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Joseph M. Davis, MAI, PhD Project Feasibility Using Breakeven Point Analysis Using the breakeven point formula, an appraiser can quickly determine the feasibility of a project from several points of veiw. An expanded breakeven point formula combines the possibilities of the land and building residual tech- niques with cash flow model analysis. The article illustrates the importance of making revisions to the original formula—which is commonly found in real es- tate investment texts—to include leasing commissions and tenant improvements in office or retail space analysis. W hen a client asks the question, what is my breakeven cost on this project, he is re- BEP = TC TR = 1 = Breakeven ally asking, “When will my project have a Breakeven cash flow analysis: Breakeven breakeven cash flow if I obtain typical financ- cash flow (BECF) analysis, as used in real ing?” estate with financing and after income taxes, Important questions like this can be an- is shown below: swered using the breakeven point (BEP), which is really a single year’s cash flow model. The PGI – V&RL = formula answers the following questions: How EGI – OE = much is the land worth for a proposed use? NOI – DS = What rental rate will be needed, given the cost BTCF – TAXES = ATCF of constructing the improvements and buying where, the land? Given market rental rates, what can PGI = Potential gross income the operating expenses be and still meet the V&RL = Vacancy and rent loss lender’s requirements? EGI = Effective gross income Breakeven economic analysis: Just as finance OE = Operating expenses and real estate disciplines had their origins in NOI = Net operating income economics, the breakeven point formula is DS = Debt service + interest closely associated with the breakeven point BTCF = Before-tax cash flow analysis of a perfectly competitive firm. TAXES = Federal and state income taxes As shown in figure 1, when total revenue ATCF = After-tax cash flow (TR) = total cost (TC), breakeven points exist: Joseph M. Davis, MAI, PhD, is president of Joseph M. Davis and Associates, Tempe, Arizona, and is a professor of real estate at Arizona State University. He received his PhD in real estate from the University of Georgia, Athens, and has previously written for The Appraisal Journal. Contact: (602) 705-0007. Fax (602) 705-0006. Email joseph.davis@asu.edu. 41 Let: Value is a function of: OE + DS BECF (before-tax) = = BEP = 1 EGI Value = f (Building value, land value) If [OE + DS ] = EGI Building value = f (Building square footage, price per OE + DS square foot) BECF (after-tax) = + TAXES = BEP = 1 EGI Land value = f (Land square footage, price per Thus, the BEP is: square foot or acre) OE + DS BEP = EGI Income or revenue is a function of: This simple formula can be used to do many Retail and office: types of real estate analysis. PGI = f (Leasable area, price per square foot per year, Breakeven point analysis: The simple BEP other income) formula is only the tip of an iceberg that leads Apartments (300-unit project): to numerous applications. Generally, it illus- PGI = f [(100 1BR/1BA × $500 × 12) + (100 2BR/2BA × $550 × 12) + (100 3BR/3BA × $600 × 12) trates the following: + other income] • BEP shows the percentage of the effec- or tive gross income (EGI) at which the be- PGI = f [(100 1BR/1BA × Y × 12) + (100 2BR/2BA fore-cash tax flow or BTCF is 0. × 1.10Y × 12) + (100 3BR/2BA × 1.2Y × 12) + other income] • If EGI – (OE + debt service or DS) = 0, EGI = f (PGI – V&RL) then, BEP = 1 and BTCF = 0. V&RL = f (%, PGI) • If (OE + debt service or DS) < EGI, then, the BTCF is positive. Operating expenses (OE) are a function of: • If (OE + DS) > EGI, then, the BTCF is negative. OE = f (Property taxes, insurance, utilities, manage- The financing, as expressed in the DS com- ment, utilities, etc.) ponent of the BEP formula, is a function of (f) the following: The BEP formula can be used to derive an estimate of any of the variables listed. The DS = f (AMC, loan amount) formula can be used to: AMC = f (i, Term) • Determine how much to pay for the land Loan amount = f (LTV, V) or how much can be spent on improve- LTV = f (%, V) ment costs DCR = f (NOI, DS) where, • Determine what the apartments or leas- AMC = Annual mortgage coefficient able area rent must be LTV = Loan-to-value ratio • Determine if the project will meet the i = Interest rate lender’s financing requirements (LTV, Term = Amortization period DCR, etc.) V = Value • Determine the maximum expenditures DCR = Debt coverage ratio for operating expenses per unit and still meet the lender’s requirements FIGURE 1 Breakeven Economic Analysis TC = Total cost $ TC TR VC = Variable cost FC = Fixed cost TR = Total revenue π = Profit maximization BEP1 = (TC = TR) Decreasing BEP2 = (TC = TR) Returns TR – TC = Profit Increasing Returns FC TC = VC + FC $ = Rent/revenue/dollars Q = Units/Square feet/quantity Q BEP1 π BEP2 42 The Appraisal Journal, January 1998 Each variable following the “function of” 600,000 + 1,074,012 1= or f above can be solved for and the BEP for- [1,140Y + 1,254Y + 1,368Y] mula can be rewritten as needed by the 3,762Y = $1,674,012 analysis to include all or portions of the vari- Y = $445 ables. Therefore, the required rent is as follows: Applications for the BEP formula are • $445 per month for a 1-bedroom/1-bath unit shown in the following examples. • $490 per month for a 2-bedroom/2-bath unit • $534 per month for a 3-bedroom/2-bath unit Example A: BEP Analysis of an Check (pro forma): Apartment Project $534,000 (1-bedroom/1-bath is 100 × $445 × 12) 1. The lender’s requirements are as follows: $588,000 (2-bedroom/2-bath is 100 × $490 × 12) $640,800 (3-bedroom/2-bath is 100 × $534 × 12) 1.30 = DCR (minimum) $1,762,800 (PGI—rental income) 25 years = Term – 88,140 (V&RL—5%) 8.5% = Interest rate (monthly payments) 1,674,660 (EGI) 75% = Maximum loan-to-value ratio – 600,000 (OE—300 units × $2,000) 9.4% = Acceptable capitalization rate 1,074,660 (NOI) – 826,163 (DS—8.5% for 25 years in monthly payments) 2. A 300-unit project is planned on a 15-acre $248,497 (BTCF) parcel of land. Current vacancy rates of 1,074,660 comparable projects in the area average DCR = = 1.30 826,163 5%. Comparable rents for tenant-paid DS 826,163 utilities projects show that: Loan amount = = AMC 0.09662725 = $8,550,000 1.00Y = 1BR/1BA (100 units) 8,550,000 1.10Y = 2BR/2BA (100 units) LTV ratio (cost) = = 0.7500 11,400,000 1.20Y = 3BR/2BA (100 units) 8,550,000 LTV ratio (market) = = 0.7479 11,432,553 Property managers’ records and pub- NOI 1,074,660 VMKT = = = 11,432,553 lished data indicate that the average an- 0.094 0.094 nual operating expense per unit is $2,000. 3. According to a preliminary sketch of the Example B: BEP Analysis of Retail Center project from an architect and estimates 1. Given the following lender’s require- of a general contractor, the project could ments: be built for $28,000–$32,000 per unit plus $8,000 per unit for the land, or a total of 1.30 = DCR (minimum) $38,000 per unit. 25 years = Term 4. What must the apartments rent for each 8.50% = Interest rate (monthly payments) month to satisfy the lender’s require- 75% = Maximum loan-to-value ratio ments? The problem is solved using 10.00% = Acceptable capitalization rate breakeven point analysis: 2. A 160,000-square-foot leasable area retail OE + DS BEP = center is planned on a 15-acre parcel of EGI land. The estimate is based on compa- Y = Required apartment rent for 1-bedroom/1-bath rable rents and expenses and property OE + 1.30DS 1= managers’ records of similar projects. [0.95(100)(1Y)(12) + [0.95(100)(1.10Y)(12) + 0.95(100)(1.20Y)(12)] The annual stabilized NOI pro forma OE = $2,000 × 300 units = $600,000 is: DS = (AMC) (loan amount) DS = (0.09662725)(0.75) (cost) $1,760,000 (PGI—$11 per square foot) Cost = $38,000 per unit × 300 units – 88,000 (V&RL—5%) = $11,400,000 1,672,000 (EGI) DS = [0.09662725 (0.75) (11,400,000)] – 480,000 (OE—$3 per square foot) DS = $826,163 $1,192,000 (NOI) 1.30DS = $1,074,012 $1,200,000 (rounded) Davis: Project Feasibility Using Breakeven Point Analysis 43 3. The maximum amount of the lender’s Breakeven cash flow occurs at 80.7204% loan is estimated using the following of the EGI, or restated: methods: PGI – V&RL = EGI × 80.7204% = BEP = [(OE + DS) DCR method: – 0.807204 EGI = 0] DCR = 1.30 DCR = NOI Working backward, BE occurs at 23% va- DS cancy; market vacancy is 5%. 1,200,000 1.30 = DS $1,760,000 (PGI) 1,200,000 410,355 × V&RL = (0.233156 × PGI) DS = = $923,077 – 1.30 $1,349,645 (EGI) DS = Loan amount maximum $1,672,000 (EGI) AMC 923,077 × 80.7204% (BEP) = $9,552,968 Maximum loan 0.096627 $1,349,645 (EGI) amount Check (pro forma): Loan-to-value ratio method: $1,349,645 (EGI) NOI V= – 480,000 (OE) R 869,645 (NOI) 1,200,000 V= = $12,000,0000 – 869,645 (DS) 0.10 $ 0 (Breakeven cash flow) LTV ratio = 75% maximum $12,000,000 × 0.75 = $9,000,000 Loan amount maximum = $9,000,000 Given a 75% LTV ratio from the lender, an AMC of 0.09662725, and building costs (BC) of 9,600,000, the appraiser then solves In conclusion, the lender will offer only for land value (LV): $9 million at 8.5% for 25 years with a maximum loan-to-value ratio of 75%. OE + DS BEP = 4. A preliminary sketch and footprint of the EGI retail center drawn by an architect has OE + [0.75 (BC + LV) AMC] BEP = been obtained. According to the EGI builder’s estimate, the cost for gross 480,000 + [0.75 (9,600,000) + LV) AMC] BEP = 1,672,000 building area is $55–$65 dollars per 480,000 + [0.75 (0.09662725) (9,600,000 + LV)] square foot (includes all direct and indi- 0.81 = 1,672,000 rect costs), or about $60 per square foot. 1,349,645 = 480,000 + [(0.072470)(9,600,00 + LV)] The gross building area is equal to the 1,349,645 = 480,000 + 695,716 + 0.07247044 LV leasable area. Thus, the estimated build- 1,349,645 – 480,000 – 695,716 = 0.07247044 LV ing cost is 160,000 square feet × $60 = 173,929 $2,400,000 $9,600,000. = Land value = 0.07247044 15 acres 5. How much can the investor afford to pay Land value = $160,000 per acre for the land and meet the lender’s re- Land value = $3.67 per square foot quirements? The total cost for the building and land is: Land residual method: $12,000,000 (Lender’s property value) $9,600,000 (Building) – 9,600,000 (Building cost) + 2,400,000 (Land—160,000 × 15 acres) $2,400,000 (Land residual value) $12,000,000 $160,000 per acre $3.67 per square foot CONCLUSION Breakeven point analysis solution: OE + DS Using the expanded BEP formula, an ap- BEP = EGI praiser can quickly determine the feasibility 480,000 + 869,645 of a project from several points of view by BEP = 1,672,000 including many other variables. As de- BEP = 80.7204% 44 The Appraisal Journal, January 1998 scribed, the BEP formula combines the pos- Generally, leasing commissions and ten- sibilities of the land and building residual ant improvements will apply when retail and techniques with cash flow model analysis. office space are analyzed. Apartment projects However, an appraiser should consider re- account for these categories in operating ex- vising the formula when leasing commis- penses: management, maintenance, and re- sions and tenant improvements are part of pairs. The revised BEP formula gives the the analysis, so that the revised formula is: owner or purchaser a more realistic cash flow breakeven expectation. The formula, whether OE + DS + LC + TI revised for LC and TI or not, can also be writ- BEP = EGI ten to reflect an after-tax analysis by adding where, income taxes in the numerator. LC = Leasing commissions TI = Tenant improvements Davis: Project Feasibility Using Breakeven Point Analysis 45