REAL ESTATE INVESTMENT

ANALYSIS
JOHN BAILEY

1. Introduction

Real estate investment analysis is an organised investigation of the various

factors and elements which affect the current and the future value of a particular
property and consideration of the relationship of those factors and elements to an
investment decision.
The first part of that statement, up to the point of current value, is more or less
the definition of an appraisal or valuation of the property. Considering future
value and relating the factors and elements affecting value to an investment decision
differentiate an investment analysis from a simple valuation problem. While a real
estate investment analysis differs from an appraisal, primarily in that it is something
above and beyond a valuation, it is based upon and uses sound valuation principles
and techniques. This paper will touch briefly upon the application of sound
appraisal principles to real estate investment analysis but will dwell more upon the
differences and additional responsibilities the valuer must accept in the performance
of an investment analysis.
'Investment' implies that the client is a passive investor interested primarily in
the potential profits and capital gains from ownership of the real asset as an invest-
ment, rather than the benefits of direct operation, use, or occupancy of the
property. A hotel operator, for example, would view a property from the stand-
point of the business income which can be generated from the operation, rather
than the pure real estate income attributable to the site and the physical improve-
ments. Emotions and personal experience often have an effect on the investment
criteria of even a passive investor. Appraisers are sometimes baffled by prices paid
in actual transactions which appear to be unexplainable by accepted investment
standards when they were truly motivated by an intended use or occupancy.
Real estate investment analyses for proposed projects require certain considera-
tions which are substantially different from the analyses of completed, existing,
income producing investment grade property. Cost elements, including hard and
soft costs and carrying charges, are a primary element in a proposed project and
potential entrepreneurial profit is the key question. I would therefore like to
confine our subject to analysis of existing projects.
We will assume that our investor/client intends to hold the property over a
relatively long investment period. We are not contemplating a distress situation or

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an opportunity for a sharp operator to make a fast buck on a quick turnover. We

are looking at the long term potential of the property to the extent to which one
can predict the future of a particular parcel of real estate.
We are assuming that some action will result from the analysis, a decision to buy,
a decision to sell or, possibly, a decision not to do either. One principal way in
which a real estate investment analysis usually differs from an appraisal is the
client's need, if not desire, for professional guidance and assistance in reaching a
decision. The assignment should be considered more one of counselling than purely
estimating value.
Valuers, at least in the United States, tend to fear that communication with the
client during the course of a study and any participation on the part of the client
in the logic and exercise of judgment which leads to the conclusions and recom-
mendations might prejudice their opinion. As one client described it to me, they
use a 'time-bomb' approach. They accept an assignment, inspect the property, and
are not seen or heard from again until they place a complete, printed and bound,
fait accompli appraisal report upon the client's desk, usually accompanied by an
invoice for their services. They put it down gingerly as though it were a time-bomb
and seem in a hurry to leave before the thing goes off.
Let me quickly say, lest anyone become alarmed, we are not espousing that the
client be permitted to predetermine answers or dictate the results. The consultant
must not be influenced by the investor's desire for a particular answer just as an
appraiser's conclusions must be completely independent to have merit. We are
saying the real estate investment analysis should provide the material facts and be
a vehicle enabling evaluation of various alternatives and options. In the end it will
be the consideration of those facts, alternatives and options taken in the light of
the investor's investment criteria which will lead the buyer to a decision to buy or
not to buy, or the seller to a decision to sell or not to sell, at a given price.

2. A computerized methodology
As required in the application of sound appraisal techniques, the real estate
investment analyst must carefully review the present condition of the property
and its leases and study the past operating performance, if the data is available,
in order to look into the future. It is the future which is most important to the
analysis of the investment.
For about two decades following World War II, at a time when many of us were
learning and developing our appraisal techniques, inflation was not an important
consideration in our economy. Properties could be appraised by calculating last
year's income or predicting the next year's income and applying a price to earnings
ratio, which appraisers call a capitalisation rate. Similar types of properties could
readily be compared to each other because the future pattern of their revenue and
expenses would probably remain similar.
At that time the ideal, prime, lowest risk investment was a property let on a
long lease to a high credit tenant with a fixed net income.
When we began to realise (and we learned a lot from the British on this subject)
that inflation was eating away investment returns, a new pattern of leasing evolved

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to enable the owner to increase the cash flow and offset the effect of inflation on
purchasing power.
As different landlords were more or less successful in changing their leasing
structure, the pattern of future cash flow in different buildings become much
more different, rather than similar, and the use of a capitalisation rate become
misleading.
The future revenue from a simple property was and is relatively easy to forecast.
Complex properties having many tenants and many leases gave us a problem.
Fortunately at about this time we were learning how to use computers to make
complex mathematical computations. The application of the computer to forecast-
ing income from a complex property was a natural. My firm, Landauer Associates,
had an opportunity to develop a highly sophisticated computerised methodology
to solve such problems when we were retained to perform an investment analysis
of the Pan Am building in New York. Our technique has been copied, enlarged,
and refined by ourselves and others.

3. A case study
Pan American World Airways was having financial problems and asked us to
study the feasibility of selling shares in their subsidiary corporation which held
title to the property. We had made previous somewhat ineffectual analyses with-
out adequate computer modelling of the course of future income. With Pan Am's
encouragement and consent we devised a computer program which enabled us
to account for changes in rents as leases expired and, using varying growth rates, to
provide for changes in expenses, vacancies, real estate tax and operating expense
escalation, periodic capital improvements and leasing commissions. We made
a detailed cash flow projection for the property supported by eight pages of
explanatory assumptions giving the rationale for our estimates. Due to the size of
the building, approximately 2.5m sq. ft of rentable area, and the number of tenants
with varying lease terms it would have been impossible for us to accurately calculate
all those changes by hand.
The explanatory comments which accompanied the cash flow projection
described our methodology and our assumptions in detail. For example, our report
stated 'Leases are accepted into the model at current base and escalation rents.
Upon expiration, a new base rent is entered from our rents matrix, escalation is
dropped to zero and a new base year is established in the fiscal year of leasing'.
A typical set of assumptions for an existing office building is included as Exhibit
A to the paper. Our original 1980 rent matrix for the Pan Am building is also
included as Exhibit B. Using details such as these and a flexible computer program
one can quickly determine the effect of changing various assumptions upon the
cash flow from the property. Varying the terminal capitalisation rate and the
discount rate shows the range of prices that might be reasonable under various
circumstances.
Before we acquired this computer capability we had thought the Pan Am build-
ing would sell for a price somewhere in the range of US $250 to US $300m. Our

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initial computer study, using the original Pan Am occupancy terms, indicated the
price might be as high as US $325m. In discussions with our client, Pan Am indicated
they were willing to cancel their original lease and take back a new, replacement
lease at rents closer to the current market. We discovered this change had a major
impact on the cash flow from the property and the probable price.
Varying assumptions and lease terms, we worked with our client and ultimately
derived the cash flow figures shown in Exhibit C attached as our best mutual
opinion of the most probable future of the building. On the basis of this analysis,
Pan Am reached the decision to offer the property for sale.
We then decided to take a bold step with the facts, figures, and opinions which
had been generated by our real estate investment analysis. John R. White, Chairman
of Landauer, wrote of our decision in a book recently published by the American
Institute of Real Estate Appraisers,
'Ordinarily such analysis would exist for the private knowledge and use of
the seller for the purpose of enlightening him as to the probable selling
price range. It was certainly not customary to reveal this information to a
buyer. However, we decided to use the rental and expense projections,
descriptive material, and market data — in fact, everything except the dis-
count process itself . . . in the offering material'.
Potential buyers of the property were given the same detailed investment analysis
we had prepared for the seller, with the exception of our opinions on appropriate
discount rates and prices. We offered them the use of our computer program to
vary assumptions, growth rates, discount rates, etc in accordance with their own
opinions and investment criteria. Several took advantage of the opportunity to
make their own confidential calculations.
To assure the potential buyers of the confidentiality of their assumptions we
designated one member of our staff to perform all the calculations and sensitivity
analyses for the buyers. The staff member would not disclose the assumptions
being made by the various offerors to each other or to us.
We represented the seller in this analysis; we do not know what assumptions the
purchaser, Metropolitan Life, made concerning inflation and the rent matrix,
although there was some indication at the time that they felt our projections were
conservative. At the publicly reported price of US S400m the first year cash flow
was a 2.4 per cent return on equity. However, I believe the internal rate of return
they anticipated over the long term was probably somewhere between 12 per cent
and 13 per cent.
It is only by working with clients such as Pan Am that one can learn their
investment goals and objectives and be of maximum effective service to them.
In this case, the client desired the highest immediate cash price they were able to
obtain. They were willing to sacrifice higher future occupancy costs in order to
obtain immediate cash. In some respects, this trade-off was similar to off balance
sheet financing at a known, reasonable interest cost. The unknown element was
the potential capital gain, but, for Pan Am, their cash may be better invested in
airplanes than in real estate.

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4. The exhibits
Turning now to the exhibits, Exhibit A contains typical assumptions one would
use in projecting the future for a major office building. This is the road map to the
data. Any or all of these assumptions may be changed or varied to give us a sensi-
tivity analysis of its effect on the future cash flow and presumably on the potential
price range.
For illustration purposes we have assumed a building in which the current
owner occupies a substantial portion of the space which will be the subject of a new
replacement lease at current market rents. To demonstrate various facets of the
problem, we have theorised a current renovation and remodeling programme as
indicated in assumptions 4 and 5. The remainder of the assumptions are fairly
self-evident.

Exhibit A
Typical cash flow assumptions

(1) For owner's space, assume same terms as current market leases: lease for
15 year term, increases based on CPI every five years, with all expenses fully
passed through. Two ten year options at market.
(2) Expenses, including increased taxes, estimated at S8.10 per sq. ft.
(3) New outside tenants will all pay current market rents.
(4) We have projected that owner will complete, at its cost, all current renova-
tion work, except for floors 19 and 21 which are currently leased to outside
tenancies. Current remodelling programme should essentially be completed
by the end of 1984.
(5) Construction cost floors 19 and 21 projected at $45 per sq. ft, grown at CPI
index; to be expended at expiration of current leases. Six months vacancy
allowed at that time for construction, releasing.
(6) Lease rollovers used for vacancy. On rollover, 33% of tenants will not
renew. Three months vacancy allowed for non-renewal tenancies.
(7) Broker's commission — 16% on five-year leases; 22% on ten-year leases.
Commission payable 50% in year one, 25% in year two, 25% in year three.
(8) Office tenants pay a pass through of increases in operating expenses and
taxes above base year. Retail tenants pay all operating expenses except
insurance, and a pass through of tax increases above the base year.
(9) All new and renewable leases for outside tenancies will be for five year
terms at then market rents, with a CPI increase at the beginning of the
fourth year.
(10) Tenant work for rollover tenancies to be at $12.50 per sq. ft, growing
in accordance with CPI increase. No allowance budgeted for tenants signing
leases in 1984.
(11) Growth rates as follows:
CPI = 6%
Market rents = 6%
Operating expenses = 6%
Utilities = 7.5%
Taxes = 2%, after adjustment for sale in 1984.

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Exhibit B
Schedule of projected office space base rents
per sq. f t (electric not included)

Floors Floors Floors Floors

Year 3-9 10-19 20-29 30-39
($) ($) ($) ($)

1980 16.00 25.00 27.00 29.00

1981 16.96 26.50 28.62 30.74
1982 17.98 28.09 30.34 32.58
1983 19.06 29.78 32.16 34.54
1984 20.20 31.56 34.09 36.61
1985 21.41 33.46 36.13 38.81
1986 22.70 35.46 38.30 41.14
1987 24.06 37.59 40.60 43.61
1988 25.50 39.85 43.03 46.22
1989 27.03 42.24 45.62 48.99
1990 28.65 44.77 48.35 51.93

Exhibit B is a schedule of anticipated average market rents for various blocks of

space in the Pan Am building projected into the future. This particular schedule
assumed that rents would grow at a steady 6 per cent per year compound. If, for
example, the 37th floor of the building was available for re-leasing this year, 1984,
we would assume the base rent achieved would be $36.61 per sq. ft. In retrospect,
that 1980 projection was conservative because that space would probably rent for
around $42 per sq. ft currently.
Exhibit C is 11 years of the actual cash flow projection we made for the Pan Am
building. In fact, we projected the cash flow 16 years because the small first
mortgage was fully amortised in 1995 and all but three leases accounting for
400,000 sq. ft (including Pan Am's 350,000 sq. ft) had been turned over and
brought to market by that time. We generally feel uncomfortable projecting that far
into the future, but it was necessitated by the facts and circumstances in this
instance. For illustration purposes here the first 11 years are adequate.
Base rents were put into the computer model lease by lease according to current
tenancy. Upon expiration of each lease, units of space were assumed to be re-leased
for five or ten year terms, depending upon their size, at rents selected from the rent
matrix (Exhibit B). Based upon our estimate of market conditions and studies or
re-leasing patterns in other Manhattan office buildings, we assumed 30 per cent of
the space would not be renewed by the existing tenant. We provided for a short
vacancy loss between tenants to allow for the rent-up period. Leasing commissions
were calculated on the basis of current practice in the market.
Expenses were escalated at varying rates from 6 per cent to 12 per cent per year
compound depending upon how much we believed they would be impacted by
inflation. Payroll, for example, was increased at 9 per cent compound; electricity at
12 per cent.
The result is a detailed line item by line item cash flow projection such as the
one reproduced here. (See over.)

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 Exhibit C
Cash flow projection (in 000 dollars)

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991

Revenue
Base rents 28,157 28,384 32,621 47,743 58,279 58,432 58,547 66,164 73,232 74,067 74,378
Escalation income 6,749 8,398 9,423 8,497 9,587 13,436 17,722 18,386 20,512 26,203 32,707
Cost of living 173 200 145 84 95 106 119 48 0 0 0
Percentage rent 607 655 504 429 446 482 520 562 607 655 708
Tenant sales 1,659 1,791 1,935 2,089 2,257 2,437 2,632 2,843 3,070 3,316 3,581
Credit loss —187 —197 —223 —294 —353 —374 —398 —440 —487 —521 —557

Total revenue 37,158 39,232 44,405 58,549 70,311 74,518 79,143 87,562 96,934 103,719 110,817
Expenses
Payroll 3,561 3,881 4,231 4,612 5,027 5,479 5,972 6,510 7,096 7,734 8,430
Related labour 784 855 931 1,015 1,107 1,206 1,315 1,433 1,562 1,703 1,856
Electric 5,824 6,523 7,306 8,182 9,164 10,264 11,496 12,875 14,420 16,150 18,088
362
Steam 2,365 2,602 2,862 3,148 3,463 3,809 4,190 4,609 5,070 5,577 6,134
Elevator maintenance 514 555 600 647 699 755 816 881 951 1,027 1,110 Bailey
Other operating 1,006 1,086 1,173 1,267 1,369 1,478 1,596 1,742 1,862 2,011 2,172
Water and sewer 82 89 96 103 112 120 130 141 152 164 177
Management 474 484 510 574 604 614 626 647 670 687 705
Insurance 320 345 373 403 435 470 507 548 592 639 690
Real estate taxes 8,404 8,908 9,442 10,009 10,609 11,246 11,921 12,636 13,394 14,198 15,050
Reserve for replacements 100 105 110 116 122 128 134 141 148 155 163

Total expenses 23,433 25,433 27,634 30,077 32,709 35,570 38,702 42,144 45,917 50,046 54,575
Net operating income 13,725 13,799 16,771 28,472 37,601 38,948 40,441 45,419 51,017 53,674 56,242
Interest 2,790 2,650 2,502 2,346 2,181 2,006 1,822 1,627 1,420 1,202 971
Amortisation 2,430 2,570 2,718 2,874 3,093 3,214 3,398 3,593 3,800 4,018 4,249

Debt service 5,220 5,220 5,220 5,220 5,220 5,220 5,220 5,220 5,220 5,220 5,220
Cash flow 8,505 8,579 11,551 23,252 32,381 33,728 35,221 40,199 45,797 48,454 51,022
Total leasing commissions 75 17 1,918 3,282 39 65 24 3,110 478 53 154

Adjusted cash flow 8,430 8,561 9,633 19,970 32,343 33,663 35,197 37,089 45,319 48,400 50,867
 Journal of Valuation: 2

Looking at the bottom line, adjusted cash flow, one sees an unusual pattern.
Leases on almost half the building, 1.1m sq. ft, expired in 1983 and 1984 with
contract rent averaging a little over $14 per sq. ft. We anticipated a strong rental
market at that time and forecast that space to be re-leased at $36 per sq. ft. With
estimated market rent increasing only 6 per cent per year, the cash flow from the
property doubled in 1984 and almost doubled again by 1988.
While the first year equity yield was only 2.4 per cent, the fifth year yield
(1985) will be a very respectable 9.2 per cent. The buyer had to be able to look
into the future with some degree of confidence to pay $400m for the property.
As I mentioned, we do not know exactly what was in Metropolitan's mind when
they made the decision to buy but for demonstration purposes I have attached as
Exhibit D a sensitivity analysis taken from the full 16-year cash flow projection,
assuming terminal capitalisation rates of 9 per cent to 11 per cent on the 1996
income, and assuming discount rates, or an internal rate of return, from 11 per cent
to 13 per cent. On the $400m price, their anticipated return was most likely
somewhere around 12 per cent unless they expected the property to perform
better than our cash flow estimate would indicate.

Exhibit D Exhibit E
Sensitivity analysis: Pan A m building — 1980 — varying Sensitivity analysis: Pan Am building — 1984 — varying
discount rate and terminal capitalisation rate discount rate and terminal capitalisation rate

Discount rates Discount rates

Terminal Terminal
cap.rate 11% 12% 13% cap. rate 12% 13% 14%
(%) ($) ($) ($) (%) ($) ($) ($)
9 462 421 386 9 634 496 462
10 443 404 371 10 510 474 442
11 426 390 358 11 490 457 426

(Including $50m mortgage balance) (Including $42m mortgage balance)

Just for fun, I have also attached an Exhibit E showing a similar sensitivity
analysis as of the beginning of 1984 assuming that the old cash flow forecast is
still viable. Using similar discount rate and capitalisation rate assumptions then and
now, the value of the property has probably increased greatly. We do not have
access to current operating numbers but with the increase in market rents and the
slowing down of inflation in the US, the cash flow is probably higher than we
anticipated.

5. Investment criteria

Up to here we have discussed the definition of a real estate investment analysis,

some of the aspects which make it different from an appraisal, an unusual use of
a real estate investment analysis as a sales tool, and a sophisticated computer
program for forecasting the financial future of an investment. At the beginning

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of this paper I indicated we would also discuss investment criteria as they relate
to an investment decision and consideration of the future value of an investment.
Let us proceed with investment criteria. Investment criteria cover a wide range
of factors which should be primarily intellectual but are sometimes emotional.
Elements of investment criteria may be generated from prior experiences (particu-
larly unfortunate experiences), expert advice, other investments in the portfolio,
pride of ownership, plain old prejudice, divine guidance, or good common business
judgement. Whatever the source of the criteria, the real estate investment analyst
must learn what they are from the investor/client and take them into consideration
in the analysis and the recommendations. This is a basic difference from an
appraisal, where the appraiser is generally assuming logical actions of prudent
people.
From our experience at Landauer, we believe one of the first things the con-
sultant must do when accepting an investment analysis assignment is to identify to
the extent possible the investment goals and objectives of the client. Relating the
various characteristics of the property to the investor's criteria will be a significant
portion of the counselor's role.
Investment criteria can be broken down into two general categories, physical
characteristics and economic aspects. The physical attributes may be further sub-
divided into intrinsic property description and geographic factors. Some investment
criteria are so simple and obvious one need not be an experienced professional real
estate analyst to ferret them out. The typical Northwestern European pension fund,
for example, tends to limit its investments to low risk types of properties — central
city office buildings and major regional shopping malls. It does not take a genius to
identify these properties.
Investors desiring higher returns on their investments in the form of income or
capital gains must accept higher risks in terms of the type of property, the intensity
of management required, or the probability of achieving and maintaining occu-
pancy. Measuring the degree of risk inherent in a property in comparison to the
potential rewards and the investors criteria is the responsibility of the investment
analyst.
Geographic locational preferences are also relatively obvious criteria. Some
investors are interested only in major metropolitan cities; some limit their invest-
ments to what we call the 'Sun Belt', the southern part of the United States which
has experienced more population and economic growth in the past two decades
than the old and climatically colder northeast and midwest. Too much investor
interest in places like Atlanta, Dallas, Denver, Houston and Phoenix has encouraged
over-abundant development and, at least for the time, created soft market condi-
tions and tarnished their image. As in the case of physical attributes, more subtle
locational criteria, medium size and smaller cities, suburbs, and locational differ-
ences within a city require careful study.
Economically oriented criteria relate primarily to the amount, quality, and
pattern of cash flow; potential for capital appreciation; risk of depreciation and
future capital requirements. We could probably take several hours to make a list of
all of the questions an investor might ask about the past, present, and future of a
particular property.

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In the case of the Pan Am building the amount and pattern of cash flow is
disclosed by the cash flow study. It is evident that an investor desiring high early
cash returns would not be interested in this property. Pan Am's immediate need
for cash, on the other hand, was a large motivation for them to sell. The quality
of the income could be determined by a study of the tenant list although at the
time the financial strength of the principal tenant may have been suspect.
The cash flow study also indicated the probability of capital appreciation over
time. A thorough study of the New York office market and the prime location of
this 'world class' building assured future occupancy. Another thorough study of the
physical condition of the building indicated a need for refurbishment of the lobby
and cost estimates were prepared. We tried to anticipate every question a potential
buyer might ask to provide our client with an opinion or an answer to it.

6. Conclusion
In summary, a real estate investment analysis is similar to an appraisal. It must
consider all the physical attributes of the real estate, the location, the functional
adequacy for the intended use, the age and condition of the property, present or
future need for capital improvements, and competitive position in its marketplace.
It must consider external economic factors such as the economic base and demo-
graphic characteristics of the community, present and potential future market
competition, and tendencies of the local real estate market.
It must consider the myriad of internal economic factors including tenancy and
leases, operating expenses, management requirements, tenant improvements and
other requirements for funds. The possibility or probability of increased revenue
due to built-in lease terms, turnover of tenants, inflation and market trends is
particularly important to most investors. Financing in place, or available in the
market, must be factored into the study.
To conclude, the principal elements which make a real estate investment analysis
something more than an appraisal are:
1. The analysis goes into more depth of study than is usually required for an
appraisal.
2. The client's investment criteria need to be considered before, during, and
after the analysis.
3. The long term future potential of the property, while considered in an
appraisal, is of primary importance in an investment analysis.
4. The results of the study include advice and counsel on an investment decision
in addition to a factual report.

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