 2009). Social and demographic Trends m Burnaby and
Neighbouring Communities - 1981 to 2006. Accessed in Dec. 21 , 2009
http://www.burnaby.ca/ shared/assets/Social and Demographic trends m Burnab
y5921.pdf?method= 1
Colwell, Peter. (2002). Tweaking the DiPasquale-Wheaton Model. Journal of Housing
Economics. 11: 24-39.
Damodaran, Aswath. (2001). Corporate Finance - Theory and Practice. 2nd edition.
Dombrow, Jonathan and Turnbull, Geoffrey. (2004). Trends in Real Estate Research,
1988-2001: What's Hot and What's Not. Journal of Real Estate Finance and
Economics. 29 (1): 47-70.
42

Geitner, David; Clayton, Jim; Miller, Norman and Eichholtz, Piet. (2001). Commercial
Real Estate Analysis & Investments. 2nd edition.
Goodman, Jack. (2004). Determinants of operating costs of multifamily rental housing.
Journal of Housing Economics. 13 (2004): 226-244.
Goodman, David and Goodman, Mark. (November 2007). It's Not Just About Cap Rates.
The Goodman Report. Issue 34.
Google Finance Canada. Accessed Dec. 8, 2009

http://www.google.ca/fmance?c lient=firefox-a&rls =org.mozilla:enUS:official&hl=en&tab=we
Himmelberg, Charles; Mayer, Christopher and Sinai, Todd. (2005). Assessing High
House Prices: Bubbles, Fundamentals and Misperceptions. Journal of Economic
Perspectives. 19 (4): 67-92.
Hwang, Min and Quigley, John. (2009). Housing Price Dynamics in Time and Space:
Predictability, Liquidity and Investor Returns. Journal of Real Estate Finance and
Economics. (forthcoming). DOl 10.1007/s11146-009-9207 -x.
Kiel, Katherine and Zabel, Jeffrey. (2008). Location, location, location: The 3L Approach
to house price determination. Journal of Housing Economics. 17 (2008) 175-190.
King, Peter. (2009). Understanding Housing Finance: Meeting Needs and Making Choices.
2nd edition.
Lai, Fu-Chuan; McDonald, John and Merriman, David. (2009). Housing appreciation
(depreciation) and owners' welfare. Journal of Housing Economics. 19 (1 ): 66-73.
Multiple Listing Service (MLS). Realtors know real estate. Accessed Dec. 21, 2009.

http://www.mls.ca/splash.aspx
Miller, Norman; Peng, Liang and Sklarz, Michael. (2009). House Prices and Economic
Growth. Journal of Real Estate Finance and Economics. (forthcoming) DOl
10.1007Is11146-009-9197-8.
Peek, Joe and Wilcox, James. (2006). New Development in Macroeconomics - Housing,
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Reduced Cyclicality of Residential Investment. The American Economic Review. 96
(2): 135-140.

43

Real Estate Bard of Greater Vancouver. Housing Price Index for Burnaby, Nov 2009. MLSLink
HPJ. Accessed Dec. 17, 2009.
http://www.rebgv.org/housing-pricc-index?region=Burnaby&typc=all&date=2009ll-Ol

Rosenthal, Edward. (2009). A Pricing Model for Residential Homes with Poission Arrivals
and a Sales Deadline .. Journal of Real Estate Finance and Economics. (forthcoming)
DOl 10.1007/s11146-009-9191-1.
Sekkat, Khalid and Szafarz, Ariane. (2009). Valuing Homeownership .. Journal of Real
Estate Finance and Economics. (forthcoming) DOl 10.1007/s11146-009-9212-0.
Somerville, Tsur and Swann, Kitson. (2008) Are Canadian Housing Markets Over-priced?
Centre for Urban Economics and Real Estate - Working Paper. SAUDER School of
Business. University of British Columbia.
Somerville, Tsur. (2006). British Columbia Real Estate's Place in an Investment Portfolio.
Centre of Urban Economics and Real Estate - Discussion Paper. Sauder School of
Business. University of British Columbia.
Stevenson, Simon. (1999). A Long-Term Analysis of Regional Housing Markets and
Inflation. Journal of Housing Economics. 9, 24-39 (2000).
Tsounta, Evridiki. (Oct. 2009). Is the Canadian Housing Market Overvalued? A Post-Crisis
Assessment. IMF Working Paper. WP/091235.
Yavas, Abdullah. (2000). Resolution of Demand Uncertainty and Competitive Rent
Adjustment. Journal of Housing Economics. 10, 472-481 (2001).

44

APPENDIX A

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45

U'IT
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Site Information
Site Area (sq.ft)
Floor Space Ratio (FSR)
Buildable Area (sq.ft)
Efficiency
Sellable Area (sq.ft)
Table 1: Site Information ofProject A

a
b
c = aX
b
d
e = cX
d

60,000
3
180,000
85%
153,000

Unit Breakdown
Unite Type
Type A (TH - 2 Bedroom +
Den)
Type B - 1 Bedroom
Type C - 1 Bedroom + Den
Type D - 2 Bedroom

Level
1

level2

Level
3-22

Total

o;o

Area Rang
sq.ft.

60
40
60
Total

16
67
44
73
200

8%
34%
22%
37%

1200
600-700
700-800
Above 800

16
7
4
13

100%

Table 2: Unit Breakdown
Site Acquisition
Ste Area (sq.ft)
Price per sq.ft
Land Cost
Property Purchase Tax (2%)
Other Acquisition Expenses

60,000
150
9,000,000
180,000
0

Total Site Acquisition Cost
Table 3: Site Acquisition Cost
Development Cost
Buildable Area (sq.ft)
Construction Cost (per sq.ft)
Total Construction Cost
Soft Cost (1 0% of const. Cost)
Contingency (3 % of const.
Cost)
Total Development Cost

ITotal Project Cost

9,180,000

180,000
220
39,600,000
3,960,000
1,188,000
44,748,000

I

53,928,000
Table 4: Development Cost and Total Project Cost (Site Acquisition+ Development Cost)

46

Vacancy Rate

Vacancy
Rate*
2.6%
2.1%
2.3%
2.6%

Unit Type
Type A (2B TH)
Type B (lB)
Type C (lB +D)
TypeD (2B)

Number of
Units
16
67
44
73

Weight
0.080
0.335
0.220
0.365

Weighted
Vacancy
0.21%
0.70%
0.51%
0.95%
2.4%

W ei2hted A vera2e Vacancy Rate
*Data Source: Rental Market Statistics, Canada Mortgage Housing Corporation- Fall 2009

Table 5: Weighted Average Vacancy Rate
Capital Structure
Project Cost
Equity%
Loan%
Interest Rate
Total Amount of Equity
Total Amount of Loan

53,928,000
20%
80%
4.25%
10,785,600
43,142,400

Annual Principal Payment

25,000

Table 6: Capital Structure and Loan Conditions

Year

1
2
3
4
5
6
7
8
9
10

Beginning
Balance
21,571,200
43,117,400
43,092,400
43,067,400
43,042,400

Interest
Payment
916,776
1,832,490
1,831,427
1,830,365
1,829,302

Principal
Payment
25000
25000
25000
25000
25000

Ending
Balance

21,546,200
43,092,400
43,067,400
43,042,400
43,017,400

43,017,400
42,992,400
42,967,400
42,942,400
42,917,400

1,828,240
1,827,177
1,826,115
1,825,052

25000
25000
25000
25000

42,992,400
42,967,400
42,942,400
42,917,400

1,823,990

42,917,400

Table 7: Debt Service and Outstandmg Balance for optiOn 1

47

Debt
Service
941,776
1,857,490
1,856,427
1,855,365
1,854,302

1,853,240
1,852,177
1,851,115
1,850,052
44,741,390

Rent Revenue
Unit Type
Type A (2B TH)
Type B (I B)
Type C (lB +D)
TypeD (2B)
Total Rent Revenue
Adjusted Rent Revenue**

Avg.
Monthly
Rent *
1,175
919
1,044
1, 169

Number of
Units
16
67
44
73

Avg.
Annual Rent
14,100
11,028
12,528
14,028

Total
225,600
738,876
551 ,232
1,024,044
2,539,752
3,809,628

*Data Source: Rental Market Statistics, Canada Mortgage Housing Corporation- Fal/2009
**Adjusted rent revenue is calculated by multiplying the rent revenue by 1.5

Table 8: Rent Revenue for option 1
Cap Rate Calculations
Current Market Rent
Project Cost for Developer
Project Market Value at (125%)*
Cap Rate

3,809,628
53 ,928,000
67,410,000

5.7%

*Assuming that the extra 25% accounts for developer profit plus taxes

Reversion Cash Flow
Projected NOI of Year 11
Terminal Cap Rate
Resale Price
Cost of Sale (2.5%)
Reversion Cash Flow

3,704,173
5.7%
64,985,483
1,624,637
63,360,846

Table 9: Cap rate and Reversion Cash Flow Estimation for option 1

48

Capital Improvement
Reversion

h

m=j+k-1

k

j=a+b+gh+i

21 ,571,200
941,776
-10,924,576
13.19%

-31,554,000
7.30%

1
-9,180,000
-22,374,000

*PBTCF: Property Before-Tax Cash Flow
**EBTCF: Equity Before-Tax Cash Flow

Table 10: Proforma of Option 1

Loan
Debt Service
EBTCF**
Levered IRR

PBTCF*
Unlevered IRR

Operating Revenue
Potential Rent Revenue
Vacancy Allowance
Total Revenue
Operating Expenses
Net Operating
Income (NOI)

c
d
e = c- d
f

g = e-f

Item
Site Acquisition
Development Cost

a
b

21 ,571,200
1,857,490
-2,660,290

-22,374,000

-22,374,000

2

1,856,427
1,564,314

3,420,741

3,420,741

3,809,628
91 ,431
3,718,197
297,456

3

49

1,855,365
1,599,584

3,454,949

3,454,949

3,847,724
92,345
3,755,379
300,430

4

1,854,302
1,635,196

3,489,498

3,489,498

3,886,202
93 ,269
3,792,933
303,435

5

1,853,240
1,171,154

3,024,393

500,000

3,524,393

3,925,064
94,202
3,830,862
306,469

6

1,852,177
1,707,460

3,559,637

3,559,637

3,964,314
95,144
3,869,171
309,534

7

1,851 ,115
1,744,119

3,595,233

3,595,233

4,003,957
96,095
3,907,862
312,629

8

1,850,052
1,281,134

3,131,186

500,000

3,631,186

4,043,997
97,056
3,946,941
315,755

9

44,741,390
22,286,954

67,028,343

63,360,846

3,667,498

4,084,437
98,026
3,986,410
318,913

10

3,704,173

4,125,281
99,007
4,026,274
322,102

11

Principal
Ending
Payment
Balance
21 ,546,200
25 ,000
43 ,092,400
25 ,000
21 ,596,200
21 ,496,200
21 ,471 ,200
25 ,000
25 ,000
21 ,446,200
25 ,000
21 ,421 ,200
6 21,446,200
21 ,396,200
25 ,000
7 21 ,421 ,200
25 ,000
21 ,371,200
8 21 ,396,200
25,000
21 ,346,200
9 21 ,371 ,200
21,346,200
10 21,346,200
907,214
Table 11: Debt Service and Outstanding Balance for option 2
Year

Beginning
Balance
1 21,571 ,200
2 43 ,117,400
3 43 ,092,400
4 21,496,200
5 21,471 ,200

Interest
Payment
916,776
1,832,490
1,831 ,427
913,589
912,526
911,464
910,401
909,339
908,276

Unit Type
Type A (2B TH)
Type B (lB)
Type C (lB + D)
TypeD (2B)
Total Rent Revenue
Adjusted Rent Revenue**

Avg.
Monthly
Rent*
1,175
919
1,044
1,169

Number of
Units
16
19
20
49

Debt
Service
941 ,776
1,857,490
23 ,427,627
938,589
937,526
936,464
935 ,401
934,339
933 ,276
22,253,414

Avg.
Annual
Rent
14,100
11 ,028
12,528
14,028

Total
225,600
209,532
250,560
687,372
1,373,064
2,059,596

* Data Source: Rental Market Statistics, Canada Mortgage Housing Corporation- Fal/ 2009

Table 12: Rent Revenue for Option 2

Price per
sq.ft

Unit Type
Area
Type A (2B TH)
600
Type B (lB)
620
590
Type C (lB + D)
780
580
TypeD (2B)
890
Total Revenue
Cost of Sale (2.5%)
Before-Tax Sales
Table 13: Unit Sales Revenue on Year 3 for Option 2
Projected NOI of Year 11
Terminal Cap Rate
Resale Price
Cost of Sale (2.5%)

2,002,584
5.65 %
35 ,443,959
886,099

Before-Tax Reversion
34,557,860
Table 14: Reversion Revenue on Year 10 for Option 2

so

Unit
price

Number
of
Units

372,000
460,200
516,200

48
24
24

Total
17,856,000
11,044,800
12,388,800
41,289,600
1,032,240

40,257,360

Capital Improvement
Reversion

c
d
e = c- d
f

h

m=j+k-1

k

j=a+b+gh+i

21 ,571 ,200
941 ,776
-10,924,576
32.67%

-31,554,000
12.58%

1
-9,180,000
-22,374,000
2

21 ,571,200
1,857,490
-2,660,290

-22,374,000

-22,374,000

*PBTCF: Property Before-Tax Cash Flo w
**EBTCF: Equity Before-Tax Cash Flow

Table 15: Proforma of Option 2

Loan
Debt Service
(EBTCF)**
Levered IRR

(PBTCF)*
U nlevered IRR

Operating Revenue
Potential Rent
Revenue
Vacancy Allowance
Total Revenue
Operating Expenses
Net Operating
Income (NOI)

g = e-f

Item
Site Acquisition
Development Cost

a
b

23 ,427,627
18,679,085

42,106,712

40,257,360

1,849,352

2,059,596
49,430
2,010,166
160,813

3

51

938,589
929,257

1,867,846

1,867,846

2,080,192
49,925
2,030,267
162,421

4

937,526
948,998

1,886,524

1,886,524

2,100,994
50,424
2,050,570
164,046

5

936,464
468,926

1,405,390

500,000

1,905,390

2,122,004
50,928
2,071,076
165,686

6

935 ,401
989,043

1,924,444

1,924,444

2,143,224
51,437
2,091,786
167,343

7

934,339
1,009,350

1,943,688

1,943,688

2,164,656
51 ,952
2,112,704
169,016

8

933 ,276
529,849

1,463,125

500,000

1,963,125

2,186,303
52,471
2,133,831
170,707

9

22,253 ,414
14,287,203

36,540,616

34,557,860

1,982,756

2,208,166
52,996
2,155,170
172,414

10

2,002,584

2,230,247
53,526
2,176,721
174,138

11

Levered Beta
Company
Equity Residential
Canadian Apartment Properties REIT
Cartwell Senior Housing REIT

Historical
Beta
1.42
0.43
1.01

Beta
1.28
0.62
1.01

Unlevered Beta
Company
Equity Residential
Canadian Apartment Properties REIT
Cartwell Senior Housing REIT

Levered Beta
1.28
0.62
1.01

DIE

Ratio
2.10
3.28
2.87

Tax
Rate
35%
35%
35%

Table 16: Levered and Unlevered Beta of the Three Comparable Companies
Company
Equity Resid entia!
Canadian Ap artment Properties REIT
Cartwell Seni or Housing REIT
Total

Unlevered
Beta
0.54
0.20
0.35

*Data Source: Google Finance

Revenue*
2103
320
725
3148

Weight
0.67
0.10
0.23

Table 18: Project Beta

53,928,000
43,142,400
10,785,600
4
0.46
35%
1.67

Average return on stocks (1970-2003)*
Riskless Rate (10-year bond)**
Risk Premium

12.72%
4.08%
8.64%

*Data Source: Geitner, Miller, Clayton, Eichholtz- "Commercial Real Estate Analysis &
Investment" (Exhibit 11-4, P252)
**Data Source: Google Finance

Table 19: Risk Premium
Riskless rate
Beta
Risk Premium

4.08%
1.67
8.64%

Cost of Equity

18.47%

Table 20: Cost of Equity

52

Weighted
Average
0.36
0.02
0.08

0.46

Table 17: Weighted Average ofUnlevered Beta
Project Cost
Debt (80%)
Equity
DIE Ratio
Unlevered Beta
Tax Rate
Project Levered Beta

U nlevered Beta
0.54
0.20
0.35

Cost of Capital = Ke (E/D+E) + Kd (D/D+E)

Cost of Equity
Before-tax Cost of Debt
Market Value of Equity
Market Value of Debt

18.47%
4.25%
10,785,600
43,142,400

Cost of
Capital
Table 21: Weighted Average Cost of Capital (WACC)

53

7.09%