Real Estate Valuation - Mortg interest and depreciation

What is the purpose of your valuation?

You need to factor in capital expenditures, leasing commissions and tenant improvement costs into your valuation. These are all after NOI.

For debt, it is only relevant in the sense of seeing what a leveraged buyer would pay (sometimes included as a part of a valuation in addition to the income capitalisation and sales comparison approaches) or if you are modelling an acquisition and are factoring in the debt you are using to see if you will hit your IRR targets.

Throw out depreciation, too.

@ Relinquis - Valuation is of a residential condo property. Purpose is to figure out what a reasonable acquisition price is. This is a case study and leasing commissions, capex and tenant improvement figures weren't given (other than 1,000,000 capex which is built into loan amount). The problem is that my valuation based on NOI / cap rate is WAY too high given the comparables provided.... i think it's due to a strange situation that is causing a yearly depreciation that is over 20% of revenue...

"The problem is that my valuation based on NOI / cap rate is WAY too high given the comparables provided"

Did they provide comps? If so, this could be a think outside of the box and "pull your own comps" type of situation if you do not believe them.

That said, as relinquis said, depreciation should not be factored in any DCF. There is a slight chance that if it was for a really small shop that you would use it to calculate your adjusted cost basis, taxable income, and other accounting impacts, but I doubt this.

I would be happy to take a look if you want. PM me.

They did provide comps. I ultimately used the comps for my valuation as my leveraged returns were way too high (i think due to the depreciation).

Will PM you separately to follow up

Is there a good guide to Real Estate valuation similar to the Pearl & Rosenbaum's investment banking book?

Looking to learn more about the industry and would like some good resources

Two most common academic texts I think are Linneman's and Brueggeman's, both titled Real Estate Finance & Investments.

For your leveraged IRR analysis, ignore depreciation, but do include mortgage interest. In a basic model:

NOI - TIs - LCs - Capex = Unlevered Cash Flow Unlevered Cash Flow - Interest Expense - Principal Amortization = Levered Cash Flow

On exit, capitalize the terminal NOI to get a sale price and remember to repay the remaining debt.

Help me understand what you mean when you say "my valuation based on NOI / cap rate is WAY too high given the comparables provided." To me the logic seems circular. The cap rate you use to get to terminal value should be the one implied by the comparables.

The problem is that the NOI / cap rate valuation (using average cap rate of comps) on my leveraged IRR analysis is 4-5x higher than what the hypothetical buyer is willing to pay and much higher than the comp properties (in terms of price / sq foot, etc.), implying an astronomical IRR. Happy to share my workbook with you via PM if you are interested in taking a look... it is the ridiculous IRR that drove me to think i was missing something and needed to construct an additional view to evaluate the impact of the depreciation... i ultimately calculated to CFAT and discounted those yearly figures using the aforementioned cap rate... flawed approach, i know, but was in a time crunch and ended up using multiples of comps anyways for my valuation figure

Yes share your workbook with me. I will be happy to take a look. I don't quite follow what's going on here. See my answer in the other thread if you want a drawn out explanation of how depreciation impacts taxable income.

hey guys-

a little off topic but related none the less. MIT hosts a Case competition and the PDF of the winning teams models are up online.

http://mitcrealumni.org/wp-content/uploads/2011/04/Blue-Coast-Capital-DCF.pdf

I was looking to get a little bit more practice with real estate valuation models before my FT job starts, so i was in the process of recreating the PDF in Excel. hit a few road bumps, but I was wondering if anyone knows of any free models that are somewhat complex and comprehensive like the one posted above?

Thanks in advance.

That MIT link looks good. The following thread has some links that you might find useful...

http://www.wallstreetoasis.com/forums/real-estate-pe-model

There are a few knowledgeable and helpful Real Estate guys on WSO so it's worth asking related questions.

i am out of my depth and stuck on a pre-interview case study on RE valuation. wondering if anyone might be willing to walk me through it? i am reluctant to just throw it out there as i would be basically asking for a full tutorial. thoughts? i dont want to abuse the generosity of the forum but i am a physics major and everyone keeps telling me i have to go for banking, just playing a bit of catch-up.

What kind of a role is this? I've never heard of a banking shop ask for a real estate case study as part of the interview process.

What are they asking you to do? Assuming the tasks of you explaining the case and me walking through the concepts can be accomplished efficiently on this forum, I will help you.

I am based in the UK and stumbled into this forum, so not sure if i am in the right place. career academic, thought Phd would be the way, but my older brother is in banking. It is a recruiter that is doing the asking and all i know about the firm is the following: "Our client who were established in 1994 have a Global footprint and operate across the Real Estate space. They are a leader in investing in real estate through opportunity funds, as well as a special situations fund focusing on debt and equity investment opportunities."

the recruiter sent over the following scenario and asked if i would be able to answer such questions at interview. so depending on if i can get my head around it, i may not make the cut for the next round...

You have been asked to advise on a freehold investment purchase of a factory of 5500 square metres which has 3 years of its existing lease left to run at a rent of £220,000 per annum.

The site is contaminated with non-migratory heavy metals from a disused adjacent engineering works also in the ownership of the same freeholder who admits that it is his responsibility and not that of the tenant. A report obtained from the freeholder suggests the cost of the remedial works necessary to bring the site to a ‘suitable for use’ condition would be £300,000.

A similar uncontaminated property of 6250 square metres in a nearby, but much poorer, location

recently sold for £3,675,000 which showed an 8.5% yield.

i have found formulas, but i am wondering if there is a trick here? since i am "talking" my way through this i need to cover all basis and sound like i know what i am dealing with. i blagged my way this far, but the role is supposed to be one to learn. so i imagine they want smart, math-heads in general.

cheers if anyone has a moment. my friends and brother have been a bit useless as the focus is on Real estate.

First, a word of caution. It is generally a bad idea to take a role for which you are unprepared, for instance by conveying a false sense of your knowledge and skillset to a prospective employer. It sounds like this particular firm may be looking for someone with real estate knowledge. It may be the case that you could do well here, and they are prepared for an entry-level trainee, but that is something you should carefully consider. Especially if the motive for the career switch is to follow your brother down a path of greater financial success, I would be careful not to take a position that would set me up for failure.

Having said that, here is how I would approach the given question/scenario. You are asked to evaluate the attractiveness of a given investment, and imply a value based on a comparable transaction. The comparable valuation statistic you are provided is a cap rate: 8.5%. If your subject property deserved to be valued for the same subject cap rate, then it would be worth £220K / 8.5% = ~£2.6MM. (I've made a simplifying assumption that rent = income, which is a fair assumption given that this is an industrial property where tenants typically pay for all operating expenses, which is called a net lease. For other properties, such as multi-tenant office buildings, tenants pay a gross rent and the landlord pays expenses.)

However, one thing that the interviewee is being asked to do in this question is to make some judgments about the relative value premium/discount of the subject property versus the comparable property. The comparable property has an inferior location, but the subject property is burdened by an environmental issue and a short term lease. The environmental issue is a bit simpler to address. The cost has been boxed-in and is the admitted responsibility of the seller. So you can address this as a buyer by making the seller hold-back some funds in escrow to address remediation. What you don't know, and would need to know in order to value the property, is the market rent for the subject property, the likelihood that your tenant will renew, and the cost and time that would be required to retenant the property if your tenant vacates in three years.

You probably would not be asked to come up with an exact value estimate, but you would probably be expected to understand how these various differences in risk profile and attractiveness would impact value and cap rate. The better location would warrant a lower cap rate (higher value multiple), but you would want to base that cap rate to some extent on market rent rather than actual rent, since the lease is only three years. If you were building a model, you might assume you earn the £220K for three years, then have a year of vacancy, pay some amount per square meter for tenant improvements and leasing commissions, and get a new tenant paying market rent, which you would value based on a cap rate lower than 8.5%, given the better location. You would then discount these values to present.

re-ib-ny has given good advice.

Side note: Generally speaking office leases in the UK are FRI (fully repairing and insuring), i.e. the tenant takes care of the expenses and the insurance for the space that is leased (similar to triple net leases in the US). Just thought I'd clarify that.

Relinquis, that's interesting. So in the UK even on multi-tenant office buildings you would not normally see what we in the US call a full service gross lease? Under an FSG lease, tenants are charged a gross rent and landlord pays for most/all operating costs in the base year, but the tenant is normally responsible for its pro rata share of increases to opex in subsequent years (with various carveouts depending on market convention).

Does "fully repairing and insuring" mean that the landlord is still on the hook for property taxes?

Yes, UK office leases are closer to triple net then FSG leases. Tenants pay for expenses depending on the space they occupy through a service charge in multi-tenanted buildings. If they have a lease for the whole building, they cover all the expenses. There might be a sinking fund for certain capital expenditure, like machinery maintenance, which the tenants would fund pro-rata to their space.

In the UK the tenant pays property taxes and any local authority rates for their space. The Landlord only pays for property taxes (rates) on vacant space. Whether tenants pay VAT charged on the rent (and reclaim it later) depends on whether or not the landlord has elected to structure it in this manner (something for the accountants / tax structuring guys to worry about during the acquisition).

The purchaser of a property has to pay Stamp Duty and Land Tax (SDLT) on the acquisition price, but that is a transaction tax and not an annual property tax. The various states in the US have similar versions of this.

There are other non-tax differences between the UK and US leases. UK office leases tend to be longer in duration (15+ years) and have upward only rent reviews every 5 years.