Development valuation help
Hi sorry if this is a stupid question (I have never worked in RE before) and needed to value a development asset for a deal
How do you value the operating asset at the time of development completion? Do you use DCF to discount your future cash flow back + terminal year NOI / exit cap rate?
However, this method doesn’t factor in your development costs, so how do you know if the future value of this business is higher than the development costs (I.e how do you evaluate if this is a good opportunity?)
If someone can please please explain to me that would be v appreciated. Thanks so much
When valuing a real estate development project at the time of completion, indeed, a Discounted Cash Flow (DCF) analysis is a common method used to estimate the value of the operating asset. Here's how it typically works:
Forecast Cash Flows: Estimate the future cash flows the property will generate once it is developed and operational. This includes rental income, operating expenses, and net operating income (NOI).
Terminal Value: Calculate the terminal value at the end of the forecast period. This is often done using the exit cap rate applied to the terminal year's NOI. The formula for terminal value using the cap rate is: Terminal Value = NOI at exit year / Exit Cap Rate.
Discount Rates: Apply an appropriate discount rate to both the forecasted cash flows and the terminal value to bring them back to their present value. The discount rate reflects the risk associated with the future cash flows.
Summation: Add the present value of the forecasted cash flows and the present value of the terminal value to arrive at the gross development value.
However, to evaluate if the development is a good investment opportunity, you need to consider the development costs. Here's how:
Development Costs: Calculate the total development costs, including land acquisition, construction costs, financing costs, and any other related expenses.
Net Development Value: Subtract the total development costs from the gross development value (the sum of the present values calculated in the DCF analysis).
Profitability Analysis: If the net development value is positive, it suggests that the future value of the business is higher than the development costs, indicating a potentially good investment opportunity. If it's negative, the future value does not justify the development costs.
Sensitivity Analysis: Conduct sensitivity analyses to understand how changes in key assumptions (like cap rates, rental income, construction costs) impact the net development value.
Remember, real estate development involves significant risk, and the accuracy of the valuation depends on the reliability of the assumptions made. It's crucial to have a thorough understanding of the market and to consider various scenarios to mitigate risk.
Sources: DCF Modeling Course ~ Pre-training text.pdf, DCF Analysis Urgent Help, 21 Finance Interview Questions and Answers, Notes for Technical Interview Questions, 21 Finance Interview Questions and Answers
Bump pls help me
To find out how good the development deal is, you would look at the “yield-on-cost”.
Ie: what is the stabilized cash flow of this asset / total costs required to generate the cash flow.
If this yield-on-cost is accretive to your AFFO it’s probably a good deal.
If I’m a company that currently has $10M in AFFO on $200M of equity then I’m yielding 5%.
If I can building an asset that generates $1M using $10M of equity then that asset is yielding 10%. So it would be accretive to my AFFO to do this deal - combined $11M / $215M equity = 5.11%.
Feel free to DM me if you want. In a nutshell, yes, you would use a DCF-esq model to model out construction costs timing, lease up, and stabilized NOI and cash flow. Then you'll make some assumptions around exit year, exit cap, debt financing, and so on to evaluate the overall project feasibility and returns.
Like the prior comment said - the two best development barometers are untrended YOC (Today's rents (assuming stabilized occupancy) - expenses / costs) and trended YOC (Projected future rents at time of stabilization - projected expenses / costs). Why these? Because they can't be as easily engineered to the degree that IRR / MOIC can be. The easiest way to quickly determine if the future value of the property is greater than costs is by looking at the spread between market cap rates today for similar product, and if your trended and untrended YOC is greater. Technically, any positive spread means the project will be profitable, but developers today typically target at least 125 - 200+ bps of spread. For example, if you think your ground up industrial building will generate $5m NOI once fully stabilized (using today's rents and not projected rents) and costs $60m to build, your untrended (or "going in") YOC is an 8.33%. Lets say brand new industrial buildings nearby recently sold at 6.0% cap rates. You have 233 bps of spread, and without even running full IRR and MOIC calculations, I know that the project will be at least a 25% IRR / 2.0x MOIC, likely much greater.
This is to "value" the entire project - if you just need to figure out what a theoretical gross terminal value (exit price) is, you can simply take the projected NOI / exit cap rate. If your total projected exit price per SF is greater than your all-in cost to build PSF.... well... your project should be profitable. Assuming a whole bunch of things that can go wrong don't go wrong.
Thank you so much for this, super helpful. Will pm you for some minor follow up questions
I know everything you said but how did you calc to a 2x multiple based of the YOC/dev spread? Is that assuming a 3 year hold?
I have the same question. As someone who’s moving into the industry, any mental math tips are helpful
Curious as well. I'm guessing that 8.33% YOC to 6.00% cap on completion/stabilisation equates to a ~39% uplift (Development margin). Assuming 65% LTC, then with 1.39x return on every 1 dollar (0.65 debt, 0.35 equity) invested, the MOIC/equity multiple is ~2x (0.35 -> 0.74)?
Personally for a quick valuation, I’d just cap the stabilized NOI at a market exit cap. Thats what an investor might pay for it when it’s complete. Otherwise ROC is a metric we use a lot to compare deals.
For clarity's sake, can OP specify whether they are looking for how to value the asset or how to determine whether it is a "good" opportunity?
How to value the asset at completion i guess
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