Valuing Real Estate
An analysis of comparables
Discounting cash flows
Considering redevelopment options
Two Distinct Questions
Are specific asset classes and locations over or
undervalued?
– Industrial versus residential
– Chicago versus Dallas
– Need to evaluate growth opportunities and discount rate
Are particular properties within an asset class over or
undervalued?
– Evaluating an Austin office building on 6th and Congress
– An analysis of comparables
Old and new valuation approaches
Valuation using standard industry practice
Valuation using the “theoretically” best approach
Use a combined approach that depends on your expected holding
period. If your holding period is short, resale value plays an
important role.
The Keynes beauty contest: Don’t pick the most beautiful property,
pick the property that others consider the most beautiful.
Three Valuation Techniques
Valuation relative to comparables
Replication values
Discounting cash flows
Ultimately, we are interested in DCF, however, replication values and
comparable values provide information about future cash flows.
Capitalization Rates
We tend to think about property values in terms of Cap rates: The income
on a property divided by the property value
i 1
CFi (1 g)
, CF1
(1 ) i
g
i 1
where - g is the capitalization rate.
Example: CF1 = 1,000
g = .05
= .14
PV = 1000/(1.14) + 1050/(1.14)2 + 1102.50/(1.14)3 + . . .
= 1000/(.14-.05) = 1000/.09 = $11,111
Why do these rates differ across properties and over
time?
Differences in growth rates
Differences in discount rates
How do market wide cap rates covary with the price/earnings ratio
on stocks?
Should cap rates vary more or less than interest rates over time?
Depends on the correlation between interest rates and
growth rates
Comparables
All the methods to value real estate within an
asset class essentially value the assets relative
to comparables
The problem is that most assets are unique
We use models as a way to think about how to
make adjustments when comparing properties
that are not exactly the same.
2,000 SF 2,000 SF 2,400 SF 2,400 SF
$160,000 $180,000 $200,000 ?
Required Adjustments
Size
Location
Time of sale
Quality and architectural style
Market conditions
Air rights etc.
Adjustments (Continued)
Characteristics of the seller (is he desperate)
Characteristics of the buyer (is this part of a larger parcel)
Financing terms (was there seller financing, are the properties
equally attractive to lenders)
Redevelopment options
Structure of leases
Tenant quality
Making the adjustments
Gut feel
Additive adjustments
– Appropriate for added square footage and amenities
– How much is a swimming pool worth?
Multiplicative adjustments
– Appropriate for quality adjustments
Hedonic regression approach
– Regress value per square foot on quality, location and amenity
variables
– Important to correctly specify additive and multiplicative factors
– Requires a lot of roughly comparable transactions
What Determines Discount Rates
Risk
– Location, property type, lease structure, tenant quality
Financing opportunities
– Determined by risk, cash flow duration, borrower reputation,
size of the acquisition
Rule of thumb:
– Projects with maximum leverage have residual returns to
equity that are about equally risky and should thus have the
same required rate of return.
Backing out discount rates and cap rates
It is generally difficult to find true comparables that do
not require substantial adjustments
Discount rates and cap rates are likely to be less
sensitive to adjustment errors than values
– e.g., a class B office building sells for substantially less per
square foot than a class A office building. However, they may
have the same discount rates and the same cap rates if
expected risk and growth rates are the same.
In general one will want to make adjustments
– differences in risk and the duration of the cash flows.
– Size of the deal and the availability of financing
Backing out discount rates when properties
are directly comparable
Step 1: Find a directly comparable property that sold
very recently.
Step 2: Estimate the property’s cash flows and use
these to calculate the IRR of the property
– Remember: Use cash flows, not NOI
Step 3: Use the IRR as the discount rate for the
property being evaluated.
Why not use the CAPM to determine the discount rate?
What determines differences in risk?
Profit margins
– Higher fixed costs imply higher risk (the operating leverage
effect)
Location
– Are CBD locations likely to be riskier or less risky than
suburban locations?
– Diversified versus focused cities
Redevelopment options
Cash flow duration
Structure of leases
Tenant quality
Multiple versus single discount rates
Should cash flows in year 3 be discounted at the same
rate as cash flows in year 10?
Everybody uses single discount rates
– Should they?
Do different properties have different durations?
– If the properties have the same durations it does not matter.
– If the properties have very different durations, the following
considerations matter.
Is the term structure flat?
How does uncertainty evolve over time?
An analysis of two properties
Property A: A downtown office building where tenants all have 3
year leases, approximately 1/3 roll over each year.
Property B: A very similar downtown office building. Half of the
building is covered by 3 year leases. However, the other half of
the building is leased to a single tenant on a ten year lease.
How do the risks of these properties compare.
Do the risks change over time?
Would you use a different discount rate for the properties?
What determines differences in cash
flow duration?
Growth rates
Maintenance needs
New supply
What is actually done in practice?
Do investors do more than simply divide NOI by cap rates?
– Austin currently has relatively high cap rates because vacancies are
expected to increase and lease rates may decline. Do buildings with
longer leases and higher quality tenants sell at lower cap rates?
How do they quantify differences in tenant quality?
Do REIT managers evaluate properties differently than private
market investors because of a need to satisfy public
shareholders?
– Will they pass on properties with high vacancies and low current NOI
because of earnings dilution concerns?
– Does this offer opportunities for other investors?
Choosing between real estate asset
classes
Requires an opinion on growth rates
– E.g., is there likely to be job growth requiring office space?
Requires an opinion on discount rates
Example: Suppose that Dallas hotels have recently sold at a cap rate
of 14 and Dallas office buildings have recently sold at a cap rate
of 10. What are the possible growth rates and discount rates that
would justify these cap rates?
Forecasting Future Cash flows: Demand
Considerations
Office: Derived from job growth, especially financial services, legal, and
technology
Industrial: Industrial output and inventories
Retail: GDP, the stock market
Multi-Family: Demographics, immigration, tax policy, GDP and
distribution of income
What is the elasticity of demand?
Forecasting future cash flows: Supply
Considerations
Availability of land
Zoning policy
Age and quality of existing structures
Credit conditions
Current construction
What is the elasticity of supply?
Do different asset classes have different
discount rates?
Some asset classes are clearly riskier
– Hotels versus multi-family
Some cities are clearly riskier
– Manhattan, NY versus Manhattan, Kansas
How important are these differences in risk
– Are we talking about diversifiable or non-diversifiable risk
Example: ABC Properties
ABC Properties owns and develops regional shopping malls. Because of the
distinctive designs of their malls, and the strength of their anchor tenants,
their malls have been very successful in medium size cities in the west,
e.g., Denver, Salt Lake City, Phoenix, Portland and Seattle. They currently
own 12 malls in these cities and subject to economic conditions, they
expect to add one mall per year for the next 10 years.
Suppose ABC is about to go public as a REIT:
How would you value ABC Properties for the IPO?
As a potential investor what issues would you raise with ABC management to
help you value their growth opportunities?
Valuing REITs
Three Step Procedure:
1. Value the individual properties to calculate an NAV.
How do you adjust for the difference between public market and private
market valuations?
2. Evaluate other ways in which the firm generates NOI. What is
the appropriate cap rate for these activities.
3. Calculate the value of growth opportunities.
Arising because of special expertise, brand values, etc.
Corporate goverance issues
Adjusting REITs for leverage
NAV = Property Value – Debt
Will more highly levered firms have greater FFO as a proportion of
NAV?
– Depends on the relation between interest rates and cap rates
– Should more highly levered REITs sell for a greater premium relative to NAV
What is the relation between dividend yield and leverage?
– More highly levered REITs are more conservative about paying out
dividends because they are riskier, but could still have higher yields because
eps is likely to be higher.
What is the relation between leverage and growth opportunities?
– How is this likely to affect the relation between leverage and the premium
relative to NAV