I'm taking a real estate class this semester, and we're suppose to do a DCF for an apartment building in Winnetka for our project. I read somewhere online that real estate investors usually don't use DCF and use other methods of valuation, but our professor wants us to use the DCF method.
The thing i'm confused about is when you're trying to find WACC, how do you find beta for an apartment?
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You don't need to find beta...use the cost of debt for the apartments.
If I were going to do a DCF model for an existing multifamily building I would use the capitalization (cap) rate. There's no one way of determining the "correct" cap rate as it is a partially objective and partially subjective measure. I'd start by getting a free LoopNet account and finding some comparable cap rate data. For everyday real estate pros, our cap rates move based on subjective measures, such as how "nice" the area is, how "desirable" the location is, and can also move subjectively based on objective measures (capital expenditure expectations, age of property, etc.). For the purpose of your class I'd go right to LoopNet and keep it as objective as possible, e.g. (6% + 7.5% + 6.75%) / 3 = 6.75% cap rate = my discount rate.
@"DCDepository" is definitely onto something there. I would also check out Integra Realty Resources' 2014 Viewpoint publication. Obviously it's a very broad, generalized overview of markets and product types but they do have a "discount rates" section for what it's worth... Best of luck.
http://www.irr.com/FileLibrary/Publication/15/IRR_Viewpoint_2014_Web2…
CBRE releases their survey of cap rates for different types of CRE in various urban and suburban markets across the country twice a year. The most recent one I have seen was the 2013 2nd half, but I am sure the 2014 1st half is out by now. Also, in many cases the discount rate for the DCF will simply be a required return set by the fund, not necessarily the cap rate you use during the income capitalization.
Discount rate is NOT the same thing as Cap rate. Discount rate is the rate which justifies the real estate investment. Cap Rates (Cap rate = NOI / Value of Building for entry monkeys...) are market driven and contain many factors (location of building, credit worthiness of tenants, proximity to transportation hubs, etc.).
For example, let's say you are trying to internally value a Core, downtown CBD trophy asset that your firm owns. It's located in Midtown Manhattan where assets will trade at a 4.0% cap rate. The building is not stabilized and you will need to do some improvements, which take time & $ and for sure there is uncertainty in the deal.... For simplicity let's say that to justify this investment, an investor would need 9.0% return.... This can be a return set by a fund or it can be asset specific.
For your model, you would use a 9.0% discount rate and a 4.0% exit cap rate (for simplicity... in reality you would not assume an exit cap in the future is equivalent to today's, so usually people add 100-200 bps to provide more cushion).
If you're doing a DCF analysis on a stabilized property, then cap rate (or something approximating a cap rate) is completely fine to use for your discount rate since your cap rate will essentially be your required return on equity. Your example is that of a non-stabilized, value-add opportunity. Obviously you start looking to the risk-adjusted cost of equity when the property isn't stabilized. An un-stabilized property has an added risk-adjustment, hence your discount rate would be different (higher).
For example, if you were purchasing a stabilized multifamily property for a 6% cap rate then you are saying that you need a 6% annual return on your equity (exclusive of capital expenditures). If you are running the discounted cash flow of a stabilized multifamily property you would discount at your cost of equity capital, which is implied to be 6% if your market cap rate is 6%.
For your exit cap rate in your DCF, as you said, you increase the current market cap by 100-200 bps.
Based on the OPs comments it appears as though he is asking about a stabilized property. If the property is not stabilized then you are basically correct.
I think you mean it would be your return on assets, not equity. Your ROE would be higher because you'd likely be using (lots of) leverage.
I'm not in RE but why wouldn't you just call your WACC your weighted ROE and weighted AT cost of debt?
This is incorrect. Your discount rate is "essentially" your required rate of return, not your cap rate. Here is a link explaining discount rate vs. cap rate ->
http://www.propertymetrics.com/blog/2013/03/01/difference-between-cap-r…
I'm not sure what you're trying to prove. Cap rate is obviously different from discount rate. That doesn't mean that your discount rate may not be the same as a cap rate in certain circumstances.
If you were to purchase a stabilized property that had a $100,000 NOI and the market cap rate was about 10% then theoretically you'd be willing to plop down $1 million for the property. If you're trying to decide if your investment is worth it, it's possible you'd use a 15% discount rate since maybe you can get better returns on your money in alternative investments. But if you're valuing a stabilized property and the market cap rate is 10% then the market has spoken--that is your discount rate for a DCF analysis when determining the VALUE of the property in the open market. This is, of course, if you're assuming unleveraged DCF analysis, which would be typical for appraisal DCF valuation. If you're doing a DCF analysis for private equity then all bets are off--the DCF analysis may include leverage, higher discount rates, etc. That's not what we're talking about here.
You're confusing valuation of a stabilized property with investment decision valuation. That's the difference between appraisal valuation and investment analysis. The OP is asking about how to VALUE a property utilizing a DCF analysis. Why would you utilize a higher discount rate than your market cap rate on a STABILIZED property? Instead of throwing monkey shit at me, which you obviously did, state your case. What would be your justification for using a discount rate above or below the market cap rate on an unleveraged DCF analysis when trying to value a property?
I’m not trying to prove anything; I’m simply trying to explain to you (and other people that might be confused) that when building a DCF, a cap rate is not your discount rate. Yes, certain instances they can be equivalent, but 9 times out of 10 they are not. Unless the property’s cash flow is expected to be stagnant, you would not have your discount rate = your cap rate.
If you clicked the link I posted, then you would see the difference between the 2. I wasn't trying to be facetious or “throw monkey shit at you”. I actually like to stay out of petty arguments and typically utilize WSO to help myself and others. There are numerous reasons why a discount rate will not be equivalent to cap rate. Cap rates tell you the value of a building based on 1 year's NOI. It's a back of the envelope proxy. It does not factor in things that will occur in the future, such as rental growth, tenant's going bankrupt, or anything else that could happen. The discount rate is equivalent to what an investor would feel is needed to purchase the building, not knowing what will happen in the future.
Dude, you have no idea what you are talking about. I haven't worked in appraisal, but I'm pretty sure discount rates and exit cap rates are standard terms & utilized the same whether you are on the principal side or not. Please stop acting like you are Mr. Real Estate Knowitall; it's getting old.
Even in your real world example, you're wrong. You think everyone buying an apt complex at a 6-cap is shooting for a 6% return?
In other, more simple words, the market--the smart money--has APPROXIMATED the cost of equity when it, through its purchase actions, has purchased properties at certain cap rates (more or less a 1-year snapshot unleveraged return on equity). Since your DCF analysis when valuing the property (not as an investor, but as the tax assessor, appraiser, bank, IRS, or general public might value the property) is unleveraged, your market cap rate closely (not perfectly, but closely) approximates what you might utilize as a discount rate, which would be your unleveraged cost of equity.
Since we're talking about a college class that gives no guidance about what discount rate to use, utilizing a market cap rate with an exit cap 150 bps higher than the market cap rate is a perfectly legitimate way to complete the assignment.
Mathematically, the discount rate is the cap rate + noi growth. Ex: If an asset is selling at a 7.5% cap rate and there's 2.5% escalators, you're implying you are requiring a 10% return. Cap rate only equals discount rate if you don't expect NOI to grow at all. It's all in the perpetuity formula, which is what valuing real estate with cap rates essentially is.
Not a RE guy, but seeing as a way of approximating the cost of equity is dividend yield + growth in dividends, this appears to be the most logically consistent way to proxy a discount factor.
...And I entered thinking it was about how to get cheaper rent in LA.
Hilarious. SB'd my friend.
Disclaimer: I am a licensed realtor in LA.
I haven't read through all of the comments in detail here, but essentially, the whole purpose of a DCF in a non-real estate context is to arrive at a value of the ASSET (irrespective of how it's financed - mix of debt/equity), and not the value of the equity in the asset.
For real estate, the cap rate is essentially the discount rate used to arrive at the value of the asset itself. Your required investment return as a buyer or lender will depend on the debt/equity mix (or loan-to-value ratio in real estate). The greater the leverage, the greater the potential return-on-equity, but that is separate from arriving at the value of the asset itself (in this case, the value of the property).
Think of NOI as somewhat analogous to unlevered cash flow used in DCF calculations - it's income less expenses, but not including financing costs (mortgage interest and income taxes; property taxes however are included in the NOI because it's derived from the value of the asset which is unlevered, and not the equity).
The cap rate is essentially the appropriate discount rate used to value the property (unlevered return on assets), and as such is not the same as the return on equity.
The primary metrics used to value apartment buildings here in LA are the cap rate and GRM (gross rent multiplier - think of it like a revenue multiple used in tech). Assume rent increase of 3% per year, prop tax of increase of 2% per year (on 1.25% of the purchase price), and operating expenses of roughly 25-30% of gross income - and you have a decent back-of-the-envelope annual NOI.
If you want your numbers to match up with the real world in LA, then your cap rates and GRMs for the west side should be around 1.5-3% and 18-20x respectively. On the other end you have South LA which is around 6-8% and 9-11x respectively. Hipster parts on the east side (Silverlake, Los Feliz) is around 4-5% and 15-18x respectively (the Valley is likely similar, but I don't know offhand). But that's a broad generalization as there's pockets within these neighborhoods that really vary.
Just want to point out the common misconception that NOI is unlevered CF. Unlevered CF is NOI less capital and leasing costs. Everyone seems to forget there's real capital expenses invloved. Also, cap rate is not the discount rate. Forgetting subjective and qualitative factors (which are very real) in determining what return you need to achieve in order to invest in a certain asset, quantitatively, it matters what kind of growth you can get out of the property.
Example (very simple, quick calcs and no capital/leasing costs, reversion value based on going-in cap): Assume: $1,000,000 purchase price $120,000 in NOI 1% annual growth =12% cap rate IRR - 13%
Now assume: $1,000,000 purchase price $100,000 in NOI 5% annual growth =10% cap rate IRR - 15%
Cap Rate does NOT equal return. If you bought only on the higher cap rate thinking you're getting a better return, well...
Good point, that is something I see (incorrectly) used interchangeably all the time. Another thing that I don't think has been mentioned (sorry if it was and I missed it) is that if you are doing an analysis on an un-stabilized asset you would probably need to do an earn-out on any future leasing costs and most likely include a return-on-cost sensitivity in your model since the year 1 (and possibly year 2) cap rate would mean nothing.
Very unlikely this will be needed since this sounds like a straightforward equity valuation without any leverage. To make your life easy since I think we are getting way too far into the woods here, I would try to value based on a 4%-6% entry cap, a 7%-10% unlevered IRR, 2.5%-3% annual rental increases and a 5%-7% exit cap rate (add 100 bps to whatever you use as the entry) and a 1.5% cost of sale (assess this only on the back-end since in most cases seller pays closing costs, remember you are underwriting the investment from a buyer's perspective).
Like MBAApply said it varies greatly on the neighborhood, but in general I think you could back up these assumptions.
EDIT: To clarify, obviously you would either price off of the cap rates mentioned above and let the IRR fall out, or the opposite.
it seems like people are making this way more complicated than it needs to be. The discount rate and IRR are the same thing. it is the rate of return that you are targeting or that a project is yielding over a specific time period you indicate. a cap rate is a market-based metric that indicates how much the market is willing to pay for the NOI stream, based on a variety of factors including location, building quality, lease-up risk/vacancy exposure, general market positioning, and basic economics of supply/demand of capital chasing deals in the market.
Getting all Internet tough nerd in here.
I have got into debates with DCDepository and I have concluded that he has no clue what he is talking about.
That, however, does not prevent him from throwing his stupidity around all over the place and and acting like he is the smartest guy on WSO.
It wouldn't be so bad if he wasn't so arrogant about his stupidity.
DCDepository = Virginia Tech 4ever.
Explains a lot...
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