Topic #2: Real Estate Valuation: Context

Real
Estate Finance - Topic #2 Valuation 1/15/20
Topic #2: Real Estate Valuation
Winter 2019
Professor Cindy Soo
Context
•  Property-level real estate analysis
–  Valuation and risk
•  Revenues and expenses
•  Financing
•  Taxes
–  Financing structures
•  Real estate market analysis
•  Securitized real estate investments
•  Real estate usage 7
1
Real Estate Finance - Topic #2 Valuation 1/15/20
How do we estimate the value of a property?
•  External Value
•  Common industry valuation/appraisal methods
•  Cap rates
This Lecture
•  Internal Value
–  Measuring real estate returns
–  Pro Forma analysis
Topics #2-5
8
Topic Goals
•  Understand the role of a range of factors in determining property
value.
•  Be aware of the pros/cons of the different valuation/appraisal

methods used in the industry.
•  Understand how cap rates are used to estimate property value.
2
This Lecture
•  What factors determine property value?
•  What are the different valuation/appraisal methods used in the

industry?
•  What are cap rates?

10
What determines real estate value?
•  What is a real estate investment?

•  Location
•  Physical Asset
•  Financial Asset
•  How do these factors impact property value?
11
3
How do we value land?

•  Fundamental characteristic of real estate
•  Defines unique location
•  Essential to building physical structure
•  e.g., 19 acres on AC Boardwalk
12
Purchased 2006: $270m Sold 2013: $30m
How do we value land?

Land Value = PV(Expected Future Land Rents)
•  What factors determine land rent?

•  Demand for space (amenities, transportation, etc.)
•  Supply of space (BTE - competitors, regulation, etc.)

•  Expectations on future land rents are priced in.
•  Growth premium: e.g. potential city expansion
•  “Call option” to develop at a future date.

13
4
How do we value the physical

asset?
2006: $70m 2012: $2.6bn 2014: $94m
•  Supply/demand for property type.

•  Added value (demand-enhancing features). 14
•  Development and operating costs, physical depreciation.
How do we value the physical

asset?
2018
2006: $70m 2012: $2.6bn 2014: $94m
•  Supply/demand for property type.

•  Added value (demand-enhancing features). 15
•  Development and operating costs, physical depreciation.
5
How do we value the financial asset?
•  Security of projected income (leases).

•  Leverage and the cost of capital.
16
•  Financial institutions and supply of funds.
What determines real estate value?

1.  Location
•  Supply/demand expectations.
i.e. the spatial organization of production and consumption

2.  Physical Asset
•  Development and operating costs.
•  Physical depreciation.
•  Added value (demand-enhancing features).
3.  Financial Asset

•  Leases, projected income.
•  Risk and the cost of capital. 19
•  Financial institutions and supply of funds.
6
This Lecture

industry?

20
(Replacement) Cost Approach

Cost of duplicating property minus depreciation

21
Longaberger Building: $30m construction cost

7
(Replacement) Cost Approach

Cost of duplicating property minus depreciation

→  Why pay less than cost?
•  Owner developer paid a premium.
•  Rent is forward-looking, expectations change.
→  Why pay more than cost?

•  Value of location/land.
•  Pre-leasing.
22
•  Never used in capital budgeting.
•  Most fruitful in engineering or cost-to-cure cases.
Market Approach: Comparable Analysis
Value of Comparable Properties (with

adjustments)

•  Commonly used by appraisers:
•  Find recent transactions of similar buildings.
•  Adjust observed prices for differences in attributes,
e.g. # bedrooms, bathrooms, soundproofing, views.

23
8
Market Approach: Comparable

Analysis
Location & Physical
Characteristics Com p 1 Com p 4 Com p 8 Com p 9
Property Name Time Warner Center 650 Madison Ave Ge Bldg Sony Plaza
Address 10 Columbus Circle 650 Madison Ave 30 Rockefeller Plz 550 Madison Ave
City, State ZIP New York, NY 10019 New York, NY 10022 New York, NY 10020 New York, NY 10022
County New York New York New York New York
Submarket Midtow n West Plaza Grand Central Plaza
Property Type Multi-Tenant Multi-Tenant Multi-Tenant Single Tenant Rental
SquareFeet/Type 1,228,000/UN 626,000/GBA 1,300,000/UN 827,686/UN
Buildings/Floors 1/54 1/27 1/70 1/37
Year Built/Renovated 2003/-- 1955/-- 1932/-- 1983/--
Asset Class A A A A
Longitude -73.982548 -73.971076 -73.9788 -73.973447
Latitude 40.768271 40.764291 40.758311 40.76106
Sale Detail
Date 1 / 2014 30-SEP-13 19-MAR-13 15-MAR-13
Price $1,300,000,000 $1,294,231,048 $1,307,965,050 $1,100,000,000
Verified NA Public Record Public Record Public Record
Price/SF $1,059 $2,067 $1,006 $1,329
Vacancy at Sale 0% 8% NA 0%
Interest Purchased 100% 100% 100% 100%
Cap Rate Analysis - Per SF/Year
NOI PSF $80.70 $85.93 $84.06 $61.97
NOI Total $99,098,249 $50,565,896 $109,275,860 $51,293,026 24
Estimated Going-In Cap Rate 7.6% 3.9% 8.4% 4.7%
12-Month Rolling Metro Office Cap Rate
NA 5.0% (Q3 2013) 6.1% (Q1 2013) 6.1% (Q1 2013)
Market Approach: Comparable Analysis
Value of Comparable Properties (with adjustments)

•  Commonly used by appraisers:
–  Find recent transactions of similar buildings.
–  Adjust observed prices for differences in attributes,
e.g. # bedrooms, bathrooms, soundproofing, views.
→  What are the problems with this approach?

–  Comparables are hard to find.
–  Transaction prices reflect unobservables.
–  Imprecise adjustments based on physical characteristics. 25

9
Market Approach: Hedonic Analysis
Property = Bundle of Components or

Characteristics
↓↓
Property Value = Value of the Property Components

1.  Estimate the market value of property attributes
using transaction prices for comparable properties.
2.  Estimated value of property is sum of observed
attributes, weighted by estimated market WTP for
each. 26

1.  Estimate the market value of property attributes j=1,…J
using transaction price data for properties i=1,…I.
HPi = a + ∑ b j X ij + ei
j
•  HPi is the price of property i,
•  Xij is the vector of j traits for the property i,
•  a is the regression intercept term,
•  b is the coefficient vector of trait prices,
•  ei is the error term.

2. Estimated value of property k is sum of observed attributes,
weighted by estimated market values.
27
!"! = ! + !! !!!" !
!
10

HPi = a + b1SqFti + b2 Bathi + b3CentralAiri + ei

•  HPi is the price of house i,
•  SqFti is the square feet of house i,
•  Bathi is the number of bathrooms in house i,
•  CentralAiri = 1 if house i has central air, 0 if not,
•  ei is the error term.
Marginal
dHP ΔHP
bj = ≈ Willingness to
dX j ΔX j Pay
•  The marginal effect of a small change in trait j on home price HP

•  How much is the market willing to pay for trait j?
28
•  “Shopping cart approach”: value of oranges is given by the difference in value
of shopping carts with and without oranges.

! = â + b! SqFt + b! Bath + b!CentralAir
HPk 1 k 2 k 3 k

•  “Computerized” comparables analysis.
•  Both start with data on comparable properties.
•  More data, systematic estimation of adjustment factors.
•  Similar problems, cast in new terminology.

•  Imprecise estimates due to data limitations.
•  Non-physical traits are still difficult to quantify.
•  Specification error:
•  Omitted variables (what is in ek?).
29
•  Backward-looking and static (b1t, b2t, b3t?).
11
This Lecture

industry?

30
What is a cap rate?

•  Real estate generates cash flows.
Net Operating Income (NOI)
NOI = Total Operating Income – Expenses

•  Property prices reflect how the market values this cash flow:
Value = NOI / C

Capitalization Rate (Cap Rate “C”): ratio of NOI of a property and its
“capital” cost or current market value.
31
C = NOI/Value

12

What is the cap rate used for?

A way to describe the real estate market.
•  Multiple : measure of company’s financial well-being

(e.g. P/E= Price/Earnings)
•  Cap Rate is an equivalent “multiple” for your property
•  Cap Rate = required cash yield on a property to warrant price.
•  Cap Rate = Inverse of a P/E ration (i.e. Earnings/Price)

•  5% cap = 1/20 = E/P
•  Investors are willing to pay a multiple of 20x the earnings for the
property.

•  Where is the real estate market over time, across sectors? 32
e.g. “Retail is at an 8-cap” , “Bought at a 5-cap, sold at a 10-cap”
What is the cap rate used

for?
A way to project the market value of a property.
•  Used to calculate the projected sale price in pro forma analysis:
V! = NOI
! / c!

•  NOI projected for the first year after sale.
•  New owner’s first year NOI
•  Before taxes and financing
•  ‘Stabilized’ i.e. steady-state, after initial ramp-up (post capex)
•  Cap rate estimated using market averages.

33
•  Taken from surveys and “comparables” transactions.
13
What is the implied cap rate for

the Longaberger Building?
• Given:
•  Cost $30m to build
•  180,000 square foot
•  Assume:
•  $20 psf
•  Opex is 33% of gross income
•  Therefore:
•  NOI =
•  Implied cap rate, c =
34
What is the implied cap rate for

the Longaberger Building?
• Given:
•  Cost $30m to build
•  180,000 square foot
•  Assume:
•  $20 psf
•  Opex is 33% of gross income
•  Therefore:
•  NOI =
•  Implied cap rate, c =
35
14
Conceptual Framework to
Understand Cap Rate Comparisons
•  Think of a property as a perpetuity with initial payment NOI and
constant growth rate g.
NOI (1+ g)NOI (1+ g) 2 NOI NOI
V= + + + ... =
( )
r−g
2 3
1+ r (1+ r) 1+ r
•  A market price for this perpetuity of V implies that the required
market yield on this perpetuity is r.
NOI
V=
r−g
36
•  So we can think of the cap rate as the yield the market requires on
real estate cash flows adjusted for the expected growth.

Conceptual Framework to
Understand Cap Rate Comparisons
c = NOI /V = rf + rp − g

•  The cap rate (c) is determined by the discount rate…

…adjusted for the risk and potential growth of real estate.
•  rf = risk-free rate (discount rate)
•  rp = real estate/property type risk premium
•  g = expected growth in real estate income
•  What happens to cap rates if

…10-year Treasury yields rise? 37
…the market decides real estate is more risky?
…the economy starts to improve?
15
Cap rates have stabilized at low levels…
38
…but spread has shown movement.
39
16
Cap Rates by Sector

Cap Rate (%) Change
Property Type Sep-18 Sep-19 (bp)
Apartment 5.52 5.40 -11.7
Hotel 8.61 8.58 -3.5

Industrial 6.49 6.19 -30.1
Office 6.62 6.59 -3.8
Retail 6.50 6.56 6.1

40
Source: Real Capital Analytics; 3 month rolling average.
Office Cap Rates by Market

Average Office Cap Rates
City 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Boston 6.54% 8.97% 7.48% 7.16% 6.36% 6.17% 6.18% 5.51% 5.58% 5.10% 6.18% 5.33%
Chicago 7.63% 8.80% 7.83% 7.37% 7.63% 7.36% 7.04% 7.14% 6.96% 6.87% 6.29% 6.97%
Columbus 7.91% 7.10% 8.80% 8.80% 8.04% 8.00% 8.51% 8.30% 7.80% 8.07% 7.82% 7.40%
DC 5.70% 7.59% 6.34% 5.89% 5.56% 5.61% 5.63% 5.79% 5.19% 5.25% 5.41% 6.10%
Houston 7.41% 9.01% 9.01% 7.44% 7.56% 7.29% 7.10% 7.23% 7.99% 7.33% 7.20% 7.57%
Manhattan 4.87% 6.45% 5.71% 5.62% 5.33% 4.81% 4.48% 4.48% 4.27% 4.45% 4.50% 4.80%
Philadelphia 7.10% 8.25% 8.65% 8.57% 8.17% 7.31% 7.04% 6.85% 7.03% 7.31% 6.62% 7.47%
San Francisco 5.14% 8.77% 6.85% 6.61% 5.47% 5.45% 5.16% 5.30% 4.96% 5.48% 5.48% 5.13%
Tampa 7.49% 8.40% 10.00% 8.20% 8.79% 8.26% 7.19% 7.13% 7.32% 7.64% 7.05% 6.77%
Source: Real Capital Analytics
41
17
Are these cash flows worth a 3- or 4-

cap?
42
May 2014: TIAA-CREF paid $274m.
Valuing Real Estate with Cap

Rates
Pros:
•  Quick way to screen deals
•  Widely used (and available) in the industry
Cons:
•  Requires stable, steady-state cash flows (net of replacement reserves).
•  In practice, ad hoc assumptions on NOI.
•  Assumes all Cash Flow components have the same risk
Bottom Line: Cap rate analysis is not enough to evaluate a deal!

… depends on many (ad hoc) assumptions … 43
18
Summary of

External Valuation Approaches
•  Deep down, the comparables, hedonics, and cap rate methods
are very similar.
•  All examine how the market valued the characteristics and cash
flows of comparable properties to estimate how the market will
value your property, given its characteristics and cash flows.
•  Comparables adds appraiser’s “insight”.

•  Hedonics processes a lot of data well.
•  Cap rate applies a simple market/sector average to a
performance summary.
44
How do we estimate the value of a property?
•  External Value
•  Common industry valuation/appraisal methods
•  Cap rates
Topic #2
•  Internal Value
–  Measuring real estate returns
–  Pro Forma analysis
Topics #3-7 45
19
Discounted Cash Flow (DCF)

•  This is the way to obtain internal investment value
of an asset.
•  Private investment value (not market value)
•  Value of property equals to its discounted
expected future cash flows.
T
•  DCF = Present Value of the Property = ∑ Ct (1+ r )
−t
t=1
•  Obtain sequence of future cash flows from pro-

forma.
•  Assume end period T, since it is quite hard to
forecast cash flows ad infinitum. 46
•  Use appropriate discount (hurdle) rate.
Note: Discount Rate ≠ Cap Rate

•  Cap rate is used to value a property, not discount cash flows.
•  Discount rates reflect opportunity cost of capital. Cap rates also

reflect growth potential.
•  Poorly-selected discount rates may not account for property-

specific risk factors such as:
•  Site-specific factors
•  Property type
•  Property market factors
47
20
DCF vs. Cap rate Valuation

•  Hold building for 5 years
•  What is the PV of the cash flows (assuming received year-end)?
•  Discount rate = 4.0 percent; cap rate = 7.0 percent

Year 1 2 3 4 5 6
NOI: 100 99 98 97 96 95
Sale price:
Cash flows:
48


Year 1 2 3 4 5 6
NOI: 100 99 98 97 96 95
Sale price: 1,357
Cash flows: Will sell at the end of year 5 to someone
who will apply the cap rate to year 6 NOI:
95/0.07 = 1,357
49
21


Year 1 2 3 4 5 6
NOI: 100 99 98 97 96 95
Sale price: 1,357
Cash flows: 100 99 98 97 1,453
/(1.04) /(1.04)2 /(1.04)3 /(1.04)4 /(1.04)5
Discount each cash flow back to the present using the discount rate
50

Year 1 2 3 4 5 6
NOI: 100 99 98 97 96 95
Sale price: 1,357
Cash flows: 100 99 98 97 1,453
Present value: 1,552
•  Internal value of project = $1,552

51
22

Hold building for 5 years; Discount rate = 4%; Cap rate = 7%
Year 1 2 3 4 5 6
NOI: 100 99 98 97 96 95
Sale price: 1,357
Cash flows: 100 99 98 97 1,453
Present value: 1,552

•  Present internal value of project = $1,552

•  Present market value?
52
Market vs. Private Investment

Value
•  As in all markets your private valuation may not correspond to the
market valuation.
•  Marginal vs. infra-marginal buyers:
P
Demand
Market P Supply
53
Q* Q
23

Value
•  How is possible for you to have a private investment value above
the market valuation of the asset: did the market go wrong?
P
Demand
Your DCF Value
Market P Supply
54
Q* Q

Value
•  If you are on the buy side (in a competitive market):
•  You will only buy if DCF > Market Price
•  You shouldn’t pay more than Market Price!
•  If you are on the sell side:

•  You shouldn’t sell if Market Price < DCF
•  You shouldn’t sell for less than Market Price
•  Auctions: beware of winner’s curse!

•  If DCF>Market Price, think critically about why this may
55
be so!
24
Appendix
56
Gordon Model Derivation: V = NOI/(r-g)

For those who are interested. Not tested.
•  Think of the property value, V, as an infinite stream of NOI’s paid at
the end of each period with growth rate, g, and discount rate, r.
NOI (1+ g)NOI (1+ g) 2 NOI

V= + + + ...
(1+ r) 2 ( )
3
1+ r 1+ r
•  Recall, infinite sum expression:
S = a + ad + ad 2 + ad 3 + … = a + d(a + ad + ad 2 + … ) = a + dS = a / (1− d )

NOI 1+ g
•  Set then V=
NOI
a= ;d =
1+ r 1+ r r−g
57
25

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Real

Estate Finance - Topic #2 Valuation 1/15/20

Topic #2: Real Estate Valuation

How do we estimate the value of a property?

• Be aware of the pros/cons of the different valuation/appraisal

• Understand how cap rates are used to estimate property value.

• What are the different valuation/appraisal methods used in the

• What are cap rates?

What determines real estate value?

• What is a real estate investment?

• How do these factors impact property value?

How do we value land?

• e.g., 19 acres on AC Boardwalk

How do we value land?

• What factors determine land rent?

How do we value the physical

2006: $70m 2012: $2.6bn 2014: $94m

• Supply/demand for property type.

How do we value the physical

2006: $70m 2012: $2.6bn 2014: $94m

• Supply/demand for property type.

How do we value the financial asset?

• Security of projected income (leases).

What determines real estate value?

3. Financial Asset

• What are the different valuation/appraisal methods used in the

• What are cap rates?

(Replacement) Cost Approach

(Replacement) Cost Approach

→ Why pay more than cost?

Market Approach: Comparable Analysis

Value of Comparable Properties (with

Market Approach: Comparable

Market Approach: Comparable Analysis

Value of Comparable Properties (with adjustments)

→ What are the problems with this approach?

Market Approach: Hedonic Analysis

Property = Bundle of Components or

Market Approach: Hedonic Analysis

Market Approach: Hedonic Analysis

HPi = a + b1SqFti + b2 Bathi + b3CentralAiri + ei

• The marginal effect of a small change in trait j on home price HP

Market Approach: Hedonic Analysis

• Similar problems, cast in new terminology.

• What are the different valuation/appraisal methods used in the

• What are cap rates?

What is a cap rate?

Net Operating Income (NOI)

NOI = Total Operating Income – Expenses

What is the cap rate used for?

• Multiple : measure of company’s financial well-being

• Cap Rate = Inverse of a P/E ration (i.e. Earnings/Price)

What is the cap rate used

• Used to calculate the projected sale price in pro forma analysis:

• Cap rate estimated using market averages.

What is the implied cap rate for

What is the implied cap rate for

• The cap rate (c) is determined by the discount rate…

• What happens to cap rates if

Cap rates have stabilized at low levels…

…but spread has shown movement.

Cap Rates by Sector

Apartment 5.52 5.40 -11.7

•  Be aware of the pros/cons of the different valuation/appraisal

•  Understand how cap rates are used to estimate property value.

•  What are the different valuation/appraisal methods used in the

•  What are cap rates?

•  What is a real estate investment?

•  How do these factors impact property value?

•  e.g., 19 acres on AC Boardwalk

•  What factors determine land rent?

•  Supply/demand for property type.

•  Supply/demand for property type.

•  Security of projected income (leases).

3.  Financial Asset

•  What are the different valuation/appraisal methods used in the

•  What are cap rates?

→  Why pay more than cost?

→  What are the problems with this approach?

•  The marginal effect of a small change in trait j on home price HP

•  Similar problems, cast in new terminology.

•  What are the different valuation/appraisal methods used in the

•  What are cap rates?

•  Multiple : measure of company’s financial well-being

•  Cap Rate = Inverse of a P/E ration (i.e. Earnings/Price)

•  Used to calculate the projected sale price in pro forma analysis:

•  Cap rate estimated using market averages.

•  The cap rate (c) is determined by the discount rate…

•  What happens to cap rates if

•  Comparables adds appraiser’s “insight”.

•  Obtain sequence of future cash flows from pro-

•  Use appropriate discount (hurdle) rate.

•  Discount rates reflect opportunity cost of capital. Cap rates also

•  Poorly-selected discount rates may not account for property-

•  Internal value of project = $1,552

•  What is the PV of the cash flows (assuming received year-end)?

•  Present internal value of project = $1,552

•  If you are on the sell side:

•  Auctions: beware of winner’s curse!

•  Recall, infinite sum expression: