Memorandum
To: Doug Shorenstein
From: Kevin Feng, Chan Ahn
Date: October 26th, 2005
Re: 9th Investment Opportunity under Fund Six
Executive Summary
After an extensive analysis of the provided data, we recommend that Shorenstein purchase the Park Avenue building under the value-added approach. Currently, the Midtown market is largest CBD in the US and is rebounding from three years of negative net leasing absorption. While there has been an increase in leasing volume and velocity, rents in the area are still being leased at a discount. After renovations, the Park Avenue will upgrade to a class A building with a revitalized presence in the heart of Grand Central in Midtown Manhattan. Thus, the Park Avenue building with its great location, high asset quality, high quality tenant roster, stable occupancy, and below market rents presents itself as a great choice for Fund Six’s ninth investment.
The Park Avenue is a superior investment to the Lexington Avenue building because of advantages in its location, tenants, and rate of return. While the Lexington Avenue building is not necessarily a bad investment, it simply incorporates less return for its perceived risks and falls out of line with Fund Six’s asset profile.
Using a 6.5 cap rate and the first year’s NOI, we value property to be worth $213m. We would be willing to bid up to $220m to acquire this property in exchange for a pre-empted sales process with an accelerated due diligence period and an assured closing date. Since the calculated value of Park Avenue is greater than our $152m of available equity from Fund Six, we will purchase this property using a 10-year fixed loan at 5.75% under an LTV ratio of 65% at a principal amount of $138m.
After purchase, we will implement renovations that would relocate the building’s entrance and redevelop the lobby. We anticipate owning and operating the property until the end of 2012 (Year 8). After sale, we forecast a leveraged return of 20% on $74m of equity from Fund Six.
The following provides background analyses and reasoning behind our recommendation towards the purchase of the Park Avenue.
Park Avenue Building
While both the Park Ave. and the Lexington building offer great potential upsides, a smart real estate investor would always consider all the downsides to an investment. Therefore, it is imperative to focus on the reasons not to purchase either property. By beginning our analysis this way, it helps us determine which risk factors to take into consideration (e.g. by increasing our discount rate) in making an investment decision between the two properties.
First and foremost, the Park Avenue was built in 1923, and despite having 26 million dollars in renovations, still carries the risk of high capital expenditures such as asbestos problems due to aged facilities. Taking this element into account, there will be increased operating expenses associated with the building as time progresses.
The Park Avenue also lacks a strong street presence, with a narrow and unimpressive vestibule that leads to the main lobby and reception desk. This present condition, coupled with its Class B+ status, degrades the property’s identity and consequently falls out of line with Shorenstein’s property profile of Class A buildings. Therefore it will be necessary to extensively redevelop the lobby and/or the building’s entrance in order to provide more of a high-quality “boutique” image.
Under the Value-Added Opportunity, the redevelopment is a risk because we must be sure that the increase in future cash flows after the capital expenditure offset the redevelopment cost. This is important because if Shorenstein cannot rebuild the property’s identity and status as a Class A- building, then Shorenstein may not be able to re-lease at or above market rates in the future.
Given costly TIs associated with re-leasing, Shorenstein assumes the risk of not finding high-credit tenants to replace current ones and securing those new leases with triple-net rents. We took this into consideration in our model by increasing the discount rate by 50 basis points in 2008 when redevelopments finished and in 2011 when 30% of the leases were set to expire (See Appendix I).
Another reason not to purchase the Park Avenue is the growing threat of terrorism and the property’s proximity to Grand Central Terminal, the largest train station in the world. In the event that terrorism becomes an everyday threat, not only would terrorism insurance on the building increase, but also new Homeland Security laws may force properties near prime locations to either employ increased security or spend more money on security-related capital expenditures.
Lexington Avenue Building
The Lexington building, like the Park Ave, also has its respective drawbacks. With regard to quality, the Lexington remains similar to many other generic institutional properties built along Third Avenue in its era. Despite a renovation in 1988, the buildings still look outdated. Similar to the Park Ave, the Lexington is a class B+ building and would necessitate expensive redevelopment efforts in order to both align itself with Fund Six’s property profile and to also remain competitive in the midtown Manhattan market, where 81% of the square footage is considered Class A. In order to bring the Lexington to a Class A/A- asset and to secure leases at or above market rates, Shorenstein must assume $25 million allocated for the renovation of the lobby and entrances.
At 1.66 million square feet, the Lexington would be the largest property in Fund Six, surpassing Two Liberty Place in Philadelphia by 400,000 square feet. The Lexington would also require more equity than Fund Six has allocated ($152m) for its ninth investment. The higher price of Lexington is itself a considerable risk; according to our calculations, with a LTV of 65%, we would need to use 186 million of equity, thus constraining Fund Six to be around 90% invested.
Furthermore, there are major risks associated with re-leasing such a large property. The reality that the main tenant vacated most of its space in Building One and plans to vacate all of its space in Building Two by the end of 2005 poses a significant re-leasing endeavor for Shorenstein. Despite increasing demand for large blocks of space, finding large corporate tenants to lease over 51% (46,304 sq ft) of the building by 2005 is a significant burden to assume. Even if the space is re-leased in blocks to large corporations, expensive TIs will undoubtedly come with large tenants who may not desire the exact layouts used by the previous tenant. According to our proformas, there would need to be $78 million in new capital allocated for re-tenanting. Combined with the $25 million renovation costs, the Lexington building assumes over $100 million in Capital Expenditures within the first three years alone.
Furthermore, the sheer size of the building and its similarity to other buildings in the area may pose as a liquidity risk in the case that Shorenstein wants to sell the asset quickly.
Given our analyses of the risks and opportunities of the Lexington building, we would expect a leveraged IRR of approximately 16.01 to 17.81% on the base case and aggressive models respectively. This is significantly lower than the leveraged IRR of Park Avenue building, which is approximately 20% on both the base and value added model, providing another reason for investing in Park Avenue instead of Lexington. The same is true with unleveraged IRR as their respective returns are lower for the Lexington building than that of the Park Avenue building (See Appendix III).
Financing Strategy
With respect to financing both properties, we chose different capitalization rates for each property because we felt that the two buildings, as previously mentioned, encompassed different risks.
For the Park Avenue building, we established a starting cap rate of 6.25; market cap rate is from 6 to 8. As the building is in a Class A location and has a high quality leasing profile which provides a steady stream of income, the cap rate should be a lower value within the market cap rate range. We did not use a lower capitalization rate because the quality of the building was not Class A.
For the Lexington building, we established a starting cap rate of 6.5 because we believed that while the property was in a relatively good location and carried attractive redevelopment efforts, it was inherently riskier than the Park Avenue building. This is because the Lexington building was much larger and carried much more risks related to re-tenanting, especially after the large pension fund vacated the premises.
Given the 6.25 cap rate of Park Avenue and the first year’s NOI, we calculated a value of $213 million. For Lexington, we used a 6.5 cap rate and subsequently calculated a value of 511 million. Since the values of both properties are larger than the 152 million allocated for development of Fund Six’s ninth investment, Shorenstein would have to take on debt to cover the costs of purchasing Park Ave (See Appendix I & II).
For debt financing, we decided to borrow at the 10-year Treasury rate plus the 10-year Loan Spread, equally 5.75% under a 65% Loan-to-Value ratio. We chose a 65% LTV for both Park Avenue and Lexington because it provided the largest present value of Net Cash Flows compared to the other LTVs of 70% and 75% under a calculated DSCR range from 1.1x and 1.25x, which translates to an LTV ratio from 67% to 76%. Although a 65% LTV is out of DSCR range, it is not significantly out of bounds. Furthermore, a 65% LTV creates the highest amount of net cash flows, thus justifying our choice. Therefore, given our 65% LTV and our values for both properties, we need to borrow $138 million for Park Avenue and $332 million for Lexington.
We will apply for a 10-year loan with an interest payment of 5.75% and no amortization. We would like to restrict as many negative covenants as possible and retain control over our operating rights, dividend payments, and the potential option to obtain additional financing.
Under these loan terms, the net cash flows for both the Park Avenue and Lexington are lower than their respective interest payments, thus increasing the return on our invested equity. Under this condition, our cash-on-cash return is greater with financing than without, thus positive leverage exists.
Purchase Price & Exit Strategy
Ideally, how much we pay for Park Avenue and Lexington would equal our valuation of that respective property ($213m and $512m respectively, as calculated above). However, in real life against other bidders who also want the property, it would not be surprising to pay more than our calculated values.
From an extensive analysis of all the risk factors and proformas given, we would bid for the Park Avenue building over the Lexington building for reasons based on comparable risks and returns. Based on IRR alone, Park Avenue generates a higher return than the respective base-case and Aggressive-case IRRs in the Lexington building. With respect to risks, the Park Avenue is 95% leased with high-quality tenants, significant investor demand, embodies potentially lucrative retail developments, and has a majority of its current leases below market rates. The Lexington on the other hand is nearly three times larger than Park Avenue, with 51% of its leases expiring in the next year, a bland image, and a secondary location.
Overall, the Park Avenue falls in line with Shorenstein’s investment strategy profile. It has sustainable leasing advantages over the Lexington building, which allows its NOI to remain stabilized even in economic downturns. Also, the redevelopment efforts associated with the Park Avenue building will add value during the holding period and mitigate capital losses. Ultimately, the Park Avenue is a better fit for Fund Six because its size, price, and general profile fall in line with the Fund’s first eight investments.
This value of the Park Avenue building in accordance with the 7.4% annualized net profit yield of Shorenstein’s Fund Six would warrant a profit target at $229 million (213*1.074). For the terminal value of Park Avenue, we decided to use a 7.5 exit cap because it represented a relatively conservative viewpoint of the financial viability of our investment in the long-term.
After purchasing the Park Avenue building, we would hold it until the PV of our NCFs post-interest payments plus terminal value equaled our projected profit target for Park Avenue (See Appendix V). According to our calculations, the PV NCF Post-Interest payments plus the Terminal value reaches $251m in 2013, $255m in 2014, and $245m in 2015. While we would want to gain the maximum value from our sale, our exit strategy would be to list Park Avenue on the market at the end of 2012 and sell it in 2013 as this leaves plenty of time for potential delays in selling the property.
To: Doug Shorenstein
From: Kevin Feng, Chan Ahn
Date: October 26th, 2005
Re: 9th Investment Opportunity under Fund Six
Executive Summary
After an extensive analysis of the provided data, we recommend that Shorenstein purchase the Park Avenue building under the value-added approach. Currently, the Midtown market is largest CBD in the US and is rebounding from three years of negative net leasing absorption. While there has been an increase in leasing volume and velocity, rents in the area are still being leased at a discount. After renovations, the Park Avenue will upgrade to a class A building with a revitalized presence in the heart of Grand Central in Midtown Manhattan. Thus, the Park Avenue building with its great location, high asset quality, high quality tenant roster, stable occupancy, and below market rents presents itself as a great choice for Fund Six’s ninth investment.
The Park Avenue is a superior investment to the Lexington Avenue building because of advantages in its location, tenants, and rate of return. While the Lexington Avenue building is not necessarily a bad investment, it simply incorporates less return for its perceived risks and falls out of line with Fund Six’s asset profile.
Using a 6.5 cap rate and the first year’s NOI, we value property to be worth $213m. We would be willing to bid up to $220m to acquire this property in exchange for a pre-empted sales process with an accelerated due diligence period and an assured closing date. Since the calculated value of Park Avenue is greater than our $152m of available equity from Fund Six, we will purchase this property using a 10-year fixed loan at 5.75% under an LTV ratio of 65% at a principal amount of $138m.
After purchase, we will implement renovations that would relocate the building’s entrance and redevelop the lobby. We anticipate owning and operating the property until the end of 2012 (Year 8). After sale, we forecast a leveraged return of 20% on $74m of equity from Fund Six.
The following provides background analyses and reasoning behind our recommendation towards the purchase of the Park Avenue.
Park Avenue Building
While both the Park Ave. and the Lexington building offer great potential upsides, a smart real estate investor would always consider all the downsides to an investment. Therefore, it is imperative to focus on the reasons not to purchase either property. By beginning our analysis this way, it helps us determine which risk factors to take into consideration (e.g. by increasing our discount rate) in making an investment decision between the two properties.
First and foremost, the Park Avenue was built in 1923, and despite having 26 million dollars in renovations, still carries the risk of high capital expenditures such as asbestos problems due to aged facilities. Taking this element into account, there will be increased operating expenses associated with the building as time progresses.
The Park Avenue also lacks a strong street presence, with a narrow and unimpressive vestibule that leads to the main lobby and reception desk. This present condition, coupled with its Class B+ status, degrades the property’s identity and consequently falls out of line with Shorenstein’s property profile of Class A buildings. Therefore it will be necessary to extensively redevelop the lobby and/or the building’s entrance in order to provide more of a high-quality “boutique” image.
Under the Value-Added Opportunity, the redevelopment is a risk because we must be sure that the increase in future cash flows after the capital expenditure offset the redevelopment cost. This is important because if Shorenstein cannot rebuild the property’s identity and status as a Class A- building, then Shorenstein may not be able to re-lease at or above market rates in the future.
Given costly TIs associated with re-leasing, Shorenstein assumes the risk of not finding high-credit tenants to replace current ones and securing those new leases with triple-net rents. We took this into consideration in our model by increasing the discount rate by 50 basis points in 2008 when redevelopments finished and in 2011 when 30% of the leases were set to expire (See Appendix I).
Another reason not to purchase the Park Avenue is the growing threat of terrorism and the property’s proximity to Grand Central Terminal, the largest train station in the world. In the event that terrorism becomes an everyday threat, not only would terrorism insurance on the building increase, but also new Homeland Security laws may force properties near prime locations to either employ increased security or spend more money on security-related capital expenditures.
Lexington Avenue Building
The Lexington building, like the Park Ave, also has its respective drawbacks. With regard to quality, the Lexington remains similar to many other generic institutional properties built along Third Avenue in its era. Despite a renovation in 1988, the buildings still look outdated. Similar to the Park Ave, the Lexington is a class B+ building and would necessitate expensive redevelopment efforts in order to both align itself with Fund Six’s property profile and to also remain competitive in the midtown Manhattan market, where 81% of the square footage is considered Class A. In order to bring the Lexington to a Class A/A- asset and to secure leases at or above market rates, Shorenstein must assume $25 million allocated for the renovation of the lobby and entrances.
At 1.66 million square feet, the Lexington would be the largest property in Fund Six, surpassing Two Liberty Place in Philadelphia by 400,000 square feet. The Lexington would also require more equity than Fund Six has allocated ($152m) for its ninth investment. The higher price of Lexington is itself a considerable risk; according to our calculations, with a LTV of 65%, we would need to use 186 million of equity, thus constraining Fund Six to be around 90% invested.
Furthermore, there are major risks associated with re-leasing such a large property. The reality that the main tenant vacated most of its space in Building One and plans to vacate all of its space in Building Two by the end of 2005 poses a significant re-leasing endeavor for Shorenstein. Despite increasing demand for large blocks of space, finding large corporate tenants to lease over 51% (46,304 sq ft) of the building by 2005 is a significant burden to assume. Even if the space is re-leased in blocks to large corporations, expensive TIs will undoubtedly come with large tenants who may not desire the exact layouts used by the previous tenant. According to our proformas, there would need to be $78 million in new capital allocated for re-tenanting. Combined with the $25 million renovation costs, the Lexington building assumes over $100 million in Capital Expenditures within the first three years alone.
Furthermore, the sheer size of the building and its similarity to other buildings in the area may pose as a liquidity risk in the case that Shorenstein wants to sell the asset quickly.
Given our analyses of the risks and opportunities of the Lexington building, we would expect a leveraged IRR of approximately 16.01 to 17.81% on the base case and aggressive models respectively. This is significantly lower than the leveraged IRR of Park Avenue building, which is approximately 20% on both the base and value added model, providing another reason for investing in Park Avenue instead of Lexington. The same is true with unleveraged IRR as their respective returns are lower for the Lexington building than that of the Park Avenue building (See Appendix III).
Financing Strategy
With respect to financing both properties, we chose different capitalization rates for each property because we felt that the two buildings, as previously mentioned, encompassed different risks.
For the Park Avenue building, we established a starting cap rate of 6.25; market cap rate is from 6 to 8. As the building is in a Class A location and has a high quality leasing profile which provides a steady stream of income, the cap rate should be a lower value within the market cap rate range. We did not use a lower capitalization rate because the quality of the building was not Class A.
For the Lexington building, we established a starting cap rate of 6.5 because we believed that while the property was in a relatively good location and carried attractive redevelopment efforts, it was inherently riskier than the Park Avenue building. This is because the Lexington building was much larger and carried much more risks related to re-tenanting, especially after the large pension fund vacated the premises.
Given the 6.25 cap rate of Park Avenue and the first year’s NOI, we calculated a value of $213 million. For Lexington, we used a 6.5 cap rate and subsequently calculated a value of 511 million. Since the values of both properties are larger than the 152 million allocated for development of Fund Six’s ninth investment, Shorenstein would have to take on debt to cover the costs of purchasing Park Ave (See Appendix I & II).
For debt financing, we decided to borrow at the 10-year Treasury rate plus the 10-year Loan Spread, equally 5.75% under a 65% Loan-to-Value ratio. We chose a 65% LTV for both Park Avenue and Lexington because it provided the largest present value of Net Cash Flows compared to the other LTVs of 70% and 75% under a calculated DSCR range from 1.1x and 1.25x, which translates to an LTV ratio from 67% to 76%. Although a 65% LTV is out of DSCR range, it is not significantly out of bounds. Furthermore, a 65% LTV creates the highest amount of net cash flows, thus justifying our choice. Therefore, given our 65% LTV and our values for both properties, we need to borrow $138 million for Park Avenue and $332 million for Lexington.
We will apply for a 10-year loan with an interest payment of 5.75% and no amortization. We would like to restrict as many negative covenants as possible and retain control over our operating rights, dividend payments, and the potential option to obtain additional financing.
Under these loan terms, the net cash flows for both the Park Avenue and Lexington are lower than their respective interest payments, thus increasing the return on our invested equity. Under this condition, our cash-on-cash return is greater with financing than without, thus positive leverage exists.
Purchase Price & Exit Strategy
Ideally, how much we pay for Park Avenue and Lexington would equal our valuation of that respective property ($213m and $512m respectively, as calculated above). However, in real life against other bidders who also want the property, it would not be surprising to pay more than our calculated values.
From an extensive analysis of all the risk factors and proformas given, we would bid for the Park Avenue building over the Lexington building for reasons based on comparable risks and returns. Based on IRR alone, Park Avenue generates a higher return than the respective base-case and Aggressive-case IRRs in the Lexington building. With respect to risks, the Park Avenue is 95% leased with high-quality tenants, significant investor demand, embodies potentially lucrative retail developments, and has a majority of its current leases below market rates. The Lexington on the other hand is nearly three times larger than Park Avenue, with 51% of its leases expiring in the next year, a bland image, and a secondary location.
Overall, the Park Avenue falls in line with Shorenstein’s investment strategy profile. It has sustainable leasing advantages over the Lexington building, which allows its NOI to remain stabilized even in economic downturns. Also, the redevelopment efforts associated with the Park Avenue building will add value during the holding period and mitigate capital losses. Ultimately, the Park Avenue is a better fit for Fund Six because its size, price, and general profile fall in line with the Fund’s first eight investments.
This value of the Park Avenue building in accordance with the 7.4% annualized net profit yield of Shorenstein’s Fund Six would warrant a profit target at $229 million (213*1.074). For the terminal value of Park Avenue, we decided to use a 7.5 exit cap because it represented a relatively conservative viewpoint of the financial viability of our investment in the long-term.
After purchasing the Park Avenue building, we would hold it until the PV of our NCFs post-interest payments plus terminal value equaled our projected profit target for Park Avenue (See Appendix V). According to our calculations, the PV NCF Post-Interest payments plus the Terminal value reaches $251m in 2013, $255m in 2014, and $245m in 2015. While we would want to gain the maximum value from our sale, our exit strategy would be to list Park Avenue on the market at the end of 2012 and sell it in 2013 as this leaves plenty of time for potential delays in selling the property.
posted by Kevin at 1:42 PM
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