Real Estate Valuation

calculating cap rates

and IRR

edit: just noticed that you wanted an explanation, too. cap rate is just first year NOI (because it increases every year. so just use the 1st year) divided by purchase price.

as far as IRR, forget the purchase price. just look at projected cash flow, but not NOI, and calculate the discount rate that will make the NPV of those cashflows = 0. the higher that discount rate (or IRR) is, the more attractive it looks.

1) cap rate = net operating income (NOI) / real estate value.
ex. 8% cap rate @ $50m NOI = $625m of real estate value

2) irr - run your model to show cash in, yearly cashflows generated by asset(s) and your cash out at sale (assuming no cap rate arbitrage). the IRR funtion is universal, not specific to RE

newhorizons, what industry you in/interested in wrt real estate?

i would also like some info regarding how to value real estate as i have a couple of interviews coming up with real estate p/e firms. the only thing i've found so far online are REIT valuations, but if anyone knew any good books or websites that went into real estate valuations that would be helpful. thanks!

I worked in commercial real estate valuation/appraisal (apartments mainly) for almost a year and am now an underwriter. The direct cap method (NOI/cap rate) is the universally used method of valuation. Sounds simple, right? Well, most of finance is pretty basic--it comes down to information and inputs. To get the proper cap rate, you need to compare cap rates from sales of similar properties in the requisite geographic region--this is simple to do in Manhattan as there is plenty of volume, a lot of comparables and plenty of analyst coverage; this is incredibly difficult to do in Mercedes, Texas, for example. Even more difficult is constructing an income statement to get your NOI. Constructing the income statement isn't that difficult for established, stabalized properties but becomes extremely difficult to do with accuracy with new construction--it comes down to operating expense comparables, research, and underwriter and developer construction expertise (which is often lacking). OpEx comparables are also incredibly difficult to obtain as there is no public information or public or private record for these. Nonetheless, even with new construction, the cap rate method is utterly dominant. It doesn't matter if you agree or disagree with it--ultimately, even in PE, if you are valuing a property and are selling it to commercial loan underwriters, the underwriters couldn't care less about your fancy formulas and DCF. The GSEs, for example, who are responsible for more than 90% of the nation's apartment loans, have very strict guidelines on this.

The DCF method is almost never used and is considered to be a joke in the real estate valuation industry. DCF is only used upon the request of a client and is only used as a check. The cost (or reproduction) approach is used in almost every appraisal, but almost always as a check. Cost or reproduction approach is mainly used by tax assessors for new properties. Information obtained for the cost approach usually comes from a handful of national companies that produce annual regional texts on construction costs. The sales comparison approach (i.e. sales price per unit) is an important method for underwriters to make sure the loan per unit is within reason compared to the sales price per unit; therefore, almost all appraisals have the sales comparison approach incorporated.

In summation, direct cap is king. The other methods are interesting checks on your work, but ultimately, sales volume is pushed by direct cap.

A good online resource for appraisal is www.appraisalinstitute.org (The Appraisal Institute) and www.appraisersforum.com (Appraisers Forum).

Thanks for the information VT4ever! Would you have any tips/info regarding RE PE interviews? Do they typically ask valuations of commercial real estate, infrastructure...etc

If you want to go into real estate appraisal, then cap rates are important to understand. So is the replacement cost method. The real options approach should be know as well for calculating land value.

If you are going into REPE then knowing DCF is important. I personally don't use argus (a real estate specific valuation program that spits out cap rates), but we get individual property reports from property valuers (think CBRE, DTZ, Cushman) and we use their outputs for our DCF models, although I did have to do argus in my training to see how it works. Calulating IRR is the single most important thing in REPE, but you really have to understand yields (UK terminology for cap rates) to calculate your terminal value. As well, making assumptions on yield expantion or compression can have significant impacts on your model, so you still have to know them.

The downside of yields is that you are calculating your purchase price from a perspective that there is no rental growth(although there are other types of yields, like stabilised yields and going out yields). You can use the gordon growth model
NOI/(r-g), where r is your yield and g is your growth rate and this may give you a better approximation, but it still doesn't capture the nuances of the cash flows you receive. For example there are rent free periods at the beginning of leases that affect your earlier cashflows. As well, if you are acquiring an asset that is independently managed and you bring it under the same management of all your other assets you may realize operating cost savings. DCF is also better when valuing alternative real estate asset classes like self-storage, retirement homes, golf courses, and infrastructure (although this is a bit different).

Hope this helps.

RE_Banker, you're almost certainly right with regard to PE. So I'm not trying to argue with you. But as a commercial underwriter I have a pretty unique perspective about long-term valuation using growth models, DCF, etc.--it's garbage. I'm 100% serious--DCF, IRR, etc., none of it is difficult to do with the correct inputs. But making long-term estimates about rent growth, expense growth, proper discount factors, etc. is basically impossible given the incredible swings in geographic regions. For example, according to RCAnalytics, US national cap rates (or yields) swung .6% in the last 44 months in the multifamily market--that makes an incredible difference in value. And the national market is highly highly diversified. So swings in individual markets will be wild. Rent growth is highly unpredictable just 1 or 2 years out (as my firm's asset resolution group unfortunately finds out quite often). Making long-term predictions about rent growth is simply a shot in the dark. My group also requires ROE calculations to be run as an input into our software system, and these calculations are almost never correct in the short-term, let alone the long. My group is responsible for about 50% of all multifamily lending in America and our VPs and directors would never ever consider DCF or growth models for rent because the most knowledgeable area professional really has no clue what 5 years will bring.

As a finance major in college, I was pretty offended when I began my career in real estate to see the "ignorance" of real estate professionals in how they disregard the complexities of DCF and fancy growth models. But when I sat down and created an Excel spreadsheet of a hypothetical valuation of the same property, you could see that DCF was the single least consistent model and suffers tremendously from human error and, honestly, human ignorance of the future. It's like comparing apples to oranges.

But it doesn't surprise me that PE firms celebrate complex (albeit useless) models to value otherwise fairly simple property. So you are giving good advice. But I will disagree with you on this--I've done a number of retirement home valuations and wouldn't touch DCF with a 10-foot pole. I think I'd agree with you on golf courses and self-storage.

you have some valid points, but i think the flexibility of DCF is more useful when you are trying to model value-add and opportunistic tactics as oppose to core properties. as well, one of the things about REPE is that we also have a shorter investment horizon then other RE investors so DCF in the short run can actually be quite useful. Don't get me wrong, i think forecasting 10 years out is ridiculous, but 5 years can be done with a bit more certainty.
looking back on retirement homes, we model them with stable cashflows, so i guess the cap rate method would yield equally good results, but i just feel the cap rate method is a bit too simplistic and doesn't give the right confidence needed in a huge investment.

Yeah, I mean, if your investment horizon is short, I can see IRR and DCF being useful. Most of the stuff we look at is 10-15 years. So I see your point.