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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   August 2008

Luck be a … Casino?

What happens in Vegas can actually help your developer or investor clients mitigate risk

c_2008-08_groover_spotEvery gambler should know the adage, “Gamblers rely on luck; casinos rely on math.” The house has a mathematical advantage over a player when it comes to games of chance.

Casino developers also look for an advantage when dealing with potential properties, and they find it through risk-management techniques.

From a risk-management perspective, casinos are similar to traditional mixed-use developments. According to a 2007 report from the Nevada State Gaming Control Board, gaming is less than 50 percent of the total revenue for Nevada casinos with at least $1 million in gaming revenue. The rest of the income comes from hotels, condominium sales, spas, entertainment venues, retail shops and restaurants -- in other words, more-traditional commercial-property amenities.

Risk-management techniques used by casino developers and operators shouldn’t stay in Vegas. You can use them to protect your clients, as well.

Don’t overleverage

One key to risk management with casino properties and other commercial developments is not overleveraging the property.

As is the case with many commercial properties, the capital structure used to finance a casino is often a critical success factor. Although each casino differs from another, wise developers know that using large amounts of equity with correspondingly low loan-to-value (LTV) ratios can lead to success. By infusing the capital structure of a casino with equity as opposed to debt, the internal rate of return (IRR) is lower than it would have been had the capital structure included more debt, with all other variables being equal.

Increased equity substantially enhances the free cash flow, however, which substantially reduces a project’s risk. Clearly, high amounts of equity in the capital structure of any real estate investment will lower risks and increase the viability of the property during all phases of the economic cycle.

For instance, the now-defunct Aladdin casino is an example of a development that had a large percentage of debt in the capital structure -- in other words, a high LTV. In this scenario, free cash flow is minimal because of the high debt service. When new competition from other casinos arrived on the Las Vegas Strip, the Aladdin did not have enough free cash flow to invest in the property to compete, according to the Online Nevada Encyclopedia. It’s now the Planet Hollywood Resort and Casino.

Another strategy to keep equity levels high is to work with a partner. By co-investing with an equity partner that has a long-term exit strategy, some casino developers and operators have been able to capitalize their properties with large amounts of equity relative to debt. At the same time, they can enjoy the benefits of a larger IRR on the equity they put into the project.

Debt-service-coverage ratio

The concept of the debt-service-coverage ratio (DSCR) didn’t originate in casino operation or development. But it is used as a tool for measuring the risks associated with the debt component of the capital structure.

DSCR is especially useful when purchasing an existing casino with an operating history. In these cases, actual earnings before interest, taxes, depreciation and amortization (EBITDA) or net-operating-income numbers exist.

The first step to calculating DSCR is projecting what the yearly debt service will be to finance the property for the next five years. Then project what EBITDA the property will generate for the next five years. Finally, divide the EBITDA by the yearly debt service for each of the five years to arrive at DSCRs for each year.

Essentially, what you have calculated is the number of times that the yearly EBITDA pays the yearly debt service.

Every property type has its own acceptable DSCR range, so you want to make sure that your customer is not overleveraging the property. Ensure that the projected DSCRs for your client’s property are within the range of standard DSCRs for that property type.

Finally, to determine the risk involved with a given amount of leverage in the capital structure, you should look at the historical EBITDA numbers and determine how much volatility there is. If you find that historical EBITDA numbers for the subject property are volatile, you may advise your client to add more equity to the transaction, change the terms of the debt financing or abandon the transaction completely.

Don’t overpay

Paying too much for real estate is one of the greatest risks to which an owner or developer can be exposed. There are two typical ways to determine the value of casinos, and both are applicable for other property types, as well.

A common metric used to value casinos is based on a multiple of EBITDA. Typically, an operating casino will be valued somewhere in the range of five to 11 times its EBITDA. That is a broad range, but it takes into account the specific attributes of the casino itself, as well as the general market appetite for casinos.

For example, assume that a larger casino on the Las Vegas Strip, such as the Bellagio, produces $350 million in EBITDA per year. Applying a cash-flow multiple of eight to this casino’s EBITDA, a value of $2.8 billion is determined.

Mortgage brokers can use the same tool to prevent their clients from overpaying in virtually any real estate purchase. The key is determining what an accurate valuation multiple and EBITDA are for the property.

Another way to express the value of a casino can be in terms of dollars per room, sometimes referred to as dollars per door or dollars per key. Take the total purchase price or development cost for the casino and divide that by the number of guest rooms.

This ratio is useful for multifamily and hotel/motel property types. It is less useful for office buildings, retail and industrial buildings.

Shift risk to third parties

Some casinos use interest-rate swaps to control risk. The Wynn Las Vegas is one example, according to its Securities and Exchange Commission 10-K filing earlier this year.

Your clients also can benefit from the swap market.

The concept behind interest-rate swaps is simple. A swap is essentially shifting risk to a third party for a fee.

An example might be a real estate developer with a construction loan based on the London Interbank Offered Rate (LIBOR) index.

The developer is exposed to interest-rate risk. If the LIBOR increases, then the interest rate of the loan will increase. But the developer can choose to shift the interest-rate risk to another party by purchasing a swap that in effect fixes the interest rate on the loan.

After the swap transaction concludes, the developer becomes immune to any risks associated with increases in the LIBOR index.

Presales and preleases

Presales and preleases are two ways to mitigate the risk involved with a new development while also bringing in revenue and increasing the value of the property.

For a large development such as a resort-casino, one way to mitigate the risks associated with financing the project is to presell the condo or hotel units and use the cash to fund development costs.

Preleasing a property also gives the developers significant opportunities to manage risk by understanding what their tenant mix is likely to look like and how much demand there is for their product before project completion.

But the real risk-management benefits from preleasing come from having access to the cash flow from the leases as soon as the doors open, rather than spending months trying to lease up a property. Additionally, the immediate increase in cash flow from the first day of operation reduces risk by providing extra cash to fund unanticipated costs. This also immediately increases the value of the property in case the owners should need to refinance or even sell it.

Leases as tools

Leases are important risk-management tools and allow the lessor to shift risk to the lessee, or vice versa.

Destination resorts often have large retail and dining spaces built into them and use the property’s amenities to help drive foot traffic. The demand for retail and restaurant space at destination resorts in Las Vegas is so strong that the lessor is able to shift many of the risks to the lessee.

Triple-net leases and expense stops are two of the ways that casino-resorts shift the risk of increased operating expenses to their tenants. The same techniques will work for your clients contemplating an investment in rental real estate.

In fact, if the tenant is profitable enough, your clients might benefit by executing a percentage lease with the tenant. This could help ensure that your client participates in the good fortune of the tenant by taking a percentage of the sales or profit over an agreed-upon threshold in addition to a base rent.


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