Depreciation + Why no 3 statement modeling questions
Hey guys,
I was wondering if anyone could help me out with a few questions.
1. Say you buy a building fee-simple, why do you not model in depreciation of the building (therefore getting a tax shield?)
2. How come nobody in RE looks at the balance sheet? Arent there significant items hidden in working capital? What about goodwill of a building and M&A math upon acquisition of that building?
Thanks!
That's more related to accounting positions in real estate. Think real estate auditing - all big 4 shops have them. Your typical real estate investor does not care (to an extent) about what depreciation write offs / tax shields / tax structure you may or may not have. Leave that bs to an accountant. We rely on them to focus on their core competency (accounting) while we focus on ours (investing in real estate).
Real estate people do not think like accountants. They do not care about balance sheets, depreciation, tax structure, etc. The only thing similar would be us looking at a "pro forma" which is essentially a projected yearly/monthly income statement. Also, no one in real estate ever thinks of goodwill. it just doesn't exist in our logic. We just think a trophy CBD iconic building will always trade at a lower cap rate compared to a building with lower prestige.
Thank you for your reply. Can you please address my points above though? What I got from your post was that you leave it to the accountants, then how is purchasing real estate assets, which come with a balance sheet, any different (besides the obvious) than purchasing a company with its balance sheet? I come from an IBD background and clearly dont get how you dont take a tax shield on depreciation (even if it were an asset sale you would write up assets/liabilities for book and cash taxes), what happens to goodwill if you buy over book value? These are all things you have to consider in a company, why not real estate? Thank you.
Most people DO factor in depreciation, hence why they're buying real estate in the first place (tax shield).
The balance sheet of a building is mostly irrelevant because the owners distribute cash (earnings) to themselves. Goodwill is already factored into a building via its rental rates.
When someone is debating to invest in real estate vs. some other form of investment, then yes I would have to agree with you. However, when you are at a real estate shop that ONLY invests in real estate assets, you will not see depreciation in any financial model.
Yes, real estate has numerous tax shields (depreciation, 1031 exchange to avoid sale taxes, and amortizing capital expenditures to "pass back" and therefore have tenants eat some of the improvement cost). However, I have never looked at a real estate investment and thought about depreciation.
The real estate-only shops don't factor in depreciation because market purchase prices (cap rates, discount rates, etc.) already implicitly factor in the data.
I'm editing this to agree with the statement below--investors have all different tax needs and structures, so the GP isn't going to really consider tax consequences as highly as a shop that is investing on its own behalf.
All we care about is that cash flow baby.
Thats why whole point though, why not? (Ive actually gotten the "Its all about cash flow baby" answer word for word a few times when asking this question to RE professionals, with no other explanation...)
Let me break it down with easy numbers: Tenant Revs: $100 Reimbursements: $50 Less: Opex: $50 NOI: $100
Then below the line you have Capex, TIs, and LCs. Why is Capex not depreciated (TIs or LCs either)? You can catch a tax break, and pass those savings to a tenant or yourself depending on lease structure.
How come the building itself has no depreciation? On every single financial statement for a company a building is depreciated over its useful life.
Lets go back to my point on purchase price accounting, I'm a REPE investor and I buy a building for $100mm. Why do I not have to write up the assets/liabilities and get the corresponding increased depreciation + amortization from goodwill? DCDepository, you say its already factored into goodwill, I have not seen it factored into any rental rates in any transaction I have looked at.
Lets say I buy a building with a large accounts payable balance (slow collections, etc), most real estate investors dont look at this?
Thanks guys and I apologize for all the questions. Coming into REPE from a banking background, it just makes zero sense how these things arent looked at.
The short answer is that the tax savings of depreciation IS considered by real real estate professionals. If it's not being actively considered then it's because the alternative real estate investments will show no material difference between the two with regard to depreciation tax savings.
However, when acquiring real estate, depreciation is often not considered because the investment is short-term or is a development flip or a value-add flip (e.g. renovation). When one develops a property there are rules that generally state depreciation can't be realized during the development process, for example.
I'll also repeat what I originally stated that depreciation is implicitly factored in to most real estate investments since tax sheltering is a major reason the investor gets into the purchasing and/or developing of real estate in the first place. If there weren't a depreciation tax shield then property values would, on average, be lower.
Also, tax savings and savings at large are rarely given back to the tenant. The owner will usually try to extract the highest rent it can by comparing rents to the market and balancing that out with the threat of possible vacancy.
I don't think you really know what you're talking about. "Goodwill" is reputation. A building's "reputation" is largely based upon its 1) location; 2) utility; 3) and age/appearance/condition. Location (Manhattan), utility (office space), and condition (Class A) are the key drivers in determining the rental rate of the property. Hence, the building's "goodwill" is factored into every single deal by the market.
The short of it is that in a RE JV structure all tax consequences are passed through to each owner and each owners situation is different.
to answer your individual questions:
1) of course you account for it and depreciate at but you don't model it, one you have no idea what your marginal taxes, your partners, your clients, whatever, are going to be anyways. two you would never do Cap Ex or TI for a tenant just for the 39 year depreciation anyways so it doesn't factor into the decision making process.
2) It does, 39 years, but who cares no matter what building you buy its always going to be the same thing.
3)you don't buy balance sheets when buying a fee simple asset. When you purchase a building its basis goes on your books at the purchase value.
4) Of course you look at this, its standard due diligence to look at aged receivables.
The accounting basis of a building doesn't matter, its a fictitious number made up by accountants, we care about the cash flow. Remember the tax consequences, including depreciation, flow through the fund vehicle, JV entity, whatever, to the end user. Its not your job to do their tax analysis because you don't know their tax structure.
Read this and ignore everything else. Thanks for saving me time SHB
Also - Malakari please don't take this the wrong way. You seem to be thinking about investing in the worst way possible (RE or not). Read some books and understand investing. Model monkeys get nowhere.
From an investment perspective, goodwill does exist in a building--it's theoretically an asset. The building's goodwill--its reputation (location, condition, utility)--determines required returns. The better a building's "reputation", the higher the premium one will pay for the building (e.g. lower cap rates). There is utility in a building's "reputation" (makes it easier to lease, for example) which is implicitly factored into the market rental rates, vacancy rate, and/or the cap rates. So whether or not an accountant ever puts the "goodwill" line item on a building balance sheet--which I've never seen--the owner should benefit economically from its reputation.
So this is what I'm getting at, OP, when I say that goodwill IS factored into an investment decision, but it is not found on the balance sheet but on the 1) income statement and 2) on the investor's required return calculation.
Example 1: you'd pay more for a Holiday Inn flag hotel than you would for the exact same hotel and cash flow that has no flag (independent).
Example 2: you'd require a lower cap rate for a property located in an elite area close to employment centers than you would for an identical property located 50 miles away from downtown.
Example 3: you'd pay more for a new Class A property than you would for an old Class B property with an identical cash flow.
Ultimately, premiums for "goodwill" are built into a property sales price--where in the investment analysis process (in cap rate, in higher rental rates, lower vacancy, etc.) will vary.
troll
I think I got it, let me detail a bit below and let me know your comments:
So upon purchase of a building, because it is an asset, goodwill is priced into market rents, cap rates, etc. From an accounting standpoint, because the asset is purchased fee simple and cash free/debt free, you have A: Building, L: Debt, SE: BV of Equity. Makes sense, you record the asset on your books at purchase price.
RE Depreciation, you state that it is included in market purchase prices, so I am getting that it is accounted for in the market rents (Developer develops the building at cost, then analyzes AT-CF which includes dep to see whats the highest rent he can charge to a tenant). Because RE taxes are more or less fixed and not related to the earnings of the building, there isnt a tax shield implicitly built in on the asset level, but on the Fund level there is.
So essentially you have: NOI less CF from Investing less CF from Financing and get to a Ending cash flow number. Then when passing the CF to the owner of the building, the depreciation on the books is factored in and you get a lower taxable income number, less taxes that the fund pays = Net Income to Fund
Sorry if Im being dense here guys, different world...thanks!
This gave me a headache to read all of this. If you are starting in REPE though, stop thinking like this (at least outwardly). You need to turn a different switch on in your brain and not look at everything as a financial statement, and not make things more complicated than they are. The posters gave you some really good explanations too.
This sentence sounds very wrong to me.- "(Developer develops the building at cost, then analyzes AT-CF which includes dep to see whats the highest rent he can charge to a tenant)." I think you skipped over the part where someone said no depreciation or tax structure is included in asset level models.
Probably not getting it, maybe RE isnt for me. I come from the M&A world so seeing these ultra simple models just confuses the hell out of me.
Most real estate deals look at before-tax cash flow and returns because, as was previously stated, you simply don't know each investors situation. For a given investment, you could have 100+ investors in one property. Typically a pass-through entity will own it. The individual investors in that LLC/LP will figure out their own after-tax return. Some investors may be investing with tax-free accounts. Many will probably be at the highest marginal tax bracket. Additionally, a lot of developers/investors may have large nol carryforwards from development years where they showed losses, so taxes are somewhat moot at that time even though they are actually cash flowing a lot of money. At the property/fund level, taxes don't matter because returns are passed through to each investor. This is really the main reason. Using before-tax measures, each investment can be compared apples to apples. If you are a sole-owner, maybe you would consider how the depreciation/taxes affect your returns.
This was a struggle for me to coming into REPE, folks mostly just care about before tax fcf, and most models are built as proforma cash models and not your traditional IS/BS/CF model which is based on accrual accounting. If you only are modeling the cash flows, then you don't need to model out the balance sheet. Also, note for most CRE assets, there really shouldn't be much WK to model. Office, retail and and MF assets would possibly have negative working capital since rent is paid immediately by tenants (unless they're in lease default), and thus you don't have much WK to worry about. Also, when you're computing NOI, you are basically computing unlevered FCF (pre-tax) if you make WK = 0 (which is the case for most RE) and so it's no different from company valuations. Remember, NOI / cap rate is an Enterprise Valuation nonetheless, ie it includes all the assets on the BS you are buying (buildings, cars, FF&E, etc). Leave it to the accountants yet to make any purchase price adjustments when you prepare the financial statements.
Nevertheless, in CRE, especially for operating business assets like hotels, casinos, resorts, theme parks, healthcare, etc, you will have to create 3-statement models for the operations of the business, although this is not done for development/modeling purposes. You will also retain your 3-statement analysis skills developed in M&A since you have to analyze the underwriting business (EBITDA) along with the CRE assets.
RE investors at the end of the day, especially in development/restructuring of an asset, care about the pre-tax leveraged IRR on the equity. Yes since most RE deals have multiple JV partners, the tax effects of losses/cap gains, depreciation/amorts are done at the invesor level, and not at the property level, so you can make an apples to apples comparison on the investment you're contemplating.
CRE can be very interesting, and you can definitely create more equity value than general corp PE whereby you are investing in a healthy going concern operating business and just recapitalizing the BS to pull out equity returns. That's fundamentally implied in CRE investing along with organically increasing income from the asset you are owning (with hotels being a major source for this).
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