Valuing economic damages in a breach of contract case

An example of a real estate deal gone bad

In this occasional series, we discuss the estimation of economic damages in business cases. In this post, which is based on a case our economists worked on as defense experts, we discuss the lost profits associated with a real estate project that did not receive funding by a California based venture capital fund. The names of the parties have of course been changed.

In this case, Earl Haderstein who was the head of an international real estate investment fund, known as East Circle Investments, sued Landwinds Inc., which is a venture capital fund that specializes in real estate deals, after it reneged on its promise to provide funding to purchase a portfolio of real estate in New Zealand.

Our economists were asked to provide an assessment of the economic damages that were the result of the defendant’s alleged breach of the contract with East Circle Investments.

A detailed description of the case and out methodology follows.

Case set-up:

In this case, a California venture capital fund called LandWinds Inc. entered into an agreement with East Circle Investments to provide the investors funding to purchase $250 million (USD) worth of office property in New Zealand. At the time of the project, the US to New Zealand dollar was about 0.66 (NZD/USD).

The office property in the portfolio that East Circle wanted to purchase included property that the local government was looking to privatize by auctioning it off to investors. The properties included office buildings and had a total value of about $700 (NZD).

Most of the properties had tenants with long term leases most with over 10 years remaining, and included a number of government agencies. The auction for the properties was to be a sealed bid auction.

The financing deal with the venture capital firm (LandWinds) had the following features.

* Landwinds would lend East Circle $250 million (USD) to purchase the real estate
* The deal would be a 10 year financing deal
* East Circle would manage the properties and receive a standard management fee of 5% of operating revenue (before any interest payments)
* The accounting profits, in this instance rent minus operating expenses, would be used to pay down the balance of the loan.
* Taxes (state, federal) are assumed to be taken care of by other means and not deducted from accounting profits
* At the end of the 10 year period the investors East Circle will sell the properties and pay off the loan balance

For reasons that are in dispute in the case, the funding to purchase the buildings was never advanced. Consequently Earl Haderstein and the East Circle Investment group lost the opportunity to purchase the property and the return that they believed they would have realized had they been able to purchase the properties.

We were asked to estimate the lost profits in this case.

The methodology

As with any asset, the value of the real estate portfolio is equal to the present value of the stream of income payments. In this case we were presented with a number of interesting nuances.

For instance, we did not know which properties would have been purchased by the consortium because it is an auction and bidding process. However, we do know that the investors intended to use the entire portion to purchase as many real estate properties as they could.

Given these facts, the best way to estimate the lost profits associated with the portfolio of real estate that the investors would have been able to acquire—had they received funding---is to use the expected return from the entire portfolio as a base.

In other words, we estimated the rate of return for the entire portfolio of real estate that the government was auction off and applied this rate to the portion of the real estate that East Circle would have been able to acquire. The implicit assumption is that the portion of the portfolio that East Circle would have been able to purchase would have been at least as profitable as the whole real estate package.

Specifically, our economists estimated the damages associated with the breach of contract in the following way.

1. We calculated the market value of the real estate portfolio at the end of the 10 year period. The market value tells us how much we can reasonably expect the portfolio to sell for at the end of the 10 year period. We used the market value to calculate the profit and the rate of return that could have been expected from the investment.

This is done by first calculating the expected yearly revenue that the properties are expected to generate. The yearly revenue is quoted net of expenses such as maintenance and building security.

Additionally yearly revenue takes into account that a set annual growth rate 4% per year is included into the existing tenants contracts.

Given the annual increase in building revenue (because of the set yearly increase), the market value of the real estate portfolio at the end of the 10 year period is equal to the capitalized value of the annual revenue at the end of the 10 year period.

The capitalized value is determined by dividing the annual revenue by an appropriate discount factor. Given the general lack of risk associated with the lease contracts and real estate deal as a whole, an interest rate discount factor that is equal to the average annual rate of return on property in the New Zealand real estate market is used in the valuation of the breach of contract damages.

Recall that in economic damage calculations in breach of contract cases or other types of cases for that matter, the interest rate discount factor reflects the opportunity cost associated with the investment. The opportunity cost represents the return that the investor could receive from the next best investment opportunity.

The capitalized value is an accounting term that means the market value of the asset (real estate) assuming that the asset (real estate) will have infinite life. In other words it is the total discounted revenue that the property will generate in all future periods.

Note: the total market value could alternately be determined by performing a present value calculation in all future periods. The result of this calculation is asymptotically the same as simply dividing the annual revenue by the interest discount rate.

2. We calculated the profit that would have been earned on the sale at the end of the 10 year period.

The profit is determined by subtracting the loan amount from the total market value of the portfolio at the end of the agreement. In this case the loan did not have an amortization schedule like a mortgage or a call.

Instead the loan was to be paid down from the accounting profits earned from East Circle Investments purchase of the New Zealand profits. The amortization schedule then simply involves calculating the interest that would be paid, subtracting the revenue (net of management fees etc, and applying that to the loan balance.

To calculate the profit in year 10 then involves subtracting the final loan balance amount in year 10 from the market value (annual revenue/interest rate discount factor) of the New Zealand properties that would have been included in the portfolio.

3. Since the case took place in 2004 the profits will have to be discounted back to the year 2004. Using the discounted profits a discounted return on investment (ROI) can be determined by dividing the discount profits by the total investment amount that was required to purchase the entire portfolio of properties.

(Remember that the investors East Circle will not be able to purchase the entire portfolio but the ROI from the total portfolio is used to calculate the potential return from the properties that East Circle would have been able to purchase had the contract not been breached.)

4. Finally the ROI from the entire real estate portfolio is applied to the investment portfolio of East Circle to determine the lost profits associated with the breach of contract.

The final calculation must take into account the exchange rate and the percentage of ownership by East Circle.