DCF Rates % ? for a real estate, ground up development.

I was wondering what discount rate would you use if you were running a DCF for a development property.

Property Profile: Undeveloped large track of land, in an upscale community, Zoned residential and allowing for a Gross development values (total built up) at $60M to $64M.

Possibly and likely, city would approve a conservation development and small portion as light commercial resulting with substantially greater yield.

Assuming 7 to 8 years, start to finish including a disposition period of 5 to 6 years. And a positive cash flow year 3 and on.

Things to consider, strong market demand, housing recession? may bounce back 18 to 36 months from now? Expected GDV's depending on various risk level which splits between a disposition ready assets, An entitlement portion and most likely to be approved component. 

Land costs, not accounted in GDV's. to be determined base on the appropriate DCF.

I'll appreciated your thoughts on how to approach the Land Values, and what would be the appropriate DCF rate/s.

Thanks in advance!

DiscountedCashFlow

GrossDevelopmentValues

NetPresentValue

Comments (28)

Sep 20, 2022 - 1:38pm
CREnadian, what's your opinion? Comment below:

Frankly, I've never seen someone value land for development using a DCF.

Typically land value is determined by taking a couple metrics in consideration together - market PSF value (PSF on future density) or per acre value based on comparable transactions, and a residual value calculation.

Residual value is calculated by taking your total development costs before land and determining a required profit margin to determine how much you can pay for your land. Let's say I think I can sell at a 4 cap, and want to build to a 5% yield (i.e. a 25% unlevered margin). I can use that margin and my expected value at stabilization to determine how much I can add to my costs before I'm not hitting my required profit.

If your residual value and market comps on a PSF/per acre basis are in the same ballpark, you've probably got a good sense of fair value. Ideally, comps are below your residual value and you can beat your underwriting targets.

A DCF to value land is just grossly overcomplicating the process. 

Sep 20, 2022 - 11:25pm
NadlanUSA, what's your opinion? Comment below:

Hi,

There are three traditional valuation approaches, Cost, Sales Comparison and Income Capitalization.

Cost approach, only provides for owners use values.

Comps approach, can be utilize when available mostly in typical and common transaction. 

In most large sized development it's uniqueness play Significant roll in it's valuation. While utilizing comps would not provide sufficient/accurate values. an income approach, aka residual value,  discounted cash flow.. usually does.

In a property that it's buy-side is predominantly developers , it's values are driven from Future value / net cash flows, GDV's. which in turn being discounted for entrepreneurial incentive to arrive at a present value indication which is the market value.

When evaluating what would be the appropriate DCF rates to utilize, we need first to know the market base rates in that segment. "typical housing subdivision" and then to adjust it to it's particular risks adding or Discounting point

In the particular development in hand. the future GDV's needed to be evaluated based on tow set of DCF rates one for income driven by what already entitled as development by-right which presents a lower risks, the other is it's potential additional income as expected from it's rezoning potential that income component exposed to a grater risk and should be giving NPV based on the appropriate DCF rate.

Bottom line:

I'm looking for the common rates for by-right development, as well as for the rates for a development pre-entitlement. 

Thanks

Sep 21, 2022 - 9:11am
CREnadian, what's your opinion? Comment below:

My friend I am well aware of the various methods of valuation and how discount rates are determined ahahah.

I'm telling you that a DCF is almost NEVER used for land. I've seen it once and it was based on discounting the land value at a PSF rate that was determined using comps over the course of multiple phases of the development to account for market risk (as it was a large mixed-use site), it was not based on future cash flows.

I'd suggest you speak with an appraiser if you don't believe me. Appraisers love the DCF approach more than anybody in the entire industry and they never use it on land - there's a reason for that.

There are multiple people telling you you are using the wrong approach here - you should probably take that into consideration.

  • Analyst 3+ in RE - Comm
Sep 21, 2022 - 7:46pm

Yeah of all my years focusing on 70% ground-up deals, never used DCF. Irrelevant for us, and anyone I've ever spoke with. IRR, EM, and yoc are the only metrics i consider.

Sep 21, 2022 - 9:04pm
NadlanUSA, what's your opinion? Comment below:

Great

So what are your target IRR rates ?

if you basically reviewing potential deal with an asking price.  then you have an IRR to evaluate if it's good/not so deal.

In my situation I need to come up with the base price.

It better be competitive or I'm not getting the deal. Therefor knowing the market Targets IRR will give me the ability to calculate the residual value.

DCF it's simply using the "IRR" in reverse to figure out what price point I should by the land.

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Sep 29, 2022 - 12:20am
NYCRE_18, what's your opinion? Comment below:

CREnadian

Frankly, I've never seen someone value land for development using a DCF.

Typically land value is determined by taking a couple metrics in consideration together - market PSF value (PSF on future density) or per acre value based on comparable transactions, and a residual value calculation.

Residual value is calculated by taking your total development costs before land and determining a required profit margin to determine how much you can pay for your land. Let's say I think I can sell at a 4 cap, and want to build to a 5% yield (i.e. a 25% unlevered margin). I can use that margin and my expected value at stabilization to determine how much I can add to my costs before I'm not hitting my required profit.

If your residual value and market comps on a PSF/per acre basis are in the same ballpark, you've probably got a good sense of fair value. Ideally, comps are below your residual value and you can beat your underwriting targets.

A DCF to value land is just grossly overcomplicating the process. 

For my benefit and perhaps for othe readers, can you explain this a bit further or show an example?

Sep 29, 2022 - 9:57am
CREnadian, what's your opinion? Comment below:

Sure thing, here's an example.

Let's say that I want to build apartments and I think I can build the project for $50M before land cost and will generate $3M of NOI once stabilized. Assume market cap rates are 4%, and I won't move forward on a development unless I have 150bps of spread (i.e. I am building to a 5.50% yield, which equates to 5.5/4 = 1.375x or a 37.5% unlevered margin on cost). My expected value at completion is $3M/0.04 = $75M, and I require a 5.5% yield so my total costs cannot exceed $3M/0.055 = ~$54.5M. Therefore my maximum price I would pay for the land (my residual land value) is 54.5-50 = $4.5M.

This is a long winded way of explaining it - in short I expect $50M in pre-land costs, $3M stabilized NOI, and a 5.5% required yield based on my required spread. My residual land value would be $3M/5.5% - $50M = $4.5M land value.

Sep 20, 2022 - 2:05pm
itsanumbersgame, what's your opinion? Comment below:

What NOI can it produce and what is the market cap rate for that property today? Take that NOI, divide it by that cap rate (+150 to 200 bps), and that's your allowable cost. Now, get a GC bid, figure out the Soft Costs & Financing Costs, and you can back into what you can pay for land. There you go. No DCF

Sep 20, 2022 - 6:52pm
NadlanUSA, what's your opinion? Comment below:

The expected NOI, are from the sale of the housing to be built on that land.

Therefore, cap rates aren't equivalent to the needed assumption.

Sep 21, 2022 - 11:02am
NadlanUSA, what's your opinion? Comment below:

I get it. we all utilizing the residual value which is the expected gross proceeds - yes base on comps -  accounting for all costs. including developer profit. the net sum, is the residual value of the land. 

so far so good.. 

Now what are the appropriate (market demand/values) developer profit ? it would deepened on the complicity, risks and above all the length of the project. as you can agree, 2 development land, both would yield and cost the same, the only different between the two are the length of the project and your "developer profit" requirement wouldn't be the same, accordingly there Residual values. 

So how do you suggest we account for the length of time in the prospective development?  you use NPV/IRR to Discounted the Cash Flow (DCF). 

Sep 21, 2022 - 11:56am
CRESF, what's your opinion? Comment below:

For condos or for-sale residential, you'd be looking at a profit margin (profit/total sellout) versus a return on cost. Probably want to see at least a 20% margin and fuck, with how crappy the for-sale market is at the moment you might want more. 

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Sep 21, 2022 - 12:04pm
CREnadian, what's your opinion? Comment below:

Generally speaking, when deciding on land value and whether to move forward on a deal developers aren't that concerned about the profit from holding income (annual yields after stabilizing, yes, but that's a separate consideration). Required profit margin for a residual value calculation is entirely based on the value creation at stabilization, in other words if you were to sell as soon as the project is leased-up. This required margin is a subjective internal risk metric, not a market demand factor. Some developers require 100bps of spread between yield and exit cap, some won't go forward without 150-200bps (or with condo it might be 15% vs. 20% required margin). It's all about internal risk tolerance and conviction in the investment thesis. This is why some companies consistently win marketed land deals, because they're willing to underwrite more aggressively and take on the additional risk associated with thinner margins.

Length of time isn't really a major factor in determining land value (unless perhaps you're considering an enormous mixed-use development that involves like 8-10+ towers, in which case I still wouldn't discount future revenue but instead would value the land based on the phased blocks, applying some inflation to the value over time for later phases, then discounting the later phases back to PV). To reiterate - the thing you are considering in determining residual value is the required incremental value the project will create at stabilization, regardless of if you sell or hold, relative to the amount of money you are putting into the deal. The reason to develop property is because you can build something cheaper than the market value, creating a spread in value over your costs. If that spread is big enough to merit the risk, you are better off developing that project than buying a similar existing property at market value. Your hold vs. sell at completion analysis is a totally separate consideration.

I don't know why you're arguing this. Again, multiple people who have a good amount of tenure in the industry are telling you you are taking the wrong approach.

Oct 2, 2022 - 3:03pm
Ozymandia, what's your opinion? Comment below:
NadlanUSA

Now what are the appropriate (market demand/values) developer profit ? it would deepened on the complicity, risks and above all the length of the project. as you can agree, 2 development land, both would yield and cost the same, the only different between the two are the length of the project and your "developer profit" requirement wouldn't be the same, accordingly there Residual values. 

There isn't any such thing as an "appropriate" developer profit.  Your fundamental issue is treating the entire thing as a zero sum game whereby you can back into a land value.  Even with favorable zoning, not all land is created equal, so a DCF doesn't really do an adequate job in letting you back into that number.  Rather, you use comps, guided by experience, and that's where the valuation comes from.

Sep 21, 2022 - 9:00am
NadlanUSA, what's your opinion? Comment below:

You get IRR when you have establish cost 

At case in hand we don't know what the cost would be. due to the main component the land values are yet to be determined. 

to determined land value we need to assume the desired IRR returns that wiling buyer would required.   

Then you utilize the desired IRR rate, to discount future earning. resulting in Now Values / Land Cost.

Then the IRR and the DCF are one of the same. 

Sep 21, 2022 - 10:07am
PVHeaven, what's your opinion? Comment below:

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