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Basic Real Estate Valuation
Given the current interest (dare I say hysteria) associated with investing in dirt and buildings, I thought it might be interesting for our readers to have a quick, dirty manual on real estate valuation. My perspective comes from years in the industry as well as some time learning at the knee of some of the better real estate minds in academia. I will separate (to some degree) 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 one's home is locked in the pleasure one gets from living in it, or consuming it. Although there are certain ego strokes to owning large buildings, an edifice complex - if you will, the value associated with land, apartments, office buildings and warehouses is locked in 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 degree to which it will provide cash flow to its owner. It is important to see office buildings, not as office buildings, but as rent creation machines. One should see land, not as dirt, but as an option to build and rent out or sell - and thus, 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 are hard to estimate?' I hear your questions, and they are good ones. 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 piece of land. There is the Discounted Cash Flow method, or DCF, there is the Cap Rate method, there is the Replacement Cost method and there is the Comparable method. Each one 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 any capital asset. DCF is the process of forecasting cash flows forward for some realistic period of time (any investment banking analyst will have done so many 10-year DCFs that he or she will be seeing them in their sleep) usually five or ten years and then discounting those cash flows back to the present to find the current value of the building. I am not going to get in to the ins and outs of choosing the appropriate discount rate (but maybe one of my fellow columnists will) but suffice it to say that the appropriate discount rate should take in to account the relative surety of the future cash flows (or more precisely, the risk associated with the cash flows specific to this asset). The cash flows include the rents or the cash that will be spit out as well as the terminal value (or the value that the building will fetch at a sale (less transaction costs) at the end of the analysis). Below is an example of a DCF analysis. Notice how one might value the building very differently depending on one's discount rate. Assume that the asking price for the building is $150 - perhaps this wouldn't be such a great investment. Building a simple model on excel and fiddling with rent flows and terminal values will show how sensitive these analyses are to even small changes. The advantages to this type of valuation are that if you are relatively sure about the future cash flows and understand the true cost of your capital as well as the correct discount rate for this type of asset, then one can get a good idea of what to bid or what you'd be willing to pay for an asset. Of course, the disadvantages are that if someone can accurately predict anything for the next ten years, I want to meet them and buy them anything they want - they are worth my weight in gold (no small number I assure you). Also, choosing the right discount rate is an art and not a science, as such, it is not only difficult, but it is also prone to be tinkered with. Or in other words, many of my colleagues (and JS is not to be held out as better than anyone else) as well as myself have worked backward to get to the asking price. Or we have done the model and then chosen the discount rate in order to arrive at a value that will in fact make the building trade. In general, I don't favor this type of valuation. It is too sensitive to judgment / errors and doesn't take in to account the vagaries of the market. Additionally, this method doesn't work well with land, vacant buildings, redevelopment opportunities or any type of asset that has no cash flow or extremely difficult to predict cash flows. Cap Rate The Capitalization method or cap rate method is similar to the DCF method. In fact, it is really just a shortcut for the DCF method. The following equation explains what a cap rate is: First Year NOI ÷ Building Purchase Price = Cap Rate NOI is Net Operating Income. NOI is basically cash flow from a building, excluding debt service and income taxes (not real estate taxes). As an example, if we take the building from the above DCF Analysis and we assume a purchase price of $100 and an NOI of $10, the cap rate is 10%. [$10 / $100 = .10 or 10%]. In order to use the cap rate method to find out what to pay for a building, one only needs to understand two things, the expected NOI for the year after purchase and the cap rate for similar assets (and this usually means tenants) in the market. If you deconstruct this method it begins to look like a DCF valuation - but those similarities and why they may or may not make sense is better saved for a later column. NOI is Net Operating Income. NOI is basically cash flow from a building, excluding debt service and income taxes (not real estate taxes). As an example, if we take the building from the above DCF Analysis and we assume a purchase price of $100 and an NOI of $10, the cap rate is 10%. [$10 / $100 = .10 or 10%]. In order to use the cap rate method to find out what to pay for a building, one only needs to understand two things, the expected NOI for the year after purchase and the cap rate for similar assets (and this usually means tenants) in the market. If you deconstruct this method it begins to look like a DCF valuation - but those similarities and why they may or may not make sense is better saved for a later column. In commercial real estate, this is the most common method of quoting property prices or talking about valuations. Brokers will talk about buildings 'trading at an 8 cap.' That means that a building sold at 12.5x its first year NOI. Be careful to delineate between 'in-place NOI' and 'projected' or 'pro-forma NOI.' Also be careful to accurately predict capital contributions needed to keep a building leased or lease-able. Because cap rates only take in to account NOI, they often don't differentiate between buildings that require massive amounts of capital and labor to keep up and ones that don't. In general, this is a great short-cut to decide if a building is worth doing more work on. Cap rate analysis is just a starting point in deciding what to bid for a property. But understanding market cap rates (or the average cap rate that assets have been trading for) is a very valuable metric. I would place this as the second best method for valuing real estate. Replacement Cost Analysis The replacement cost analysis is exactly what it sounds like. The replacement cost is the cost to recreate that exact asset in that exact location. A good replacement cost analysis will not only take in to account land values and building costs but also developer profit and carrying cost for construction debt. Although brokers often say 'this is going to trade below replacement cost' it is often not the case and also, that is usually not a relevant metric. The replacement cost is a backward looking metric and one that doesn't take in to account the most important thing, what the building will be able to earn right now. Remember, cash is king. I will say that in general, this method is unhelpful. The argument that if you buy something under replacement cost, 'you can only get hurt if no one ever builds here again' is a shabby one. If you are buying in a vibrant market with high volatility, this argument could have some merit. But unless you are getting an off-market deal or there is some reason to believe that other informed buyers haven't been made aware of the deal you are exploring, you should ask yourself why you can buy something at below replacement cost. Comparable Analysis This is the most important method for valuing any type of asset, but it is especially helpful in real estate. The comparable method or comp method is simply looking for assets in the market that are similar to the one you are acquiring and looking at what they have traded for on a per square foot, per acre or per unit basis. If you are paying more, then everyone else in the market, there had better be a good reason. And if you are paying less, figure out why. This method is best for 'hard to value assets' like vacant buildings, land and residential homes. For those items, cash flows are non-existent or too difficult to estimate. Embedded in this method of valuation is a central theme, that of the efficient market. So long as there are ample bidders and relatively fair market disclosure the prices at which assets have been trading are probably the best indication of their value. If you have more specific questions about another method or about something in this article, please do not hesitate to write me or post it to http://www.whatbubble.com. J.S. Silver is a real estate investor and co-editor-in-chief at whatbubble.com. If you would like to post your own comments, or have any financial questions answered by an expert for free or if you would like to just read more on this subject please visit http://www.whatbubble.com. If you wish to re-publish this article, we request you retain all links.
MORE RESOURCES: L.A.âs Real Estate Upfronts Reveal Penthouse A at Rosewood Residences Beverly Hills Hollywood Reporter Real estate mogul cautions about avoidable mistake when buying a home, explains how to avoid 'drowning' Fox Business Massachusetts real estate transactions for Hampden, Hampshire and Franklin counties May 19, 2024 edition MassLive.com Real estate transfers: May 17, 2024 RiverheadLOCAL London Real Estate Is About to Get the âSelling Sunsetâ Treatment Hollywood Reporter Real Estate Newsletter Articles this Week: Housing Starts Increased to 1.360 million Annual Rate in April Calculated Risk Mid-May Greenwich Real Estate Market Report Greenwich Sentinel Should I Buy a House Now or Wait Until 2025: Expert Forecast Norada Real Estate Investments Dodge County Real Estate Transfers Fremont Tribune The Michael Houck Real Estate Guide for May 19 Oil City News Washington state ahead of the game as lawsuit rewrites real estate commission rules The Business Journals MCB Real Estate Revives Long-Awaited Viva White Oak Mixed-Use Project Source of the Spring STAR resource center Department of Taxation and Finance Yes, there are other coastal Delaware towns besides Rehoboth Washington Blade Dutchess County, NY real estate 2024: What's on the market for $579K Poughkeepsie Journal Baltimore real estate: 4 waterfront condos for sale The Baltimore Banner Revolution in real estate: How the NAR settlement is changing the game Eden Prairie Local News Real Estate Briefs: Lakeside homes, news condos, and more news Rough Draft Atlanta Home Prices Hit Record Highs in April 2024: Trends & Forecast Norada Real Estate Investments REAL ESTATE | UPDATE | Johnson Bus selling lot for new West Bend Fire Department No. 1 washingtoncountyinsider.com VIDEO | REAL ESTATE | Construction finally underway for Taco John's in West Bend, WI washingtoncountyinsider.com Coloradans negotiating lower fees for real estate agents with new law on horizon Colorado Public Radio Innovative Leaders Vanderstraaten and Rohrman Inducted into North Texas Commercial Real Estate Hall of Fame ... dallasinnovates.com James Quinn's Data Center Advisory Expertise at JLL Drives Innovative Real Estate Solutions for Global Corporations Markets Insider Oceanport's Denholtz recognized by commercial real estate organization themonmouthjournaleastern.com Here are recent property transfers up to $1.28 million St. Albans Messenger Westmoreland County Real Estate Transfers | Real Estate | latrobebulletinnews.com latrobebulletinnews.com Real Estate Mogul Grant Cardone Closes Largest All-Cash Multifamily Deal In South Florida This Year Yahoo Finance Routt County real estate sales at $17.6M for May 9-15 Steamboat Pilot & Today China Says It Will Start Buying Apartments as Housing Slump Worsens The New York Times OT Real Estate Spotlight of the Week: 2115 Sheridan Place The Owensboro Times Robert Willett may be targeting female Realtors in Northeast Ohio Akron Beacon Journal Refined Real Estate: Unique Leschi home with lake views lists for $1,395,000 seattlerefined.com Number of homes for sale in Metro Atlanta increased significantly, real estate brokerage says â WABE WABE 90.1 FM Billy Joel spends over $10M for sprawling East Hampton pad with horse farm, neighbors other A-listers New York Post What's real estate wellness? 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