R.42 Private Real Estate Investments Flashcards
Basic forms of Real Estate investments
Benefits of Equity Real Estate Investments
Risk Factors for Investing in Commercial Real Estate
Benefits of Equity Real Estate Investments
Current income – through leasing or renting the property
Price appreciation
Inflation hedge – both rent and prices should increase with inflation; this makes the real rate of return less volatile
Diversification – real estate is not highly correlated with stocks and bonds; but this may be exaggerated due to appraisal-based pricing
Tax benefits – real estate may receive favorable tax treatment (e.g. depreciating the property over a time shorter than its real useful life)
Risk Factors for Investing in Commercial Real Estate
Business conditions – the demand for space depends on economic conditions
Long lead time for new development – market conditions can change during this time
Cost and availability of capital – must compete with other investments, such as stocks and bonds
Unexpected inflation – real estate is a good inflation hedge if the increasing costs can be passed on to customers through rent increases
Demographics – size, age distribution, and growth all affect real estate values
Lack of liquidity – takes much time and cost to sell real estate
Environmental
Availability of information – still limited compared to other investments, but improving
Management – includes asset management and property management
Leverage – affect the returns but not the value of the underlying property
Other (e.g. natural disasters)
Types of RE value
Intro to RE valuation approaches
Types of Value
- Market value – probable sales price for a typical investor
- Investment value – value to a particular investor
- Value in use – value for a particular user
- Mortgage lending value – more conservative value
Introduction to Valuation Approaches
Appraisers use three approaches to estimate value.
1. Income approach
The value equals the present value of the expected future income, discounted at a rate commensurate with the risk. Net Operating Income (NOI) used for both Direct Capitalization method and DCF method.
2. Cost approach
The value is the cost of buying vacant land and developing a comparable property.
3. Sales comparison approach
The value is consistent with comparable properties sold in the current market, adjusted for specific differences with the subject property.
The three approaches will not generate the same value. It is best to use multiple approaches and reconcile the differences.
Highest and Best Use
The highest and best use of a vacant site maximizes the value of the land. The implied land value is the value after construction less the cost of construction.
At times the land is more valuable if the existing building is demolished and a new building is placed on the site.
Unique Characteristics of Real Estate
Unique Characteristics of Real Estate
- Heterogeneity and fixed location – no two properties are the same
- High unit value – indivisibility of real estate property makes the unit value high and limits the number of potential investors in private transactions
- Management intensive – active management of the property is required for private equity investors of real estate
- High transaction costs – buying and selling real estate is costly and time consuming
- Depreciation – buildings depreciate from use, time, and even location desirability changes
- Need for debt capital – the interest rate on loans can influence real estate prices
- Illiquidity – many of the above factors lead to real estate being illiquid
- Price determination – limited transactions and unique local situations lead to less efficiency in pricing; estimates and appraisals must be used in lieu of transaction prices; value is generated with superior knowledge
Net Operating Income (NOI)
Rental income at full occupancy
+ Other income
= Potential gross income
– Vacancy and collection loss
= Effective gross income
– Operating expenses
= Net operating income (NOI)
The Income Approach to Valuation
a. Methods
- Direct Capitalization method
- DCF
Both methods use NOI.
Direct Capitalization method: value based on capitalizing 1-st year NOI of the property using a capitalization rate. Know cap rate…comes up often. Expectations about future growth are implicit in cap rate.
Cap rate = discount rate - growth rate
V0 = NOI1 / cap rate
Cap rate = NOI1 /comparable sales
Discounted Cash Flow (DCF) method: just like dividend growth model for stocks
- Cap rate + growth rate = discount rate
- V0 = <span>NOI </span>/ (r - g)
- V0 = <span>NOI<strong>1</strong> </span>/ [1+ (r - g)]
- See solution for Different lease structures:
- Term and Reversion Valuation: calculate the value of the two components – term rent and reversion rent – separately
- Layer Method: assumes the current contract rent continues indefinitely and values the incremental rent separately.
The Income Approach to Valuation
b. Advantages and Disadvantages
c. Common Errors
Advantages of more complex DCF approach
- Captures cash flows that investors care about
- Does not depend on current/comparable transactions/sales
Disadvantages of more complex DCF approach
- Much detailed information is required
- Difficult to determine the discount rate and terminal cap rate
- Small assumption changes → big impact on value
Common Errors
- Discount rate doesn’t reflect the risk
- Income growth greater than expense growth
- Terminal cap rate not logical compared to going-in cap rate
- Terminal cap rate applied to atypical income
- Cyclical nature of real estate not recognized
The Cost Approach: estimates the value of the building based on adjusted replacement cost. This is added to the estimated land value to get the total value.
- Adjustments for depreciation types?
- Advantage/disadvantages?
- Example question/answer
Adjustments for depreciation types:
1. Physical deterioration
- Components of the property wear out over time. The physical deterioration is curable if the cost of fixing the problem is not more than the value that will be added if it is fixed. The physical deterioration is incurable if the cost of fixing the problem is more than the potential added value. Incurable depreciation is accounted for by assuming an effective age relative to the building’s economic life.
2. Functional obsolescence
- New buildings have designs that are better than old buildings. The loss in value due to an outdated design is called functional obsolescence. This normally leads to a lower ROI than could be realized with a newer building. For example, but old building could be less efficient and have higher operating expenses.
3. Locational obsolescence
- Locational obsolescence occurs if the desirability of the location changes. This can affect the building and land value. For example, the rent on luxury apartments may need to be reduced if a manufacturing plant is built in close proximity.
4. Economic obsolescence
- If new construction is not currently feasible, economic obsolescence results. Typically, this is because the rent levels are not high enough to justify new construction costs.
Advantages: Considered an upper limit on the value. Wouldn’t make sense for investor to pay more than cost of land plus cost to build comparable building.
Disadvantage: Difficult to estimate depreciation for property.
The Sales Comparison Approach
- What is it?
- Disadvantages?
Sales Comparison approach
- bases property value on what other comparable properties are currently selling.
- ideal to find comparable properties that are the same size, age, location, and quality
- adjustments made b/c exact matches never found.
- common to begin with a price per square foot.
- More weight given to properties more similar to subject property.
Disadvantages:
- not reliable if there are not a sufficient number of comparable sales transactions.
- assumes transaction prices are derived from rational buyers and sellers.
- Bubble prices could emerge when the market is too exuberant.
Reconciling the different valuation methods
Due Diligence
Reconciliation
- The three valuation approaches – income, cost, and sales comparison – will not arrive at the same value.
- Differences should be reconciled to determine the best estimate of the value.
- One approache may have more credibility in certain situations. For example, in active markets the sales comparison approach may be reliable.
Due Diligence
- Investors go through a due diligence process when assessing the value of a property. This involves verifying the facts and conditions about the property. There are many items to check, including leases for major tenants, bills for operating expenses, cash flow statements, physical/engineering inspection, and service and maintenance agreements.
- A letter of intent (LOI) is often signed when an investor intends to purchase commercial real estate. Usually the LOI is subject to due diligence. Depending on what is uncovered during the due diligence process, the price or other terms can be renegotiated.
Real Estate Indexes:
Appraisal-Based
- Formula to calc return
- Disadvantages
Transaction-Based
- Methods
- Disadvantages
DSCR - debt service coverage ratio
ratio formula
Appraisal-based indexes
- Appraisals necessary to value properties if not enough relevant transaction data.
- NCREIF Property Index (NPI) is well known US index. Member investment managers contribute information that is used by NCREIF. The holding period return is calculated with the formula below:
- Return = NOI - Capital expenditure + (Ending MV- Beg MV)
Beg MV
Disadvantages of appraisal indexes
- Appraisal lag present because appraised values do not capture sudden market shifts. Transaction prices move before appraised prices.
- Some properties are not even appraised every quarter. This tends to artificially smooth the index, which understates the volatility and correlations.
- Complicated techniques are available to unsmooth the index.
Transaction-based indexes
- Methods to address that different properties sell each quarter
- Repeat sales index relies on repeat sales of the same property. This should be a good indication of the market value changes. A regression analysis is used to build the index
- Hedonic index does not require repeat sales. Regression variables control for differences in properties that are sold, such as size and age.
- Disadvantages
- random movements due to the statistical estimation techniques. This noise can be distracting when trying to measure market trends.
DSCR - debt service coverage ratio
- DSCR is the ratio of the first-year NOI to the loan payment that includes interest and principal.
DSCR = (NOI) / (Debt Service)
- Financing amount/type won’t affect property value.
- Interest rate levels do affect market values.
- Debt is limited by the loan-to-value ratio (LTV) and the debt service coverage ratio (DSCR). Leverage will increase expected return/risk of property.
