Depreciation + Why no 3 statement modeling questions

That's more related to accounting positions in real estate. Think real estate auditing - all big 4 shops have them. Your typical real estate investor does not care (to an extent) about what depreciation write offs / tax shields / tax structure you may or may not have. Leave that bs to an accountant. We rely on them to focus on their core competency (accounting) while we focus on ours (investing in real estate).

Real estate people do not think like accountants. They do not care about balance sheets, depreciation, tax structure, etc. The only thing similar would be us looking at a "pro forma" which is essentially a projected yearly/monthly income statement. Also, no one in real estate ever thinks of goodwill. it just doesn't exist in our logic. We just think a trophy CBD iconic building will always trade at a lower cap rate compared to a building with lower prestige.

Thank you for your reply. Can you please address my points above though? What I got from your post was that you leave it to the accountants, then how is purchasing real estate assets, which come with a balance sheet, any different (besides the obvious) than purchasing a company with its balance sheet? I come from an IBD background and clearly dont get how you dont take a tax shield on depreciation (even if it were an asset sale you would write up assets/liabilities for book and cash taxes), what happens to goodwill if you buy over book value? These are all things you have to consider in a company, why not real estate? Thank you.

Most people DO factor in depreciation, hence why they're buying real estate in the first place (tax shield).

The balance sheet of a building is mostly irrelevant because the owners distribute cash (earnings) to themselves. Goodwill is already factored into a building via its rental rates.

All we care about is that cash flow baby.

Thats why whole point though, why not? (Ive actually gotten the "Its all about cash flow baby" answer word for word a few times when asking this question to RE professionals, with no other explanation...)

Let me break it down with easy numbers: Tenant Revs: $100 Reimbursements: $50 Less: Opex: $50 NOI: $100

Then below the line you have Capex, TIs, and LCs. Why is Capex not depreciated (TIs or LCs either)? You can catch a tax break, and pass those savings to a tenant or yourself depending on lease structure.

• How come the building itself has no depreciation? On every single financial statement for a company a building is depreciated over its useful life.

• Lets go back to my point on purchase price accounting, I'm a REPE investor and I buy a building for $100mm. Why do I not have to write up the assets/liabilities and get the corresponding increased depreciation + amortization from goodwill? DCDepository, you say its already factored into goodwill, I have not seen it factored into any rental rates in any transaction I have looked at.

• Lets say I buy a building with a large accounts payable balance (slow collections, etc), most real estate investors dont look at this?

Thanks guys and I apologize for all the questions. Coming into REPE from a banking background, it just makes zero sense how these things arent looked at.

From an investment perspective, goodwill does exist in a building--it's theoretically an asset. The building's goodwill--its reputation (location, condition, utility)--determines required returns. The better a building's "reputation", the higher the premium one will pay for the building (e.g. lower cap rates). There is utility in a building's "reputation" (makes it easier to lease, for example) which is implicitly factored into the market rental rates, vacancy rate, and/or the cap rates. So whether or not an accountant ever puts the "goodwill" line item on a building balance sheet--which I've never seen--the owner should benefit economically from its reputation.

So this is what I'm getting at, OP, when I say that goodwill IS factored into an investment decision, but it is not found on the balance sheet but on the 1) income statement and 2) on the investor's required return calculation.

Example 1: you'd pay more for a Holiday Inn flag hotel than you would for the exact same hotel and cash flow that has no flag (independent).

Example 2: you'd require a lower cap rate for a property located in an elite area close to employment centers than you would for an identical property located 50 miles away from downtown.

Example 3: you'd pay more for a new Class A property than you would for an old Class B property with an identical cash flow.

Ultimately, premiums for "goodwill" are built into a property sales price--where in the investment analysis process (in cap rate, in higher rental rates, lower vacancy, etc.) will vary.

troll

I think I got it, let me detail a bit below and let me know your comments:

• So upon purchase of a building, because it is an asset, goodwill is priced into market rents, cap rates, etc. From an accounting standpoint, because the asset is purchased fee simple and cash free/debt free, you have A: Building, L: Debt, SE: BV of Equity. Makes sense, you record the asset on your books at purchase price.

• RE Depreciation, you state that it is included in market purchase prices, so I am getting that it is accounted for in the market rents (Developer develops the building at cost, then analyzes AT-CF which includes dep to see whats the highest rent he can charge to a tenant). Because RE taxes are more or less fixed and not related to the earnings of the building, there isnt a tax shield implicitly built in on the asset level, but on the Fund level there is.

So essentially you have: NOI less CF from Investing less CF from Financing and get to a Ending cash flow number. Then when passing the CF to the owner of the building, the depreciation on the books is factored in and you get a lower taxable income number, less taxes that the fund pays = Net Income to Fund

Sorry if Im being dense here guys, different world...thanks!

This gave me a headache to read all of this. If you are starting in REPE though, stop thinking like this (at least outwardly). You need to turn a different switch on in your brain and not look at everything as a financial statement, and not make things more complicated than they are. The posters gave you some really good explanations too.

This sentence sounds very wrong to me.- "(Developer develops the building at cost, then analyzes AT-CF which includes dep to see whats the highest rent he can charge to a tenant)." I think you skipped over the part where someone said no depreciation or tax structure is included in asset level models.

Most real estate deals look at before-tax cash flow and returns because, as was previously stated, you simply don't know each investors situation. For a given investment, you could have 100+ investors in one property. Typically a pass-through entity will own it. The individual investors in that LLC/LP will figure out their own after-tax return. Some investors may be investing with tax-free accounts. Many will probably be at the highest marginal tax bracket. Additionally, a lot of developers/investors may have large nol carryforwards from development years where they showed losses, so taxes are somewhat moot at that time even though they are actually cash flowing a lot of money. At the property/fund level, taxes don't matter because returns are passed through to each investor. This is really the main reason. Using before-tax measures, each investment can be compared apples to apples. If you are a sole-owner, maybe you would consider how the depreciation/taxes affect your returns.

This was a struggle for me to coming into REPE, folks mostly just care about before tax fcf, and most models are built as proforma cash models and not your traditional IS/BS/CF model which is based on accrual accounting. If you only are modeling the cash flows, then you don't need to model out the balance sheet. Also, note for most CRE assets, there really shouldn't be much WK to model. Office, retail and and MF assets would possibly have negative working capital since rent is paid immediately by tenants (unless they're in lease default), and thus you don't have much WK to worry about. Also, when you're computing NOI, you are basically computing unlevered FCF (pre-tax) if you make WK = 0 (which is the case for most RE) and so it's no different from company valuations. Remember, NOI / cap rate is an Enterprise Valuation nonetheless, ie it includes all the assets on the BS you are buying (buildings, cars, FF&E, etc). Leave it to the accountants yet to make any purchase price adjustments when you prepare the financial statements.

Nevertheless, in CRE, especially for operating business assets like hotels, casinos, resorts, theme parks, healthcare, etc, you will have to create 3-statement models for the operations of the business, although this is not done for development/modeling purposes. You will also retain your 3-statement analysis skills developed in M&A since you have to analyze the underwriting business (EBITDA) along with the CRE assets.

RE investors at the end of the day, especially in development/restructuring of an asset, care about the pre-tax leveraged IRR on the equity. Yes since most RE deals have multiple JV partners, the tax effects of losses/cap gains, depreciation/amorts are done at the invesor level, and not at the property level, so you can make an apples to apples comparison on the investment you're contemplating.

CRE can be very interesting, and you can definitely create more equity value than general corp PE whereby you are investing in a healthy going concern operating business and just recapitalizing the BS to pull out equity returns. That's fundamentally implied in CRE investing along with organically increasing income from the asset you are owning (with hotels being a major source for this).