Comments (44)

 
Sep 16, 2015 - 3:33am

I think it's worth splitting theory and practice on this question. Theory would tell you to DCF the unlevered cash flows. You can look for average recent cap rates in comparable transactions (note that you would want to use or adjust for economic cap rates that account for normalized long-term capex rather than nominal cap rates that just use NOI), and then convert those cap rates into unlevered IRR expectations. If the prevailing market economic cap rate is 4%, and long term growth is 3%, then the target unlevered IRR is 7%.

In reality, real estate practitioners rarely come up with an asset-specific discount rate to determine a property's NPV and assess its merits due to a discount or premium to offering price. This is probably because real estate is not as liquid as public equities, so investors can't easily justify an investment on a catalyst will lead to a near-term correction of mispricing. Instead, real estate investors typically have their own target returns (whether they are pension or insurance plans with target returns, PE funds with a hurdle rate, or REITs with a market-based cost of debt and equity) and evaluate whether a given deal meets those required returns and fits within their risk and business plan parameters.

When brokers prepare a BOV and value a property on NPV, they typically determine the appropriate risk bucket of the likely buyer (core, value add, or opportunistic--or in between). If it's a core investment in a major market, lately it seems groups are solving for 6-7% unlevered IRRs. I would say value add returns these days are 12-15% on a levered basis, and opportunistic investors are shooting for 18%+ (increasingly difficult to find without high leverage, development, or tertiary market risk).

 
Sep 16, 2015 - 2:05pm

The WACC is simply WdKd + WeKe, where Ke is the levered cost of equity targeted return for the investor (think their IRR). You're not tax effecting the debt cost of capital like you do for company valuations because this is an asset valuation.

 
Sep 16, 2015 - 6:08pm

Wouldn't the tax shield still be in place when calculating WACC? If we are running a DCF on a commercial property then a fair assumption would be that debt is being used to finance the property acquisition or that debt is already part of the capital structure in which case taxable income would be reduced by the debt service payment effectively delivering the same tax-benefits of any other company.

 
Sep 16, 2015 - 6:55pm

you're not valuing a company you're valuing a physical asset..customarily in RE the LLC the income taxes are not paid by the company but are made by K-1 distributions to the shareholders based on their pro rata equity contributions/amount of equity held...so there is no consideration of income taxes taken into account in RE valuations typically

 
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Sep 17, 2015 - 8:04am

Unless your are an appraiser, usually you would be looking at the resultant IRR based on your assumptions rather than trying to determine a single point price estimate. So....put your assumptions in and see what the IRR is, if it makes sense based on the risk then pull the trigger.

 
Oct 18, 2015 - 11:05pm

Thanks, everyone. I appreciate your insight on this. I am still a little unclear though. So thinking about it from a personal investment perspective.. If I have two projects, both opportunistic and equally risky, but in one project I lever it up 75% with a very high interest rate, and in another I lever up only 50%, would I be using the same 18% opportunistic return hurdle to discount my cash flows to equity? Personally, I would want to adjust the discount rate on the 75% project to account for the increased leverage risk. And leverage risk is just one example, could also be tenant credit risk with one tenant being risky, and another very risky.. would both be using the same 18% hurdle as a discount? Conceptually the more risk there is, the more I want to discount the cash flow. So I was wondering why a flat 18% opportunistic hurdle is used. Thanks in advance!

 
Oct 20, 2015 - 5:58pm

Of course. Your required return on equity is 100% reflective of the cap structure. The more you lever up, the higher "cost of financial distress" you incur and the higher your return rate on the equity would be. That's why in the cap structure theory the curve is the laffer curve, whereby the higher debt you add on yes the lower your overall cost of capital, but at some point the equity required return increases to account for leverage/liquidity risk and thus the cost of capital thereby increases. If it was just the case that equity required return never changed notwithstanding leverage changes in capital strucutre, then theoretically oyu would just add on as much debt as possible to improve your return.

 
Oct 20, 2015 - 8:39pm

HI Socola, thanks for your reply. I agree but the questions was more so on how this affects the discount rate used for a property. From what I have gathered.. REPE investors discount properties based on the required rate of return of the fund. So if it is opportunistic (18% return hurdle), they will discount all of their opportunistic property investments by the 18% rate. But if you have two opportunistic properties and one is more risky than the other.. would it not make sense to discount the riskier one more? I am not a REPE investor so although intuitively this sounds right to me.. I would like to know how people do it in the industry.

 
Oct 20, 2015 - 10:35pm

What discount rate would you use? (Originally Posted: 05/16/2014)

Hey, guys. I've built out a subdivision land development and townhouse unit construction model to run the residual value of the land to determine if our Borrower is purchasing the property at a reasonble price (it looks like they are, for what it's worth). I'm using a 15% annual discount rate over 6 years (life of the project), discounted quarterly. Given the subdivision's location in a wealthy but exurban county (sort of far out from the main employment center but it's well located next to public transportation and high capacity roads), adjacent to a future metro station (2018 delivery), what would you all think a reasonable discount rate would be? I guess I'm just surveying the board, expecting maybe 5 responses. Any good mathematical, objective way of putting together a discount rate?

The gross investment to acquire the land and to build out the project over 6 years is $300 million and the expected gross, absolute dollars return is $111 million over 6 years, which is a ~5.4% annualized return on investment (although double the return on investment with 50% leverage). So I'm thinking 15% may be a little high for the discount rate. Although just the land developer (our borrower, which is separate entirely from the builder) is looking to make 22% per annum on its money when utilizing leverage. In addition, with leverage the homebuilder is looking at about 22% per annum of return on investment.

Thoughts on the discount rate?

 
Oct 20, 2015 - 10:36pm

Not on the lending side but wouldn't a lender just look at comparable land value? Its not a lenders job to run a reversion and ask if that's an investable price (you dont know how return tolerance). Lenders just care about their exit strategy and on construction deals that's generally the value of the land. Wouldn't a lender just look at land comps and get comfortable with a number they could sell the land at if the project goes south?

But anyways if the developer is looking to make 22% irr I would use 22% as my discount rate.

 
Oct 20, 2015 - 10:49pm

DCDepository - I'm not totally clear on the allocation of returns to various parties - project level vs. land developer vs. homebuilder. The fact that total outflows and inflows are $300mm and $411mm, respectively, is clear. That said, I would not use the unlevered rate of return as others have suggested - you'll obviously get an NPV of 0 per the definition of an IRR so that's not helpful. Two approaches that might work for you: compute a WACC, OR you can take the risk free rate plus risk premium (similar to the components of a cap rate - RFR + Risk Premium - Growth), risk premium being completely subjective but which can be informed by opportunity cost and the actual risks present. In example, entitlements, if present, are a significant reason to bump your risk premium.

 
Oct 20, 2015 - 10:50pm

Post is a little unclear but I'll try my best...

DCDepository:

Hey, guys. I've built out a subdivision land development and townhouse unit construction model to run the residual value of the land to determine if our Borrower is purchasing the property at a reasonble price (it looks like they are, for what it's worth). I'm using a 15% annual discount rate over 6 years (life of the project), discounted quarterly. Given the subdivision's location in a wealthy but exurban county (sort of far out from the main employment center but it's well located next to public transportation and high capacity roads), adjacent to a future metro station (2018 delivery), what would you all think a reasonable discount rate would be? I guess I'm just surveying the board, expecting maybe 5 responses. Any good mathematical, objective way of putting together a discount rate?

The gross investment to acquire the land and to build out the project over 6 years is $300 million and the expected gross, absolute dollars return is $111 million over 6 years...

So let's say the land developer/builders unlevered annual CFs (excluding land purchase price) are as follows:

Yr. 1: $-10mm
Yr. 2: $-10mm
Yr. 3: $-10mm
Yr. 4: $-70mm
Yr. 5: $-200mm
Yr. 6: $411mm

What you are asking is, what is a fair unlevered rate of return for the developer/builder to earn over the life of this project? Let's say that number is 15%. The NPV of the numbers above at 15% (annually discounted) is $15.4mm, which would be the 'fair' purchase price for the raw land. Is 15% fair? Doesn't seem crazy to me, but I don't look at these types of deals, so would defer to others.

DCDepository:
Is there a good mathematical, objective way of putting together a discount rate?

Not really, this is pretty subjective (IMO). Would base it on what other developers are accepting for returns and what you think the risk of this development is relative to similar projects.

Now where your post begins to become unclear:

DCDepository:
...which is a ~5.4% annualized return on investment (although double the return on investment with 50% leverage).

5.4% is the annualized ROE assuming the $300mm was all put in up front. I would think the $300mm will be funded over the life of the project, so 5.4% is meaningless.
DCDepository:
Although just the land developer (our borrower, which is separate entirely from the builder) is looking to make 22% per annum on its money when utilizing leverage. In addition, with leverage the homebuilder is looking at about 22% per annum of return on investment.

I am assuming you are looking at this project level (borrower/builder as one entity) so am ignoring this.
 
Oct 20, 2015 - 10:51pm

The way I determined the discount rate was to look at an industry chart that said homebuilders have an average cost of equity of 11.66%. Couldn't find anything on land developers, so I used 12%--my boss said use 18%. The correct answer is the cost of equity is whatever your boss says it is, even if he's wrong (I'm pretty sure he's wrong since it runs the valuation to $49 million when the bidders put in offers of $59, $70, and $80 million).

 
Oct 20, 2015 - 10:52pm

Whch discount rate to use? (Originally Posted: 04/03/2017)

I have a client with investment in South Africa. The client is based in US. The investment is currently under negotiation for sale at ZAR 15m (equivalent to USD 1m at today fx rates) but settlement is in 3 years. The receipts are in ZAR though we value the investment in USD. So instead of currently valuing the investment at $1m, i need to discount this value to take into account the 3 year settlement period. Which discount period should i use??? I guess i could value the investment at ZAR 15m at South African discount rates and then convert to USD at exchange rates (not sure which rates) OR value at USD 1m discount at US interest rates. I obviously dont get close results. Receipts not hedged.

 
Oct 20, 2015 - 10:53pm

You should start with a US based discount rate and modify it to include Damodaran country risk premiums (ratings based default spread and equity risk premium modifier). You should also consider a currency risk adjustments - I'm a bit rusty on how to actually do this but it has something to do with the fisher effect.

“Elections are a futures market for stolen property”
 
Oct 20, 2015 - 10:54pm

Can someone dumb down discount rates? (Originally Posted: 02/03/2016)

Relative to RE? Difference between one and IRR? I understand the whole time value of money but whether its for RE or in regards to corporate finance I just can't understand it really. What rate would you use for a property? When would you create a discounted cash flow?

 
Oct 20, 2015 - 10:56pm

IRR is the specific rate at which the NPV of an investment is equal to zero.

 
Oct 20, 2015 - 10:58pm

In its simplest form, the discount rate is your REQUIRED return on a project. If you need a 10% annual return (using a discounted cash flow model) then that is your discount rate (the rate you use to discount your cash flows)--and nothing will change that number other than your investment demands. If you want to develop a new multifamily property in, say, Forth Worth, TX, maybe your required rate of return is 10% per year. If you are developing that same property in, say, New York City, perhaps you only need a 5% annual rate of return because NYC is a less risky market. So your discount rate will be impacted by risk and return metrics, which are mostly subjective.

Your IRR is the discount rate that sets your cash flows to $0. In its simplest form, the IRR is the annual rate of return of the project. If your discount rate--required rate of return--is 10% and your projected IRR is 12% then the project meets your return specifications. If the IRR is 8% then it does not meet your return specifications.

IRR is also used to compare two projects. If you have finite money and you have to choose between a project that is throwing off a 15% IRR and one that is throwing off a 12% IRR then, in theory, you would move forward with the project with the highest IRR.

Array

  • 1
 
Oct 20, 2015 - 10:59pm

Virginia Tech 4ever:

If you have finite money and you have to choose between a project that is throwing off a 15% IRR and one that is throwing off a 12% IRR then, in theory, you would move forward with the project with the highest IRR.

Assuming risk is the same of course.

Array

 
Oct 20, 2015 - 11:02pm

RE DCF discount rate? (Originally Posted: 11/13/2012)

How do you calculate the discount rate for a real estate DCF valuation? Cost of debt is straightforward, but how to get cost of equity? I imagine you can't use CAPM because there's no beta or benchmark index.

 
Oct 20, 2015 - 11:04pm

PTS, by NOI/cap rate you estimate sell price, but valuation may be performed for other purposes, too. E. g., when you apply for a loan, the bank demands official DCF valuation report for the purposes of guarantee / pledge / risk management.

As for the discount rate: it may be (and in my case it IS) not WACC but rather composite rate which reflects all risks attributable to your RE project. All components of the rate are very judgemental.

For example, doscount rate is composed as:
Risk-free rate 3%
+
Local RE market risk 4%
+
Risk of delay in construction 3%
+
Risk of lease arrangement not being prolonged (if you use land under lease agreement) 3%

etc.

Yes this is rough and very subjective. But if you invest in, say, construction, WACC makes even less sense (especially if the project is executed through single-purpose SPV).

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