To value rental property, it is important to understand how leases determine cash flows and how the valuation models for real estate differ from those for other asset classes.
Like equity analysts, real estate investors need to develop basic valuation skills and be able to determine a property’s prospective cash flows in order to make purchase and sell decisions. Although the different types of cash flows available to commercial properties can add complexity, even simple cash flow models can help an investor determine an approximation of true value.
And for potential purchasers of residential rental property, creating an estimate can help to determine if the property can support a prospective sales price.
Although almost all real estate transactions require that a certified appraisal be completed, an investor’s valuation may differ from an appraisal due to a variety of factors. First, appraisals tend to be backward looking, focusing on the replacement cost of properties and comparing past transactions for similar types of properties to determine a value range. For this reason, appraisals tend to lag the market: They overvalue assets when market fundamentals are deteriorating and undervalue assets when real estate markets strengthen.
Although commercial appraisers will also prepare a discounted cash flow analysis, there may be significant differences of opinion among investors and appraisers about a property’s ability to attract and retain tenants or about the rental rates to assume when projecting a property’s future earnings. Assumptions about investment risk, which take the form of applied discount and capitalization rates, will also differ among investors depending on their opinion on future rental rate growth and space absorption in the market.
A Look at the Income Approach
Most investors determine the value of income-producing property using the income approach. Following the same model used to value stocks or bonds, real estate analysts employ the discounted cash flow (DCF) method to determine an asset’s net present value (NPV).
Incorporating the investor’s assumptions for both market and property fundamentals, the NPV is the price today that will achieve the investor’s risk-adjusted return (discount rate) over the investor’s assumed holding period. The NPV is determined by discounting the asset’s projected cash flow available to owners by the investor’s required rate of return — the rate of return that is required to compensate the investor for the risks involved in owning and holding the property; the value derived is a risk-adjusted value for that individual investor. By comparing the discounted NPV with recent market transactions, an investor is able to make a buy, hold, or sell decision.
Although most real estate investment companies have access to advanced computer models from vendors like ARGUS Software to help them estimate property cash flows, individuals can produce an appropriate valuation using common and available tools, such as an Excel spreadsheet.
Developing a spreadsheet-based valuation can give an investor a good idea of value for most income-producing properties.
Income-producing real estate can be valued in a way similar to that of equities or bonds, specifically by discounting or capitalizing property cash flows. The only difference in the valuations is that the cash flows (instead of resulting from loans or other debt instruments, or from company operations) are derived from leases that dictate the rental income tenants must provide for using leased space.
Finding opportunities in the real estate market often requires that buyers find properties that are undervalued by the market. In order to sell property above market value, owners need to manage properties at a level that surpasses market expectations. In order for owners and prospective buyers to make good investment decisions, valuations must accurately estimate a property’s future income-producing potential.
Valuing Real Estate
A commercial real estate property derives the predominant amount of its revenue from contractual leases that generate rental income. In addition to spelling out the amount of rent that tenants are obliged to pay each month, leases will denote any future increases in rent (rent escalations) or rent concessions, capital costs to be borne by the landlord, as well as any options for additional space in the future.
Leases will also lay out how much of a property’s operating expenses must be borne by the tenant and how those expenses are calculated. Total revenue is determined by estimating any other income (additional or ancillary income, such as parking or retail revenues) and adding it to rental income.
Commercial properties will also derive income in the form of operating expense reimbursements, which are property expenses borne by tenants. Calculating the actual amount that a tenant must reimburse the landlord for operating the property will usually depend on the lease type.
The most common leases are one of three types: full service leases, net leases, and triple net leases. The differences in these contracts revolve around how property expenses are allocated among tenants. With full service leases, tenants do not pay anything above their stated rent. In net leases, tenants usually do not pay any expenses for the first year of their rental but pay their pro-rata share of any increase in operating expenses for the rest of the rental period. Triple net leases oblige tenants to pay their pro-rata share of all property operating expenses. Once reimbursements are calculated, they must be added to rental income to arrive at total property revenue.
As with any discounted cash flow analysis, to value real estate, analysts must estimate a property’s potential income during the proposed holding period. All expenses must also be modeled and deducted from revenues to determine net operating income (NOI). Any capital expenses are then deducted from NOI to determine the property’s cash flow. A reversion or selling price for the property is derived by dividing the property’s income at time of sale by an appropriate cap rate. The property’s cash flow and reversion are then discounted by an appropriate discount rate or required rate of return (RROR) to determine its present value.
The image below provides assumptions that can be used to produce a simple valuation model that can be used to value most income-producing properties:
If we assume that the building is fully rented and that leases expire well after the holding period, the previous assumptions and model factors result in a cash flow estimate and valuation as can be seen in this excel spreadsheet: Real Estate Valuation (the analysis for properties that are not fully leased or that have expirations during the analysis period would need to include the timing and velocity of new leasing and the extra income and expenses that would result from leasing new space and for lease renewals):
The discounted cash flow analysis shown in the attachment is a valuation (from assumptions in the image below) of a 100,000 square foot, fully leased building. The in-place rents (starting at $20) grow at a rate of 4% per year until Year 10, at which time rental growth slows to 3% per year. Because tenants have net leases, only a portion (50%) of operating expenses are recovered as additional income. Other income, such as parking or retail revenue, is assumed to equal 10% of rental income. On the expense side, operating costs average 40% of rental income, and capital expenses to maintain the property are assumed to be 1% of total income.
The value of the property in the reversion Year 10 is determined by dividing a stabilized income stream from Year 11 by a reversionary capitalization rate. The cap rate (which equals the inverse of the income multiplier or P/E) is equal to the income return that investors would require for purchasing the property. The cap rate is derived by subtracting the anticipated growth in income from the investor’s required rate of return (k – g), or in the case of this valuation, 11% – 3% = 8%. By capping Year 11 NOI by 8% or multiplying it by the income multiple of 12.5 (1/0.08), we can determine the value of the property in Year 10 as approximately $33 million. The reversion is then added to the property’s cash flow, which is then discounted at the investor’s required rate of return (11%) to achieve a NPV of $23.74 million.
The Investment Decision
If the projected holding period cash flows are correct, the discounted net present value of a property is the purchase price that will provide investors with the required rate of return. Because the RROR should take into account all investment risks, if buyers can purchase the property for an amount equal to or less than the assessed value, then they should have a high probability of achieving the appropriate investment return for the risks involved.
If the valuation is being performed for the property owners, then they should be interested in any purchase offers that exceed the property’s NPV or intrinsic value. If offers do not exceed the owners’ assessment of the property’s intrinsic value, then the owners may wish to hold the property until disequilibrium in supply and demand forces prompt market prices to rise.
Although many investors use financial engineering and leverage to enhance investment returns, financing should not affect the purchase decision. To make the financing decision, investors should simply conduct both a standard and leveraged valuation to see if the potential increase in the leveraged returns will more than compensate them for the financial risks (default risk for one) that are involved. When conducting the leveraged valuation, the investor’s RROR or discount rate should be increased to include the prospective financing risk. Although purchasers should buy on unleveraged valuations, financing should be considered when determining the right time to sell a property. Financing structures can carry certain restrictions and penalties (prepayment penalties for instance) that can impede a sale or significantly reduce the net sales proceeds of a transaction. Maintaining beneficial financing can be an impetus not to sell a property especially similar financing arrangements are no longer available and cannot be transferred to a new purchase. In addition to reinvestment risk, there is the risk of not being able to finance assets in a manner that appropriately compensates investors for the financial risks involved.
Even if you do not have access to sophisticated real estate valuation tools, it is possible to create an accurate enough cash flow estimate and valuation of real estate properties to help with the purchase or sales decision. The formulas for calculating NPV from a series of periodic cash flows are straightforward and included in most spreadsheet programs. The basic model is the same for all property types, although how income is generated and how expenses are incurred may be different depending on the type of commercial property being analyzed. For example, a hotel is simply a commercial real estate property that has many tenants and very short leases (as short as a one-night stay).
Once the analyst has reviewed the local market and gained information on certain fundamentals, such as rental rates, lease structures, leasing commissions, capital allowances, tax rates, and other market standards, then these factors can be included in the valuation model to help achieve a better estimate of value. Once a property’s intrinsic value has been determined, it can be compared with offering prices and other market transactions to determine if it is being under- or overvalued by the marketplace.
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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
Photo credit: danchristie