DCF in Real Estate
What are some of the differences between a DCF in a normal valuation vs. a real estate property valuation? Is the WACC still the discount rate? How does terminal value compare to sale price?
In real estate, you can model cash flows in a pro forma. You utilize a pro forma like an LBO to calculate the financial performance of a property (Cap Rates, Cash-on-cash return, and ROI).
In terms of terminal value, in real estate you find the Gross Sale Price. Gross Sale Price = (Next year's NOI) / Terminal cap rate (expressed as a percentage) to get the terminal value. The terminal capitalization rate, also known as the exit rate, is used estimate the resale value of a property at the end of the holding period by looking. You find this value with comps (like you would with a multiple).
You also have three appraisal and valuation methods: replacement cost approach (cost of duplicating the property minus depreciation), comparable analysis, hedonic analysis.
What discount rate do you use in your cash flow modeling?
The discount rate would be the IRR you are targeting, which would depend on the firm and the investment strategy, i.e core, core-plus etc.
The concept of WACC applies to real estate, but it far less useful. Here's why...
The traditional corporate model has capital financing decisions independent of project/deal decisions, i.e. they raise equity/sell bonds/take out loans to finance whole company not individual projects usually. Thus one firm level WACC is easy to calculate and meaningful to apply to capital budgeting decisions.
For most real estate "deals", financing is often independently determined with unique property level debt, and even custom LP/pref equity. Thus every deal's WACC could be different, thus having a 'hurdle rate" or WACC to apply is kinda pointless and hard to compare. Thus, most use IRR and just compare to benchmark for deal type/risk profile (i.e. core, value-add, etc.).
So if you think of each real estate deal like a corp M&A or LBO, it will make a lot more sense. That is the better comparison and why real estate is so much structured finance all the time. The exception is firms like REITs that raise debt/equity like most corp firms, they could use a more standardized WACC and would need to in order to figure out if a deal is accretive to value or not.
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