Graybar Redux
An Analysis of Investment Risk in GraybarBuilding Associates
Prepared by:
Newt Ganugapati & Josh Klaetsch
for
Real Estate 870, Professor T. Riddiough
March 12, 2007
UNIVERSITY OF WISCONSIN – MADISON
SCHOOL OF BUSINESS
BUSINESS 870: ADVANCED REAL ESTATE FINANCE
SPRING 2007
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Purpose
This report will analyze the specific risks that we examined when analyzing the investment in Graybar Property Associates (henceforth, Associates). The proposed investment is for a share of a leasehold in the GraybarBuilding, located in New York City’s business center on Lexington Avenue between 43rd and 44th Streets. The investment is rather legally complex and has several financial tiers which must be examined. Additionally, the operating environment of the building requires us to look at several other risks which must be considered before investing.
i. Investment Risks
The list below details what we see as the risks to investment in Associates, with the most relevant risks listed first.
• New construction supply
•Operation of property
• Tax treatment of distribution
•Tax law changes
•Competition
• Conflict of interest between legal counsel and Associates
• Depreciation/maintenance/repair
• Increasing operating expenses
• Agency risk in each JV operation
•Lease cost increase on ground lease
•Poor physical inspection
•Default of superior lessees
ii. Discussion and Explanation of Investment Risks
One thing to note is that many of the risks we cite cannot be quantified. On a qualitative level, however, each of the points below carries a level of risk.
• New construction supply: Given that new construction is being added to the Grand Central area and other new parts of New York, Associates’ investors must be aware that this new supply could potentially pull lessees from Graybar’s tenant base. This will lead to decreased rental revenue, increased lease-up expenses, or both.
• Operation of property: Investors in Associates must be aware that Webb & Knapp is one of New York’s largest real estate companies. Their interest in other properties, both from an operations and from a development standpoint, is quite broad, and they may not be motivated to concentrate just on the operational effectiveness of the Graybar building.
• Tax treatment of distribution:At the time of considering this investment, there is a resolution before the Senate to adjust tax law as it relates to the amortization of investments. This should be of concern to investors in Associates because it means a larger percentage of payments in the near term will be treated as capital gains instead of a repayment of investment dollars. With this, more tax dollars will be due in the near term than under current regulations. These tax payments will be discounted less than those that would occur later, thereby reducing the net present value of the investment.
• Tax law changes: Currently the accounting law opinions that Associates has received indicate that Associates’ income will be taxed as a partnership or joint venture. However, these opinions have also indicated that there is a possibility that Associates could be taxed as a corporation. The impact of this change would decrease the amount of Net Income that Associates receives.
• Competition: Associates competes in an environment with many other lessors. If one of the lessors chooses to decrease rent for whatever reason, this rental decrease could also impact Associates ability to increase rent in new leases.
• Conflict of interest between legal counsel and Associates: It must be noted that the two partners of Associates are also partners in the legal firm that is responsible for organizing Associates. This conflict of interest should be investigated and monitored to ensure that the best interests of Associates are kept in mind.
• Depreciation/maintenance/repair: According to the terms of Associates lease under MetLife, Associates is responsible for all maintenance and repair of the property. This responsibility leaves Associates exposed to any increases in maintenance costs and the necessity to replace the property if anything happens to it.
• Increasing operating expenses: The terms of the lease with MetLife require Associates to cover all tax and insurance costs related to the property. This leaves Associates exposed to increases in tax and insurance costs.
• Agency risk in each JV operation: Associates is to be broken into two joint venture arrangements. Each joint venture will be chaired by an Agent. The Agents have the right to act on the behalf of Associates. This setup exposes investors in Associates to more agency risk, especially considering that the two current Agents currently work for Associates’ legal counsel.
• Lease cost on ground lease: The New York City Railroad’s (NYCRR) ground lease escalator clause agreement leaves Associates subject to the risk of significantly increasing rent on the ground lease after the initial term expires.
• Poor physical inspection: Associates is hiring an outside firm to perform inspection of the property annually. By hiring an outside firm at a fixed annual rate, Associates subjects itself to additional knowledge and communication risk.
• Default risk of superior lessees: Because Associates’ lease on the building is subordinate to MetLife’s ground lease with NYCRR, Associates could lose their lease if MetLife defaults with NYCRR.
iii. Risk Management
While myriad risks exist in any property transaction, a good investor will do all that can be reasonably done to mitigate these risks. As such, we recommend that the following actions be taken to manage risk in an investment in Associates.
• New construction supply/competition: In managing both new construction supply and competition risk, we recommend that any investors in Associates have a thorough understanding of the lease schedule that is in place and the completion schedule of any new construction projects. All efforts should be made to minimize overlap between the two.
• Operation: Because a potential conflict of interest exists in Webb & Knapp’s management of the property, it would be wise to implement more oversight of their operations and require collateral for the upside that they can receive from managing the property.
• Conflict of interest between legal counsel and associates: A wise investor in Associates should also have a separate personal counsel that can review all documents and provide sound advice from a legal standpoint.
• Depreciation/maintenance/repair: Associates’ agreement with Webb & Knapp shifts the responsibility for these things onto them.
• Increasing operating expenses: Again, the agreement with Webb & Knapp makes them responsible for operating expenses.
• Agency risk in each JV position: The contractual layout of Associates entitles the investors in Associates to veto Agent actions by an 80% decision. As such, investors have more control over Agent actions.
• Lease cost on ground lease: Associates has agreed to a ceiling amount for the ground lease that will not let it exceed five percent of land value at the time of option exercise.
• Poor physical inspection: As Helmsley-Spear must maintain its reputation in New York’s business environment, Associates can trust that they will act accurately and professionally.
• Default risk of superior lessees: Because MetLife is an insurance company and has significant financial holdings and a need to protect its name, Associates should not be concerned about default. Additionally, the NYCRR only has tax obligations, which are already being paid for the lessees, and thus has very little to no risk of defaulting to the government.
iv. Conclusions
Risk in commercial real estate based on the premise that the most important source of this risk is the market’s fundamentals. This risk, in turn, derives from uncertainty about demand and supply.
The most important ratio to understand when making income property loans is the debt service coverage ratio. It is defined as:
DSCR = Net Operating Income (NOI) / Total Debt Service (Cash Flow)
Net operating income is the income from a rental property left over after paying all of the operating expenses. To calculate the debt service coverage ratio, simply divide the net operating income (NOI) by the mortgage payment. From a lender's viewpoint it should be clear that they want as high a DSCR as possible.
The borrower, on the other hand, wants as large a loan as possible. The larger the loan, the higher the debt service (mortgage payments). If the net operating income stays the same, and the loan size and therefore the debt service increases, then the lower the DSCR will be. Life insurance companies are very conservative and generally require a 1.25 or 1.35 DSCR. This means that their loan-to-value ratios are low. Savings and loans (S&L's) generally only require a 1.20 DSCR, and sometimes will accept a DSCR as low as 1.10.
A DSCR of 1.0 is called a break even cash flow. That is because the net operating income (NOI) is just enough to cover the mortgage payments (debt service).
A DSCR of less than 1.0 would be a situation where there would actually be a negative cash flow. A DSCR of say .95 would mean that there is only enough net operating income (NOI) to cover 95% of the mortgage payment. This would mean that the borrower would have to come up with cash out of his personal budget every month to keep the project afloat.
Generally lenders frown on a negative cash flow. Some lenders will allow a negative cash flow if the loan-to-value ratio is less than around 65%, the borrower has strong outside income
The return on Real Estate is between bonds and stocks and actually closer to stocks.In the case at hand
DSCR
NYCRR-6.66
Met Life -1.11
Associates-1.0
With DSCR of 6.66 (very low risk) and a return of 5% NYCRR matches investment grade corporate bonds which is is a good reward.Met life being an insurance company would have liked a little higher DSCR but unlevered commercial Real Estate which is volatile yields 8-12% and stocks with significant volatility yield 8-12%,so with in the context of comparative risk/returns this investment looks good to me. With Associates it is like stock and a return of 12% with not as much volatility looks OK to me. I would have preferred a larger amount being allocated to NYCRR just to get more efficient diversification but again it depends on the investors risk appetite and it appears that they are fairly compensated for the risk.