How to find a property's intrinsic cap rate?
I am at an otherwise traditional PE/HF firm that is pretty much doing its first RE deal...so we are all new to this shabang.
My boss wants me to find a way to get a property's intrinsic cap rate, as in he does not want to rely on market comparables or transaction data or anything. This means he needs to find a property's intrinsic value. After doing some research, and PLEASE correct me if I'm wrong, but the only way to do this is to do a DCF on the property.
Great. But what's an objective (or at least non-vacuous) way to derive a discount rate? Risk free rate is given, sure. Take the country's debt securities. But what about risk premium? Keep in mind this business is being done in an emerging market, where historical property returns (a la NCREIF) are not very reliable or well documented. So how do I derive Rp in a non-arbitrary way?
So how do I get a discount rate for this DCF? I have no way of finding out the full OCC of this investment.
Or, alternatively, is there another way to find out a cap rate without looking at the market or transactions?
Thanks WSO...
Use whatever your fund's target gross IRR is, and discount it back for the DCF. As an aside an intrinsic cap rate is complete horseshit, roughly the same as asking for an intrinsic multiple, cap rates are determined by what the market will bear.
Thanks...but that answer wouldn't be taken too kindly by my boss haha
How about intrinsic property value? How about that? If you had 0 comparable transactions/properties, but you know the cash flow profile of the property, how would you get the intrinsic value? What would you discount them by if you didn't have your fund's target IRR?
I know this all probably sounds stupid but how do I estimate the actual value of a property based on its cash flow in and of itself? What is a way to find the risk premium? This resulting NPV shouldn't differ between investors in the same market, hence why I am not considering the fund's target IRR.
One of the easier ways: 1) Calculate your properties NOI (net operating income; similar to EBITDA). Roughly speaking: Rents - operating costs (e.g. maintenance, non recoverables, property taxes etc.) 2) NOI / Market value = Cap rate (for market value you could do a DCF, or as a proxy, take your assumed purchase price)
Maybe you can get a real estate book. Look in the valuation section. You will likely find (a) GRI multiple approach (basically rent multiplied by a certain multiple from the market=market value), (b) Capitalization rate approach (NOI divided by cap rate = market value) and (c) DCF (Forecasting CFs for c. 10 years, present value of all 10 CFs (e.g. NOI minus Capex), + present value of terminal value (either GGM or again capitalization rate approach). (On a sidenote, you might find additional valuation methods such as replacement cost analysis)
Hope that helps. Fyi: That is what I would do for something "quick and dirty". Obviously you can go much more into detail on the calculation of each valuation method etc. (although I often think that "keep it short and simple" is a better approach than complex valuation models).
I think discount rates are a bunch of baloney. Especially terminal value, since it is directly related to the discount rate. Don't even get me started on TV. TV is meaningless, a number plucked out of thin air. Yet, it comprises 60-70% of the entire value. It doesn't surprise me when people lose out on their investment when it is based on TV and discount rate.
I want hard cash at the end of the day. Money in my bank. Only 1) hard assets and 2) cash.
1) In this case, how much is my building worth? Replacement cost analysis, which is the cost of building the asset from scratch (land + infra + building material + labor).
2) How much cash, or NOI, am I getting from my asset? This is straightforward. How many years will you own the property? 5, 10, 20 years? Then, I would multiply the NOI by the number of years of ownership.
So, if the replacement cost of the building is $1 Million and I am getting $100k in NOI annually, and if I own the asset for 10 years, the building's intrinsic value is $1 MIllion + 10 years x $100k = $2 Million.
Of course, the market could say the asset is worth $5 million, so you would be lowballing the valuation.
However, that's fine. Management will probably filter thousands of potential assets, until they find one where intrinsic value exceeds the market value. In that case, you have an asset that has low downside, and high upside potential. Liken it to value investing.
Another way to think of it is getting the Stock Holder's equity in a balance sheet and adding 10 years of operating cash flow to get your intrinsic value. Will the company stay in business for 10 years? Most likely.
I am a private investor btw. Not working at a firm. My 2 cents.
Soooo you don't believe in the time value of money? Ok.
"So, if the replacement cost of the building is $1 Million and I am getting $100k in NOI annually, and if I own the asset for 10 years, the building's intrinsic value is $1 Million + 10 years x $100k = $2 Million."
So if your building's "intrinsic value" is $2mm, you believe that your exit (or "TV") is $1 MM---appreciating zero dollars from your original purchase price of $1 MM. I'm sorry, but I would be fired if I said that out loud in my office. You will never win a bid with that type of reasoning.
This is nonsense. An asset is worth what someone is willing to pay for it.. thats all
There is no such thing as an "intrinsic cap rate" for a property. The cap rate is a function of the specific market for that product, determined by buyers in said market. You can't say "this building is a 5 cap" just because I say so - it's up to the buyers in the marketplace to determine what they will pay for that building.
Basically this.
Having started my career in real estate and moved over to PE and being exposed to the hedge fund and credit world, OP's boss is going to have a hard time doing a real estate deal. In HF's (and PE to a lesser extent because you're dealing with illiquid unique assets) you can zero in and get to intrinsic values, especially on the debt and derivatives side. At the end of the day it only matters what someone else is going to pay but everyone uses more or less the same analyses to come to the same numbers and the markets tend to be somewhat liquid.
In real estate you could be trying to buy or sell a building and argue with the guy on the other side of the table that according to my super complex in-depth analysis the property is worth X and the guy will tell you to go pound sand if he doesn't agree because he's a guy that really knows the market. It's about the market (macro, micro and submarkets) then about the building itself (you're buying 123 Main Street but it's kinda known as a crappy building by brokers in the market even though from the outside-and I don't simply mean external to the building-it appears to be just as good as 124 Main Street across the street, which is a building every broker and tenant loves and tries to get into, and therefore 124 is usually fully occupied and commands better rents and less concessions to get tenants) a ton of variables within the building itself, some of which are easily quantifiable, others of which you need to know how to operate a building from an Asset Management pov (lease turnovers, TI's and brokerage fees needed to keep/attract tenants, etc) and property management (the nuts and bolts of the building and subsequent costs and things like that). The guy who's a real estate expert in that market can basically quantify that in his head and the mention of intrinsic values will make him laugh.
I wouldn't recommend getting into real estate as a HF truthfully. It's just not the same business at all. Reminds me of the old saying: "You know how to make a small fortune in real estate? Start with a large one."
dubyawhy,
I'm more accustomed to dealing in IRRs than NPVs, but this is how you would build up the discount rate:
1) Find the nominal rate of return of a comparable property in your home country. 2) Remove inflation from that rate of return in your home country to get the real rate of return of that comparable property. 3) Add a risk premium (assuming the transaction country is riskier than your home country) associated with the relative riskiness of the transaction country. 4) Add the rate of inflation of the transaction country. 5) Boom, there's your discount rate.
Example: 1) 5.0% 2) 5.0% - 2.0% (inflation) = 3.0% 3) 3.0% + 1.5% (country risk premium) = 4.5% 4) 4.5% + 5% (transaction country inflation) = 9.5% 5) Booom, 9.5%
Calculating the IRR (leveraged and unleveraged) within a cash flow, I've seen the buy side use the cash flow minus CapEx and Cap Reserves. I've seen the sell side do the opposite---not subtracting the CapEx or Cap Reserves to get their IRR (making it higher). Its obvious why these two parties calculate in the opposite way--- one is being conservative and one is being aggressive. Is one of these calculation methods considered the "correct" way?
You can approach your own cap rate calculation by doing the following: cap rate= required return - expected rental growth rate over the holding period.
What?
http://bit.ly/1Ht9XMY
what yield on cost is the property expected to generate upon stabilization? And does that % yield compensate your firm for - the risk of investing in that local area, the lock-up of capital, the potential downsides, the better uses of that cash? I would back into the purchase price from there. And from that you can determine what the initial cap rate (NOI/PP) would be
If its a specific asset or portfolio, best to start with the latest valuation. From there, you can weigh their assumptions and methodology (depends on the country of the transaction) and the premium or discount that you think "should" be applied to that value and break back to the implied cap rate.
If tenants' debt is public, you can look at that yield and add premium for things like liquidity and asset-specific risks, etc. to get a cap rate.
As others have pointed out though, this is all finger in the air stuff to a certain extent.
In reality, you'll get a price, in today's market its going to feel too high or will get bid up and then you need to get comfortable with whether the risks are ones that you can understand and mitigate with a decent probability of success and whether there is enough upside potential to make it worth while.
Listen to Dingdong08, he is right on all points. I studied math in undergrad so when I first started, I spent way too much time trying to derive the "right" value with all the complex methodologies that you can think of. It did not take me long to figure out that all the rocket science stuff doesn't mean much if someone is willing to pay higher and have good track record of closing.
If your boss still wants to do the deal, try to find some experts in that market/country and talk to them. Unless you somehow have relationship with those guys or their firms, it is difficult to get any helpful guidance. But again, it is RE, you gotta know how to get info from people and use it for your leverage.
I don't know how you can calculate intrinsic cap rate but one caveat is that don't focus too much on cap rate. I have seen many deals that have low going-in cap rate, say 4%, and higher exit cap rate, say 5%, yet IRR is north of 20% and more than 2.0x money because of value-added/redevelopment programs. Look at cash flow stream, project different cash flow scenarios for value-added/redevelopment, and play with the numbers to see if you are comfortable with the price you have to pay for it.
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