Introduction to

Alternative Investments
Real Estate Performance,
Valuation and Due Diligence
1. Performance and Benefits
2. Valuation Issues
3. Due Diligence
 Categories of Real Estate Performance Indices
Appraisal Indices Repeat Sales Indices REIT Indices
based on periodic estimates based on change in prices of based on the actual trading
of property values by experts properties with repeat sales prices of REIT shares

Shortcomings Shortcomings Shortcomings

Can be subjective Properties sold in a period my Index is not necessarily
Infrequent appraisals →lower not be representative of market representative of the properties
volatility than actual sales →sample selection bias of interest

Real Estate Performance, Valuation and Due Diligence

1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
 Diversification Benefits
Appraisal Indices Repeat Sales Indices REIT Indices

Strong correlation with equity

Low correlation with traditional asset returns
Low correlation with bonds

Direct real estate investments may have

good diversification benefits REITs may have good
diversification benefits for
(methods of index construction may be a factor in the low reported
portfolios heavy in bonds
correlations →actual benefits may be less than expected)

Real Estate Performance, Valuation and Due Diligence

1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
 Comparable Sales Approach
based on recent sales of similar properties

Adjustments
Sold @ $1.5M
are made for:
Sold @ $2M
✤ age

✤ location

✤ condition
Valued @ $2.1M
✤ size
Sold @ $2.5M

Sold @ $1.8M

Real Estate Performance, Valuation and Due Diligence

1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
 Income Approach
Discounted Cash Flow
present value of expected future cash flows to the owner

Owner
Resale Value

Annual operating cash flows

0 time

Real Estate Performance, Valuation and Due Diligence

1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
 Discounted Cash Flow Income Approach Direct Capitalisation
present value of expected Income Statement
Rental Receipts
future cash flows to the owner - Operating Expenses
NOI
- Depreciation
- Interest costs
Owner - Income Taxes Property
Value
or Net Operating Income (NOI) $3M
= $60M
Capitalisation Rate (Cap) 5%
= Discount Rate - Growth Rate = 1/0.05 = 20x multiple

Based on:
0 ✤ business conditions
✤ property qualities
✤ management
effectiveness
✤ sales of comparable
properties

Real Estate Performance, Valuation and Due Diligence

1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
 Cost Approach

Replacement Cost = Land Value + Rebuilding Cost

Using current construction costs

✤ building materials
✤ labor to build,
✤ architectural costs
✤ engineering costs
✤ legal costs
✤ environmental
assessment costs

Real Estate Performance, Valuation and Due Diligence

1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
 REIT Valuations
Income-based Approach Asset-based Approach
Portfolio of companies

Real Estate Performance, Valuation and Due Diligence

1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
 REIT Valuations
Income-based Approach Asset-based Approach
Direct Capitalisation

Net Income
(Non-cash charge) + Depreciation Expenses
(Non-recurring)
- Gains from property sales FFO
+ Losses from property sales - CAPEX
Cash Flow Measure FFO AFFO

Capitalisation Rate (Cap)

= Discount Rate - Growth Rate

Based on:
✤ business conditions
✤ property qualities
✤ management
effectiveness
✤ sales of comparable
properties
Real Estate Performance, Valuation and Due Diligence
1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
 REIT Valuations
Income-based Approach Asset-based Approach
Direct Capitalisation

Net Income
(Non-cash charge) + Depreciation Expenses
(Non-recurring)
- Gains from property sales FFO
+ Losses from property sales - CAPEX
Cash Flow Measure FFO AFFO

Capitalisation Rate (Cap)

Total Assets - Total Liabilities
= Discount Rate - Growth Rate ≈ NAV
Num of shares Outstanding
Based on:
✤ business conditions
✤ property qualities
✤ management
effectiveness
✤ sales of comparable
properties
Real Estate Performance, Valuation and Due Diligence
1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
 Factors to Consider in Real Estate Investments

Global and national

economic growth Property Values

Local real estate $

$
market conditions

Manager Investor
Interest rate levels % Manager Skill

Real Estate Performance, Valuation and Due Diligence

1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
 Factors to Consider in Real Estate Investments

Selecting

Financing

Managing

Manager Investor
Manager Skill

Real Estate Performance, Valuation and Due Diligence

1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
 Factors to Consider in Real Estate Investments

Financing

Degree of leverage
Debt Amplifies gains and losses
↑risk to both debt and
equity holders
Equity

Manager Investor
Manager Skill

Real Estate Performance, Valuation and Due Diligence

1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
 Factors to Consider in Real Estate Investments

Property Development ↑ Risk due to:

Regulatory Issues

Zoning, obtaining permits, environmental considerations, etc.

Changes in Economic Conditions

Renders property’s value lower than expected after completion

Inability to get Long-term Financing

Projects may end up incomplete

Real Estate Performance, Valuation and Due Diligence

1. Performance and Benefits 2. Valuation Issues 3. Due Diligence
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