Real Estate DCF Valuation (upcoming interview!)

Hey guys,

Can someone help me to understand real estate DCF valuation specifics?

How exactly is the WACC calculated for a real estate DCF model? Does the tax shield diminish the cost of dept like in the classical WACC calculation? Maybe a silly question, but does WACC calculation interfere with the cap rate somehow-could I just use the cap rate instead of WACC?. Is NOI used as Free Cash Flow to the Firm? Why is the terminal value calculated by dividing the cash flow sum by cap rate and not WACC?

Also a couple of questions to cap rates: Why is cap rate considered the inverse of a PE multiple-I would say it corresponds more to an EBIT multiple, no? Does it make sense to calculate cap rates by taking publicly traded companies' multiples (e.g hotel chain ratios)?

Thanks!!

Comments (28)

Apr 8, 2011

Its fairly unusual to build up a WACC for use in real estate valuation. The discount rate / IRR is typically estimated via surveys and also by the spread between what an appropriate cap rate would be and the amount of growth expected in earnings over the holding period.

I'm not sure who told you that cap rate is considered the inverse of the PE multiple but I would probably agree that it is more closely related to EBIT. When someone does RE valuation it typically is done on an unlevered basis and before income taxes.

Apr 8, 2011
prnz:

Its fairly unusual to build up a WACC for use in real estate valuation. The discount rate / IRR is typically estimated via surveys and also by the spread between what an appropriate cap rate would be and the amount of growth expected in earnings over the holding period.

I'm not sure who told you that cap rate is considered the inverse of the PE multiple but I would probably agree that it is more closely related to EBIT. When someone does RE valuation it typically is done on an unlevered basis and before income taxes.

Let me preface w. dont know much about RE but..why do RE guys always use perpetuity for TV vs exit multiples? Seems like in CRE if an asset is income producing then you could apply a TV exit multiple inferred from precedents. Perhaps precedents in RE never disclose income hence inability to infer multiples

Apr 8, 2011

Not sure but my guess is that this is because the use of cap rates is so ubiquitous and it's pretty easy to add a spread of 100 - 200 basis points to your going in cap rate to figure out what an acceptable terminal cap rate might be.

Apr 8, 2011
prnz:

Not sure but my guess is that this is because the use of cap rates is so ubiquitous and it's pretty easy to add a spread of 100 - 200 basis points to your going in cap rate to figure out what an acceptable terminal cap rate might be.

Ya but how do you map that to what properties have traded and are trading for? Couldn't you get a little more granular and map sq. ft., growth, and profitability metrics to appropriate multiples inferred from precedents?

I think this is why RE guys get so absolutely destroyed peak to trough. How can one possibly do a sanity check on LT avg. perpetuity growth when the most relevant path to liquidity (asset sales) are ignored in favor of conceptual things like cap rates

Apr 8, 2011
DurbanDiMangus:

Let me preface w. dont know much about RE but..why do RE guys always use perpetuity for TV vs exit multiples? Seems like in CRE if an asset is income producing then you could apply a TV exit multiple inferred from precedents.

I think this is why RE guys get so absolutely destroyed peak to trough. How can one possibly do a sanity check on LT avg. perpetuity growth when the most relevant path to liquidity (asset sales) are ignored in favor of conceptual things like cap rates

I'm not sure what you're asking. Why do you think "the most relevant path to liquidity (asset sale)" is ignored in valuation? An asset sale is assumed in year X based on cap rate of Y%. Then that number is discounted to today along with the cash flows that are generated along the way. This is what I have seen in acquisitions.

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Apr 8, 2011

I suppose you could with perfect knowledge, but obviously that's not the case.

The RE industry really isn't that scientific. Most investors are going to ask themselves whether at the end of the day they can be happy with the returns that a particular deal might generate.

To your second point, you aren't far off. The PE funds go out there are raise a ton of money and then have a few years to buy assets or else they have to give the money back. Further, the ability of these funds to raise capital is linked to the rise and fall of asset cycles. Most PE funds are not, I'm sorry to say, going out and doing the equivalent of value investing in the stock market. Instead, they have capital committed from a large pension fund that wants exposure to the RE sector and which is happy to get a market yield.

Apr 8, 2011
prnz:

I suppose you could with perfect knowledge, but obviously that's not the case.

The RE industry really isn't that scientific. Most investors are going to ask themselves whether at the end of the day they can be happy with the returns that a particular deal might generate.

To your second point, you aren't far off. The PE funds go out there are raise a ton of money and then have a few years to buy assets or else they have to give the money back. Further, the ability of these funds to raise capital is linked to the rise and fall of asset cycles. Most PE funds are not, I'm sorry to say, going out and doing the equivalent of value investing in the stock market. Instead, they have capital committed from a large pension fund that wants exposure to the RE sector and which is happy to get a market yield.

I think we all know it isn't too scientific as purported by the ridiculous valuations of the mid 2000s which kind of brought us to where we are today. And the self-satisfaction/complacency with using non-scientific methods is all too common in RE, from my pov. There is no excuse for using a jacked up Lt growth rate to win a deal that gives you a writedown when you mark it to fv in a few months.

May 6, 2011

You should do a search on Modern Portfolio Analysis as the basis is the same. An individual can reduce risk by holding assets that are not perfectly correlated. By having multiple properties you can reduce your exposure to any one individual asset.

Diversified assets > more reliable income stream (FCF) > lower discount rate

May 6, 2011

so even with a housing bust in phoenix, if your portfolio also owns commercial property in shanghai, warehouses in germany, etc... the argument can be made that the assets of the company (i.e. - "portfolio") is more diversified than a regular company, thereby having multiple/diverse cash flow streams.

May 6, 2011

on the topic of RE banking DCFs....is there any place online or does anyone have any pdfs or anything on how to use and familiarize oneself with modeling in ARGUS?

May 6, 2011

Also,say you own a bunch of properties in a geographic location,you can consolidate expenses and build a critical mass.You can work this even on the revenue side of the equation-you negotiate multiple deals with a bank and have them as a tenant at mutiple properties that you own.You get better quality tenants for longer period of time.This brings stability as well sizeable cashflows to the company.

May 6, 2011

yea, i am also interested in knowing any book/material/example on real estate DCF..any suggestions?

May 6, 2011

send me your personal email and I will send you a sample DCF I made during school and is very similar to what we use at work.

May 6, 2011

mod edit: Spam

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Apr 8, 2011

I don't disagree but would argue that this not specific to real estate.

May 6, 2011

Edit: Essentially the question is why do you use NOI instead of the regular FCFF for DCF analysis

May 6, 2011

Because different investors have different tax implications: Potential buyers could includes REITs (No Corporate Income Tax assuming they meet the requirements), Private Families or Funds which will all be taxed differently - in many cases the tax implications will only take place at a personal level not a corporate level.

Apr 8, 2011

I don't disagree but would argue that this not specific to real estate.

Apr 8, 2011

Thanks! I dont quite understand how private equity real estate funds perform the valuation. Do they estimate a discount rate, use it on a dcf model and compare the NVPs of various projects, or do they estimate their target IRR and do an LBO valuation based on entry Value (entry NOI/Cap rate) vs exit value (exit NOI/Cap Rate)

Apr 8, 2011

Sorry I meant "NPVs"

Apr 8, 2011

Its totally unusual for you to model RE with WACC.

I am assuming this is an interview for some kind of entry-level job?

This is basically what you need to know, focusing on operating CF:

  • Potential Gross Income-Vacancy Allowance+Other Income-Operating Exp=NOI...If this for an entry-level job, this is all you will be expected to know (and I hope you know at least this much).
  • NOI-(Tenant Improvements+Leasing Costs)=Before Tax Cash Flow (BTCF)

*Know how to calc cap rate and what it means.

If this is not an entry-level job, keep reading...

  • What you typically call Discount Rate in finance is typically known as Opportunity Cost of Capital (OCC) in RE:

DR=OCC=Expected Return=(risk free rate)+(risk premium), where risk free rate is typically (T-bill-100bps) and risk premium is usually based on NCREIF historical data. Without going through the calcs, OCC was typically 6-7.5% for institutional assets and 8-11% for higher risk assets back in 2005. I'm quoting 2005 because the last time I had calc OCC was in college in my RE finance course (nowadays, 8-10% and 12-15% are more common for today's risk) There is more to it, but this stuff is rarely used in practice.

In practice, you have the asset's operarting statements and a set of market leasing assumptions. You input both into Argus, and then calc yields (both property and fund level) with the firm's debt/cost assumptions.

man made the money, money never made the man

Apr 8, 2011

Thanks a lot! Yeah, its in an entry level job:)

So do I use the following FCF approximation then: NOI (1-tax rate)- Capex = Cash flow to be discounted ?

Apr 8, 2011

BTCF=NOI-CapEx

where BTCF= before tax cash flow and capex=TIs+LCs

I edited my last comment.

Don't think too hard.

man made the money, money never made the man

Apr 8, 2011
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Apr 8, 2011