27th Sep, 2013 Real Estate Investment

Back of the Envelope Analysis (BOE): Your Investment Master Key – Part 1

One of the most useful tools allowing seasoned real estate investors to sift through the dozens of potential transactions that arrive on their desk each day, is the famed ‘Back of the Envelope’ (BOE) Analysis.

The idea of a BOE analysis elicits images of real estate moguls writing quick calculations on scraps of paper while an agent spews information down the other end of the telephone. Within just a few minutes, one imagines, there is a simple ‘yes’ or ‘no’ conclusion; either the property passes the litmus test and receives a more in-depth analysis, or it gets thrown onto the scrap heap along with numerous other potential sites that failed to make the cut.

The process may seem rough and inaccurate, to those young investment bankers accustomed to marathon Excel sessions, consisting of numerous spreadsheets, incomprehensible formulas and multiple sensitivity scenarios. William Poorvu, author of The Real Estate Game, compares the BOE analysis to watching your grandma whipping up her soup without any apparent precision but remarkable results. In this two part blog, Trident Real Estate Capital attempts to demystify this staple of the real estate investor’s toolkit.

In order to illustrate the process, we will use a potential development site on Mitchell Road in Alexandria, South Sydney, which Trident Real Estate Capital recently assessed.

It all begins with a broad picture of the investment opportunity to screen for any obvious red flags. The two most important figures that sit at the top of all BOE analyses are the asking price and size of the plot or floor space of the existing building. In the case of the Mitchell Rd project, the projected net leasable floor space (i.e. after deducting communal areas such as stairways, etc.) was 2,000 square metres (sqm) and the asking price, AUD$5 million. With these two figures you can derive the price per square meter, a base metric for many of our other calculations. For the development in question, we would be paying AUD$2,500 per sqm just in terms of land value. This seems quite high, given that apartments in the area are selling at circa AUD$8,500 to AUD$9,500 per sqm. Nevertheless, we carry on and check how the numbers play out.

Before running any further numbers, it’s important to piece together the rest of the initial survey, which takes the form of a ‘pros’ and ‘cons’ list.

Although the complexity of the design, suggesting high construction costs, is cause for concern, there’s no reason to immediately discard the opportunity. The lack of constraints to competition — which is another way of saying that another developer could build a similar development in the vicinity — does not pose too great a threat either, due to the high levels of demand currently being experienced in the area. Pre-sales in South Sydney in 2013 have been particularly strong, with some developments seeing more than 90% take-up.

So, after passing the first check points relatively unscathed, the next step is to consider what kind of value we could derive from this development. There are two stages to this. The first is attempting to calculate the amount it will cost to complete the development. The second is how much the developer could sell or rent the units for.

Let’s start with the costs. According to our past experience, as well as tools such as Cost Web, we know that average hard construction costs (direct costs of the physical components of the construction project) for a residential development in Sydney, of fewer than 10 levels and of medium quality, are AUD$3,250 per sqm. This means that hard construction costs will be approximately AUD$6.5m.

There are, however, also soft costs to consider. These include such aspects as land planning fees as well as engineering and architecture fees. On traditional developments, soft costs can be around 5-7% of hard costs. On this assumption, soft costs will total AUD$0.45m, bringing our project costs to approximately AUD$6.95m. If we put this in terms of construction costs per sqm, we have AUD$3,475/sqm. In addition, Statutory Fees such as section 94 Contributions, Long Service Levy and Voluntary Planning Agreement payments for bonus floor space equate to AUD$0.72m. Adding this to the land costs, our total Project costs are $6,335/sqm.

In Part 2 of this blog series, Trident Real Estate will review the revenue side of the BOE analysis and will consider the implications of leverage and how this juices up an investor’s equity returns.