1. Real Estate Metrics and Terminology The Devil Is In The Details Thomas Nealon – LNR Partners, LLC Miami, Florida Thomas Kaufman – Goulston & Storrs PC, Washington, DC

2. Goals Introduce Business Economics, Terminology and Drafting –Discuss Finance Terms and Business Impacts –Give Examples of Practical Effect or Implementation of These Terms –Give Specific Drafting Examples and Discuss 2

3. How Much Do You Pay? (What is Fair Market Value) Capitalization Rate (Cap Rate) “Cap Rate” the return demanded by investor on the asset Cap Rate developed pre-computer Cap Rate = Net Operating Income (NOI)(Stabilized) Purchase Price Purchase = Net Operating Income (NOI)(Stabilized) Price Cap Rate Multiplier = 1/Cap Rate e.g., If Cap Rate = 10% Purchase Price = 10 (=1/.10) x Income If Cap Rate = 5% Purchase Price = 20 (=1/.05) x Income 3

4. How Much Do You Pay? (What is Fair Market Value) Why do you care about Cap Rate? 1.Cap Rate increase (decrease) decreases (increases) sale price of asset and therefore affects return on investment 2.Many other and better valuation methods Discounted cash flow Internal rate of return 3.The best spreadsheet does not determine who wins in a real estate investment or who maximizes their return 4.Cap Rate adjustments by rating agencies 5.Cap Rate change effects on value are minimized as length of holding period increases 4

5. How Much Do You Pay? (What is Fair Market Value) Required Increase in NOI as a percentage to maintain constant Fair Market Value given an increase in Cap Rates 5 Cap Rate NOI Increase New / Old 5%6%8%10%12% 4%25%50%100%150%200% 5%20%60%100%140% 7%14%43%72% 9%11%33% 10%20%

6. How Do You Finance ? (Debt Covenants in Loan Documents) Debt Service Coverage Ratio (DSCR) Definition: The ratio of net operating income (NOI) to the annual debt service on a property DSCR = NOI / annual debt service Often used in financial covenants to: –Impose cash management restrictions (lock box or additional consent requirements) –Condition a loan extension –Increase or decrease interest rate –Allow “earn out” advances –Trigger defaults or mandatory reductions in outstanding principal –Condition permitted assumptions of loans –Release guarantors –Release of reserve –Requires a reserve to be set up 6

7. How Do You Finance ? (Debt Covenants in Loan Documents) DSCR and related definitions “Debt Service Coverage Ratio” shall mean the ratio of (a) the NOI (hereinafter defined) produced by the operation of the Property during the twelve (12) calendar months period immediately preceding the calculation to (b) the Annual Debt Service. “Annual Debt Service” shall mean, with respect to any particular period of time, scheduled payments due under this Agreement and the Notes (and any other indebtedness). 7

8. How Do You Finance ? (Debt Covenants in Loan Documents) Net Operating Income or “NOI” NOI = all Revenue from the property – reasonably necessary Operating Expenses Revenue is rents, parking fees, service fees, vending income, tax and cost pass throughs Operating expenses are costs of maintenance, insurance, real estate taxes, management fees, utilities, cleaning service fees, etc 8

9. How Do You Finance ? (Debt Covenants in Loan Documents) NOI is pre-tax and excludes: Taxes (income and personalty) Payments on loans (P&I) Capital expenditures Depreciation Amortization General & administrative expenses NOI is used for: Cap Rate calculation Debt Yield computation DSCR computation 9

10. How Do You Finance ? (Debt Covenants in Loan Documents) Why NOI ? Independent of capital structure Harder to fudge Does not consider depreciation ≠ Net Income or EBITDA Cash Flows are paramount in real estate Operating / Investing / Financing Many Real Estate Investment Trusts use FFO (Funds from Operations) 10

11. How Do You Finance ? (Debt Covenants in Loan Documents) Debt Yield = NOI (or NCF) through previous 12 months / Outstanding Principal Balance (as %) ≈ Cash on cash return if the lender foreclosed Replaces or augments DSCR as DSCR varies based upon –rate –Amortization Used to size loans 11

12. How Do You Finance ? (Debt Covenants in Loan Documents) Loan to Value Ratio (LTV) = Loan Balance / Fair Market Value (FMV) One of several metrics used to size loans Factor in determining loan risk Since FMV more art than science => significant variations in LTV Since FMV changes => need to regularly recalculate LTV 12

13. How Do You Finance ? (Debt Covenants in Loan Documents) Cash Management What is it? –Hard or Soft Lockbox When does it take effect? –DSCR –Default –Other triggers Termination –DSCR Test –Time Period 13

14. How Do You Finance ? (Debt Covenants in Loan Documents) Economic Guarantees Contrast to Non-recourse Carveouts Guarantees Minimum Net Worth Tests –How Defined GAAP Spousal Assets –Test Periods –Reporting Release of Guaranty What Happens If Loan Assumed 14

15. Modeling Problems (Models Are Never Wrong – Are They?) Modeling Introduction Unforeseeable Events Unrealistic Sale Prices Income and Expense Growth Projected Rent Increases and Lease-Up Vacancy and Collection Losses Failing to Model Events after the Projected Holding Period 15

16. Discounted Cash Flow (How Do You Pick the Discount Rate) Discounted Cash Flow (DCF) Factors: –Perceived Inflation –Risk –Term –Market Simple – One rate for all projects Cost of Capital –Debt 16

17. Discounted Cash Flow (How Do You Pick the Discount Rate) –Equity –Weighting (Eg. 60% Debt and 40% Equity) 60% X Debt Cost + 40% X Equity Cost = Specific Cost of Capital 60% X 5% + 40% X 12% = 7.8% Complex Cost of Capital - Multiple levels of equity and debt (eg common stock or limited liability interests, preferred equity, multiple tranches of debt) - Weighted Average Cost of Capital (WACC) –Capital Asset Pricing Model 17

18. Discounted Cash Flow (How Do You Pick the Discount Rate) Alternate method is further risk adjusted cost of capital. E.g. if investing in US Treasury Securities or triple net lease for Fortune 100 company facility the risk factor is much less so justifies lower discount rate. Changing Discount Rate – virtually never used, but more accurate 18

19. What Happens When Things Go Well (Further Loan Advances) Earn Out Advance Limits: –Time to Achieve –Financial Covenants (typical) Total debt (with advance) has Loan to Value Ratio (LTV) not to exceed 75% Total debt (with advance) has DSCR of 1.47 (1.47:1.00) [or Debt Yield of ≥ 10%] No defaults or Events of Default 19

20. What Happens If Things Go Wrong (Cash Management) Cash Management How is it implemented? –Hard or Soft Lockbox When it takes effect? –Single Tenant –Default –Other triggers Impacts –Reserves –Shortfalls 20

21. How Well Did It Do? (Methods of Valuing Returns on Investment) Measuring - Both Before and After Investment: Net Present Value (NPV) - is a discounted cash flow calculation. It computes a discounted cash flow for each and every payment to and from the investor. Convention: Investments into project negative value; payments from the project to investor are positive. Discount Rate determined as above. If NPV ≥ 0 Invest If NPV < 0 Do not invest 21

22. How Well Did It Do? (Methods of Valuing Returns on Investment) Measuring -- NPV Since all amounts are discounted to today’s dollars, they can be added and subtracted Model allows an investor to more easily determine the costs and benefits of increases or decreases in the time to complete or lease-up the project Most academics argue that this is inherently the best system because it allows a better allocation of resources when resources are constrained. 22

23. How Well Did It Do? (Methods of Valuing Returns on Investment) Measuring -- IRR IRR method is a variation of the NPV which calculates the discounted cash flow of each and every payment into and out of the project. In fact, IRR is a specific solution where the NPV is equal to zero (as %). The IRR mathematically can have multiple rates of return IRR assumes that funds paid to investor are reinvested at the IRR, which is usually not accurate. IRR is not as useful a tool when there are competing projects and limited resources 23