Walk me through a DCF? Real estate
I know that dcfs are different for the real estate industry then the general finance industry, but I am confused about the steps and how to answer in an internship interview situation.
Can someone go through the steps and how they would respond during an interview? Thank you
Hi Prospect in RE - Other, any of these threads helpful:
More suggestions...
Fingers crossed that one of those helps you.
Than. Pls fix.
only know dtf for RE. Not sure what this dcf is.
Probably just the general line items especially for an internship. Where are you interviewing?
Small to midsized repe firms so far. I am only a rising sophomore, so no place that is super prestigious.
repe! prestigious! yeah!
That video does a pretty good job of breaking it down, it goes into a little more complexity than you'd need for an internship interview, but it goes over the basics.
Essentially, you take Gross Potential Rent, subtract vacancies and incentives to get Effective Rent, subtract all your expenses and you get NOI. Do this for each period you are holding, and in the period you sell (or refi, but that's a bit more complicated) you take your NOI and divide by your exit cap to get your sale price. From there you can calculate unlevered metrics like IRR, equity multiple, cash on cash, etc. The next line would be adding in debt, subtracting debt payments, and subtracting your loan repayment, resulting in your Free Cash Flows, and from where you can calculate your levered metrics.
That might be good enough, they might ask for a basic waterfall in which case you'd build up the capital accounts for each partner (usually including pref accrual for the LP), pay those out with FCF and once the capital has been paid back take any remaining cash and pay out at the rates agreed to in the waterfall. You can sum all the distributions to each partner (return of capital and each level of the waterfall) to get investor-level returns. And that's pretty much your basic pro-forma.
Each line item can be made far more complicated (i.e. you can model vacancies as a flat % or actually plan out vacant portion of the building, break out OpEx line-by-line or just use flat %, debt is I/O for a portion of time before amortizing, etc.) and the level of detail you need will change per industry. For example, in multifamily vacancy is almost always just assumed as a percentage, like 5%, whereas office or retail might actually break out empty blocks of SF or storefronts. OpEx is fairly straightforward for office or MF, but it's a huge deal for hospitality since they rely heavily on operational leverage so you can't just make a flat assumption to get a reasonable number.
One of the big items is what constitutes an expense, and an entry-level question is often what costs are not included in NOI. The general answer is anything that is owner-specific: taxes, interest expense, CapEx, etc. The reason is so that NOI represents the asset and the asset only. If a tax-exempt entity is owning the building they don't care about taxes, debt is dependent on the owner and what terms they can get, i.e. it's not tied to the building.
Hope that helps.
Thank you! It helped a whole lot.
How would you answer walk me through a dcf if it was for a 1st year analyst position instead of an internship where you are expected to have less knowledge. Thank you!
I can't imagine it's that much different, at a basic level DCFs are all the same regardless of what your job level is. What I would do is give the general layout so you demonstrate schematically what's going on, but then elaborate on the finer details. I think the most important parts of running through a DCF at a more advanced level is understanding the company's needs. As anyone will tell you, modeling real estate is fundamentally the same across any function, but everyone looks at it differently because they have different goals and exposures. If you're interviewing for a debt shop you might want to focus on how to model in downside protection sensitivities, DSCR and debt yields to show that you're thinking about loan preservation and the metrics that are most valuable to a mortgage holder. If you're interviewing with a developer you should hit items like the timing of hard and soft costs, sensitivity to land prices, cap rate expansion, etc. If you're interviewing with a brokerage shop you should demonstrate knowledge on how to use a random number generator (kidding!). Knowing what your interviewer is most concerned about is key to a good interview.
This is a good walkthrough of a property operating statement, but OP if they ask to walk through a DCF bear in mind you also need to explain the actual DCF methodology. To value through DCF, take the above through to NOI, then deduct below the line items aside from debt service (e.g. leasing costs, necessary capex, etc.), then apply a discount rate to all the cash flows to get to a PV.
I included those items in my second paragraph, you get to your Free Cash Flow and then can calculate whatever metrics you want: IRR, C/C, EM, etc.
If you answered this question like this to me I would then proceed to ask you “Ok, now explain everything you just said and the methodology behind it”.
Yeah because I'm not going to write out an interview answer verbatim, that'd be dumb and a waste of my time. I was giving the framework of how to answer it. Give a man a fish yada yada yada.
Bump
DCFs for real estate are just like how you would do them for a company in a finance class.
That being said, from my experience in CRE we never use this valuation technique but instead divide the given year's NOI by a market cap rate - this is the industry norm.
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