Not laying bricks, or pouring concrete, the most important element of building a skyscraper is the finance, says Phil Wombwell. The essence of real estate is not bricks and mortar, as most would think, but cashflow.
Put in simple terms, there are three possible outcomes from a property investment: make money, lose money or break even.
Other than a few extra zeros on the end of the price, the concept of making money out of a skyscraper is much the same as buying a three-bed villa in the Springs. In both cases you are taking other people's money, investing it, and promising them a return.
There are two ways to make money in either scenario: capital appreciation, ie your property increases in value so that, when you sell it, it's worth more than what you paid for it; or a positive income return, usually rent. Ideally, it will be a combination of the two.
Getting into the Game
So, you understand the concept, but how would you put this into practice on the big stage and attract investors to put your idea into practice. Like any business idea it needs a business plan, or in the case of real estate it's called a 'feasibility study'.
A document put together which includes a site survey, details of the concept, economic demand analysis, market area analysis, development analysis, cost estimates, financial structure and not forgetting the rate of return analysis.
The major difference with large development ideas is that it takes a couple of years to build, so all your projections and valuations are based on anticipated future cash flows that will accrue from the investment. In the industry this is called the cash flow model.
Its primary importance is that of a performance measure to compare alternative investment scenarios. It converts the projected investment cashflows to a single amount in order to simplify direct comparisons at a single point in time.
As part of the feasibility study all sorts of ratios are used to help gauge the relationships between various measures of value and performance.
Income multipliers are used to determine the relationship between price and income. This can be broken down further into gross income multipliers, net income multipliers, and break even ratios.
Then there are profitabilty measures, which include capitalisation rate, equity dividend rate and payback period.
The Bottom Line
The most important measure for investors, however, is something called net present value, (the present value of cash inflows subtracted by the present value of cash outflows). If the result is a positive number you could be in with a chance and will merit further investigation.
Another important number is the IIR, or internal rate of return, which equates the present value of a projected cashflow with any initial cash investment.
If your IRR is equal to or greater than the investors required rate of return then you have the possiblility of making some money. If it is less, then quite simply you will be shown the door.
* BIG MORTGAGES
The great thing about real estate is that it can be leveraged to a much greater degree than other investments, ie you can borrow a lot more in relation to your own stake.
However, borrowing millions of dollars comes at a price. This is why the use of such borrowing techniques is critical to the business plan.
Sometimes, the cost of equity (self) financing is greater than the cost of mortgage debt, incentivising the investor to finance as much as possible of the project with debt.
This is why you often hear of very wealthy people and cash rich companies borrowing heavily despite having lots of cash at their disposal.
However, monthly repayments on a commercial mortgage do not come cheap. Just to give you an idea, on a mortgage of $7.5 million (based on interest at 7.75 per cent) the monthly repayment would be (approximately) $54,000 per month.
For that reason many developers look for private equity partners, an investor who will give cash in exchange for a slice of the company, rather than charging interest.
It is quite common for an equity partner to look for an exit within three to five years with a rate of return between 20 per cent to 40 per cent.
So, the business plan should have this in mind in order to make the venture attractive. There are many investment institutions around with an awful lot of money.
In fact, the availablility of funds is rarely the issue at the moment, but finding suitable projects to deploy the cash.
Fund managers do a great deal of research to find where the markets are heading and propose portions of cash for certain countries and types of projects, such as shopping malls or office towers.
They'll plan this five years in advance and track the markets accordingly.
With all the research in hand these fund companies then persuade large pension companies, which hold billions of dollars, to apportion some of their cash into their funds, and make gains for their pension holders.
* TRYING IT ALL TOGETHER
Now you have an equity partner, and a commercial mortgage, but together they do not cover the total cost of the project, and a further $15 million of finance needed.
What do you do? You could get another loan secured against the land or property, but this type of financing is never cheap, so a more efficient method is to look at the much talked about method of financing, called mezzanine finance.
This financing bridges the gap in an unsecured fashion through a mixture of debt and equity, usually charged at quite high rates of interest. The whole concept of financing a project relies entirely on creating a debt structure that will reduce the costs of the project.
The role of the financing team assisting in the funding engagement is therefore crucial to the success of the project. And don't forget there is a whole world of financing techniques in Islamic financing too, but that's another article.
Phil Wombwell MBA consults in finance
© 7Days 2005
