Instructions:
1. Read the case study below
2. Answer the nine questions
3. Summarize the case in your own words
The Dream Team Invests in Real Estate, or How to Lose $280,000
OVERVIEW
About two years ago, Mick Olson and Reed Nelson were discussing their stock portfolios. Each had done fairly well in the stock market and had created quite a nest egg. Reed suggested that while he had been very happy with his return on investment, he was itching for a more active, interesting investment, preferably in real estate. Mick said that he was thinking the same thing and wondered if they could come up with something. The two men found a parcel of land near a retail development area. The parcel was owned by an elderly woman who knew nothing about real estate except the relative value of land in the area.
Mick and Reed found five other people who were equally interested. Each of the investors was approached because of their professional expertise. It was felt that the investment group should consist of people who could bring money to the deal but who could also bring their personal knowledge to the group as well. An accountant, a developer, a marketing manager, a lawyer, and a project coordinator joined the group.
A deal was made for the land. The purchase price was $700,000, and they paid cash for it. The parcel was almost four acres square, 400 ft. wide x 450 ft. deep, in size and fronted on a moderately busy street. It backed up to a large wetland that encroached on the property about 100 feet.
These real estate investors, who now called themselves “The R/E Dream Team,” then set to work to determine the best use for the land. They inquired about possible tenants, and they received numerous inquiries about the property. After about a month of considering possible tenants, they felt that they had nine viable options which included a gas station, a theater, a strip mall, a muffler shop, and others. They discounted all but the theater and the strip mall because those two options offered, far and away, the best possible return.
The Dream Team was then faced with making a decision as to which course to take. They calculated the net present value (NPV) and the internal rate of return (IRR) for both the theater and strip mall and found that each yielded about the same return. They then reviewed the marketplace. Using a large map, they put a circle around the area from which they expected to draw the most customers, then put pins where each of the other theaters and strip malls were currently located. Calculating the number of residents in the areas, they came up with a number of possible customers for each investment. The theater was slightly easier to study because there were figures on how often people go to movies. The strip mall’s tenants had a large degree of variance, so its attractiveness to the consumer would fluctuate.
In the end, the theater came out looking like the better investment but only by a small margin—a margin that was not enough to sway the investors from ignoring other factors. They felt that a group of tenants would be a better investment than a single tenant. If the theater did not work, they would be left with a single-use building and no tenant at all. If they lost a tenant or two from the strip mall, the other tenants would still be paying rent, so they could stay current on their payments. They felt it was unlikely that all of the tenants in the strip mall would fail at the same time.; however, they delayed their decision about which investment to pursue until they gathered more facts.
Unfortunately, the Dream Team was about to become the Reality Team. It turned out that the developer in the group did most of his homework but not all of it. Once the team decided to go ahead with the building, the developer contacted a civil engineer who would help them design the layout of the land, with building placement, parking, and street access. They took their concept plan to the city engineer. After barely glancing at the plan, the city engineer asked them what they intended to do about the wetland. They told him that they intended to fill in about 50 feet of the encroaching wetland and then to use the rest of the area for runoff from the parking lot. The city engineer informed them that the site would not work because not only could they not disturb the wetland, but they had to provide for a 50 foot buffer and sediment ponds so that their parking lot runoff did not go directly into the wetlands. Once those were in place, the space that was left would not be sufficient for setback requirements from the road plus required parking. The building, as planned, would not meet the code.
Over the next couple of weeks, the team tried to come up with every conceivable layout for the property but could not make it work with the wetland. They then reconsidered previously discarded plans like the gas station and muffler shop. They contacted prospective clients, but only two businesses had interest and neither was a national chain, meaning they would be a high risk.
The team members were terribly disillusioned with their investment, and there was a great deal of finger-pointing going on between investors. In the final analysis, since the investment was not going to result in a good, or even fair, return, they just wanted to get out. They sold the land to the gas station business for $420,000 and disbanded the Dream Team.
WITNESS 1
Penny Lopher, Accountant
I was the Dream Team’s accountant. I crunched numbers and determined whether this project would work assuming all went well (which it didn’t, of course). What would you like to ask me? Relevant Facts
Items
Start-up costs
• Investment objectives
• NPV numbers using anticipated rent
•
Relevant Facts:
When we undertook this investment, it was with the clear understanding that we wanted to guarantee that our return on investment would exceed the current return on investment that we were getting from the stock market. Part of that investment strategy also required that we make sure that the added risk was built-in to the anticipated return.
With slight variations, we were all getting about 9.5% return from the stock market. We had hoped to get at least five percent more from this investment, or a 14.5% return. We also felt that there would be more risk if we ran the business ourselves. In each case, the theater or the strip mall, we felt that we needed to add three percent to the return figure in order to account for this added risk, resulting in a 17.5% required return.
We calculated that the cost of preparing the land for use, the construction of the building itself, and any other costs we would have for setting up shop. The construction costs came to $850,000. Our initial land cost of $700,000 was going to sit for at least 18 months before we saw any return, so we added $99,750, rounded to $100,000 to represent that loss of return on $700,000 at 9.5% for 18 months. The resulting cost to get this thing going was $1,650,000.
We then anticipated rent, net to us after expenses, and taxes at $192,000 per year, increasing by 5% each year. We estimated that the building and land would increase in value by 8.5% each year, and to be safe, we estimated that the land would not appreciate until a building was on the site. Our figures, based on looking ahead five years plus the sale of the building, looked like this (numbers rounded to the nearest dollar):
Year Return percentage Net Rent to us Today’s value of Return
1 (1.175)1 $192,000 $163,404
2 (1.175)2 201,600 146,021
3 (1.175)3 211,680 130,487
4 (1.175)4 222,264 116,605
5 (1.175)5 233,377 104,200
Sell Property in yr 5 (1.175)5 2,255,485 1,007,049
1,667,766.00
Since our initial outlay is $1,650,000 and our present value of the stream of payments with 17.5% return is $1,667,766, the difference is a positive $17,766–more than we need. With these figures, the deal works for the team. Of course, to do this calculation, you must have an investment objective, like 17.5%. We then did the calculation for internal rate of return and found that the result was reasonable to our expectations. The amount of return just met our expectations, so we felt we could proceed with the investment.
The trouble with the wetlands obviously destroyed our plans, so we sold the land and went our separate ways. We had all invested $100,000 each to buy the land. We got $60,000 back after almost a year.
Irrelevant Facts Items:
• Investment objectives
• The cost of the project
• Reverse NPV to determine rent
Irrelevant Facts:
When we undertook this investment, it was with the clear understanding that we wanted to guarantee that our return on investment would exceed the current return on investment that we were getting from the stock market. Part of that investment strategy also required that we make sure that the added risk was built in to the anticipated return. We started with the concept that we needed a return of 17.5%. This figure is a good deal above our current yield on all of our investments, but we wanted more for our involvement in the project and for our added risk as a start-up business.
Our first step was to determine the cost of the project. We added in the cost of the land, the cost of the building, the cost of running the project in general, and the loss we suffer by not having our $700,000 invested in stock. We came up with a total investment figure of $1,650,000.
Our next step was to determine the amount of rent that we would need in order to make this a worthwhile investment. We figured that rent would increase about 5% per year, and we estimated that the value of the land and buildings would increase by 8.5% each year. To be safe, we assumed the land would not appreciate until the building was on the site. With that information, we had a
good idea of where we were, and we knew full well where we wanted to go with the investment, but we still needed to set rent. First, we set up this table to see what was known and what was unknown.
(all numbers rounded to the nearest dollar ;x, x1, y, y1, etc. are variable that will be determined once the first year’s rent is set)
Year Return Percentage Net Rent Needed Today’s Value of Return
1 (1.175)1 $x $x1
2 (1.175)2 y y1
3 (1.175)3 z z1
4 (1.175)4 a a1
5 (1.175)5 b b1
Sell Property in yr 5 (1.175)5 2,255,485 1,007,049
NPV > Initial Investment ($1,650,000)
Working a little with the numbers, we determined the first year’s rent, and then the rest of the values fell into place (remember, we planned on a 5% increase in rent each year).
Year Return Percentage Net Rent Needed Today’s Value of Return
1 (1.175)1 $195,000 $165,957
2 (1.175)2 204,750 148,302
3 (1.175)3 214,988 132,526
4 (1.175)4 225,737 118,427
5 (1.175)5 237,024 105,829
Sell Property in yr 5 (1.175)5 2,255,485 1,007,049
1,678,090.00
At the end of five years we could review our investment, but if we wanted to sell the place, we could expect that it would be worth $2,255,485 (five years of appreciation at an 8.5% increase each year), which amount would be separate from the income for that fifth year.
Using these figures, we could add the expenses and other costs to the Net Rent Needed figure to arrive at a rent amount that we would need from the tenants. By this process, we use the Net Present Value formula in reverse to determine, in an easily calculated manner, the amount of rent we will have to charge. All team members, as well as our bank, appreciate the ease with which the figures can be determined and verified each year.
Then we learned of the wetland issue. We sold the land and went our separate ways. We had all invested $100,000 each to buy the land. We got $60,000 back after almost a year.
WITNESS 2
Otto Piehlet, Business Manager
I would have been the business manager had this investment panned out. As you probably know, there are many considerations when managing a business and it was my job to figure out what expenses there would be if we went through with this. So shoot. What do you want to know? Relevant Facts
Items:
• Relative costs of building upkeep
• Procuring a loan
• Monthly expenses for running the building
• Relevant Facts:
I am a business manager for several real estate ownership groups. My job on this project, as on several other projects, was to arrange the ongoing finances, to collect the rents, and to pay the bills. Of course, there would be the regular maintenance, cleaning, repairs, trash removal, and snow plowing, but I expected to contract with the people who did these jobs for me at other sites, or I would contact local companies to handle the work.
It was my job to investigate the relative costs of each expense that the building would incur and report those expenses to the group. This aided us in making our decision about what type of building we wanted to construct. My biggest job at this point was to work out the lending situation with our bank. Each of us had our own banks we liked to work with, but we wanted to chose a bank that would like to see us succeed, one that would be familiar with the area and our tenant’s customer base. We chose a bank that was new in the area and was within the neighborhood of where we would draw our customer base.
I approached the bank and let them know of our plans. They took a fairly detailed application, along with detailed financial information about each of the team members. Together we estimated our financial needs for the construction loan, for the end loan, and the ongoing need for a line of credit. We would all have to personally guarantee the business debt.
The amount of debt we would need to cover would be $850,000, which would be the cost for improvements to the land. At an advantageous interest rate of 7.5%, we would have to pay $63,750, or $5,312.50 per month, but that would be for interest only. When we eventually sold the building, we would still owe the full $850,000. If we wanted to amortize the debt, we would have to pay $5,943.33 per month for a 30-year amortization or $7,879.15 for a 15-year amortization. Due to the uncertainty of the business, we decided to look into the lower payment which came with the longer term, 30-year plan. At the end of 30 years, if we stayed that long, we would have paid all the interest and the entire principal and would owe the bank nothing.
We had a few more remaining expenses we had to worry about. One was property taxes which came to about $30,000 per year. Property taxes are about 2% of the value of the land and buildings but can go to 4% for commercial property. We hoped to be able to stay at the 2% property tax rate. We also had to figure in insurance which would run about 1% of the value, or $15,000 per year. These expenses, combined with the other expenses paid on a monthly basis, would be about as follows, allowing for a good deal of other unforeseen expenses in the first year:
Bank debt service ($5,943.33, rounded to $6,000) $6,000
Property taxes 2,500
Property insurance 1,250
Maintenance service (Done weekly) 800
Trash removal (Bi-weekly) 400
Snow removal (Seasonal as needed) 50
Window washing (Bi-annual) 50
Unspecified maintenance and expenses 550
11,600.00
Our last item would be the income taxes. This is a different issue that does not occur when someone invests in stocks. Rental income is an annual income. Taxes on any profits are due annually. With stock, the only time you make a profit is when you sell. If you hold stock for 20 years, you only pay the tax on the profit, if there is any, at the time of sale.
We completed our calculations. First, we decided what we could spend based on the rent in order to make the deal work and obtain for us the return on investment that we all sought. Following that, we calculated the costs and expenses, then calculated to see what kind of return we would get based on the anticipated rents. Both ways, the deal worked out. If it wasn’t for those wetlands, it would have been a good project.
Irrelevant Facts Items:
• Terms of triple net lease
• Setting rent based on the projected returns for a triple net lease
• Financing with Dream Team money instead of paying a bank 7.5% interest
Irrelevant Facts:
I am a business manager for several real estate ownership groups. My job is often to arrange the ongoing finances for a property, to collect the rent, and to pay the bills. Also, I figure out the financial picture for a property by considering rent, taxes, maintenance, insurance, and other expenditures.
On this project, the Dream Team also wanted me to investigate other options. Specifically, they wanted me to look into a triple net lease. With this arrangement, the Team could pass on the expenses of taxes, maintenance, and insurance to the tenants. They figured they could set a rent amount to make sure they got the return on investment they wanted, and because the tenants would be footing the other bills, this would assure them of a good return.
They also wanted me to investigate the option of the Team financing the project with their own funds. Their thinking was that they could save money on points and closing costs, and perhaps even save money on interest. I looked into this option and found that the bank was offering a 7.5% interest rate. So for the $850,000 that we would need for the construction of the building, a bank, at 7.5% interest, would charge us $5,943.33 monthly for the loan. The Dream Team could then set the rent to make sure it would yield a 17.5% return goal.
WITNESS 3
Ned Ryerson, Developer
As the Developer of the land, it might be said that I dropped the ball on this. I did tons of research, but none of the research I did turned up information on the wetlands. This excuse has not improved my standing in the Dream Team’s eyes. Since you are one of the few people still talking to me, what can I help you with? Relevant Facts Items:
• Governmental agencies and property development
• Verbal approval on a project as a means for improving the chances of success
• Natural wetlands defined
Relevant Facts:
The job of a real estate developer is probably the least publicly understood profession of the people who are involved with our team. Everyone knows what an accountant is, or a leasing agent, but my job is less recognized because most people do not see what I do. It is my job to take a parcel of property and arrange for it to be improved and made ready for its intended use. The term “improved” means that something is done to the property with the intent of making it more valuable. You can improve a property by building a structure. In certain rare cases, you can improve a property by removing a dilapidated building. But mostly, improved property is property that has gone from a vacant state to a state where it is ready for the construction of buildings.
Developing property also means dealing with the myriad of governmental agencies that now have a hand in the development process. Since the water and sewer lines are public utilities and the streets are publicly owned, several agencies have the final word in whether property can be developed. The governmental agencies that are most often involved are the city government, the county government, and any metro government. Depending on your part of the country, water is a significant part of the development process. If there is too little water, then you have to arrange for access. If you have too much, then you have to deal with rain runoff and flood plains. In addition, the several governmental agencies have divisions within them. The cities may have a planning departments, a zoning board, an engineering department, a forester, an inspections department, roads, and others.
In this case, we had the verbal approval of several of the governmental agencies and divisions. Of course, the final approval is granted by the city council after application and hearings, but you can generally get an impression of the chances you have of succeeding if you present your plans to the city staff. We approached the city staff and showed them our plans. We met with approval from most of the divisions, with others withholding approval pending a full application. With that verbal approval, we felt that we could proceed with the project.
Our downfall was the wetland issue. We knew that there were wetlands, but we had reason to believe that we could drain the wetlands and bring in extra dirt to fill in the low areas so that we could use our whole parcel. Our area is considered very wet. If you cover land with some impervious surface like a building or a parking lot, you have to find a place for the rain water to go. In some places, storm sewers do the job, but in others you have to make ponds on the land to accept all the water you will have to divert. We thought that we could divert our water to the wetlands, but we found out that was not the case. You cannot use a natural wetland as a ponding area because it is already there, by natural causes, to take as much rain water as it can.
Our approval from the city planner, the city engineer, the forester, and so on meant nothing once the engineer determined that the wetland would be impacted. That was the end of our project. I only wish that we had the right to take the land back to the seller and get our money back, but the seller did nothing wrong, and now she would not want it back. This just became our loss.
Irrelevant Facts Items:
• Reasons a development can fail
• “Platting” land
• Applying for rezoning and recouping the investment through a nine-house subdivision
Irrelevant Facts:
The job of a real estate developer is probably the least publicly understood profession of the people who are involved with our team. Everyone knows what an accountant is, or a leasing agent, but my job is less recognized because most people do not see what I do. It is my job to take a parcel of property and arrange for it to be improved and made ready for its intended use. This is called the “platting” process. Once I have a parcel of land, I study it in every physical way possible. I have the property surveyed, I obtain a topographical map to show high and low points, I test the ground for its ability to accept water, and determine its ability to hold a road or building. Once these issues are addressed, I present my findings to the city for review and approval in the form of an application for platting. The city can approve the plat or it can turn it down for any number of good reasons. This plat never even got to the formal approval stage because the wetland issue became so obvious in the early stages.
With our failure occurring so early in the process, I had to look into options to try to recover our investment. I looked into getting the land zoned as a residential area. A development also has to be compatible with the city’s planning department. Each city wants to confine development of certain buildings to certain areas. Factories should be separate from retail areas, which in turn should be separate from residential areas. Even within a residential district, a mobile home park will not be located next to an area of high priced homes. The planning and zoning departments keep track of these issues to insure an orderly development of the city. I thought it seemed reasonable to change this commercial land to residential.
The wetland cost us about an acre of the property, but we still had three acres left. You can usually get about three housing lots per acre. With three acres, we could have sold nine vacant lots to home builders who would have built homes that would not have encroached on the wetlands. These would have been high priced homes that would have been very near to an attractive retail area.
A residential development would be using the same services as a commercial development, so the property would be ready for that type of use. The water and storm sewer services are basically the same for residential as for commercial zoned areas. We may have had a small problem because the sanitary sewer, the one that takes away household sewage as opposed to storm water, did not extend to our project. We would have had to extend the service ourselves, wait for the city to extend it at some distant time in the future, or use on-site sewer treatment that would consist of a septic system and drain field. Although all of these might have been expensive, we still would have had a chance to recover our investment.
When I proceeded with this proposed application, my bigger concern was with the city forester.
Our project would eliminate all of the trees on the four acres. Today, many cities are intent on keeping all of their significant trees. We would have to cut many significant trees and would have no additional land on which to plant new trees to take their places.
WITNESS 4
Phil Connors, Marketing Agent
We assumed this project would get off the ground sooner or later, and I guess we got a tough lesson in what happens when you assume things. Anyway, it was my job to find potential tenants for both the strip mall and theater projects. What information do you think would have helped me find the best tenants?
Relevant Facts Items:
• What the marketplace needed
• Determining potential tenants
• Avoiding competition between tenants Relevant Facts:
If we had gone ahead with the development of the theater, I would have had very little work to do on the project. The theater gave us a single tenant who was identified even before we started our development work. The strip mall would have required eight tenants, with the understanding that any one of the eight could fail at any time and need to be replaced. If we went with the strip mall, my work would have been ongoing. Because of the greater complexity that went with the strip mall, I will focus my attention on my research with that project.
My contribution of labor to the project consisted of finding tenants that would be compatible with the property and the other tenants. However, before I could find these tenants, I had to have an idea of what kind of tenant I was looking for and what kind of a presentation I would make to entice them to come to our building. I needed to find tenants that were likely to thrive in this strip mall. (If I had been working on the theater project, I would have had to determine if the community was large enough and interested enough to support a theater.) To learn these facts, I had to complete a market analysis of the area to determine what the area lacked.
Determining what the marketplace needed was my first issue. This was a tricky issue because you have to look at the surrounding areas and find out what is not there—and then try to fill that need. To do this, I obtained information on the local malls within the surrounding 20 miles and made a list of the shops that would fit our needs, then I subtracted from that list all of the shops that were located within our target area. I knew that our target area would be the customers in the surrounding three to five miles, so any of the shops that were already in this area were excluded. That gave me a list of about 40 possible tenants.
The list of possible tenants was only a starting place. There were other possible tenants that would suit our needs but were just harder to identify. The market may only need one quilt shop or locksmith every 20 or so miles. These types of unique shops have to find you. Therefore, my marketing plan consisted of approaching existing chain and/or franchise operations and offering our space. I also advertised publicly for possible tenants. I made many connections with our main target group, but whether I would make the more unique businesses aware of our building would not be known until they contacted us. But I figured that later down the line, once people got to know about this strip mall, we could make some of those contacts.
The last issue that I had to contend with was competition within the mall. Two liquor stores or two dry cleaners cannot normally thrive in the same mall. Each takes business from the other and neither prospers. I had to make sure that we had eight different businesses. Fortunately, there appeared to be sufficient businesses in the area that we could have filled the mall fairly easily. Unfortunately, my work came to naught.
Irrelevant Facts Items:
• Searching for an anchor tenant
• Broad-based customer analysis: what business could be supported?
• Attracting tenants through on-site signs Irrelevant Facts:
In many situations, an anchor tenant would be desirable. An anchor tenant is the tenant that gets the most business and is therefore a large draw, like a grocery store. The other tenants get their business from the people who have come to shop at the anchor tenant. I was able to identify a number of possible anchor tenants, but none agreed to take our space. Each of my options needed more space than we had in our whole building. Of course, an anchor tenant would only work in a
strip mall. In a theater, no anchor tenant would be needed since it would take up the whole property.
When looking at the customer base for the entire area, you get tons and tons of information. Everything has a need, and there’s a need for everything–that’s how it works. With the location of our building, we would have been easy to find and had sufficient numbers of local residents to support just about any kind of business. From fast food to theaters to dry cleaners to hobby shops, all types of business existed and thrived.
My next effort was to take a “supply side” approach to finding tenants (of course, this is specific to the strip mall project–the theater would have had one and only business and so finding tenants would have been unnecessary). Instead of trying to find the right kind of tenant, I simply advertised our building in every conceivable manner. We alerted business brokers, advertised in the newspapers, and put up signs on the property stating that we would soon have space to lease. That way I would be able to let potential tenants know that we would have space for them in the near future. With this approach, the real marketing would occur only after the potential tenant found us. Then we would go to work selling the place to the tenant.
HANDLING THE CASE
1. For one of the formulas that help you decide return on investment, you start with your required return amount, say 20%, and then calculate to see if this investment will meet your goals. That formula is the
A. fair market value.
B. net present value.
C. taxable value.
D. Pythagorean theorem.
2. The other formula that helps to determine if you are getting the return you require on an investment calculates the investment over a number of years and gives you a percentage figure that is your return on investment. That formula is called the
A. quadratic theorem.
B. theorem of diminishing returns.
C. internal rate of return.
D. economic recovery theory.
3. There is a concept that suggests that the team should have just paid the minimum down on the land and borrowed the rest at 6% rather than committing $700,000.00 to the land at the start. This concept is called
A. financial leverage.
B. deficit spending.
C. OPM, or “Other People’s Money” investing.
D. collateral borrowing.
4. Most investment stock can be sold in one day, whereas most real estate takes several months to sell. What is the term that describes an investment that is easily converted into money, like stock?
A. Ready cash B. Stock portfolio
C. Blue chip stocks
D. Liquidity
5. When making the final calculations regarding their return on investment, the Team seemed to put a lot of weight on a single element that seemed to be fairly arbitrary, optimistic, and distant in terms of time. What was that one element?
A. The ending sale price–the value of the building would have to go up about 20% per year to result in this sale price
B. The ability to replace tenants by using the leasing agent
C. The purchase price for the land–it had to be no more than 25% of the final cost of the Project
D. The desire of all of the investors to be able to leave their investments in the project until the fifth year
6. There are four generally accepted types of shopping centers. What type was the Dream Team trying to create?
A. Superregional shopping center
B. Neighborhood shopping center
C. Regional shopping center
D. Community shopping center
7. In real estate development, the expenses of the project are greatest at the beginning and then become more regular thereafter. While income from rents should be fairly regular, the business can suffer when the income from rents or the expenses fluctuate. Many businesses fail in these times of fluctuations because they have not managed their very well.
A. Tenant selection
B. Marketing approach
C. Cash flow
D. Investor contributions
8. If “location, location, location” is the operative concept when searching for and buying real estate, what is the operative concept in terms of what to do with the land?
A. Tenant, tenants, tenants
B. Similar buildings, similar buildings, similar buildings
C. Financing, financing, financing
D. The market, the market, the market
9. What could the Dream Team have done to protect itself from the losses in this type of investment?
A. It could have rented to the theater company.
B. It could have purchased the land with a provision that the sale would not close unless the investment intentions of the Team was realized.
C. It could have demanded that the seller become one of the investors before they would agree to buy the land.
D. It could have tried to sell the property to an unsuspecting buyer for the price they paid.
CASE CONCLUSION
The history of real estate development is punctuated with great success stories and great failures. It is a risky, volatile business. It is sometimes described as a business that has 100 questions. If you answer all 100 questions correctly, then you can make a great deal of return on an investment. If you answer 95 correctly, then you can make some money. A mere 90 correct brings you even, and any fewer correct ensures that you will lose money.
In this case, the investors were all knowledgeable in their areas but threw caution to the wind and put up a great deal of money with no real understanding of the impact of their actions. When they first started, they had no real reason to believe that their project would succeed. They had picked a good location and found savvy investors who had the financial strength they needed.
Yet they failed. Fortunately for them they found out about their project before they lost any more money. To be sure, the loss they suffered was large, but it could have been much larger. They could have been approved and started construction, only to find that the nearby retail center was failing because of a change in the direction of the highway that abuts the center. The team could have had money in the land and paid for the construction, only to find that they had no chance of recovering any of their investment.
This case is fairly simple in that the sole reason for the failure of the project was the wetland issue. In reality, projects like this are subject to a plethora of issues that can make or break them. Competition, a change in the marketplace, or a change in the overall economy or in area buying habits can affect a project. The best way to proceed with investments of these types is to commit as little to a project as possible in the early stages, and then contribute more as the risk in the major issues declines or is satisfied. Otherwise, real estate development investment can be a deep hole for unwise investors to dump a great deal of funds.
WITNESS 1
Penny’s relevant information helped determine the amount of return that the team members were getting and used that as a base, then determined the amount of return that would be required in order for the team to go forward with the project. She used both the net present value formula, which starts with an answer and then seeks to find if the calculations reach that answer, and the internal rate of return formula, that starts with the calculations and gives an answer that can be compared with a preset goal. By applying these facts and figures to the projected rental income from the project, she was able to show that the project made sense.
Any discussion Penny made about using the Net Present Value formula in reverse order to set the rental value was irrelevant. The Dream Team could control the amount they paid for land, the cost of improvements, and even the selection of buildings and tenants. They cannot control rent. Rent is a market figure. By her calculations, Penny was saying, “We need to make x dollars, so you will pay us the rent that will allow us to make x dollars.” The market does not work that way.
The market tells you what you can get. That is your beginning point, even when it is estimated. You must then work backwards to your costs to see if the investment works, not vice- versa. The reverse plan produces a very attractive, easily explained and defended calculation. But it does not work in reality. Note that the partners, and even the bank, were happy with the figures.
That is because they are easy to calculate. Do not be fooled.
WITNESS 2
Mr. Piehlet’s job was to arrange for the balancing of the income and expenses for the project. He started by looking at the rental income and then addressing the expenses. He addressed the bank debt first and foremost. Clearly, the bank debt, payment of which is known as the “debt service,” was going to be the largest. A percentage point mistake either way would make a great deal of difference to the value of the investment and would certainly mean more to the deal than a percentage point swing in any of the other expenses. Mr. Piehlet then listed the other regular and anticipated expenses, along with the tax obligation. If his job is done right, there should be no expense or income left unaccounted.
With his other information, Mr. Piehlet undertook to determine the income and expenses as if the Dream Team members were fronting the money necessary for the building. Notice that the team members figured that they could simply add the additional cost to the rent. Rent is market driven. Here, the team members acted as though they could set the rent based on what they wanted in return, rather than reacting to the market. You might be surprised how often this actually occurs. Further, the team members should have borrowed as much money as they could at 7.5%. They were already getting 9.5% return on their stock market investments, so they would lose 2% if they took their money from the stock market and put it in this deal.
He also described the triple net lease, but again, they planned on setting the rent based on their desired return instead of the market conditions. A more thorough analysis might reveal that a triple net lease is plausible.
WITNESS 3
Ned discusses the job he has to undertake to aid the development of the land. His job is to work with the various governmental agencies, and there are a lot of them, who have a hand in the approval process. In the relevant information, he discussed the several layers of agencies and the large number of approvals he must obtain. He then specifically addressed the wetland issue and how it affected, and eventually sank, their investment.
Ned’s irrelevant information about the platting process involves a change in zoning. It is highly unlikely that the city would ever approve a change in zoning since it is clear that the area is scheduled for commercial use.
Ned also suggests that the property could be sold for housing. But if you considered all the expenses, you would have known this was a bad idea. The land cost $700,000. The cost of development can be as high as $15,000 per lot to install new water and sewer lines and any road the project may require, not to mention surveyors’ and engineers’ bills. Add $135,000 to the land cost of $700,000 to get $835,000. Next, remember that they would have only been able to put nine lots on the property. So divide by the number of housing lots and you get an average lot price of almost $93,000.00. Even if the city agreed to change the zoning, no one would pay that kind of money for a vacant lot. This project would be a marketing nightmare.
WITNESS 4
Phil’s job here was to determine the marketplace for the leased spaces. He undertook this job by studying the market as it existed. With that information, he could go to other markets and find out what they had and see if there was anything missing in the Dream Team’s market. There would always be something missing that would give him some direction in seeking tenants. This part of the job would be fairly time consuming, although easy. His harder job would be to try to attract tenants who would not show up on his market study. For this, his only option would be to advertise. There would be several other marketing studies that he could have undertaken, but the size of the proposed strip mall or theater did not support the cost for any more aggressive market research.
Phil’s information about anchor tenants, while important for some projects, was unnecessary for this one. The building was only going to have eight units (if it was strip mall) and all of those units would have been the same size, hence defeating the point of an anchor tenant. With the theater project, there obviously would have been no need for an anchor tenant since there would have been only one business on the property.
