Valuing a property

If I paid $100M for a building and it has 75% leverage, how much does it need to sell for to double my equity?

$125M. With 75% leverage, you would invest $25M of equity and borrower $75M of debt. If you doubled your equity, you'd get $50M ($25M x 2) of cash flow to equity and still need to pay down $75M of debt. $50M of equity + $75M of debt = $125M sale price.

The Debt Yield (DY) is useful to lenders as it represents the

lender's return on cost were it to take ownership of the property.

At the market level supply often increases, which gives you

less bargaining power over your tenants and generally lowers rents

The Debt Service Coverage Ratio is calculated by

dividing the net operating income by the debt service payment. It is often expressed as a multiple (i.e. a DSCR of 1.20x).

When projecting out cash flows make sure your leverage isn't

driving you returns

IRR is the percentage return achieved on

each dollar invested for each period it is invested.

Core plus property owners typically have the ability to increase cash flows through

light property improvements, management efficiencies or by increasing the quality of the tenants.

Real estate lenders use the loan-to-value, together with debt yield, debt service coverage ratio, among others to assess the risk of a

loan and arrive at an appropriate loan amount.

Unstabilized is when the property requires...

major renovations, high expense ratios, below markets rents and higher than market vacancy rates. Usually value add plays

To find sales comps look at

-Zillow or Loopnet -Pull market reports from brokerage

Three ways of valuing Real Estate:

1. Cap Rates: 2. Comparable Transactions: 3. Replacement Costs:

Walk me through a DCF

1. Project out cash flows for 5 - 10 years depending on the stability of the company 2. Discount these cash flow by WACC to account for the time value of money 3. Determine the terminal value of the company using an exit multiple where steady CF growth might not be a valid assumption (high-growth tech companies) beyond your projected time horizon, so that market sentiment is incorporated (can use perpetual growth model but not often used) 4. Discount the terminal value to account for the time value of money 5. Sum the discounted values to find an enterprise value 6. Subtract Net Debt and divide by diluted shares outstanding to find an intrinsic share price

The riskiest RE assets are

1. hotels 2. Office 3. MF

If the cap rate is 7% investors get a

7% return

Secondary mortgages are most common when the senior mortgage is less than

70% of the capital stack, such that the combination of the senior and junior mortgages total 70% to 80% of the total capital.

As a general rule, it's a problem if more than

70% of your profit is coming from appreciation on the sale

As a general rule of thumb, the senior mortgage is usually no more than

70-75% of the total capital stack.

Core Plus' is synonymous with

'growth and income' in the stock market and is associated with a low to moderate risk profile.

Value-Add' is synonymous with

'growth' in the stock market and is associated with moderate to high risk.

Opportunistic is also synonymous with

'growth' in the stock market, like 'value-add,' but it is even riskier.

Default Ratio =

(Debt Service + Operating Expenses) / Gross Operating Income

Equity Multiple =

(total profit + max equity invested) / Max equity invested

The Real Estate Setup:

- Potential Gross Income plus reimbursement income less vacancy and credit loss = Effective Gross Revenue - Subtract out operating expenses (Common area maintenance (CAM), insurance, taxes) = NOI - Subtract out leasing and capital costs to get Cashflow from Operations or free and clear cash flow available to cover debt service (Unlevered) - Subtract out debt service and any ground lease payments to get Cashflow after financing (Levered)

Types of RE Investments:

-Opportunistic -Value Add -Core Plus

Real estate investors make their money in 3 primary ways:

-The yield from the initial cap rate -Juicing the cap rate with high debt -Cap rate compression

Walk through a basic cash flow proforma for a real estate asset.

A: The top line is revenue which will be primarily rental income but might also include other revenue lines and will almost always include deductions for vacancy and leasing incentives like rent abatements and concessions. After revenues you subtract all operating expenses to get to NOI. After NOI, you subtract any capital expenditures and account for purchase and sale of a property. This will get you to unlevered cash flow. To get from unlevered to levered cash flow you subtract financing costs. BE ABLE TO DRAW ONE FROM SCRATCH

NNN (triple net):

All expenses are paid by the tenant Effective Rent > Base. Revenue is = to NOI

For that same building with $60M NOI at a 4.0% cap, what's my Y1 cash on cash yield if I issue 50% leverage at a 5.0% fixed cost?

Answer: Cash on cash = (pro forma levered cash flow) / (equity invested). In this example, the building is worth $1.5B and you issue $750M of debt, so you invest $750M of equity. You know NOI is $60M and your interest expense is $37.5M, so your Y1 LCF is $22.5M. $22.5M LCF over $750M equity is a 3.0% Y1 cash on cash.

- Fee and Clear Return =

CFO/Value in a given year

Comparable Transactions:

Can inform per unit or per Sq. foot valuations or current market cap rates

Why would a seasoned multifamily investor consider capital maintenance to be an operating expense rather than a capital event? What impact does this distinction have on valuation?

Capital maintenance expenditures keep the roof from caving in. These expenses are guaranteed to recur every year, thus they're as much of an operating expense as others such as utilities, insurance, and property taxes. Unsophisticated investors often forget to include a capital maintenance reserve in their NOI, thus their valuation is inflated. This mistake often leads to an erroneously high valuation

Typical metrics for the income capitalization approach are

Cash flow (EBITDA or NOI multiple) IRR/NPV basis

If you purchase a property for $1M at a 5.0% cap rate with 60% leverage and a 5.0% fixed cost of debt, what is the cash-on-cash yield?

Cash-on-cash yield = levered cash flow / equity invested and levered cash flow = NOI - cost of debt. 60% leverage implies $600k of debt and $400k of equity invested. A $1M purchase price at a 5.0% cap rate implies $50k of annual NOI. $600k of debt at a 5.0% fixed cost implies $30k annual cost of debt. $50k annual NOI - $30k annual cost of debt = $20k of levered cash flow. $20k levered cash flow / $400k equity invested = 5.0% cash-on-cash yield.

In commercial real estate, there are a few generally accepted methods for appraising (or valuing) real property. The three most common are the .

Cost Approach, the Sales Comparison Method, and the Income Approach

The Income Approach includes two methods,

Direct Capitalization and Discounted Cash Flow.

The second method of the Income approach, uses the

Discounted Cash Flow to calculate the present value of a real estate investment's forecasted future income and reversion value. The Income Approach is the most common appraisal method used to evaluate income-producing real estate."

The formula for Net Operating Income is:

Effective Gross Income - Operating Expenses = Net Operating Income

Types of leases:

Full service gross NNN (Triple Net) Modified Gross

the DCF is broken into three parts:

Investment Cash Flows, Operating Cash Flows, and Reversion Cash Flows.

Modified Gross:

Janitorial, Utilities and Gross Receipts Tax are reimbursed on a net basis (think the same structure as an NNN lease) while all other expenses are reimbursed over a base year. Both the "net" portion and the "base year" portion are reimbursed on a prorata basis. Prorata simply means your proportionate share, which is calculated by dividing the specific tenant's square footage by the total square footage of the building. So if the building is 100,000 SF and the tenant's space is 10,000 SF, the tenant's respective share should be 10%.

Make sure most of your profit isn't coming from

appreciation on the sale instead of income during the hold period

- Cash on Cash Return =

Levered Cash flow /Equity

Full-service gross:

Listed base rent is the effective rent you get. No Reimbursements

Loan to Value (LTV) =

Loan Amount ÷ Property Value

- LTV =

Loan amount/property value

A cap rate is the

NOI / Property (sale) value

- debt service coverage ratio (DSCR) =

NOI/Debt Service Debt Service = Current Debt = Interest *(1-tax rate) + Principle

- Debt Yield =

NOI/Loan Amount

- Funds from Ops =

Net Income + Dep + Amort. - Gains from sales

Debt Yield is the ratio of

Net Operating Income (NOI) to the mortgage loan amount, expressed as a percentage. Want it to at least be 10%

Debt Yield (DY) =

Net Operating Income ÷ Loan Amount

Debt Service Coverage Ratio (DSCR) =

Net Operating Income ÷ Loan Payment

The sum of the cash flows from each section result in a

Net Unlevered Cash Flow. Once we layer in debt, the sum of the cash flows from each section is called Net Levered Cash Flow.

Replacement Costs:

Never purchase a property for more than you can build it new

- Operating Expense Ratio =

Operating Expenses / Revenue measures costs to operate vs income it generate

Cap Rates:

Property Value = NOI/Market Cap Rate

- Floor Area Ratio =

Ratio of area of floor to land

If you had two identical buildings that were in the same condition and right next to each other, what factors would you look at to determine which property is more valuable?

Since the physical attributes, building quality and location, are the same, I would focus on the cash flows. First, I would want to understand the amount of cash flow. You can determine this by looking into what average rents are in the buildings and how occupied the buildings are. Despite the same location and quality, the management and leasing of each building could be different leading to differences in rents and occupancy. Second, I would want to understand the riskiness of the cash flows. To assess this, I would look at the rent roll to understand the creditworthiness of tenants and the term of leases. The formula for value is NOI / cap rate. NOI will be informed by the amount of cash flow. The cap rate will be informed by the riskiness of the cash flows. The property with high cash flow and less risk will be valued higher.

There are three primary methods for valuing a property.

The sales comparison approach The income capitalization approach The discount to replacement cost approach

If you purchase a property for $1M at a 7.5% cap rate, have 0% NOI growth throughout the hold period, and exit at the same cap rate after 3 years, what is your IRR?

We know that NOI / cap rate = value. If a property's NOI and cap rate do not change, then the value also remains the same. Because there is 0% NOI growth and after 3 years we are selling the property for the same 7.5% cap rate we purchased it for, we will sell the property for $1M, resulting in no terminal value profit. Since there is no terminal value profit, the only profit comes from interim NOI, which is simply $1M x 7.5% and remains constant each year. Because IRR is our annual return, in this case, our IRR equals our cap rate, or 7.5%.

In the Sales Comp approach you need to

accurately find buildings that are most similar to the one you're looking at. Location, age, tenant profile, recent renovations etc.

ground-up developments are when you

acquiring an empty building, land development and repositioning a building from one use to another are examples of opportunistic investments.

For the industrial sector cap rates are relatively low because of the

benefits from e-commerce trends, longer term leases, and simple operations.

unsecured debt is most often utilized by large firms with the ability to

borrower based on the strength of their balance sheet.

Flaws with the cash flow approach / income capitalization approach are that it often assumes

both the market conditions and that asset conditions will stay the same.

For the office sector cap rates are averagely high because office is closely correlated to the

broader economy but has longer term leases.

All real estate assets are valued off

cap rates

only the entry and exit yields are referred to as

cap rates

The real estate capital stack is the collection of

capital sources, both debt and equity, used to fund an investment.

Opportunistic properties often have little to no

cash flow at acquisition but have the potential to produce a tremendous amount of cash flow once the value has been added

Value-add properties often have little to no

cash flow at acquisition but have the potential to produce a tremendous amount of cash flow once the value has been added.

Income Capitalization Approach or Cash Flow Approach is when you value the property based on the

cash flow it is spitting out every year

Types of equity in real estate include

common equity and preferred equity.

The Sales Comparison approach is the most

commonly used approach, especially in residential real estate but used extensively in commercial real estate too

The sales comparison approach involves looking at

comparable buildings to see what they sold for

Discount to replacement cost approach refers to how much it would

cost to build the property, brand new, from the ground up

Debt service coverage ratio (DSCR or DSC) is a measure of a property's ability to

cover its debt obligations.

Retail trades at higher cap rates because the

credit worthiness of retail tenants is increasingly in question due to trends in e-commerce.

Preferred Equity is at greater risk than any of the

debt tranches, but at less risk than the common equity tranche.

Another way of describing IRR is the annualized

effective compounded return rate. That means that IRR takes into account the time value of money into an investment. Cashflow earned earlier in the hold period will yield you a higher IRR than cashflow earned later in the period

While mezzanine is debt, it is not secured by real property but rather by the

entity that owns the real property. As a result, if the borrower defaults on the mezzanine loan, the mezz debt converts to equity since the mezz lender assumes ownership of the entity controlling the real estate.

A typical real estate capital stack includes one or more slices (or tranches) of

equity and one or more slices of debt. The debt slice(s) is usually, but not always, larger than the equity slice(s).

Preferred equity has a priority claim, relative to common equity, on

equity cash flows.

the Direct Capitalization Approach can not be used with

for-sale real estate investments such as condos, for-sale single family, land development, etc.

Stabilized: is when the property is

fully leased or leased to the market occupancy, property rents are at markets rates, tenant turnover is minimal in short term and staggered over the long term, minimal capital improvements to maintain present operating standards

The riskier the asset, the

higher the cap rate

Hotels generally trade at the

highest cap rates because cash flow is driven by nightly stays (extremely short-term leases) and more operationally intensive activities like restaurants and conferences.

As the most risky piece of the capital stack, common stock also has the

highest return potential.

From highest cap rate (most risky) to lowest cap rate (least risky) -

hotel, retail, office, industrial, multifamily.

- IRR is the rate at which

investment grows/shrinks.

secondary or junior mortgage is often referred to as subordinate debt, because

its claim on property cash flow and repayment are secondary to those of the senior mortgage.

You can juice the cap rate with debt, if you buy at a 7% cap rate and you borrow at a 4% interest rate you make money off the initial return but you're also

juicing that return by leveraging the spread between the interest rate and the cap rate

Markets where you can buy at a discount to replacement cost are the best types of markets to invest in because you can be relatively sure that the

market conditions (supply) will not change., which allows you to take on variable out of the equation, so you only have to focus on the asset level.

In Markets with discounts to replacement costs there is room for market valuations to grow because the difference between the

market price PSF and the replacement cost PSF will equalize, meaning your asset will increase in value

The DSCR is used by lenders to determine the

maximum loan amount offered to a borrower and to assess the probability that a borrower might default on the loan. Above 2 = good Above 1 = okay Below 1 = Don't do it

Mezzanine financing, informally called mezz debt, is a hybrid between

mortgage debt and equity.

Cap rates are the

most commonly used method to value commercial real estate

Net Operating Income is the

net income from a property, in a given period, after deducting operating expenses but before deducting capital expenditures, debt service, and taxes.

Cap rates are simply the

net operating income / property value

Core investments are typically

newer properties in great locations with high occupancy and very creditworthy tenants.

Value Add properties often times have

occupancy issues, management problems, deferred maintenance or a combination of all three. These investments require a deep knowledge of real estate, strategic planning, and daily oversight by their owners.

The Income Approach includes two methods. The first method, the Direct Capitalization Method, is a process whereby

one year's Net Operating Income is divided by a market Capitalization Rate to arrive at an estimated value.

Loan to Value (LTV) is the ratio of the

outstanding loan balance to the value of the property expressed as a percentage.

IRR incorporates time but is not the best gauge of

overall profit potential, say little about distribution of CF throughout a project

- Equity Multiple provides a nice snapshot of

overall profitability of an investment does not take into account TVM.

The preferred equity investor is offered a

preferred return that must be paid out before the common equity receives its share.

Hotels are compared on a

price per key room basis

Office buildings are compared on a

price per square foot basis

Multifamily buildings are compared on a

price per unit basis

Income Approach can be used generally with any property that

produces consistent, predictable income.

Common equity is generally handsomely rewarded through

promoted interest when the investment meets or exceeds certain investment return targets.

There are different metrics for comparison dependent on the

real estate asset type

The senior mortgage is secured by the

real estate.

The secondary or junior mortgage is also secured by

real property.

The higher the loan-to-value, the less likely the borrower will be able to

repay the loan at maturity.

Net operating income is

revenue minus expenses before debt

An example of unsecured debt commonly seen in real estate is the

revolving line of credit.

Common equity is the capital most at

risk, being the first dollar in and the last dollar out.

Opportunistic is the

riskiest of all real estate investment strategies.

Core is the least

risky and therefore targets the lowest returns.

The senior mortgage is the least

risky tranche of debt, in that it is the last dollar in and the first dollar out of any real estate investment.

Multifamily is thought of as the

safest asset class because no matter how the economy is performing, people will need a place to live.

Types of debt in real estate include the

senior mortgage (i.e. 1st lien position secured by real estate), secondary or junior mortgage(s), mezzanine debt (i.e. debt secured by the ownership entity rather than the real estate), and unsecured debt such as revolving lines of credit.

Cap rate compression: when you sell for a lower cap rate than you bought for, it means that

someone else is accepting a lower rate of return than you did. The only way someone will accept a lower rate of return is if you made the property less risky by adding value or improved market conditions

To compress cap rate you need the

total value of the property to rise more than the NOI

Public REITs for example generally have a substantial revolving line of credit that allows them to

transact (e.g. acquire) quickly, before putting in place a long-term capital solution (e.g. raising public equity, securing permanent debt).

- Default Ratio is used by lenders when considering

underwriting a loan for properties.

Mezz debt is most common when the real estate is

unstabilized (e.g. value add) or as an alternative to a secondary mortgage.

The default ratio tells a lender how

vulnerable a property might be to defaulting on debt if income stream declines (85% or less as rule of thumb)

During the investment, the cap rate, or the unlevered (pre-debt) return can change, this is referred to as the

yield even though it is the same thing as the cap rate

If there is a large gap between your leveraged and unleveraged returns

you do not have a good investment, just high leverage