Two Superdays Next Week--Advice On How To Answer Two Possible Questions

Hi guys, I have two superdays next week: one for a large Real Estate Private Equity Firm and another for a Large REIT. In my previous interviews I've been fairly confident in my answers to technical questions aside from two:

  1. Walk me through a DCF valuation on an asset.....How do you find an appropriate discount rate?
    So I understand the basics of a DCF (forecasting CF's and applying a discount rate to get present value) but I may not be describing it efficiently enough and I am sort of lost on where we get a discount rate from in the world of real estate. How is the Discount Rate linked to the cap rate?

  2. There are two identical (age, condition, etc.) assets across the street from each other, why might one be more valuable than the other?
    I know that one of the main reasons is due to tenant grade quality and lease rollover schedule. But sometimes the interviewer asks, "What if both have identical tenants and lease rollover schedules?"

If some of you real estate pros could provide me with some guidance, it would be much appreciated. Thanks!

Comments (14)

Mar 28, 2016 - 8:02pm
  1. Walk me through a DCF valuation on an asset.....How do you find an appropriate discount rate?

Your discount rate is the return of the next best deal you could undertake. So a good starting point is the unlevered IRR your could achieve on a comparable deal. For a database of discount rates, look at IRR's annual Viewpoint publication. Discount rate is your total return (income plus appreciation). Cap rate is the income component of your total return.

  1. There are two identical (age, condition, etc.) assets across the street from each other, why might one be more valuable than the other?

Maybe one property is actually is in a different county than the other, resulting in a different tax rate (and different utility rates?). Maybe the way they are being valued is different (one is using the DCF approach, while the other is using the direct cap approach). Maybe different contractors are used for services/repairs/landscaping, resulting in higher/lower costs at one of the properties. That's all I can think of...I'm sure there's more.

Best Response
Mar 30, 2016 - 2:53pm

There are really are a number of factors that can play into answering #2, many have already been said

Different Tax Codes
Different access points - turning lanes, street lights, traffic counts...etc
One building can have much more attractive transferrable debt
Tenant Roster
Space allocation
Valuable/Less-Valuable lease structures (Reimbursements, tenant roll, termination rights)
Leaner operations
Walkable amenities - or even on-site amenities for an office building (café, gym, cleaners, day-care, etc...). The 'street' can be a freeway that you cannot really walk across
Different Zoning
Environmental - Cleaners and Gas Stations can play a role into this
Parking can certainly come into play

Many more too...but I think the major ones have been listed

Mar 30, 2016 - 3:24pm

Thanks guys-all very helpful. I'm still a bit confused about how to find an EXACT discount rate for, let's say, a hotel deal. Is it literally just whatever the cap is (ex. 7 cap for a hotel) plus what we think the average YoY growth in CF will be (ex. 3%)? So we would end up using 10% discount rate in our DCF?

Mar 31, 2016 - 10:27am

For number 2: It's probably related to zoning, school district, county, taxation, etc... maybe environmental issues? though I think that's an annoying question because most people would think you knew enough after you mentioned lease roll / tenant quality, which is the key point.

Mar 31, 2016 - 7:04pm

Also, for #2. Might sound silly, but one side of the street could get better sunlight. This can be huge. Also, even more obvious than the first point, the views the building has. You could have 2 exact buildings, exact tax structure, exact everything. But if one building's views are obstructed, you better believe the one with unobstructed views will command higher rents & be more valuable.

Mar 31, 2016 - 11:26pm

On a high level, I find it helpful to think of discount rate (in any asset class) as compensation for the risk you are taking. As mentioned, you may look at comparable deals to get a sense of what a similar asset is yielding (or has been sold / traded for, and thus what someone else views as an appropriate yield / return for that asset) and establish a starting point for how to think about your deal. This is true across all asset classes.

When you get into the practical side of it, it becomes asset class specific, because different assets have different risks and different ways to look at that risk. So as mentioned, you can break down discount rate for a real estate asset into income + growth (or WACC for a company, or risk free rate + credit spread for a bond, or risk free rate plus beta * market risk premium for a stock), but idea is the same and they all attempt to capture the same thing: the value of the risk.

Something that is riskier will have a higher discount rate (or higher required yield) resulting in a lower price to reach that yield, and something less risky (like treasury bonds) will have a lower discount rate rate (or lower required yield, higher price). Coming up with your discount rate is ultimately how you come up with the price you are willing to pay for the asset.

In your hotel example, if you've come up with reasonable assumptions on rent (income) and sale (growth / appreciation), then those two components will give you a sense of what your required discount rate should be.

Hope that helps.

Also, I find for these interview types, it is more about showing you understand the big picture than the specific answers, so for #1 emphasize risk / yield and #2 highlight that you understand you can think critically through various reasons why two assets might be different besides what's on the surface or despite being told the easier variables are the same (similar tenants, similar size, similar location etc)

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