Real Estate Finance and Investments: Risks and Opportunities, Edition 5.1

Peter Linneman, PhD and Bruce Kirsch, REFAI

Case: Welcome to the Big Leagues

Introduction

You have finally arrived! Congratulations! After leaving college, you have gone on to a successful business career, and now, after 10 years of waiting, you have succeeded your mother as the head of your familys trust fund. Your grandfather and his two brothers estates created this trust 14 years ago, when they distributed the familys assets into trusts for each branch of the family. It is now day 1 of Year 1. The current trust portfolio is shown below.

• Marketable Securities: The trust has a portfolio of $69 MM in stocks and bonds in primarily thinly-traded securities and cash which currently yield 4.15% per annum on a blended basis.

• Convertible Mortgage Note: The main asset is a $70 MM participating convertible mortgage (Convertible Note) in a retail property by the name of Regency Mall (Regency), the only regional mall in Pueblecito, a metro area of 200,000 people. Twenty-three years ago, your grandfather made his name in the local real estate community developing the Regency. The subject property is a 3-anchor, 450,000-leasable square foot mall with outparcels of a tire store and three restaurants. Each anchor is 100,000 square feet and there is 150,000 square feet of in-line space. At the time the note was written, the property was valued at an 8% cap rate. Your grandfather structured a convertible participating mortgage that would give the trust a claim on 60% of the equity. As of eight years ago, the property had appreciated greatly in price and it seemed Grandpa had made a good deal. Notably, since then, a Walmart super center opened in the market and Cap rates on solid stabilized regional malls in comparable cities are 8.5-10.0%.

The details of the Convertible Note are as follows:

• The note pays 8% per annum.
• It is a non-amortizing mortgage due at the end of Year 6.
• It is convertible into 60% of the equity ownership of the property at the start of Year 3.
• If Regencys NOI (after a normal capital expenditure reserve) exceeds $10 MM, the note receives 10% of the incremental NOI over $10 MM.
• The note is the only debt on the Regency and is a secured first mortgage which prohibits any debt or preferred equity to be placed on the property without your approval.
• Eight years ago, the Regency was appraised at a value of $100 MM, with an NOI of $9 MM (after cap ex reserves).
• At the end of last year, the Regencys NOI had declined to $7 MM (after cap ex reserves) and the Regency was appraised at $65 MM.
• During Year 2, 40% of all leases will expire, with a further 20% expiring in Year 3, and 10% in Year 4.

The Trust Portfolios Liability

When your grandfather died, your mother decided to diversify the familys portfolio into stocks and bonds. To do so, she arranged a $50 MM loan for the trust with the local bank, secured by the trusts Convertible Note on the Regency Mall. The bank loan is interest-only, matures at the end of Year 2, and bears a 9% interest rate. This bank loan contains a provision that if the appraised value of Regency Mall is less than 120% of the loan, the loan can be called at any time by the bank. In addition, the bank loan forbids any other debt being taken on by the trust so long as the loan is outstanding. The loan also has a sweep provision that allows the bank to take all trust cash inflows until the bank loan obligations are satisfied.

Market Information

• The 3-month LIBOR is 2.25%, the 5-year LIBOR is 4.5%, the 10-year LIBOR is 6.0%, and the 30-year LIBOR is 7.0%. Floating-rate mortgage spreads are between 80-125 bps.
• Short-term interest rates are expected to rise over the next few years as they are historically low.
• Having spoken with Billybob Clinton, your hometown banker, he tells you that it is unlikely that you will be able to get financing with terms similar to your $50 MM loan. He notes that currently, first mortgages require a Debt Service Coverage Ratio of at least 1.2x and a Loan-to-Value of roughly 70%, though you may be able to go beyond this.
• Two years ago, a new 220,000-square foot Walmart super center opened about 2 miles away from the subject property. The area approaching the Walmart is surrounded by several freestanding restaurants, a Best Buy, and a Bed Bath and Beyond.
• The Market occupancy rates:
  • Class A retail is 92% occupied, with a total of 600,000 square feet of space
  • Class B retail is 86% occupied, with a total of 1,300,000 square feet of space
  • Class C retail is 78% occupied, with a total 1,000,000 square feet of space.
• There are no other regional malls in Pueblecito.
• Market occupancy is expected to remain stable over the next 5 years.
• Pueblecitos residential communities will probably not grow materially in the next 5 years.

The Trustees

The principal beneficiaries of the trust are your mother (50%), your sister (25%) and yourself (25%). The beneficiaries are accustomed to total annual distributions from the trust of approximately $2-3 MM to cover their living expenses.

The Proposal

Regencys owners have approached you with concern that market conditions for Regency continue to weaken. They believe that they will be able to successfully re-lease their space as leases expire over the next few years, although at lower rents and greater concessions. The historical and their projected NOI and TIs/commissions are shown below:

The owners of Regency propose that they buy your note on Regency from the trust for $47 MM in cash plus a stub that converts into 35% equity ownership of Regency at the end of Year 6. They are willing to agree not to place more than 80% leverage on Regency prior to the end of Year 6 conversion date. The owners also would agree that prior to this conversion date they will not allow the interest coverage ratio to go beneath 1:1. You have no idea if the owners are sandbagging you, but Billybob tells you that in this market, with the new Walmart, these numbers seem to be in the ballpark. A broker, who stands to earn a fee, says that it sounds like a great deal.

Need to determine if the proposal is a good deal based on the parameters (Trust Portfolio's Liability, Market Information, and the Proposal) and recommend how should the trust proceed.

Your Task

So, are you still glad to be the head of the family trust? After leaving school you have had a successful business career but have no further real estate experience beyond having taken a real estate finance class what is now a very long time ago. You must write a business memo to your fellow trustees (the long-time family minister; the family lawyer; the President of the local bank who made the loan to the trust; your 28-year-old sister for whom the trust is her primary source of income; and your retired Mother) on how you recommend the trust proceed. The memo is not to exceed 3 pages, plus no more than 2 pages of exhibits with any charts/tables/graphs you choose to use. Welcome to the big leagues!

Current Trust Portfolio Stocks Value P/E Div. Yield Cash Flow Bid Ask 6.00x 13.62% 3.35% $19.00 $33.59 12.43x YPF SA ADR Oil Trading Partnership BB&T Bank SCS Trucking Subtotal $2,000,000 $15,000,000 $10,500,000 $27,500,000 $272,400 $502,500 $0 $774,900 $20.00 $34.00 $11.97 NA 0% $11.52 2.82% Bonds Value Face Amount YTM Cash Flow Bid Ask Citigroup 5-Year 5% Bonds 10-Year 6.5% Treasuries 5-Year Zero Coupon Treasury Strips Subtotal $9,000,000 $25,000,000 $5,350,000 $39,350,000 $10,000,000 $24,000,000 $6,000,000 $40,000,000 7.47% 4.48% 4.63% 5.15% $500,000 $1,560,000 $0 $2,060,000 $90.00 $104.17 $89.17 $90.50 $104.35 $89.30 Cash $2,150,000 $2,150,000 1.25% $26,875 Marketable Securities Total $69,000,000 $42,150,000 4.15% $2,861,775 Note Receivable Value Face Amount Interest Cash Flow Notes Regency Convertible Mortgage TBD $70,000,000 8.00% $5,600,000 Est. max. CF assuming no incremental participation. Regency Mall Historical and Projected NOI, Tls and LCs Year NOI * Tls/LCS 6 Years Ago $9,200,000 $500,000 5 Years Ago $9,300,000 $200,000 4 Years Ago $9,600,000 $300,000 3 Years Ago $9,800,000 $400,000 2 Years Ago $9,700,000 $100,000 Last Year $7,000,000 $200,000 This Year / Year 1 $6,800,000 $500,000 Year 2 $4,000,000 $3,000,000 Year 3 $5,000,000 $2,000,000 Year 4 $5,800,000 $500,000 Year 5 $6,000,000 $200,000 Year 6 $6,500,000 $200,000 Post-cap ex reserves, but pre-TI and LC reserves Current Trust Portfolio Stocks Value P/E Div. Yield Cash Flow Bid Ask 6.00x 13.62% 3.35% $19.00 $33.59 12.43x YPF SA ADR Oil Trading Partnership BB&T Bank SCS Trucking Subtotal $2,000,000 $15,000,000 $10,500,000 $27,500,000 $272,400 $502,500 $0 $774,900 $20.00 $34.00 $11.97 NA 0% $11.52 2.82% Bonds Value Face Amount YTM Cash Flow Bid Ask Citigroup 5-Year 5% Bonds 10-Year 6.5% Treasuries 5-Year Zero Coupon Treasury Strips Subtotal $9,000,000 $25,000,000 $5,350,000 $39,350,000 $10,000,000 $24,000,000 $6,000,000 $40,000,000 7.47% 4.48% 4.63% 5.15% $500,000 $1,560,000 $0 $2,060,000 $90.00 $104.17 $89.17 $90.50 $104.35 $89.30 Cash $2,150,000 $2,150,000 1.25% $26,875 Marketable Securities Total $69,000,000 $42,150,000 4.15% $2,861,775 Note Receivable Value Face Amount Interest Cash Flow Notes Regency Convertible Mortgage TBD $70,000,000 8.00% $5,600,000 Est. max. CF assuming no incremental participation. Regency Mall Historical and Projected NOI, Tls and LCs Year NOI * Tls/LCS 6 Years Ago $9,200,000 $500,000 5 Years Ago $9,300,000 $200,000 4 Years Ago $9,600,000 $300,000 3 Years Ago $9,800,000 $400,000 2 Years Ago $9,700,000 $100,000 Last Year $7,000,000 $200,000 This Year / Year 1 $6,800,000 $500,000 Year 2 $4,000,000 $3,000,000 Year 3 $5,000,000 $2,000,000 Year 4 $5,800,000 $500,000 Year 5 $6,000,000 $200,000 Year 6 $6,500,000 $200,000 Post-cap ex reserves, but pre-TI and LC reserves