and IRR

edit: just noticed that you wanted an explanation, too. cap rate is just first year NOI (because it increases every year. so just use the 1st year) divided by purchase price.

as far as IRR, forget the purchase price. just look at projected cash flow, but not NOI, and calculate the discount rate that will make the NPV of those cashflows = 0. the higher that discount rate (or IRR) is, the more attractive it looks.

_______________________________________ http://www.drmarkklein.blogspot.com/
 

i would also like some info regarding how to value real estate as i have a couple of interviews coming up with real estate p/e firms. the only thing i've found so far online are REIT valuations, but if anyone knew any good books or websites that went into real estate valuations that would be helpful. thanks!

 
Best Response

I worked in commercial real estate valuation/appraisal (apartments mainly) for almost a year and am now an underwriter. The direct cap method (NOI/cap rate) is the universally used method of valuation. Sounds simple, right? Well, most of finance is pretty basic--it comes down to information and inputs. To get the proper cap rate, you need to compare cap rates from sales of similar properties in the requisite geographic region--this is simple to do in Manhattan as there is plenty of volume, a lot of comparables and plenty of analyst coverage; this is incredibly difficult to do in Mercedes, Texas, for example. Even more difficult is constructing an income statement to get your NOI. Constructing the income statement isn't that difficult for established, stabalized properties but becomes extremely difficult to do with accuracy with new construction--it comes down to operating expense comparables, research, and underwriter and developer construction expertise (which is often lacking). OpEx comparables are also incredibly difficult to obtain as there is no public information or public or private record for these. Nonetheless, even with new construction, the cap rate method is utterly dominant. It doesn't matter if you agree or disagree with it--ultimately, even in PE, if you are valuing a property and are selling it to commercial loan underwriters, the underwriters couldn't care less about your fancy formulas and DCF. The GSEs, for example, who are responsible for more than 90% of the nation's apartment loans, have very strict guidelines on this.

The DCF method is almost never used and is considered to be a joke in the real estate valuation industry. DCF is only used upon the request of a client and is only used as a check. The cost (or reproduction) approach is used in almost every appraisal, but almost always as a check. Cost or reproduction approach is mainly used by tax assessors for new properties. Information obtained for the cost approach usually comes from a handful of national companies that produce annual regional texts on construction costs. The sales comparison approach (i.e. sales price per unit) is an important method for underwriters to make sure the loan per unit is within reason compared to the sales price per unit; therefore, almost all appraisals have the sales comparison approach incorporated.

In summation, direct cap is king. The other methods are interesting checks on your work, but ultimately, sales volume is pushed by direct cap.

Array
 

If you want to go into real estate appraisal, then cap rates are important to understand. So is the replacement cost method. The real options approach should be know as well for calculating land value.

If you are going into REPE then knowing DCF is important. I personally don't use argus (a real estate specific valuation program that spits out cap rates), but we get individual property reports from property valuers (think CBRE, DTZ, Cushman) and we use their outputs for our DCF models, although I did have to do argus in my training to see how it works. Calulating IRR is the single most important thing in REPE, but you really have to understand yields (UK terminology for cap rates) to calculate your terminal value. As well, making assumptions on yield expantion or compression can have significant impacts on your model, so you still have to know them.

The downside of yields is that you are calculating your purchase price from a perspective that there is no rental growth(although there are other types of yields, like stabilised yields and going out yields). You can use the gordon growth model NOI/(r-g), where r is your yield and g is your growth rate and this may give you a better approximation, but it still doesn't capture the nuances of the cash flows you receive. For example there are rent free periods at the beginning of leases that affect your earlier cashflows. As well, if you are acquiring an asset that is independently managed and you bring it under the same management of all your other assets you may realize operating cost savings. DCF is also better when valuing alternative real estate asset classes like self-storage, retirement homes, golf courses, and infrastructure (although this is a bit different).

Hope this helps.

 

RE_Banker, you're almost certainly right with regard to PE. So I'm not trying to argue with you. But as a commercial underwriter I have a pretty unique perspective about long-term valuation using growth models, DCF, etc.--it's garbage. I'm 100% serious--DCF, IRR, etc., none of it is difficult to do with the correct inputs. But making long-term estimates about rent growth, expense growth, proper discount factors, etc. is basically impossible given the incredible swings in geographic regions. For example, according to RCAnalytics, US national cap rates (or yields) swung .6% in the last 44 months in the multifamily market--that makes an incredible difference in value. And the national market is highly highly diversified. So swings in individual markets will be wild. Rent growth is highly unpredictable just 1 or 2 years out (as my firm's asset resolution group unfortunately finds out quite often). Making long-term predictions about rent growth is simply a shot in the dark. My group also requires ROE calculations to be run as an input into our software system, and these calculations are almost never correct in the short-term, let alone the long. My group is responsible for about 50% of all multifamily lending in America and our VPs and directors would never ever consider DCF or growth models for rent because the most knowledgeable area professional really has no clue what 5 years will bring.

As a finance major in college, I was pretty offended when I began my career in real estate to see the "ignorance" of real estate professionals in how they disregard the complexities of DCF and fancy growth models. But when I sat down and created an Excel spreadsheet of a hypothetical valuation of the same property, you could see that DCF was the single least consistent model and suffers tremendously from human error and, honestly, human ignorance of the future. It's like comparing apples to oranges.

But it doesn't surprise me that PE firms celebrate complex (albeit useless) models to value otherwise fairly simple property. So you are giving good advice. But I will disagree with you on this--I've done a number of retirement home valuations and wouldn't touch DCF with a 10-foot pole. I think I'd agree with you on golf courses and self-storage.

Array
 
Virginia Tech 4ever:
RE_Banker, you're almost certainly right with regard to PE. So I'm not trying to argue with you. But as a commercial underwriter I have a pretty unique perspective about long-term valuation using growth models, DCF, etc.--it's garbage. I'm 100% serious--DCF, IRR, etc., none of it is difficult to do with the correct inputs. But making long-term estimates about rent growth, expense growth, proper discount factors, etc. is basically impossible given the incredible swings in geographic regions. For example, according to RCAnalytics, US national cap rates (or yields) swung .6% in the last 44 months in the multifamily market--that makes an incredible difference in value. And the national market is highly highly diversified. So swings in individual markets will be wild. Rent growth is highly unpredictable just 1 or 2 years out (as my firm's asset resolution group unfortunately finds out quite often). Making long-term predictions about rent growth is simply a shot in the dark. My group also requires ROE calculations to be run as an input into our software system, and these calculations are almost never correct in the short-term, let alone the long. My group is responsible for about 50% of all multifamily lending in America and our VPs and directors would never ever consider DCF or growth models for rent because the most knowledgeable area professional really has no clue what 5 years will bring.

As a finance major in college, I was pretty offended when I began my career in real estate to see the "ignorance" of real estate professionals in how they disregard the complexities of DCF and fancy growth models. But when I sat down and created an Excel spreadsheet of a hypothetical valuation of the same property, you could see that DCF was the single least consistent model and suffers tremendously from human error and, honestly, human ignorance of the future. It's like comparing apples to oranges.

But it doesn't surprise me that PE firms celebrate complex (albeit useless) models to value otherwise fairly simple property. So you are giving good advice. But I will disagree with you on this--I've done a number of retirement home valuations and wouldn't touch DCF with a 10-foot pole. I think I'd agree with you on golf courses and self-storage.

This is a pretty good indictment of the valuation community and a good look into the simplistic minds that greased the wheels of the CRE bubble.

Any valuation is about providing a fundamental context for prices in the market. Any method is either backward-looking, an attempt to take observed values and derive inputs or forward looking, where estimated inputs are used to project the value output. The simple cap rate approach is useful because many practitions use it but it's a proxy for more robust techniques. All the estimate variables are still there, but their embedded in a much simpler formula. Any valuation should be done simulataneously with mutliple methods in order to peg the output to inputs that make sense. IRR models rely on dozens of assumptions but since the guys buying assets use IRRs to determine prices, they are employing an approach that rests on these assumptions. Ideally, they get comfortable with these assumptions or are willing to bet on them, but still 'value' only exists in a framework of many, many assumptions. In the process of executing a transaction, buyers will get a valuation done to get an independant, substantiating view and (more importantly) tick a legal box

 

you have some valid points, but i think the flexibility of DCF is more useful when you are trying to model value-add and opportunistic tactics as oppose to core properties. as well, one of the things about REPE is that we also have a shorter investment horizon then other RE investors so DCF in the short run can actually be quite useful. Don't get me wrong, i think forecasting 10 years out is ridiculous, but 5 years can be done with a bit more certainty. looking back on retirement homes, we model them with stable cashflows, so i guess the cap rate method would yield equally good results, but i just feel the cap rate method is a bit too simplistic and doesn't give the right confidence needed in a huge investment.

 

Direct cap is great for stabilized, core properties. It is also great for valuations in this market where vacant spaces are getting little on the valuation side. On the other hand, DCF is great for opportunistic properties and developments where the stabilized NOI isn't until year 2,3,4. You can't direct cap a development or value-added assets.

 

You can't direct cap a development, nor can you with any accuracy DCF a development and it's frankly a waste of time. As mentioned in another thread, my brother-in-law is a 25-year veteran of real estate development and a former Toll Brothers Vice President--the idea of a DCF valuation to him is an absolute joke. I know of no one who uses DCF in the industry (underwriting, development, etc., but excluding PE--I want to be clear on that, private equity is different). But there is one notable exception--favorable financing is always DCFed, but this DCF is only used to find the adjusted cap rate! So we get back to square one--direct capitalization is king!

Array
 

Okay -- so you're talking about what, underwriting for loans? I think most people who are on a finance message board asking about real estate valuation is talking about private equity investing. I'm also not entirely sure what you mean by development. Most REPE shops are doing development and value-added work. They are using DCF. Keep in mind, the DCF is using terminal cap values, so nobody is discarding the importance of cap rates to real estate finance (it is critical).

Direct cap has become increasingly important in the past 6 months as investors discard speculative lease-ups in pricing etc due to all of the distressed selling going on thus creating a "buyer's market" (if they can get the financing).

So, in conclusion, what are you directly referring to in the "underwriting" and "development" umbrellas that think what most appraisers and most PE/reits use to value their assets and acquisitions is a joke? I am not debating the subjectiveness of DCF inputs etc, but it is absolutely used heavily in real estate.

 

In case you missed it, let me copy and paste what I wrote:

"...underwriting, development, etc., but excluding PE--I want to be clear on that, private equity is different."

As implied, I am well aware that PE firms and some commercial investors use DCF. I am also well aware that PE is an extremely small universe in the real estate world. I will re-assert this fact--DCF is not heavily used in real estate outside of private equity, and that's simply a fact.

I also don't understand how you can so easily dismiss "underwriting for loans" with regard to commercial real estate. The overwhelming majority of residential AND commercial real estate conforms to traditional bank and GSE underwriting standards in the investment analysis. The GSEs are directly responsible for 70% of multifamily lending and indirectly responsible for 90% of single-family lending. I assure you--DCF does not see the light of day in these transactions outside of an amateur Excel user running an analysis on the property before quickly discarding it as a useless real estate metric.

I've also seen many hundreds of real estate schedules (list and value of real estate holdings) of dozens upon dozens of owners, including AIMCO, one of the largest REITs on the planet. How is the RE valued? NOI/cap rate and pasted into Excel. My group just completed a 24-property structured deal with AIG--how did AIG value their loans? NOI/cap rate. All $150 million.

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Cap rate is a good measure but DCF is what really gives you an idea of a property if you are making opportunistic/value-added/etc PE type analysis. You are a fool if you buy a property solely based on comp cap rate especially in this market.

 

I read it the first time.

Don't you work for Freddie or Fannie or some resi/multi company? Do you really feel like you're in a place to comment on CRE as a whole? The only type of assets that direct cap really provides a fair metric are stabilized, core properties. Before you insult me by saying "amateur Excel users", you understand that APPRAISERS, the one assessing the f-ing value for most transactions are using DCF as their primary metric? As stated above, it is becoming increasingly more common to blend the values between direct cap and DCF. The values typically are less than 3-5% different anyway.

PS - $150M is a lot to you?

 

PS -- what?? Single-family valuation? I have absolutely no idea. If that is what we're talking about, fine. But I don't think that was the OP's question. Maybe you're right about all things resi, but do not generalize.

 

VT, consider this. Let's say I have two 750,000 Class A office buildings, each with the same NOI, each in the same market. Let's say that one of the buildings has all of its leases rolling in two years, and the other one has all of its leases in place for ten years. Generally speaking, since they're the same asset class and in the same market, you'd apply the same cap rate to both, but do you really think that the market prices of the buildings would be identical?

No one on this thread is arguing that cap rates aren't important. But if you have any asset where you expect material volatility in NOI during your hold period (or during the term of your loan), you have to make some assumptions about how NOI will move in order to accurately value it--and this means a DCF. Apartments (which it sounds like are the property type that you work on the most) tend not to have much volatility in NOI because they have short-term leases and not much operating leverage, so it doesn't surprise me that people in the multifamily loan underwriting world don't use DCF much. But anyone who's working across asset classes has to understand it. Your anti-DCF evangelizing just makes you come across as a dick.

 
Hoover1:
VT, consider this. Let's say I have two 750,000 Class A office buildings, each with the same NOI, each in the same market. Let's say that one of the buildings has all of its leases rolling in two years, and the other one has all of its leases in place for ten years. Generally speaking, since they're the same asset class and in the same market, you'd apply the same cap rate to both, but do you really think that the market prices of the buildings would be identical?

No one on this thread is arguing that cap rates aren't important. But if you have any asset where you expect material volatility in NOI during your hold period (or during the term of your loan), you have to make some assumptions about how NOI will move in order to accurately value it--and this means a DCF. Apartments (which it sounds like are the property type that you work on the most) tend not to have much volatility in NOI because they have short-term leases and not much operating leverage, so it doesn't surprise me that people in the multifamily loan underwriting world don't use DCF much. But anyone who's working across asset classes has to understand it. Your anti-DCF evangelizing just makes you come across as a dick.

Although I don't agree with VT on cap rates, you can easily just use a stabilised cap rate to solve the volatility problem. With that said, I still love my DCF lol. Also, I do a lot of work at the aggregate level and never at the property level so DCF is needed, but when looking at the property level we will sometimes so a cap rate to double check if it makes sense. Valuers use Argus which is a I think is blackbox that uses DCF as well.

 

What I'm gathering is that you all believe that cap rates are volatile, but compared to what? Compared to DCF, which assumes 1) price, 2) stabilized long-term cash stream with pre-determined measures of volatility, taxation, and income and expense growth, 3) Risk-free rate, 4) risk spread, and 5) the experience of the guy running the DCF. Ok, if the FACTS don't strike off something in your brain that tell you this is an utterly absurd form of valuing commercial real estate with any level of certainty, then a reasonable person is wasting his or her time.

"Before you insult me by saying "amateur Excel users", you understand that APPRAISERS, the one assessing the f-ing value for most transactions are using DCF as their primary metric?"

This is WRONG, WRONG, a THOUSAND TIMES WRONG. This may surprise you, but I have 1,200 hours logged in commercial real estate appraisal. DCF is ONLY used upon the specific request of a client, and ONLY as a check. Yes, Argus and Dyna use DCF, but Argus and Dyna are not the most widely used tools in appraisal--Excel is, by far, the most widely used appraisal tool, and it's not even close.

With regard to the assertion that apartments have stable, easily predicted cash flows, are you insane? Have you lost your mind or do you just not work with apartments? There is nothing remotely predictable about apartment valuations, underwriting, or investment analysis (which is what underwriting is)--from macro market forces and natural disaster to poor management companies and lack of money for maintenance due to fiscal issues with the owner, there isn't one thing on this planet that is predictable.

But hey, I'm sure all you DCFers can tell me the market risk spread between the 10-year Treausry and a 25-year fixed CRE loan in 2013.

Array
 

Seriously, all I can do is laugh at this point. Nobody is running Argus and Dyna as a CHECK. That is just ridiculous. Obviously cap rates are volatile, so are discount rates and cash flows. The argument being made was that cap rates are typically grabbed from comp deals, and they don't take into account lease expiration schedules, demographic shifts, or potential value-added endeavors. Which is FINE if we're looking at core real estate or "buyers markets" where they don't factor in potential upside (which is often the case right now). But in general, all non-core, value-added,core-plus, or opportunistic real estate rely HEAVILY on DCF because they aren't expecting the same y1 cash flows for the next 5 years.

And again, I have no idea about the residential aspect of valuation. the OP was talking about CRE. If your experience is on that side, why did you even bother replying to this?

Dude, nobody is saying DCF is flawless. But direct cap takes future potential out of the picture and is simply not how things are usually priced for non-core assets. Have you ever worked on a real estate non-residential acquisition?

 

Krakauer, at this point, I'm not confident that you can read:

As I've stated, I have 1,200 hours logged in COMMERCIAL REAL ESTATE APPRAISAL (toward the MAI in Virginia) and I currently underwrite APARTMENTS, which IS considered commercial real estate, particularly when apartments have RETAIL AND OFFICE SPACE attached to them, which is often. I've worked on more than 150 commercial real estate transactions, valued around $2 billion. What are your credentials to haughtily ask, "what commercial projects have you worked on?" What commercial projects have YOU worked on???

And I'll ask you, tell me the 10-year Treasury and the probable risk-spread on average in 2013 and then run me a DCF on a retail property in Northeast Washington, DC, making sure to adjust for volatile tax assessments and the oh-so-obvious year 2009-2019 weighted vacancy rate for NE DC class-B retail space.

Array
 

i am going to reply to this discussion, not to add anything but just to come back to it bc its a pretty interesting discussion.

--- man made the money, money never made the man
 

i'll just add real quick, if anybody cares:

DCF Method:

*Recognizes present value as a function of future cash flows - obviously, this is the 'bread and butter' of investing *Factors in a long-term perspective (5-10 yrs) in investment decision making, which is important since re is relatively illiquid *The process in analyzing investments from a DCF perspective can help keep investors from being swept up in asset bubbles and reveal problems with assumptions not discovered before in the diligence; basically, it answers a very important question: 'is cash flow potential related to asset value?' * Disadvantage: The analysis is only as good as the assumptions going in, can be easily manipulated, and usually is inconsistent

Direct Cap:

*It's a shortcut, a convenient one
*Basically, cap rate is a way of quoting 'market prices' of transactions that closed *Usually reliable and widely accepted among the appraisal community * Disadvantage: Can only compare between investments with direct cap if they both have similar risk-reward profiles, are in the same mkt, are the same kind of asset, etc.

DCF vs Direct Cap

*DCF is usually more reliable when valuing assets with long-term, stable, and predictable cash flows. For example: industrial, office, 'A class' retail w/ anchor, institutional grade assets, relatively larger assets, etc.
*Direct Cap is appropriate for assets with volatile cash flow that cant be easily predicted. For example: almost any multi family building, smaller office/industrial building in non-core mkts, mixed use buildings, etc. (This is why vtech tends to defend direct cap, it's widely accepted in HIS profession).

^^^You can see this in any good RE finance text book.

My opinion:

I work mainly work in socal industrial mkts, usually with institutional assets. I underwrite using DCF at the property and portfolio level, with both Excel and Argus. In my profession, DCF makes more sense. But its just another tedious step in an already tedious due diligence process. Niether DCF nor Direct Cap is a substitute for critical thinking. This is something finance-types often forget.

--- man made the money, money never made the man
 

Hello all I am jumping in on this conversation quite late but hopefully I can offer something.

I am an Australian, ex commercial property valuer and ex Analyst at DB RREEF. 1234, I agree with what you were saying

Principles of valuation state that you are trying to achieve the market value between a willing buyer, willing seller, in an arms length transaction, where both parties are cognisant of all details pertaining to etc etc (no duress)

As a valuer you are most trying to mirror approaches and methodologies that the notional willing buyer would use to price the purchase. As such each method has its place as both primary valuation methodology and supporting valuation methodology.

Cap Method: The capitalisation rate is equivalent to an all in risk/return rate that the notional purchaser is willing to accept for the asset into perpetuity. This rate takes into account lease profile, long term capital works, market risk, asset risk etc, etc. It is used across a large number of transactions in certain markets and creates an easy way of benchmarking transactions together for use as comparable sales evidence.

Valuers (appraisers) love using this approach as it doesnt require forecasting of Market Rental Growth, Expense Growth, Terminal Cap Rates, Void Periods etc. With some relatively simple analysis a valuer can quite accurately define the capitalisation rate that a purchaser used when acquiring the asset.

Generally classifications of properties will be purchased in this method. IE Non institutional grade assets under 20mil. (allot of privates tend to use this method). Also we found that as a market was gathering steam purchasers tended to use this method more as it was easier to make the numbers work.

Often valuers create additions and deductions from the derived capital value (post method) to allow for near term vacancy, near term capital expenditure or more risky income like phone tower licenses (this risky income may be kepy out of the capitalisation approach before this step)

DCF: The DCF methodology uses a very large number of assumptions including assumptions on, Growth in CPI, Market Rates, Parking Rates, Void Periods etc. Additionally assumptions in static data like renewal probabilites, capital allowances, etc. Valuers are more hesitant to use this method as it requires them to make value calls on the inputs and we all know how courts love judgement calls. Therefore you will find that valuers use a very prescriptive approach when analysing comparative sales. In this way they can be sure that they are comparing apples with apples. (it also means that the DCF analysis of the same sale by two different valuers can give hugely different IRR's)

Most institutional investors in Australia will use DCF as the primary method of valuation with CAP as a secondary method. Possibly direct comparison as a 3rd approach.

As someone above pointed out the DCF is highly useful for any asset that is likely to have a volatile cashflow. It is almost the only way to value a potential redevelopment opportunity.

A point for every one to note is that the Discount Rate and Cap Rate are the same the difference in the value of between them is the growth. IE a discount rate of 10% is the same as a cap of 7% and 3% growth in income annually . You need to do the DCF over about 33 years (to be considered into perpetuity).

 

CAP direct is ideal to stabilize the basic properties. It is also ideal for assessments in this market where vacancies are few places in part of the evaluation. Moreover, the DCF is ideal for opportunistic properties and events that the notice of intent does not stabilize until 2,3,4. Can not the CAP is a direct development or value-added goods.

 

Wow, I come off as a complete jerk in this thread. My apologies. I don't feel like that's who I am anymore (this is over 18 months ago). I still agree with my points generally but feel like I could have made them in a more constructive manner. I apologize if I offended anyone here. But I feel like this is a value adding thread, so I'll bump it, but please forgive me for being a jerk. Here 19 months later, I think I'm certainly ready for some value-added discussion about valuation. I'd like to hear some thoughts of others.

Array
 

I know this is an old thread, but thought I'd comment in case any of you are still around.

I just wanted to make the distinction between Value and Price when considering the two approaches (direct capitalisation Vs DCF). It has always seemed to me that direct capitalisation using market cap rates from comparable transactions seeks to establish the market "price", whereas the DCF approach is usually more subjective as it involves more value judgements re: different variables, this also makes it more suitable for the needs of the specific analyst/buyer/underwriter assessing the intrinsic value of the asset or rather the value of the asset to a particular buyer (or particular type of buyer).

 

I am a DCF Yield Rate proponent. Cap rates are too simple.

So how do you value a multi-tenant property with long leases? What if the leases are above or below market? Furthermore, during the long lease periods there are limited to no TI's and LC'S paid out. Cap rates don’t include TI’s, LC’s, and Capital Expenditures. And how do you compare this property’s value to a cap rate sale of a property with less desirable shorter leases and more TI's and LC's to be paid out as leases roll. You have to do a DCF yeild rate analysis.

This is why the big sophisticated buyers like institutions use DCF yield software consistently. And it is why cap rates are "yield driven" especially for the big dollar properties. If you want a cap rate, then you use the DCF yield analysis to back into it while you hold a yield rate, of say 9%, constant. Its easy if you use quality software like ModernValue.

I know this because I have been a commercial appraiser and an institutional buyer of office and retail nationwide. As an institutional buyer, we would never buy based on a cap rate, even with apartments which have short term leases because we calculated forecasts of capital expenditures like roof replacements and parking lot refinishing.

 

How are appraisers seen in the industry? Are they just monkeys completing a formality? I don't know if that's true, but I've heard people in the industry say things along those lines.

Maybe it's useful to say: As a formality... An appraiser would... Do X, Y, Z; while on the other hand, a REPE or REIT team would do, X, Y, Z. I'm not saying that nobody has done that so far, but just that the line should be drawn thicker.

 

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