Basic property valuation

Given the current interest (dare I say hysteria) associated with investing in land and buildings, I thought it might be interesting for our readers to have a quick and dirty manual on real estate valuation. My perspective comes from years in the industry, as well as a time learning on the knees of some of the best real estate minds in academia.

I will separate (to some extent) investing in one’s residence, for consumption, from investing in real estate for fun and profit. The reason for this separation is that much of the utility or value of the home itself is locked in the pleasure that comes from living in it or consuming it. Although there are certain ego hits to owning large buildings, a building complex, so to speak, the value associated with land, apartments, office buildings, and warehouses is locked into the cash flow they provide or will provide. [That edifice complex comes in to play with large, trophy assets – I wouldn’t expect any of our readers to be buying the TransAmerica Pyramid or the Sears Tower, but there is an interesting argument as to why those buildings deserve premiums over their nearby competitors – that discussion will have to take place at another time.]

The first basic principle to understand is that any asset is only valuable to the extent that it provides cash flow to its owner. It is important to view office buildings, not as office buildings, but as rental creation machines. One should see land, not as land, but as an option to build and rent or sell and therefore create cash flow.

“But, JS, how can I decide what to pay for those cash flows?” And ‘JS, what if the cash flows are unpredictable or difficult to estimate?’ I listen to your questions and they are good. And that is why there are different ways to assess the value of real assets.

There are four basic ways to approximate the value of a building or land. There is the Discounted Cash Flow, or DCF method, there is the Cap Rate method, there is the Replacement Cost method and there is the Comparable method. Each has its own advantages and disadvantages.

DCF

Discounted cash flow analysis or DCF analysis is not unique to real estate; in fact, it works with most capital assets. DCF is the process of forecasting cash flows forward over a realistic period of time (any investment banking analyst will have made so many 10-year DCFs that they will see them in dreams), usually five or ten years and then discounting those the Cash flows return to the present to find the current value of the building. I’m not going to go into the ins and outs of choosing the right discount rate (but maybe one of my fellow columnists will), but suffice it to say that the right discount rate must take into account the relative guarantee of future cash. flows (or more precisely, the risk associated with the specific cash flows of this asset). Cash flows include the rents or cash that will be spit out, as well as the ending value (or the value the building will earn from a sale (less transaction costs) at the end of the analysis). Below is an example of a DCF analysis. Notice how the building can be valued very differently depending on one’s discount rate. Suppose the sale price of the building is $ 150; this may not be a great investment. Building a simple model in Excel and playing with income flows and terminal values ​​will show how sensitive these analyzes are to even small changes.

The advantages of this type of valuation are that if you are relatively certain of future cash flows and understand the true cost of your capital, as well as the correct discount rate for this type of asset, then you can get a good idea of ​​what to offer. or what you would be willing to pay for an asset. Of course, the downsides are that if someone can accurately predict anything for the next ten years, I want to meet them and buy whatever they want; they are worth my weight in gold (no small amount, I assure you). Also, choosing the right discount rate is an art and not a science, as such it is not only difficult, but also prone to manipulation. Or in other words, many of my colleagues (and JS should not be considered better than anyone else), as well as myself, have worked backwards to arrive at the asking price. Or we have made the model and then we choose the discount rate to arrive at a value that the construction trade will actually do.

In general, I am not in favor of this type of assessment. It is too sensitive to judgments / errors and does not take into account the vagaries of the market. Also, this method does not work well with land, vacant buildings, redevelopment opportunities, or any type of asset that has no cash flow or is extremely difficult to predict cash flows.

Capitalization rate

The capitalization method or the capitalization rate method is similar to the DCF method. In fact, it’s actually just a shortcut for the DCF method. The following equation explains what a capitalization rate is:

First Year NOI ÷ Building Purchase Price = Capitalization Rate

NOI is net operating income. The NOI is basically the cash flow of a building, excluding debt service and income taxes (not property taxes). As an example, if we take the building from the DCF analysis above and assume a purchase price of $ 100 and a NOI of $ 10, the capitalization rate is 10%. [$10 / $100 = .10 or 10%]. To use the capitalization rate method to figure out what to pay for a building, you only need to understand two things, the expected NOI for the year after purchase, and the capitalization rate for similar assets (and this usually means tenants) in the market. If you deconstruct this method it will start to look like a DCF assessment, but those similarities and why they may or may not make sense are best saved for a later column.

NOI is net operating income. The NOI is basically the cash flow of a building, excluding debt service and income taxes (not property taxes). As an example, if we take the building from the DCF Analysis above and assume a purchase price of $ 100 and a NOI of $ 10, the capitalization rate is 10%. [$10 / $100 = .10 or 10%]. To use the capitalization rate method to figure out what to pay for a building, you only need to understand two things, the expected NOI for the year after purchase, and the capitalization rate for similar assets (and this usually means tenants) in the market. If you deconstruct this method it will start to look like a DCF assessment, but those similarities and why they may or may not make sense are best saved for a later column.
In commercial real estate, this is the most common method of listing property prices or talking about valuations. Brokers will talk about trading buildings with an 8 ” cap. That means a building sold at 12.5 times its first year NOI. Be careful to delineate between ‘NOI in place’ and ‘NOI projected’ or ‘proforma’. Also be careful to accurately predict the capital contributions required to maintain a rented or leasable building. Because capitalization rates only take NOI into account, they often fail to distinguish between buildings that require large amounts of capital and labor to keep up and those that don’t.

In general, this is a great shortcut to deciding if a building is worth more work. Capitalization rate analysis is just a starting point for deciding what to bid on a property. But understanding market capitalization rates (or the average capitalization rate that assets have been traded by) is a very valuable metric. I would rank this as the second best method of valuing real estate.

Replacement cost analysis

Replacement cost analysis is exactly what it sounds like. Replacement cost is the cost of recreating that exact asset at that exact location. A good replacement cost analysis will not only take into account the value of the land and construction costs, but also the developer’s earnings and the cost of maintaining construction debt.

Although brokers often say ‘this will trade below replacement cost’, this is often not the case and furthermore it is generally not a relevant metric. Replacement cost is a retrospective metric that does not take into account what is most important, what the building will be able to earn right now. Remember, cash is king.

I will say that in general this method is useless. The argument that if you buy something below replacement cost, “you can only get hurt if no one builds here again” is unfortunate. If you are buying in a vibrant market with high volatility, this argument could have some merit. But unless you get an off-market deal or there is some reason to believe that other informed buyers have not found out about the deal you are exploring, you have to ask yourself why you can buy something below replacement cost.

Comparable analysis

This is the most important method of valuing any type of asset, but it is especially useful in real estate. The comparable method or offset method is to simply look for assets on the market that are similar to the one you are acquiring and look at what they have traded per square foot, per acre, or per unit. If you are paying more than everyone else on the market, there better be a good reason. And if you’re paying less, find out why.

This method is best for “hard-to-value assets,” such as vacant residential buildings, land, and houses. For those items, the cash flows are either non-existent or too difficult to estimate. Embedded in this valuation method is a central theme, that of the efficient market. Provided there are many bidders and relatively fair market disclosure, the prices at which the assets have been traded are probably the best indication of their value.

If you have more specific questions about another method or about something in this article, feel free to write to me or post it at http://www.whatbubble.com.