Assignment 1

Assignment 1 The Assignment In this assignment, you must assist Tom Wolfe   do a valuation of Evergreen Centre. The case describes the shopping centre, Tom’s situation and the assumptions necessary to do the valuation. Your answer to the assignment must include the following: ? ? A written valuation report indicating your valuation, all assumptions that are not given in the case and a justification for those assumptions. You are free to change the assumptions in the case, but if you so, you must justify the change. A spreadsheet giving your calculations. You calculations should be annotated either in cells on the left or right size of the calculations or using Excel comments (under Review on the ribbon). Not all calculations must be annotated. You must use you judgement on reasonable analyst would need explanation. You are free to you the Workbook containing the Wyndham Park calculations as a base for analysis. You will be graded on you completeness, accuracy and the quality of your explanations. The assignment is worth 25% of your final grade, but I will mark it out of 100 points. Introduction Tom Wolfe was working late. He was reviewing the papers that accompanied his inheritance of a neighbourhood shopping centre, Evergreen Centre. The centre is a thriving property in the wealthy, leafy suburbs of Melbourne. It was developed by his father, Sam Wolfe, in 1988 and managed by him until his recent death. The centre had always been a huge part of his father’s life. Tom had not followed in his father’s footsteps, but had pursued the law instead. His career had prospered and he was now a partner in large law firm on Collins Street. Tom’s dilemma is that he has neither the time nor the inclination to manage the shopping centre. Tom’s interest in selling peaked when he found among his father’s papers an unsolicited offer to purchase the property for $15 million from a major developer that was dated six months ago. This was just prior to his father’s diagnosis of progressive cancer. Since the offer was unsolicited, it was probably a low-ball offer designed to entice his 67 year old father into further discussions. His father told the developer that “he was not interested at this time.” Tom wondered: What the centre was really worth? Could it be worth significantly more if redeveloped? Evergreen Centre Sam Wolfe was a born in 1948 – a true baby boomer and a true entrepreneur. He opened his first shop in 1973 at the age of 25: Evergreen Premium Grocery. During his “overseas experience” he had seem that premium grocery stores and delicatessens could do well in major centres if situated in affluent areas with sufficient young and upwardly mobile clients. In Evergreen Premium Grocery he sought to capture this market in Melbourne. His business degree taught him to do his market research and this told him to locate in one of the leafy suburbs. His business degree also taught him Page |2 to have a solid business plan. His was ambitious. To develop a reputation for excellence with his small Evergreen Premium Grocery, but to move up to a larger site and possible develop a shopping centre as soon as practicable. Evergreen Premium Grocery was not an instant success, but was thriving after five years of hard work. Sam began looking for a larger site, for financial backers and for a bank that would help fund the project. Both came together in 1988 with the opening of Evergreen Centre. The centre was anchored by a significantly enlarged version Evergreen Premium Grocery. The other shops were selected to complement the grocery and all shops had to meet Sam’s vision of excellence. The centre had done well from the beginning. The strategy of offering a wide range of quality groceries in one location became increasing popular over time. Moreover, there was little competition until recently. Sam paid his debt and financial backers for the project within 20 years. He did a refurbishment in 2008 (20 years after opening) and has since paid his debt for this. The centre is currently debt free. The Property The neighbourhood centre is located on a rectangular site of 3,504M2. The gross leasable area of the specialty grocery store and related shops is 1,366 M2 (see Table 1); parking and parking accessways occupy 620 M2; and 152 M2 is devoted to footpaths and other non-leasable space. The centre is a classic L-shaped neighbourhood centre, with the specialty grocery located on the foot of the L, the remaining shops located on the bar of the L and parking is located in the space to the right of the buildings forming the L. Zoning regulation requires 3.5 car spaces for every 100 M2 of leasable area or portion thereof. On this basis, this shopping centre requires 49 car park spaces. Evergreen Centre just meets this requirement, but any expansion of gross leasable area creates a parking problem. The parking design results in the following allocation of space. Parking Accessway Total Spaces Required 49 49 M2 200 420 620 The Leases The rent roll in Table 1 indicates that shopping centre’s gross rental revenue is $1,058,818 per year and has an average rental rate of $775 per M2 per year. This average rental rate is considerably higher than the $595 per M2 per year for neighbourhood shopping centres in Melbourne as a whole. However, the average rate in the centre is buoyed up by the $958 per M2 per year recorded for the specialty grocery store. Since the specialty grocery owns the centre, it does not pay rent. Therefore, the $958 is not a rent at all, but it is the net revenue from operating the store. Hence, it is the maximum rent that could be paid for the space. The average rental rate for the other six shops is $685 per M2 per year. While this is also higher than the Melbourne average, the 15.2% premium is justified by the shopping centre’s premium location in an upper income area. Page |3 Table 1: Rent Roll Tenant Number 1 2 3 4 5 6 7 Tenant Specialty Grocery Boulangerie/Pâtisserie Bakery Butcher Seafood Full Service Restaurant Cards Total/Average GLA M2 450 178 150 127 127 230 104 1,366 Current Rent (per M2) 958 800 770 709 625 600 600 775 Current Rental 431,100 142,400 115,500 90,043 79,375 138,000 62,400 1,058,818 Start Date (BOY) na 2014 2013 2015 2011 2012 2013 2013 Lease Term na 5 7 5 5 7 3 5 Years to Lease Expiration na 3 4 4 0 3 0 2 Table 1 also shows that that the shopping centre has signed tenants on varying dates with a mix of 3, 5 and 7 year leases, with the average lease signed in 2013 and being 5 years in duration. One aspect of the leases that should be noted is that two of the leases are in their last year (0 years to expiration) and the average lease has only two years to run. All of the leases are subject to rent review, with the exception of the specially grocer. The dates of the last rent review, the next rent review, the timing between reviews and type of rental adjustment on review are given in Table 2. From the table, the leases are reviewed every two or three years and all of pre-expiration leases are indexed to the Consumer Price Index (CPI) for food and non-alcoholic beverages. The two lease that are due to expire will be marked to market on lease renewal or if a new tenant is signed. Data for indexing the CPI indexed leases is presented in the Appendix in Table 7. Projections of the index are given in the Appendix in Table 8. The shaded area in this table contains data and the unshaded area contains forecasts. Table 2: Rent Reviews Tenant Number 1 2 3 4 5 6 7 Tenant Specialty Grocery Boulangerie/Pâtisserie Bakery Butcher Seafood Full Service Restaurant Cards Last Rent Review na 2014 2013 2015 2015 2014 2013 Next Rent Review na 2016 2016 2017 -2016 -- Rent Adjustment Timing na 2 3 3 On renewal 2 On renewal Type of Adjustment na CPI: Food and Non-Alocoholic Beverages CPI: Food and Non-Alocoholic Beverages CPI: Food and Non-Alocoholic Beverages Mark to Market CPI: Food and Non-Alocoholic Beverages Mark to Market The Tenants Boulangerie/Pâtisserie A specialty cake and pastry shop had been a fixture at Evergreen Centre since its opening. The current Boulangerie/Pâtisserie is the second such shop. Emma’s Cakes was the first shop, but Emma retired in 2013 and was replaced the current proprietor in 2014. While Emma’s Cakes had been a successful business, the current product line for the Boulangerie/Pâtisserie has been dubbed “too French” and “just not Emma” by some of the centre’s patrons. Evergreen Centre management need to help this proprietor achieve success. Page |4 Bakery This bake shop focuses on artisan breads. Originally, Evergreen Premium Grocery supplied quality breads made by bakers in Melbourne. However, artisan bread has become popular with customers, so the centre approached a locally recognized baker and persuaded him to open a shop in 2013 on a 7 year lease. The shop has been an immense success and a considerable draw for the centre. Butcher The standalone butcher shop opened in 2015. Standalone butcheries have disappeared from many shopping centres, replaced by vac-packed meats in your local supermarket. However, in the tide is turning as more customers are worried about the use of growth hormones and other drugs in meat production and as other customers worry about the quality of life for the animals themselves. The birth of high-end butcher shops featuring quality meats began in the US and UK over five years ago. The butcher in Evergreen Centre is in this mould. The initial response to this shop has been weak, but this is a new venture that may fare better over time. BBQ season is coming. This will be a test. Seafood The standalone fishmonger is also a new venture designed to capture the market for quality seafood. It opened in 2011, but has struggled. Customer surveys reveal that a significant number of the centre’s patrons appreciate the shop, but even more would like the shop to do classic Australian fish and chips. Sam Wolfe refused to allow this and made it a condition in the lease that proprietor not become a “chippy.” He saw this as diluting his vision of excellence. In addition he suspected that full service restaurant would object. Full Service Restaurant The restaurant is operated by Stavros, a friend of Sam Wolfe. The restaurant opened with the centre in 1988. It has been a steady performer. It does especially well in the summer months when it provides al fresco dining in its courtyard at the tip of the L in the centre. Sam always saw this as an oasis of calm for the patrons of Evergreen Centre. A food court was not in Sam’s vision. While the restaurant trades well, Stavros is 64 years old and may soon retire. The death of his friend Sam may tip the balance. Cards Evelyn’s Card and Curios is another long-time tenant. The shop was added to the centre to provide a service for patrons seeking last minute cards and gifts. It traded well for many years, but its customer base has been declining. The original proprietor sold out in 2012. The new proprietor lacks imagination and the shop struggles financially. One of Sam’s last acts before his illness was to ask his real estate broker to look out for a replacement for Evelyn’s. Tom’s Assumptions 1. Tom assumes that his specialty grocery will increase net revenue at the rate of food and non-alcoholic beverage inflation. Tom questions the approach of booking net operating revenue as rent in the financial analysis as done by his father. He believes it is overstates gross potential income because net operating revenue includes a return to equity. 2. Evergreen Centre has always signed triple-net leases with its tenants and Tom plans to continue this. Page |5 3. An examination of the rent roll shows that all of the leases expire during the cash flow forecast period. After examining his father’s notes in the tenant files, Tom believes that there is a small chance that some of the tenants may not re-sign leases at the end of their tenancy. His best estimates of the probability that a tenant will relet are given in the Table 3. Table 3: Re-lease Probabilities New Lease Tenant Years Boulangerie/Pâtisserie 2019 Bakery 2017 Butcher 2020 Seafood 2016 Full Service Restaurant 2019 Cards 2016 Prob. of Relet 80% 100% 70% 25% 60% 60% 4. If a tenant relets, the centre must renegotiate the lease. Tom believes that all leases should be marked-to-market on lease renewal. However, this may increase the chance that the tenant vacates the property. This is a judgement call that will be made at the time of negotiation. In the valuation, Tom must decide to estimate value based on his market-tomarket view or suggest a different rent position. 5. Table 3 gives the probability that a tenant will renew at the end of the current lease. Some leases will terminate twice during the forecast period. Tom must decide and justify a probability of re-lease for these subsequent re-lease times. 6. The centre has always employed a commercial broker to help find new tenants and to help negotiate new leases. A commercial broker charges 3 per cent of the total value of the lease as commission. The total value of the lease is the simple sum of the rents to be paid by the tenant over the term of the lease. Technical Note: To help with setting rents and determining broker commissions, a rent calculator and a commission calculator are supplies along with the assignment in the spreadsheet Rent and Commission Calculators. 7. Tom has decided to follow the top-down approach to determining the potential for vacancy. He consults a local real estate advisory to obtain estimates of the market vacancy rate from 2015 to 2015. These are given in the Table 4. In addition, the real estate advisory informed him that there are 112,593 M2 of neighbourhood shopping centre space in his market area other than Evergreen Centre and that there was no foreseen development of space until 2018/19 when about 2,500 M2 might be constructed. Page |6 Table 4: Projected Market Vacancy Rate Year 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Projected Vacancy Rate 2% 2% 3% 4% 5% 5% 5% 5% 5% 5% 5% 8. The financial statements for Evergreen Centre reveal the following centre expenses. ? Property taxes are levied at the $2.50 per $1,000 of net annual value, where net annual value is the assessment of the net rental income from the centre. This value is equal to effective gross income less the land tax insurance and maintenance costs. The current state government has capped property tax increase by the rate of inflation. ? Land tax for a property of this value is equal to$24,975+2.25%×Land Value. Land value is approximate 60 per cent of the value of the property, so Land tax ? $24,975+2.25%×60%×Property Value. ? The remaining cost figures come from the centres financial accounts. ? Tom will have to hire a top-fight grocery store manager to replace his father. The current salary of a good, experienced manager is $100,000 per year and manager salaries have increased by 2 per cent per year recently. Tom muses: Should the manager’s salary have performance incentives? ? Technical note: The property taxes and land tax are approximated in Table 5 because they depend on the calculations. Start with these figures and replace the approximate values with your own calculations later. In addition, since property value is what you are trying to determine, the land tax cannot be determined until you complete the preliminary valuation. Once you have a preliminary valuation, substitute the formula and change your Excel options to enable iterative calculations. Table 5: Expenses Base year expenses Property rates Land tax Insurance Maintenance Administration Total $ $ per M2 4,000 2.93 250,000 183.02 35,000 25.62 175,000 128.11 20,000 14.64 484,000 354.32 Cost Inflation 2.5% per year 2.5% per year 5.0% per year 3.0% per year 5.0% per year 9. There are no expense reimbursements. 10. After a property inspection and discussions with tenants and staff, Tom realizes that centre has not been refurbished since 2008. The centre is still in good shape, but many small things Page |7 need to be attended. He estimates that an immediate expenditure of $250,000 is needed to cure these deficiencies. 11. During his meetings with tenants, several tenants note that the local competition from the high street is increasing and Evergreen Centre will have to pick up its game just to stay even. Tom believes that at least $5 million will be need for a refit (including tenant incentives during the refit). The refurbishment will take planning and council permissions will be needed. The earliest date for the refit would be 2018. Tom plans to borrow as much of the refurbishment cost as possible and to pay off the balance within five years (assume a 5 year fixed rate mortgage.). 12. To complete the analysis, Tom used the following rates. Table 6: Rates and Percentages Rate Appreciation rate Going-out cap rate Sales costs Borrowing rate Maximum LTV Return to equity Required rate of return Per Cent 3.00% 8.00% 2.00% 8.50% 80.00% 7.50% 7.75% Page |8 Appendix: Table 7: CPI Indexed Leases Percentage Change Tenant Number 1 2 3 4 5 6 7 Tenant Name Specialty Grocery Boulangerie/Pâtisserie Bakery Butcher Seafood Full Service Restaurant Cards CPI on Rent Review na 102.20 101.30 103.90 103.90 102.20 101.30 CPI Today (June 2015) na 104 104 104 104 104 104 Years Since Review na 1.5 2.5 0.5 0.5 1.5 2.5 Figure 8: CPI Projections Year F&B CPI 2013 101.3 2014 102.2 2015 103.9 2016 105.0 2017 106.6 2018 108.2 2019 109.8 2020 111.4 2021 113.1 2022 114.8 2023 116.5 2024 118.2 2025 120.0 Since Last Review na 0.98% 0.94% -0.38% -0.38% 0.98% 0.94% Past 5 Years 1.53% 1.53% 1.53% 1.53% 1.53% 1.53% 1.53%