Valuation of Commercial Real Estate
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Transcript of Valuation of Commercial Real Estate
Valuation of Commercial Real Estate
Aaron Mesmer – Block Funds
• Block Real Estate Services, Founded in 1940• 350 Partnerships• $2 billion of assets under management• 30 million square feet under management• Annual sales/leasing volume of $900 million• Started Block Funds in 2004• Continued Syndication Model• 2014: $150mm acq. and $100mm dev.
Block Funds Overview
• Office• Industrial• Retail• Multi-Family
Types of Commercial RE
• Range from single-story to sky scrappers• Highest profile “trophy” properties• Fundamentals most impacted by employment• Highest costs upon lease rollover• Trends towards larger floor
plans, open working spaces, mixed-use environments
Office
• Lowest TI costs of all property types• Distribution Warehouse Space
– Trend towards larger spaces, higher clear heights– Driven by demand for storing and distribution
• i.e. BNSF Intermodal – Gardner, KS
– Just-in-time delivery drives demand for location• i.e. UPS Worldport – Louisville, KY
• Manufacturing Space– Diminishing demand – Most functional obsolescence– Potential redevelopment
opportunities (i.e. Paseo)
Industrial
• Most glamorous of the product types• Most quickly evolving– Post WWII strip center development– 1960’s and 1970’s grocery anchored model– 1980’s and 1990’s enclosed mall model– Current trend toward lifestyle centers • Live, work, play
• Highest credit risk
Retail
• New household formation improving apartment demand• Least correlation to performance of other property types• Fundamentals highly linked to job growth• Most subsidized form of real estate– Affordable housing increasing in importance– Section 42, section 8, LIHTC, etc.
• Trend toward sustainable housing
Multifamily
• Individual Ownership• Syndicates or Partnerships – LP or LLC– Based on individual transaction
• Private Equity Funds – LP, “Reg D” structure– $25 to $500 million of equity
• Institutional Advisors – Advise pension funds, large endowments, etc.– $500 million to $1.25 billion– Minimum deal size of $25 million– Mix of domestic and international holdings
Private Equity Buyers
• Real Estate Investment Trusts (REITs)• Similar to institutional advisors• Advantages:– Access to capital (debt and equity)– Broad reach to emerging markets
• Disadvantages:– Public reporting - competition can monitor strategy– Long-term nature of real estate not well understood on
wall street which emphasizes quarterly returns– Decisions made to boost short-term earnings may not
maximize long-term investor returns
Publicly Traded
• Cash Flows• Debt Principal Reduction• Appreciation
3 Ways to Build Wealth
• Net Operating Income– Operating Revenues – Operating Expenses = NOI– Maximizing NOI is most important aspect of asset
management– Market assumptions have big impact on NOI projections
• Impact of debt on cash flows• Key cash flow return criteria:– Capitalization rate– Cash-on-cash return
Cash Flows
KU Corporate Center100 Jayhawk Way
Office Building100,000 SF10 Tenants
Average Rent = $20.00 PSFAverage Expenses = $8.00 PSFBuilt in 1995
Cash Flow Example #1
KU Corporate Center Cash FlowsIncome 2009 Notes
Potential Rental Income $2,000,000 100,000 SF x $20.00 PSFParking Revenue $12,000 10 Reserved Spots x $100 per month x 12 monthsBillboard Revenue $60,000 $5,000 per month x 12 monthsEquals: Gross Potential Revenue $2,072,000 Less: Vacancy Allowance (10%) ($207,200)
Equals: Total Operating Income $1,864,800
ExpensesTaxes $200,000 $2.00 PSF per yearUtilities $300,000 $3.00 PSF per yearInsurance $100,000 $1.00 PSF per yearRepairs & Maintenance $150,000 $1.50 PSF per yearManagement $50,000 $0.50 PSF per year
Equals: Total Operating Expenses $800,000
Net Operating Income $1,064,800 Income less expenses
Capital Repairs $25,000 $0.25 PSF per year
Income Before Debt Service $1,039,800
Wildcat Towers300 Trailer Way
Multi-Family8 UnitsAverage Rent:
$500 per monthAverage Expense:
$250 per monthBuilt in 1965
Cash Flow Example 2
Wildcat Towers Cash FlowsWildcat TowersCash Flow Example
Income 2009 NotesPotential Rental Income $48,000 $500 per month x 8 units x 12 monthsLaundry Revenue $1,500 $125 per monthEquals: Gross Potential Revenue $49,500 Less: Vacancy Allowance (5%) ($2,475)
Equals: Total Operating Income $47,025
ExpensesTaxes $4,700 Utilities $3,600 $300 per month for common areas and vacant unitsInsurance $1,200 $0.15 per square footRepairs & Maintenance $6,500 Includes make-ready expensesPayroll $5,000 For property manager and landscaperManagement $3,000
Equals: Total Operating Expenses $24,000
Net Operating Income $23,025 Income less expenses
Capital Reserves $2,000 $250 per unit per year
Cash Flow Before Debt Service $21,025
• Varies depending on capital structure• Even most institutional buyers use leverage
– Enhance returns by “positive leverage”• Compare loan constant vs. cap rate
– Diversify holdings by increasing purchase capacity• Each month principal balance is reduced
– Lowers risk– “Make money in your sleep”
• Importance of loan terms– Amortization, maturity, perm/short-term, recourse/non-recourse,
prepayment ability, stated vs. effective rate
Debt Principal Reduction
KU Corporate Center Possible Debt
Principal Balance LTV Cash RequiredInterest
Rate Payments Monthly Payment Annual Debt ServiceLoan Balance at End of 5
YearsLoan Balance at End of 10
Years% of Principal
Reduction
$6,500,000 50% $6,500,000 5.75% 240 ($45,635.43) ($547,625.14) ($5,495,529.10) ($4,157,397.49) 36.04%
$6,500,000 50% $6,500,000 5.75% 300 ($40,891.92) ($490,702.99) ($5,824,366.43) ($4,924,303.88) 24.24%
$6,500,000 50% $6,500,000 6.25% 240 ($47,510.33) ($570,124.00) ($5,541,062.06) ($4,231,411.84) 34.90%
$6,500,000 50% $6,500,000 6.25% 300 ($42,878.51) ($514,542.12) ($5,866,309.37) ($5,000,859.12) 23.06%
$6,500,000 50% $6,500,000 7.00% 300 ($45,940.65) ($551,287.77) ($5,925,539.91) ($5,111,170.77) 21.37%
$8,500,000 65% $4,500,000 5.75% 240 ($59,677.10) ($716,125.18) ($7,186,461.14) ($5,436,596.72) 36.04%
$8,500,000 65% $4,500,000 5.75% 300 ($53,474.04) ($641,688.53) ($7,616,479.18) ($6,439,474.31) 24.24%
$8,500,000 65% $4,500,000 6.25% 240 ($62,128.90) ($745,546.77) ($7,246,004.23) ($5,533,384.72) 34.90%
$8,500,000 65% $4,500,000 6.25% 300 ($56,071.90) ($672,862.77) ($7,671,327.63) ($6,539,585.00) 23.06%
$8,500,000 65% $4,500,000 7.00% 300 ($60,076.23) ($720,914.78) ($7,748,782.95) ($6,683,838.69) 21.37%
$9,750,000 75% $3,250,000 5.75% 240 ($68,453.14) ($821,437.70) ($8,243,293.66) ($6,236,096.24) 36.04%
$9,750,000 75% $3,250,000 5.75% 300 ($61,337.87) ($736,054.49) ($8,736,549.65) ($7,386,455.82) 24.24%
$9,750,000 75% $3,250,000 6.25% 240 ($71,265.50) ($855,186.00) ($8,311,593.09) ($6,347,117.76) 34.90%
$9,750,000 75% $3,250,000 6.25% 300 ($64,317.76) ($771,813.17) ($8,799,464.05) ($7,501,288.68) 23.06%
$9,750,000 75% $3,250,000 7.00% 300 ($68,910.97) ($826,931.66) ($8,888,309.86) ($7,666,756.15) 21.37%
Purchase Price $13,000,000
Note: Difference between 20 and 25 year amortization is an additional 11.85% reduction of principal over 10 years
• Driven by demand• Driven by increases in replacement costs– Important as commodity prices increase rapidly
• Appreciation higher in U.S. in costal cities• Depreciation risks– Functional obsolescence– Changing market fundamentals– Unexpected occurrences
• Construction, traffic patterns, natural disasters
Appreciation
KU Corporate Center DispositionYear 6 Projected Income: $1,125,266
Sales Cap Rates Sale Price Cost of Sale (2%)Debt Principal
Retirement Net Proceeds from
Sale6.50% $17,311,787 ($346,236) ($8,799,464.05) $8,166,088 6.75% $16,670,610 ($333,412) ($8,799,464.05) $7,537,734 7.00% $16,075,231 ($321,505) ($8,799,464.05) $6,954,263 7.25% $15,520,913 ($310,418) ($8,799,464.05) $6,411,031 7.50% $15,003,549 ($300,071) ($8,799,464.05) $5,904,014 7.75% $14,519,564 ($290,391) ($8,799,464.05) $5,429,708 8.00% $14,065,827 ($281,317) ($8,799,464.05) $4,985,047 8.25% $13,639,590 ($272,792) ($8,799,464.05) $4,567,334 8.50% $13,238,426 ($264,769) ($8,799,464.05) $4,174,193 8.75% $12,860,185 ($257,204) ($8,799,464.05) $3,803,517 9.00% $12,502,958 ($250,059) ($8,799,464.05) $3,453,434 9.25% $12,165,040 ($243,301) ($8,799,464.05) $3,122,275 9.50% $11,844,907 ($236,898) ($8,799,464.05) $2,808,545 9.75% $11,541,192 ($230,824) ($8,799,464.05) $2,510,904
10.00% $11,252,662 ($225,053) ($8,799,464.05) $2,228,145
• Sales comparables approach– Good for quick benchmark– Hard to get “apples to apples” in commercial RE
• Cost approach– Know “top of market” pricing not to exceed– Good philosophy = buy below replacement cost
• Income capitalization approach– NPV, IRR, Capital Accumulation
• Instinct
Valuation of CRE
• Gross Rent Multiplier• Capitalization rate• Cash-on-cash return• Discounted cash flows– NPV– IRR– Capital accumulation
Income Capitalization
• Price divided by Gross Income• Least used method – more common with MF• Advantages– Very little info required, easy to obtain– Use for quick comparisons of similar properties
• Disadvantages– Does not take into account many important factors,
including appreciation, operating expenses, leverage, taxes or risk level
Gross Rent Multiplier
• NOI/Purchase Price = Cap Rate• NOI/Cap Rate = Purchase Price• Advantages
– Takes into account income/expenses– Most commonly used method– Easy comparison
• Disadvantages– Does not factor appreciation, leverage, taxes, risk– Only considers 1st year projected income– Not appropriate in many situations (near-term rollover, heavy
capital requirements, low occupancy, value-add situations)
Capitalization Rate
• COC = cash flow after debt but before taxes initial equity investment
• If paying cash, COC = Cap Rate• Good way to determine “yield” in early years• Most comparable to dividend yield rate on a stock or the coupon
rate on a bond• Advantages
– Takes into account capital costs and debt structure– Easy to understand for cash oriented buyers
• Disadvantages– Does not account for appreciation/depreciation, taxes or risk level– Hard to get meaningful comparison among potential investments
Cash-on-Cash Return
• Use forecasting model of expected cash flows• Can determine IRR, NPV and capital accumulation• Advantages
– Takes into account all facets of an investment, including cash flow, capital repairs, debt and sale
– Recognized as best method for valuation– Use of Argus Software and other models helps
• Disadvantages– Can be difficult to get all info – relying on estimates– Heavily “back-end” weighted due to impact of exit assumptions
Discounted Cash Flows
• Sum of the present value of all future cash flows minus the initial investment
• Advantages– Allow investors to set return benchmarks and price accordingly– Good for comparing alternatives
• Disadvantages– No compensation for size/time disparities– No consideration of how intermediate cash flows can be
reinvested– Positive and negative cash flows discounted at same rate
Net Present Value (NPV)
• Percentage rate earned on each dollar invested for each period its invested
• IRR is the rate at which NPV = $0• Advantages
– Good method for comparing alternatives– Answers basic questions about expected timing and amount of
+/- cash flows• Disadvantages
– No compensation for size/time disparities– No consideration of how intermediate cash flows can be
reinvested
Internal Rate of Return (IRR)
• In addition to cash flow stream from DCF model, capital accumulation takes intermediate cash flows and reinvests them at a “safe rate”
• Allows comparison of investments with different time periods and sizes
• Impractical, not commonly used
Capital Accumulation
• Don’t let a higher potential returns override your gut instinct
• If it doesn’t feel right, walk away• Only way to factor in all of the intangibles that can’t be
quantified– Who are you buying from?– What city are you buying in?– What market factors are at work?– General sentiment?– Touch/feel of a project
Instinct
• Most analysis is done on a pre-tax basis– Individual taxes vary, some are tax exempt
• However, ability to shield income is one of the most important benefits of real estate
• Writing off interest expense• Cost recovery (aka depreciation)– Commercial = 39 years, apartments = 27.5 years– Tenant improvements = useful life– Cost segregation can advance schedule– Shields only income, not capital gains
Tax Considerations
• “Fourth” way to build wealth in real estate• Allows a seller to defer capital gains and cost recovery
recapture taxes as long as seller purchases “like kind” property of equal or greater value (both debt and equity)
• 45 days after closing to identify; 180 to close• Can “reverse” exchange – buy trade prop 1st • Careful to follow rules so that IRS recognizes• Similar 1033 trades and 721 contributions to “upload”
property into a fund
1031 Exchange
Examples of 1031 BenefitsAssumptions
25%Cost Recovery Recapture Rate
20%Capital Gains Taxes
Cost Recovery Recapture: ($399,306)
Capital Gains Taxes: ($129,274)
Total Taxes Due Upon Sale: ($528,580)
Taxes Saved by Using 1031 Trade: $528,580
Reinvested Tax Proceeds:
5 Years 10 Years 15 Years
5% $674,616 $861,000 $1,098,879
12% $931,538 $1,641,688 $2,893,215
15% $1,063,162 $2,138,399 $4,301,084
16.50% $1,134,331 $2,434,275 $5,223,953
18% $1,209,262 $2,766,498 $6,329,078
Basis adjusts to market value upon death
Use government tax dollars to create wealth
• No investment is worth sleepless nights• Historically real estate seen as higher risk – Return hurdles higher than equities/bonds– Recent thought that more transparency and available
information decreased risk – not true– Still less transparent and less regulated than most– Recent “credit crisis” is partially due to inappropriate
pricing of real estate risk• Never enough potential return to account for a bad
deal
Risks of Real Estate
• Financial Risk– Will NOI cover debt service?– Potential for capital calls even in good deals (i.e. TI’s)
• Inflation Risk– Agreements lock in rates for many years – will they keep pace with
inflation?– Some LL’s use CPI rate increases to hedge– Most have base stops for expenses or NNN structure
• Political Risk– Changes in laws change inability to produce NOI– Zoning, building codes, environmental law, tax law– Examples: 1986 tax law changes, ADA compliance
Types of Risk
• Market Risk– Changes in economic and market conditions– Can be micro or macro
• Projection Risk– Use numerous assumptions when creating DCF– Changes to assumptions has big impact on CF’s– Importance of conservative underwriting– Only thing you can be certain of is that you will not
hit your projections exactly
Types of Risk (2)
• Liquidity Risk– Real estate is a cash business. Cash is always king. Needed for
tenant improvements, operations, debt service, capital repairs, etc.
– Never assume something can be sold, even at a deep discount– Capital markets (both debt and equity) serve as “oil” of the real
estate engine. • Interest Rate Risk
– Floating rate loans typical for construction and short-term notes
– Can hedge with caps, floors, collars, swaps, etc.
Types of Risk (3)
• Due Diligence– Know everything about a property you can before you buy
• Diversification– Buy different product types in different markets– Key advantage of fund structure vs. one-off deals
• Insurance• Credit Enhancements
– Lease guarantees, loan guarantees, letters of credit, corporate backed lease
• Shifting Risk to Tenants– CPI, base stop and/or NNN
• Non-Recourse Debt
Risk Management Strategies
• Less Risky Features:– Lower leverage or no leverage– Diversity of product type/location– Stabilized, income producing properties– Rated credit tenants
• Development is most risky• Buying value-add deals second most risky
Risk Variables
• Building Relationships, Building Wealth• 8.0% cash-on-cash target• 15.0% IRR target• Buying in cities around U.S.• Apartments, Medical Office, Industrial• www.blockfunds.com
Block Income Funds