Risk Adjusted Yield and Valuing CRE

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Risk Adjusted Yield and Valuing CRE

1 Odessa Realty Investments, LLC

The valuation bubble in commercial real estate (CRE) made it all too apparent that many industry

professionals either did not have a good grasp of fundamental real estate valuation techniques or chose to

ignore the basic precepts of smart investing. This type of speculative investing that occurred during 2005

to 2007 and continues in some sectors affects you directly as you will often be outbid on commercial real

estate assets.

Buying assets at a fair price is absolutely critical to your

success in making money and achieving the proper Risk Adjusted

Yield on your investment. While institutional investors often

overpay for assets in an effort to deploy capital, it is imperative that

you do not follow their folly. The good news is that valuing an

asset can be relatively simple.1 You are simply looking at the

revenues and expenses related to the property and determining a

realistic net operating income, net income and cash flow from

operations. If the cash flow from operations provides a sufficient

Risk Adjusted Yield on your cash investment, then your pricing is

fair.

Yet and this is important the valuation mistakes frequently made in the industry are nowlegendary! Billions and billions of dollars were lost by the Wall Street investors who ignored the

fundamental rules to pricing commercial real estate we discuss below.

I. Risk Adjusted Yield

Proper valuation begins with an understanding of the appropriate Risk Adjusted Yield you should

be seeking in a real estate investment. In other words, what percentage yield do you need on a cash-on-

cash or internal rate of return (IRR) basis? This Risk Adjusted Yield will vary depending on how much

riskis involved in producing that return.

Low levels of risk are associated with low potential returns, whereas high levels of risk areassociated with high potential returns. The least risky investment is U.S. Treasuries. If you can invest in a5-Year U.S. Treasury note yielding 2%, you can be certain that you will receive your interest payments

and the principal at the end of the term. Other investments are riskier and along with the higher rates of

return they afford, you have increased risk of losing your investment. For example, investing in a

publically traded REIT will provide you with dividend yields and the prospects of stock price volatility.

The question you need to answer is how much greater return over Treasuries is needed to investin an asset class. Your investment yield needs a risk premium to the risk-free rate of U.S. Treasuries to

compensate you for the potential of losing money. In other words, the risk premium is how much more

you need to make in a risky investment as compared to a risk-free investment.

Risk Adjusted Yield is a combination of the risk-free rate of U.S. Treasuries and a risk premium.Mathematically this is shown as:

Risk Adjusted Yield= Treasury Rate +Risk Premium for the Investment

1One note: this article is about how to value a commercial real estate property and not about how to select the right

asset to buy. In other words, we are discussing valuation techniques and not how to choose a property. If you buy

the wrong asset or in the wrong location, even at a great price, it may still fare poorly.

The pricing of risk is

determined by global capital

markets and the

heterogeneous investment

characteristics of the asset.
http://www.investopedia.com/terms/r/riskadjustedreturn.asphttp://www.investopedia.com/terms/r/riskadjustedreturn.asp


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Forecasting cash flow growth is a highly problematic, albeit essential, component of valuing a

property. For academics in finance and Wall Street practitioners, cash flow growth estimates are a

legitimate part of valuation. Yet, it requires predicting the future and as baseball legend Casey Stengel

said, Never make predictions, especially about the future.

The Wall Street money that drastically overpaid for assets during recent years relied partially on

cash flow growth assumptions to support their faulty investment conclusions. Financial models that relyon internal rates of returns for the investment analysis are great in theory and horrible in practice.

Anyone can tinker with assumptions about the future operating margins, capitalization rates and growth

rates to justify a purchase price. Even worse is relying on the Greater Fool Theory which assumes thata greater fool will come along and buy the asset at a higher price. That works during an economic bubble,

but when the music stops, guess who is looking for a chair?

Leverage, or the amount of debt you have on the asset, is a key factor in determining the riskiness

of your equity investment. If you have a low loan-to-value ratio, say 50%, the risk of the asset not paying

the monthly interest and amortization payments is less than if this ratio is, for example, 80% or above. A

relatively large loan as a percentage of the propertys value means you have invested less capital, but thechances of you losing the property increases if the property has cash flow problems.

Liquidity and control are two key concepts in assessing the risk premium you require over a risk-

free investment. Investing in the stock of a large publically traded REIT enables you to sell your stock for

cash immediately. However, you will have no control over how the REIT manages its affairs. Investors

pay a premium for liquidity and also pay a premium for control. While liquidity is of huge import to

investors, the premiums for liquidity and control generally are not that differentiated. Your desire to own,

manage and grow a private asset may offset your need to quickly monetize your investment in this asset.

It is important to note that in this article we are addressing pre-tax yields. Real estate has

attractive tax features, but so do various alternative investments such as tax-free municipal bonds. One

should always compare the after-tax yield of an investment to alternative opportunities. For example,

taxes on dividends are currently 15%. A 9% dividend yield on your asset will result in a 7.7% after-tax

yield. What if the tax rate on dividends was increased to 40%? Then, the after-tax yield would be 5.4%,and alternative investments such as municipal bonds might be more compelling. With this example, youcan see how your real estate investments can lose value with changes in the tax code as the next buyer

would require greater returns.

To summarize, properly buying an asset requires the fundamental discipline of Risk Adjusted

Yield. It is imperative that your investment offers a cash flow or IRR yield that is compelling, on a risk

adjusted basis. Underestimating the risk premium or relying on unreasonable growth expectations willsignificantly increase the risk that your property loses value or gains insufficient value during the holding

period.

II. Focus on Cash-on-Cash Returns

We are believers in cash-on-cash returns. Simply stated, how much money are you putting in

your pocket at the end of every year, counting all expenses, capital expenditures and a very healthy

contribution to the reserve fund? As one old-timer told us: Ebit, Shmeebit. I know how much money is

in my wallet.

Properly valuing a property is best done by looking primarily at the yield you expect to receive inyear 1 of owning the property. Returning to our hypothetical purchase of a B building requiring a 9.5%Risk Adjusted Yield, our primary objective is to have a 9.5% return on the entire amount invested into the


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property. The initial investment amount would be inclusive of equity, closing costs and any initial capital

expenditure requirements. If the building can provide a net cash flow or dividend yield of 9.5% on the

initial investment, then this would be a fairly valued building and we would proceed with the acquisition.

Mathematically this is shown as:

Cash-on-Cash Returns (9.5%) = Net Cash Flow / Total Initial Investment

As mentioned above, there are many valid reasons to increase or decrease your Risk Adjusted

Yield for a particular property. If the property has a phenomenal location and fits your business plan

exceedingly well, in certain circumstances you may feel justified in looking out several years for the

proper yield. In these situations you may be paying the seller for a bit of the upside and accept thatpremise knowing that you have a jewel of an asset.

Contrastingly, if the building is subject to major improvements and leasing efforts, a higher Risk

Adjusted Yield is required. If the property is empty and we need to carry the building, plus pay broker

fees and tenant improvements to lease the property, we add these amounts to the initial investment. And

we expect a higher yield based on the free cash flow projected for the property when it is stabilized.

Depending on the asset class, we often require a projected 15% to 25% cash-on-cash return for assets that

involve substantial physical work and lease up.

As stated previously, we are not big fans of discounted cash flow analyses to value a property as

these are highly subjective and prone to operator error. In DCFs, future cash flows are expressed in a

present-day yield known as the internal rate of return. The hypothetical IRR result is a true yield rate,

which can be directly compared to other before tax, unleveraged return rates such as stock and bondyields. The challenge is perfectly predicting the future cash flows associated with an asset, particularly

the assets valuation in the terminal year. Terminal valuations are often over weighted in determiningproject IRRs.

We are sometimes bemused by the fact that DCFs are relied upon so widely in the industry.While we look at DCF valuations for all acquisitions, we rarely give them much weight in our final

decision making process. Nothing is more assuring than knowing your initial investment will most likely

receive an appropriate dividend satisfying your Risk Adjusted Yield requirements in year 1. A high

yielding IRR analysis with assumptions made for the next ten years works in the classroom, but not in

reality. As we like to say, When a theory works in practice, it just might work in theory.

III. Conclusion

Buying an asset at the right price has a tremendous impact on the success of your investment.

Paying too high of a price and relying on unrealistic growth assumptions to rationalize a purchase will

inevitably lead to a loss of investment. The bubble years of 2005-2007 reflected the herd mentality of

smart Wall Street investors who booked fees, paid bonuses, and professed a belief that rental growthwould soon legitimize their purchase prices.

Fundamental valuation begins with an understanding of the percentage return you should be

seeking in a real estate asset, given the risks associated with that investment. The quality of the asset

(location in particular!) is the largest single determinant in determining your investment return. Youryield is heavily influenced by Treasury rates, illiquidity, mortgage interest rates and leverage. Additional

key factors include property supply and demand dynamics, capital markets trends, and returns in

alternative investments such as bonds or equities. Thus, the pricing of risk is determined by global capital

markets and the heterogeneous investment characteristics of the asset.


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We are conservative investors and spend considerable time

on each asset purchase to evaluate the risks associated with each

asset. At times it is challenging to ignore the irrationalexuberance in the market place and stick to fundamentalinvestment principles. Investor sentiment erodes the practical use of

DCF models for valuation purposes. Maintaining a focus on cash-

on-cash returns is helpful as this analysis is focused on the nowand possible.

Importantly, once you have a strong sense of the proper

returns for a given investment, valuing an asset can be relatively simple. If the net cash flow provides a

sufficient Risk Adjusted Yield on your cash investment, then you are paying a fair price. The

complications in determining commercial real estate cash flows are relatively limited when compared to

doing the same for operating companies such as Apple, General Electric or Citibank.

Commercial real estate rightfully has a significant position in any investment portfolio due to its

operational simplicity, tax advantages, and inflation-hedging characteristics. Avoiding over paying for an

asset, however, is instrumental in achieving the requisite investor returns.

October 2010

The author, Dan Pryor, is a partner at Odessa Realty Investments, LLC. Mr.

Pryor has twenty-two years of cumulative experience in real estate investing

and investment banking. He has dirt experience in numerous aspects of real

estate, including acquisitions restructurings, repositioning, and property

management. His past investments and property management include office,

multifamily, retail, recreational and medical properties.

Mr. Pryor also has an institutional financial background as an investment

banker with Lehman Brothers and Salomon Smith Barney (now Citigroup).Mr. Pryor graduated from Middlebury College and the Yale School of

Management (MBA).

You should never pay the seller

for upside that is likely to result

primarily due to your expertise

in managing the asset.

Risk Adjusted Yield and Valuing CRE

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