Value-oriented real estate investors believe that real estate assets have an underlying intrinsic value that can be determined by analysis and evaluation. Opportunities for profitable investments arise when the asset’s purchase price is below its intrinsic value.
Value investors evaluate an investment’s opportunity by understanding the relationship between value and price. Thus, the essential task of a successful real estate value investor is to determine the intrinsic value to capitalize on inefficient market mispricing.
In determining the intrinsic value of real estate investment assets, value investors use two generally accepted methods: replacement cost and net present value.
Replacement Cost Method
While most commonly recognized by industry professionals, the replacement cost method can be quite complex to calculate. Often used for new developments, it can provide a guideline for existing projects, especially in today’s market where capitalization rates on high-vacancy properties are not useful.
Determining a building’s replacement cost requires gathering construction-related estimates such as:
• hard costs (site, building, parking),
• soft costs (third-party consultants, permits, and fees),
• contingency costs (unforeseen events),
• fees (developer, construction, profit),
• marketing and leasing costs, and
• financing costs.
Common practice is to measure the total cost to replace a building using a cost per square foot method. For example, it might cost $90 psf to replace a multifamily property in Tucson, Ariz., or $125 psf to replace an office building in Atlanta. It really depends on the local market and product type.
When assessing replacement cost on an investment asset, contact two or three reputable developers or contractors who are familiar with your market and product type to obtain replacement cost estimates. Make sure the cost estimates are an apples-to-apples comparison.
The rule of thumb is to be a buyer of real estate when prices fall below replacement cost, and a builder of real estate when prices rise above replacement cost. Therefore, replacement cost is the line in the sand — the base line to assessing potential value creation opportunities.
Net Present Value Method
The NPV method determines a real estate investment asset’s intrinsic value by finding the present value of future cash flows.
Present value is properly calculated as the sum of current and future cash flows with each dollar of future cash flow appropriately discounted back to take into account the time value of money. Future cash flows are discounted to present values using an interest rate that the investor could earn in the next best alternative investment. This is known as the discount rate.
For example, an investor buys a property for $950,000 that has a value creation opportunity requiring $50,000 of capital improvements. The investor’s total initial cash investment is $1 million.
As part of the value creation strategy, the investor plans to renovate the property by painting and landscaping and to upgrade the resident profile by adding some unique services and amenities. With the new look and upgraded resident profile, the investor expects to raise rents.
It will take 12 months to stabilize the property. So, in year one, there is no cash flow because of expected vacancy and down units during the repositioning process. But in year two, the property is stabilized with higher rents and occupancy; it generates a $50,000 cash flow. In year three, the property continues to remain strong with rents slowly increasing and generates a $60,000 cash flow.
In year four, the investor receives an unsolicited offer from a real estate agent to buy the property for $2 million. The investor decides to sell the property.
The net sale proceeds, after paying real estate commissions and closing cost, is $1.75 million. When the sale proceeds are combined with a $50,000 cash flow in year four, the property generates a $1.8 million cash flow in year four.
The investor finds an alternative investment of similar quality and risk yielding 7 percent, creating the discount rate for the NPV calculation.
In this simple example, the NPV is $1,465,861. That’s the intrinsic value of this property assuming the investor successfully executed the value creation strategy. So, an investor can buy this property for $1 million knowing it has intrinsic value of $1,465,861.
Key NPV Factors
Because NPV involves future cash flow, it is critical to forecast accurate assumptions when modeling a property investment. Here are a few key factors when determining NPV.
Investment strategy. Modeling a stabilized property versus a high-vacancy property requires different forecasting assumptions. Use worst-case scenarios to offset potential forecasting and assumptions errors, especially on properties without a consistent operating history.
Discount rate. The discount rate should reflect market conditions. An increase in the discount rate in the example from 7 percent to 13 percent would reduce the NPV to $1,185,000.
Income and expenses. Forecasted income and expenses should be reasonable and supported by factual data. Forecast lease-up absorption on vacant properties using market standards. Also, use industry standard expense benchmarks in model assumptions.
Future sales price. Use a capitalization rate appropriate to the asset’s location, class, and product type that conforms to trending market conditions. Forecasts for capital markets, the local economy, and real estate fundamentals should reflect a safe cap rate when modeling future sales prices.
Make sure the assumptions in your modeling are founded on sound and reasonable data when determining the intrinsic value of a real estate investment. Understanding the investment strategy, proper discount rate, accurate income and expenses, and future sales price will improve the accuracy of the intrinsic value end result. For protection, value-oriented investors insist upon a margin of safety by buying low in case the intrinsic value calculation was too optimistic.
Integrating replacement cost and NPV methods into your financial analysis and modeling will help uncover more value-oriented real estate investment opportunities. As the general real estate market improves in the coming years, such opportunities will be harder to pencil out, so take advantage of today’s opportunities using intrinsic valuations as your measurement stick.
Source: CCIM By Craig Haskell