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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 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.

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 whatbubble.com.

-js

When I was a young child I had many annoying tendencies.  My mother explained to me that the most annoying was my need to write on the walls of every room.  I would take my crayons and ruin wallpaper up and down the house.  These actions did not go unnoticed or unpunished.  I would be yelled at, I would be restricted to my room, I would have my crayons confiscated.  When the punishment receded, I would return to my artistic roots and ruin the walls again.  The calculation of damages is still ongoing.

My mother finally learned that I was incapable of controlling my drawing urge.  So instead of trying to get me to stop, she decided to mitigate the destruction.  She bought be washable markers and crayons.  And her trips to pick out new wallpaper were turned in to sponging and washing excursions around the house.  In the end, I got to express myself and she had walls that didn’t make her cringe with embarrassment.  It was a win-win.

What does this have to do with the financial markets or investing?  I think that the average American has a similar problem, only they aren’t excited by writing on walls, they are addicted to buying real estate.  What I’d like to do is find an interim solution so that they can carry on with their investing and I can feel like I have done a little to save their walls (sorry, I always take analogies too far).

At cocktail parties I hear the questions, ‘should I 1031 my profits from my condo sale in to a four-unit apartment building?’  Questions come in to this website, ‘Is it a good idea to take a second out on my house to go in with some friends on a small office building in the next county over?’  My mother asks if she should do a land deal in Fresno – she lives in Los Angeles and has another job.

As someone who is a firm believer in the vicious competitiveness of the American capital markets, I would never suggest that an ill-capitalized novice should make an undiversified bet in something that they only partially understand.  Through almost any analysis, that person should have their financial ass handed to them.  But the American dream is always set squarely in our minds.  So I have a solution, the washable marker if you will.

Readers, if you have the real estate investment bug, try investing in public REITs or (for the more single family residentially-minded) public homebuilders.  The reasons for doing so far outweigh the few added costs. Real Estate Investment Trusts or REITs offer an excellent alternative to buying individual assets, they buy, manage and sell real estate.  Public home builders typically buy large tracts of entitled land and build and sell single family homes. 

Why REITs Are Better than Buying an Office or Apartment Building –

Liquidity -

The first reason is simple, liquidity.  This is something that is dangerously overlooked by individual real estate investors (and in my job, I buy from those sellers).  If you have plunged a significant amount of your hard earned cash in to a real estate asset and you then have a need for it, you are in trouble.  Liquidating real estate is a slow, costly and difficult process.  I understand that selling a home right now seems easy – but selling an office building or apartment building can be extremely difficult.  Also, your ‘need for speed’ will translate in to a lower price for your asset.  Public REITs obviously don’t have that problem, your shares are always liquid and your need to sell will likely not affect the price. [Unless of course you are trying to place hundreds of millions of dollars – in which case you should probably call me and we should date or at least party together.]   Never underestimate the value of liquidity.

Diversification –

Because REITs are large, they typically own many different buildings, rather than just one.  If you’ve read Seneca’s article on diversification, then you can skip to the next paragraph.  When you and your brother scrape together money to buy a single real estate asset, you are taking on a huge, undiversified risk.  If that building has a tree fall on it, catches fire or even just has a couple of pipes burst, you are in a tricky situation.  You have taken on a large amount of building specific risk.  By investing in a REIT you get the value of their diversification.  If one of Sam Zell’s buildings catches fire, it is ok.  Sam (chairman of Equity Office Properties – EOP) owns 699 others that probably haven’t caught fire.  He has spread his risk over far more buildings.  Small real estate investors don’t have this luxury.

Professional Management –

I know that it seems easy to run a building.  You rent it out, collect the rent and spend the money.  But it isn’t that simple.  I am a landlord for a real estate investment company and it takes time and energy to keep a building leased and operating.  To run a building well takes expertise, experience, software, good contacts (among contractors, plumbers, lock smiths, brokers…) and lots of time.  When you buy a REIT you get the benefit of their professional management.  The slight drawback is that you pay for it.  But unless you are planning to quit your day job to run your property, you too will be paying for management.  Additionally, because REITs typically have large portfolios, they can run the buildings more efficiently. They can buy supplies in bulk and cut better deals with service providers.  Try negotiating your leasing commission with a broker when you own one building – then imagine how much easier it would be if you owned 40 buildings.

Virtually Guaranteed Cash Flow –

REITs pay dividends (it is part of their corporate structure, they are obligated to pay out 90% of their taxable income to shareholders.)  If you own your own building there are going to be times when you are funding capital needs and sitting with vacant units or suites. But REITs will pay you every quarter.  Of course there have been situations where REITs have cut or suspended their dividends – but in general the cash flow from owning REITs is predictable.  And yields right now are higher than one would expect.- as an example, EOP is yielding 6% (as of the date of this printing).

The Drawbacks –

There is one large drawback to investing in REITs, you cannot use your 1031 funds without first paying your capital gains.  But with capital gains taxes at low levels, and the froth in the real estate market so high, this would be a great time to pay those taxes and move your money in to something a little less dependent on your own skill and know how.  The second drawback is that you cannot take advantage of your own local knowledge.  If you have better information than the market about a specific asset, then you should think about investing in that asset rather than buying a REIT.  But be leery – often, like with hot stock tips, one usually isn’t as smart as one thinks.  Fees and overhead are also drawbacks.  REITs have to pay great sums of money to accountants and lawyers to publish their results every quarter and comply with federal regulations.  Additionally, they have to pay their brass large salaries to keep them interested and motivated (see my fly away article).  And also, they have the disadvantage of having to disclose to their competitors their pricing and strategy – such is the plight of public companies.

Homebuilders –

Many of the arguments above hold true for the homebuilders as well.  The one difference is that homebuilders are not structured as REITs and thus are not obligated to throw off cash.  However they typically do offer dividends.  They still offer liquidity, diversification and professional management.

In closing, when you are looking at an investment in real estate, be realistic about your competitive strengths and weaknesses.  Be realistic about the time, energy and skill it takes to run a building efficiently.  Have some foresight about your own cash needs and what would happen if you or your family had a sudden need for cash.   REITs and public equities offer an excellent alternative to buying your own buildings.  Give them a look.