Most Important Part of Real Estate Valuation - Measuring the Risk Premium?

anyone have any insight?

OP, you have a lot of really good thoughts and I commend you for them. From what I've seen, in practice, risk is measured by intuition, especially when you are familiar with the area and product type. Intuition based on experience with comparable properties drives what people are willing to pay for a project. In minutes, most experienced professionals could figure out a defensible discount rate of a project.

Thank you everyone for your input. It helped clarify some of the questions I had around the risk premium.

I'm definitely more UK centric in my understanding but will chime in anyway. Totally agree that investors will have pre-established risk appetite often illustrated in the form of an Unlevered Yield/IRR/CoC/EM. In most cases their strategy is defined and they have a hurdle rate or minimum return which has already incorporated the risk premium required for the given strategy. Initially the first and most important metric is going to be the net initial yield as this in most cases is the current situation of the property and relies the least on any forecasts. If an investor is an income player then this will need to satisfy their yield requirements immediately. If they are IRR players the next key metrics are going to be rental growth and cap rate compression. Investors will know very quickly if an asset is worth underwriting.

Typically most investors I have worked with asses risk through sensitivity analysis around price, rent growth, cap compression and interest rates. They will also look at income volatility through statistical analysis. Scenario analysis looking at a base case and then conservative and aggressive across the key variables. This can be taken further by assigning probabilities but this is where things become highly subjective and prone to input error. But overall this level of analysis will give a clear indication of under what circumstances the investment will still satisfy the investors return requirements. If probabilities are assigned to the scenarios distribution curves can be used to try and ascertain what percentage chance there is of returns falling within a certain band.

So to sum up I don't think investors try to come up with a risk premium for a property. Rather they have a required return related to strategy, for which they will then manipulate the variables to see if such a return can be maintained when accounting for downside risk.

I work for a pe firm that operates in the capacity of fund manager and real estate developer/operator. When I did not have any work experience I thought in a similar manner. I tried to translate academics into deal scenarios. It is important to paint a risk profile picture for a deal (asset specific, market, strategy, leverage, and make sure the prior align with macro trends). However, do not try to quantify this into a risk premium or discount rate - throw it into a qualitative presentation for the partners.

Concern yourself with the type of return you can juice out of an asset/project. The riskier the asset/project (secondary & tertiary markets, development, opportunistic plays) the higher return you and your investors are going to demand - set the acquisition price accordingly (valuation). The purpose of buying real estate is for future cash flow, examine an opportunity as such. Hope this helps.

This is a rough risk/reward profile for our projects on a levered basis

Core 8%+ Value-Add 12%+ Opportunistic 16%+ Development 20%+

Thanks everyone, this discussion was very helpful. Seems like the discount rate doesn't fully account for the entire investment risk, but a qualitative analysis must be done afterwards. Just to cement the way professionals think about this.. I would like to do an example:

Single-Tenant Triple Net Lease Retail property in a prime location comes up for sale with an in-place lease with a Triple A tenant [say CVS] with 15 years left on the lease and the expectation that is it likely to renew the lease at maturity given strong location and demographics. NOI is $1mm. CVS is the highest paying retail tenant for that space and the land is in its best use [no "core+", "value-add", or "opportunistic" opportunities, only a "core" income stream].

1. Investor analyzes property risk and buckets the investment between four buckets (Core, Core+, Value-Add, Opportunistic). In this example it is Core.
2. Based on the bucket, Investor demands a certain return and underwrites the property using that return. In this example, say it is 5% for Core bucket.
3. The investor then runs sensitivity analysis and manipulates the variables (to account for downside risk) to see what the chances are of the property hitting the return or not. Based on this sensitivity, the Investor has three options: Option 1- If he feels that the project is too risky (should be underwritten at higher rate than 5%), he will let it go Option 2 - If he feels the project is risky enough to meet the exact discount rate it is underwritten at, he buys Option 3 - If he feels the project is not as risky (should be underwritten at lower rate then 5%) he will invest and realize additional "risk-free" returns above the 5% return that way (5% - lower rate = "risk-free" return) or bid higher to the point where he realizes the lower rate

I guess this is where I have additional questions. Based on the comments above, everyone seems to use Core, Core+, Value-Add, and Opportunistic buckets to underwrite properties. So say that was done in the above investment.. everyone would bucket the property as Core and underwrite the property at 5%, valuing it at $20mm. They would then all have preliminary bids of $20mm in the auction.

So what differentiates all the investors out there who bucketed the investment as "Core" and allows one investor to outbid the rest? It would be step 3 - the qualitative/sensitivity analysis. But to determine the additional amount an investor is willing to pay.. wouldn't they need to put a price to step 3?

Wouldn't they need to say "hey this is a core investment. everyone is bidding $20mm since everyone has the same 5% return for core investments. but based on my sensitivities and qualitative analysis of the downside risk, I feel that this investment is not risky enough to demand a 5% return. I feel it should demand less return. Therefore, I am willing to bid more for the investment. But how much more should I bid? How much more am I willing to pay to the point that I feel I will get the lower return I need for this investment's risk?"

If that is the case.. wouldn't they end up quantifying the "qualitative" step anyway? I guess I am still confused a bit.. but hope this helps clarify my confusion. I guess the main question is how would investors determine just how much more they are willing to bid for the property if it is in a certain risk bucket.

• Thanks again for everyone's input!

So the "end of the day" purchaser would absolutely fall under the "option 3" that you listed, you're right. The purchaser will have a bottom dollar return that he is willing to pay for this investment and this should be predetermined..."I will not buy any NNN CVS that has a cap rate lower than 5% because my group's criteria says so". But this CVS is 2 blocks from the principal's child hood home. He knows people who shop here. In fact, this CVS has been located in this same location since he can remember. The purchaser might have a personal connection to the building and he might have market knowledge that is better than other purchasers. The fund is a long term hold type of fund and they won't sell until year 10, and by then CVS will have increased their rent 3% annually over the last 10 years and the investor likes where he perceives cap rates are going (lower).

The purchaser then submits his first round bid at say 4.9% cap because he think its a steal at 4.9% even though the investment world might look at it like a 5.0% cap deal (purchaser is keen at predicting interest rate directions). After Purchaser submits the bid he gets feedback from the broker. This is where being a wheeler and dealer comes into play. The broker might come back and say "gee, we have 3 bidders who are bidding at around a 4.45% cap, can you get there?". You read the broker and decide whether he's making you bid against yourself or if there are real players bidding against you in this deal. You might come back with, "Tell you what, I'll resubmit at 4.5% which is the absolute bottom dollar amount that I'll pay for this, take it or leave it". But you also might want to say "I'll resubmit at 4.75% but I'll close quickly--give me 15 and 15 to close an I won't re-trade on you". The purchaser and his partners have pre-determined what they are willing to pay should they get into a bidding war for this particular asset (this asset may fall into their "core" strategy but its "special"). If they don't want to lose the property they will bid their bottom dollar amount, say a 4.5% cap and give favorable closing terms. If they think the broker is bullshitting them and the seller isn't a real seller, they'll move on. Its about feel. Every single deal in real estate is different and after the basic financial models are run, qualitative decisions take over rather than quantitative. So here, the purchaser quantifies what he is willing to NOT pay and lets the bidding war sway him downwards until he is unwilling to continue on-- unless he simply doesn't believe the broker and thinks he is bidding against himself-- in that case he will give his last and final offer and let the chips fall where they may.

"everyone would bucket the property as Core and underwrite the property at 5%, valuing it at $20mm. "

This is where I lose you a little bit because its so far from reality. Not everyone has the same core "buckets" and not every investor underwrites risk the same. Its how the investor perceives the risk---if the investor thinks that they are excellent at lease-ups and all a property needs is a a lease-up campaign then they will underwrite that risk lightly and bid more. If the investor isn't fully integrated and doesn't have a construction manager or a project manager and the property needs a facade and internal face lift, then this particular investor will underwrite that risk heavily and will bid less. If a company is local and understands the local market better and they are bidding for a core property in the market that they are experts in, they will underwrite their market risk lightly (because they might have a lot of confidence in the market due to their familiarity for the players or tenants in the area) and bid more vs. a player on the west coast bidding for an east coast property that they aren't quite as familiar with (more shaky and higher market risk).

You are asking the right questions, they do not have short answers. Everyone underwrites differently - it's an art not a science. Sure it's easy to say slap a 5% cap on a NOI of $1MM, but that's not too realistic. A basic example of an asset being worth more to firm A than firm B, ultimately allowing firm A to bid higher: firm A has in-house property management which increases yields by 100k. Firm B pays 100k to property manager.

...time horizon, asset, portfolio or firm strategy, capital structure, fund mandates, manager incentives, capital allocation requirements, desire to hold wealth in safe USD assets, the list goes on and on.

cre123 haven't been focused on core assets lately. developing in gateway (sub)markets and neighborhoods