When discussing valuation, we often use real estate transactions to give a context or framework. To many people, valuing a company is an abstract thing, with its many moving parts and variety of assets. However, a real estate asset is totally tangible and something that most people can understand. For example, a leveraged buyout, in its essence, works the same way as buying a home. We put down very little equity, 20% or even less if it’s allowed, and the rest is financed with debt (or leverage). If the value of the house goes up over the life of the loan (often 30 years in length), the increase in value over the purchase price belongs entirely to the owner once the debt is paid off. Another real estate example that is often used in discussing valuation is the concept of comparables. Anyone who has ever looked at renting or buying real estate has used comparable properties to help determine if the value is commensurate with the market.
In practice, real estate valuation can be more intuitive and more complex than the valuation of a traditional non-real estate corporate entity. In most cases, real estate assets increase in value over time and are the primary drivers of value in a real estate transaction. Coming to terms with the market value of the real estate assets will get us much closer to the ultimate value. This is not the case with non-real estate corporations which may own valuable property or building assets, because a company’s value is most likely driven by other factors. Here I will discuss some of the challenges and complexities of real estate valuation.
1. The future is still the future
Regardless of the target, valuation is rarely done in retrospect. Of course, established track records and strong earnings histories make great cases for high valuations, but if the outlook for the company or industry is not strong it is not likely to fetch much. If a real estate asset is being purchased solely as a value play, meaning that it is underpriced or there is an expectation that buildings will increase in value in the near future, then the current market price is the only thing that needs to be considered. However, in most cases, buildings are purchased to generate future earnings in the form of rents and services. Therefore, a sound forecast that considers all the various ways a building can generate cash flow is critical. The model will have to factor in such issues as vacancies, rent increases, tenant improvements, lease types, etc. Adding to the complexity is the fact that most buildings are not purchased empty, meaning that due diligence must be done to determine the value of the current leases.
2. Often used metrics like cap rates have limits
A cursory glance at commercial real estate listings might reveal metrics such as cap rate or yields being mentioned. Cap rate, or capitalization rates, are the initial return expected on a property based on its forward net operating income or NOI. NOI is very similar in theory to EBITDA in that it is an unlevered, pre-tax, cash flow based, operating-earnings driven metric. The formula for cap rate is:
Net operating income (NOI) of next twelve months / Market value of the building
If there is a current asking price for a building, this would serve as the market value (a negotiated sale price could also be used). Cap rates do use future earnings but are limited to the next twelve-month earnings. This is incredibly shortsighted when considering the long nature of a building asset.
3. Are we dealing with a single asset, a collection of assets, or a real estate company?
If we are buying a single asset or even a selection of assets, then the analysis is much simpler. We can look at those buildings in a number of ways to determine what it is we need to pay for them. We can use cap rates or a similar metric. However, if we are purchasing a collection of buildings or valuing a REIT (Real Estate Investment Trust), then calculating a cap rate for multiple buildings becomes much more involved or even impossible.
Furthermore, once we have begun looking at real estate corporations and REITs, there are other factors that drive earnings such as the quality of management and other intangibles. The valuation begins to look a lot more like a traditional non-real estate corporate. There is also a wide variety of revenue streams from the various real estate assets, as well as partly or jointly owned assets and fees to operate and manage the buildings. A Net Asset Valuation is a real estate-specific approach that calculates the market value of a wide variety of real estate assets and revenue streams.
4. Tax is a major driver
The relative liquidity of real estate assets is what makes valuation unique compared to other companies and assets. However, sales of real estate also trigger major tax events due to the often-rising nature of property prices and long hold periods. Most real estate operators work diligently to minimize or postpone taxes. This is one of the key advantages of the REIT structure.