Real Estate Financial Modeling Case Study HELP - Getting to Purchase Price??
Hi, so I've recently applied to a RE investment firm and they gave me this case study. I've been trying to read through some case studies online, but I can't find anything that is similar to the one they gave me.
Basically, there is a target Office Building to be acquired with 1 year of renovations before being leased out to a tenant, and then an exit by Year 4. The property will be funded by equity, mezzanine, and senior debt. Now, usually, case studies provide the purchase price for the target property as well as an exit cap rate at the end to determine the returns of the investment.
However, in this case, they did not give me a purchase price nor any cap rates. They only mentioned that the minimum equity IRR for the Investor should be 22%. How should I compute the purchase price for this? I'm stumped on how I would have to do this.
To find purchase, calculate a first year stabilized NOI divided by a cap that you researched to be the most reputable in the area. The most likely want you to assign your own cap!
Oh, so basically I need to compute for the NOI in their first year of operations? And for the cap rate, I've found that the cap rates in this area range from 7% to 9% generally. So say, I assume an 8% entry cap rate. My purchase price will then be Year 1 NOI / 8% cap rate?
But what cap rate should I assume for when they exit? Will it also be up to me to assume that exit cap rate?
Good job on finding a going-in cap and probable purchase price! 8% sounds good.
Now, exit caps are almost always an assumption because predicting the future is hard, so this is definitely up to your assumption. I'd suggest the cap rate expansion method : 0.1 * holding period. So if you have a 10 year hold: 0.1 * 10 = 1%. Add that to 8% for a 9% exit cap. If you can find the data: Find historically how cap rates have increased per year in the area for office buildings and use that average change number (instead of 0.1)
Also, if you're allowed to ask- it wouldn't hurt to ask for a purchase price to use just so you're a little more accurate in your model
Also yep you calculated purchase price correctly.
Lastly! Do you have a sale price? Exit cap would be easy to calculate at that point. Forward NOI (Year 5) divided by sale price would get you an exit cap, too.
Thank you for the really helpful replies man! I'll certainly look at your recommendations! They did not give me purchase price, sale price, nor any entry/exit cap rates as reference. They didn't even give me the lease rates for the building lol. From what I've watched so far, most of the time, these are assumptions that are directly given in the case studies. So I guess they also want to assess my research skills lol.
I'm thinking of asking my employer but this is what they said in the case study: "Executive summary of transaction with your recommendation on deal structure and pricing of the Asset that will achieve a minimum of 22.0% equity IRR". Based on this, I think they really want me to come up with my own purchase price. At the same time, however, they also want me to compare my purchase price with comps to determine if asset pricing is cheap and attractive relatively. But if I'm already basing on market rates, wouldn't that just be kind of pointless? I'm thinking i'd just be going back in circles if i do that.
You're overthinking this. Just use goalseek on the purchase price to get to a 22% IRR. The comps stuff is just for after when you're making your summary.
What if you're looking for the purchase price of the land itself, not an actual building? How would you go about determining that?
If you know the IRR should be 22%, just adjust a purchase price by guessing, until your leveraged IRR equals 22%. I assume your debt is based off of your purchase price, so once you set your purchase price, say $10MM, your debt will become, for example, $6.5MM and $1MM, and if your IRR at this price shows 18%, lower your purchase price and see what your IRR is. Rinse and repeat (in either direction) until your purchase price equals a 22% IRR.
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