What are the value levers of a Real Estate PE investment?
I know that in normal PE you can make money by ebitda growth, multiple expansion and de-leverage, but how does PE make money when investing in real estate assets? what are the value levers? Also, would appreciate if you can point me to a book/website/article that explains in full detail the REPE investment process. Blackstone apparently's been killing it in real estate - heard their real estate fund was much more profitable than normal PE...hence my curiosity.
thanks
interesting question. would love to hear responses.
I'll venture a guess and say that if FFO > mortgage/debt costs, that money flows to pay down principal (like in an LBO cash sweep) and in effect increases the REPE firm's equity value. Also, the RE market appreciates/declines, and so I'm guessing as cross-the-board values increase as does the value of the property(ies) - like multiple expansion.
The most significant value lever for RE is leverage. Outside of debt, there aren't many opportunities to exploit RE investments. Other than debt, an aggressive lease-up strategy (revenue increases) and expense controls are really your only other options (our version of EBITDA growth).
You shouldn't underestimate the significance of financing in RE. Debt capital markets have an overwhelming influence of RE prices - if you can time the ebb and flow of debt capital markets, you can crush it. Blackstone is a good example. Their returns were driven by entering and exiting at the right time and the debt volitility in the last couple of years has worked in their favor. Chalk it up to skill, luck or a combination of the two; either way, BX is sitting pretty.
The key metrics that drive RE investment decisions are IRR, Cap Rates and Strategy:
-an office REIT employing a core strategy will take a look at year 3 and 5 cash IRR and expect 6-7% -an industial REIT with core strategy will take a look at in-place cap rate and expect 5-6% for a fully-stabilized, high-quailty warehouse, with year 10 cash IRR of about 7-9% -an opportunistic REPE may look only at in-place cap of 8-12% and expect to pay below replacement cost for office investments - pension funds, life co.'s and other institutional groups will typically look at a year 10 cash IRR of around 8-10% for stabilized buildings
@fomc: some good books
-Real Estate Finance and Investments - Brueggeman and Fisher Pretty much the standard when it comes to RE investing. If you don't know much about RE, this is where you should start.
-Commercial Real Estate Analysis and Investments - Geltner Heavy on property-level analysis. Great if you already have a fundamental understanding of RE, not so great as an introduction to the business.
-Real Estate Finance and Investments: Risks and Opportunities - Linneman Like the Bruegemman book, another good intro.
interesting. In terms of returns how do you differentiate between IRR and cap rate? What's the difference between them? Wouldn't it make sense to go for a a project with a cap rate of say 15%? How do you fundamentally calculate cap rates? and I dont mean income/purchase price....is it essentially IRR-expected growth? Just looking for more details around this IRR vs cap rate debate.
All three books are the top line-up. Geltner also focuses on RE as an asset and its treatment within a portfolio. Great post RE Capital Markets.
Not an authority on the U.S. real estate market, but in China, you can produce very high returns without the use of serious leverage. How? Focus on financing new development projects--- things that can be sold quickly like large scale mixed use properties with a high proportion of residential / retail. The key variable for this type of project is the price at which you purchase the land.
The capitalization rate (NOI/EV) is the standard Reit valuation metric.
An interesting way of looking at this from an individual's investment perspective is buying blocks of units pre-construction. One could acquire large blocks of units pre-construction with a downpayment of say 10% (note, this would be an all cash transaction). From here, the remainder of payment would not be due until construction was finished (1-2 years depending on the project). Furthermore, one may be able to delay remainder of payment for a few months post construction, or even when the unit was resold. Assuming growth in a major market such as NYC/Chicago/LA (emphasis on assuming), any appreciation on that asset (due to a host of factors), minus selling costs would be a handsome profit for the investor. Another nice benefit of buying large blocks pre-construction is avoiding those annoying carry charges on the real estate. Developers are keen to selling 51% of GLA in new construction in order to qualify the building for conventional financing for other prospective non-cash buyers. From their point of view, better to sell the first 10% or so of GLA at a discount in hopes of reaching 51% sooner rather than later, thus increasing demand and selling the remaining at MV or above, than to hold an expensive project with vacancy upon completion due to the lack of available financing.
Any thoughts on this?
I would say a large driver of value is the residual value. If you don't have an exit or are too aggressive in your underwriting you will get burned. Residual value can make up 70+% of the total cash flows during your investment horizon. Like this post a lot OP, thanks!
You're absolutely right to equate a cap rate with a discount rate minus perpetual growth (like the PGM), but the wacc would have to only be for equity and the IRR would only be unlevered IRR.
However, it's better to think about a cap rate as you would an ebitda multiple, its inverse, rather. The ebitda multiple would not give you a real sense of the expected return. The main reason for this is leverage. If you were to buy a building at an 8 cap with 100% equity, then the cap rate would actually give you a really close estimate of your IRR. As you put it, the market bakes the expected growth into the cap rate, and the private real estate market, the market in this world, is pretty accurate. This is why cost of capital is so important to real estate investors, and, subsequently, why public reits took a nose dive at the first hint of rising rates.
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