The final course of the specialization expands the knowledge of a construction project manager to include an understanding of economics and the mathematics of money, an essential component of every construction project. Topics covered include the time value of money, the definition and calculation of the types of interest rates, and the importance of Cash Flow Diagrams.

From the lesson

Real Estate Finance for Development Projects

Professor Anthony Webster introduces real estate finance providing an overview of the real estate project lifecycle, a discussion on zoning code parameters, and examples of estimating the sales price of a property.

Instructor, Department of Civil Engineering and Engineering Mechanics, Columbia University Director of Research and Founder, Global Leaders in Construction Management

The third method, as I said before, of estimating the sale price of a property

is using discounted cashflow methods.

Okay here's our D, here's our C, here's our F.

You started to learn about these with Professor O'Dell

in his Mathematics of Money chapter.

We're going to review this a little bit more in our next chapter,

but for now let me say a few things about DCF.

Okay, one common discounted cash flow

method is called the net present value method

which looks mathematically like this.

And what it says in words is the net present value

of a project is equal to the sum of each cash flow for

the sponsor, for always one entity at a time,

of this project, for the sponsor of this project

brought back to its equivalent at T equals 0.

As you've learned in your Mathematics of Money chapter, you can't,

when you're being careful and using discounted cashflow methods,

you've gotta consider cash as a function of time.

So you can't add up cashflows to or from an entity, a developer, a sponsor,

a lender until you first brought them back to an equivalent time, say T = 0.

So, that's what's going on here.

Each cash flow for the developer of the project is being brought back

to time T = 0, the beginning of the project.

Once we've done that we add them all up, and now what do we have?

We have a set of apples-to-apples cash flows.

And if the sum of the positive cash flows for

CAG is on this apples to apples discounted basis is greater

than the sum of the expenditures on this apples to apples discounted basis,

then that's a positive number.

Than means they've made money, okay?

And that's what we call the NPV.

The NPV is simply just the sum of all those discounted casuals.

If it's positive, it means they estimate the project that will make money for CAG.

If it's not positive, they don't.

And the great thing about DCF that makes it so much better than cap rate

is that we've got a set of future

cashflows that we're looking at here, not just one year.

So, you can go out five years and say well, demand in the first year is going

to be pretty good, but in the second year it'll be more, we can raise our rates.

We'll have a higher NOI, etc, etc, so

we can build a better model of the future with DCF methods.

Okay, all the definitions for everything in this equation are down here.

You're welcome to review them.

We are going to cover them a bit in my next module, so

if you want to wait, that's fine.

So we're not going to do a UCF calculation right now,

that'll come in the next two modules for this project, but

just a few words on how we think about NPV, okay?

So from CAG's perspective, right, they would like

the NPV to the project buyer to be a slow as possible.

So they'd like the buyer to make a mistake, and get a negative NPV for

the buyer.

They're expecting, what's fair is NPV at zero,

that's considered the fair deal for the seller and the buyer.

And if CAG is a bad negotiator, makes a big mistake and sells the property for

too little they're going to find the buyer has an NPV of greater than zero.

Okay, so problems with DCF methods,

NPV in particular, why aren't we using it right now?

It's very complicated.

We need to review what you're done with Professor O'Dell before we get there and

we're going to need to learn a few more things before we're able to do this for

real estate projects like this development project.

And determining some of the quantities is complicated because now,

we're not just looking one year ahead, we've gotta look farther ahead and

the farther you look ahead, the more obfuscated and nebulous things look.

Also we're going to have to think about, from the buyer's perspective, they're

going to sell the building in 5 or 10 years, what are they going to get into it?

That's even harder to estimate.

Etcetera, etcetera, so add it all up, DCF valuations,

we just don't use in feasibility studies, we just use gain and return.

But we use them often, but not always in financial plans,

which we're going to get to in my third module.

Okay, so let's think about the overall thoughts on

our analysis and our conclusions here.

Okay, so our gain and return estimates for

the comps method, I'm just going to jump right to return,

which really tells us everything we need to know, all positive.

Okay, and same thing with the cap rate method,

okay, all positive.

Always good to do at least these two methods even in a feasibility study

because you might make, it's easier than you think to make

a big mistake in one of these methods especially the cap rate method.

So if the two methods give you wildly different results, that's telling you

you better go back and look very carefully at everything you've done,

you probably have a mistake somewhere.

Okay, when you get similar numbers like this, this is looking pretty good here.

So they're going to get a return, if things work out as expected,

even if market conditions aren't as great as they think.

If market conditions are better than they think,

then they get 10, 11% return in a year.

And remember again, this is all no borrowing,

100% equity financing, which is always conservative.

And also our tax assumptions were pretty conservative.

If we got together with a real estate tax professional,

we could maybe do a little bit better on taxes, okay.

So, that's sort of the good.

You know, you compare these returns in one year, 6,

7% expected always positive to

a one year treasury, which at for example,

November of 2016 is paying less than half of one percent.

Maybe good place to put your money is to put it

into this project and expect that you will do better.

And some of the downside things for

us to think about here are that we did do a pretty

good job of estimating sale price in different conditions.

We used two methods.

We used the comps method and we used the cap rate method and

for both of those methods, we considered three scenarios.

What did we not do for the costs we projected for this project?

We did not do any of that, we just came up with one single cost estimate.

We didn't, we threw in a little number, possibly for cost overruns but

we didn't really seriously consider different scenarios for cost.

Okay, so definitely the cost estimates could use some improvement.

We didn't include variability, good situation, bad situation,

expected situation.

And variability, synonym for risk, so

we didn't consider risk and it would be good to do that.

But overall, everything said, I would vote that this project

is definitely worth a closer look, worth looking further at it.

And our next step for doing that is to develop

a financial plan, and that's going to be where we're going.

We need to do a little bit of review and

a little bit of expansion of the mathematics of money and

discounted cash flow evaluation methods first, but

then we're going to jump right back into apex and do a financial plan for it.

Okay, so what do I mean when I say financial plan?

We want to improve on our feasibility studies.

These are only for

projects that have passed that first feasibility study hurdle.

And specifically, we're going to look at the timing of the cash flows.

In the feasibility study, we just lumped all the costs together,

we didn't say when they happened.

As you know from Mathematics of Money, cash is an exponential function of time,

so we really need to consider it in time and

the, now we're going to want to bring in a lender,

a construction loan lender, maybe a land lender too, and

we want to see if we can improve our modeling of

variability and risk, particularly in costs.

Okay, so that's what's coming, okay?

And in the next module, we're going to review some

of the time value of money concepts that Professor O'Dell went over and

we're going to learn some new stuff about discounted cash flow methods for

project evaluation.

And after we do that, we're going to jump right back into Apex and

look at a financial plan for Apex, so stay tuned.

I look forward to seeing you in the next two modules, take care.