REPE Technicals

Question 1

What are the RE valuation methods?

Answer 1

Sales Approach: Look at comparable properties on a price/sq. ft basis (more applicable for residential but can work for commercial) – make adjustments since no two buildings are the same
Replacement Cost Approach: Look at the cost of replacing the building, then subtract the cost of any improvements that are necessary (i.e., minus estimated depreciation), then add on the cost of the land – typically only used for unique properties like churches or schools.
Capitalization Approach: Calculate the annual NOI of a property, and use the market cap rate for similar properties to back out the value: Value = NOI / cap rate
DCF
IRR: The most widely used approach. Often firms have a hurdle they must meet before they choose to invest. Higher IRR is better given two assets with similar risk characteristics
Unlevered IRR: Measures ROI at the asset level ignoring capital structure
Levered IRR: Represents returns to equity investors

Question 2

What is IRR?

Answer 2

The discount rate that makes the NPV of all cash flows equal to 0 – used to analyst investor returns
It is the average compounded annual income growth rate than an investment is expected to generate

Question 3

Whats the relationship between IRR and NPV?

Answer 3

The IRR is the discount rate required to make your NPV equal to 0
It does this by discounting your future cash flows so that their present value is equal to your investment

Question 4

What is a Cap rate and what are its three major determinants?

Answer 4

Opportunity cost of capital: Comes from the capital market / investor sentiment – basically, higher rates and/or higher expected returns on other investments will require higher expected returns in RE and therefore higher cap rates – higher rates also mean there is less capital available
ERV growth: Higher growth expectations will allow a lower cap rate, as investors will be willing to pay more $ for a given amount of current income since the income will grow
Specific risk of the property: Could come from competition in the specific submarket or from greater macroeconomic factors like interest rates, consumer trends, demographic changes etc. Greater risk or greater sensitivity to risk will require higher cap rates

Question 5

What would you look for in a RE credit deal?

Answer 5

Direct origination - not buying loans in the secondary market that other lenders have originated - all the deals are originating directly with the borrower - gives a lot of control over the structure of the loans they are investing in - especially important in a volatile market
Fundamentally focused on the quality of the RE - high quality assets in strong markets - consider risks associated with lending in worse markets, e.g., Birmingham vs London
Quality of the sponsor they are lending to - GS have an ongoing relationship throughout the duration of the loan but require the sponsors to have quality expertise in the sector, e.g., Blackstone, Brookfield, generational RE families
Downside protection - if the asset is worth more at the end, they get paid the coupon and the par value of the loan regardless - therefore, downside is more of a consideration… not upside