Week 3 slides (1)

TOPIC 3

CALCULATING THE INVESTMENT VALUE OF REAL ESTATE ASSETS: THE PROCESS AND CORE INFORMATION NEEDS

Topics covered

• Rationale, required knowledge and rough approach• A hypothetical example• The hypothetical cash flow• The missing detail• The Key Inputs

– Forecasting rents– Forecasting sale prices– Forecasting depreciation– Forecasting void costs– Setting the target rate of return

Why?

• BECAUSE MOST MAJOR INVESTORS UNDERTAKE FINANCIAL MODELLING OF REAL ESTATE ASSETS IN ORDER TO– TO WORK OUT HOW MUCH THEY CAN PAY

FOR AN ASSET THAT THEY ARE CONSIDERING BUYING

– TO WORK OUT WHETHER AN ASSET THAT THEY OWN WILL DELIVER THEIR REQUIRED RETURNS

Some basic concepts• AN ASSET’S VALUE IS TAKEN AS THE PRESENT VALUE OF ITS FUTURE

REVENUE STREAMS. • THIS IS A FUNCTION OF THREE THINGS

– THE REVENUE STREAM– THE TARGET RATE OF RETURN– TIME

• “INVESTMENT VALUE” IS THE WORTH OF AN ASSET TO AN INVESTOR OR A CLASS OF INVESTORS

• You can think of Investment Value as similar to equity analysts trying to establish whether companies’ share prices are overvalued or undervalued. Equity analysts often estimate the future cash flows of the companies to estimate the present value of the dividend flows. You see phrases like “intrinsic”, “fundamental” or “fair” value being used to mean the same thing as IV. They then compare this estimate of value to the actual price at which companies’ shares are trading .

A common approach is to

• Set out on an annual (but could be quarterly or monthly) basis– How much cash (do we estimate) will be paid out?– When (do we estimate that) it will be paid out?– How much cash (do we estimate) will be received? – When (do we estimate that) it will be received?

• You need to estimate a target rate of return• Then estimate the Gross Present Value of the

net cash flow produced by the asset

2. A HYPOTHETICAL EXAMPLE

An example

• Let’s take a hypothetical example – and strip out some of the detail for now

• Where? A real estate asset in London’s West End• What? 10,000 sq m of office space• Who? It was let three years ago to a tenant on a 15

year lease with rent reviews to Market Rent every five years.

• How long? The investor has a seven year holding horizon

How much? Just the basic inputs for now• How much (1)? The tenant is paying £6,500,000 rent per annum

• How much (2)? Recent deals suggest that if let today the Market Rent is £7,500,000

• How much (3)? The research department estimate that Market Rents will grow at 3.5% per annum for the next seven years.

• How much (4)? The research department also estimate that offices experience

rental depreciation at 1% per annum – i.e. loses value

• How much (5)? The research department also think that the asset will sell for 20 times

its rent in seven year’s time – that’s an (exit) yield or cap rate of 5%

• How much (6)? The investor has a target rate of return of 7.5% per annum

• How much (7)? The existing owner wants £150,000,000 for it.

3. THE CASH FLOW

Here goesYear Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

This is the rent review five years into the lease. The lease started three years ago. The Market Rent is currently £7,500,000. However, the research department are forecasting Market Rents to grow at 3.5% per annum. However, this asset is also expected to depreciate at 1% per annum. £7,879,688 represents £7,500,000 grown at 2.5% per annum for two years. This stays fixed for five years until the next rent review.

Sale Price £178,302,863

The sale price is a product of the rent at sale and the rental multiplier (exit yield at sale). The rent at sale is expected to be £7,500,000 grown at 2.5% per annum for seven years. This is £8,915,143. The expected exit yield is 5% or the multiplier is 20. This gives £178,302,863.

PV @ 7.5% 1.0000 0.9302 0.8653 0.8050 0.7488 0.6966 0.6480 0.6028

GPV £146,731,169This the sum of the discounted cash flows.It is how much the investor should pay if they require a 7.5% return

Total revenues from rental income and sale price

(1+i)-n

PV factor * Net Cash Flow

Rental income £0 £6,500,000 £6,500,000 £7,879,688 £7,879,688 £7,879,688 £7,879,688 £7,879,688

Net cash flow £0 £6,500,000 £6,500,000 £7,879,688 £7,879,688 £7,879,688 £7,879,688 £186,182,551

DCF £0 £6,046,512 £5,624,662 £6,342,838 £5,900,314 £5,488,664 £5,105,734 £112,222,445

As you should realise, if they pay the £150 million, they

won’t receive their target rate of return of 7.5% per annum.

The IRR is below the target rate of return and the NPV is negative

Cost -£150,000,000 £0 £0 £0 £0 £0 £0 £0Rental income £0 £6,500,000 £6,500,000 £7,879,688 £7,879,688 £7,879,688 £7,879,688 £7,879,688Sale receipts £0 £0 £0 £0 £0 £0 £0 £178,302,863

Net cash flow -£150,000,000 £6,500,000 £6,500,000 £7,879,688 £7,879,688 £7,879,688 £7,879,688 £186,182,551

DCF -£150,000,000 £6,046,512 £5,624,662 £6,342,838 £5,900,314 £5,488,664 £5,105,734 £112,222,445

NPV at 7.5% -£3,268,831IRR 7.12%

Alternatively, if they are trying to work out how much to pay, there is no initial cost – and the surplus is what the asset is worth

to them

Year 0 1 2 3 4 5 6 7

Rental income £0 £6,500,000 £6,500,000 £7,879,688 £7,879,688 £7,879,688 £7,879,688 £7,879,688Sale receipts £0 £0 £0 £0 £0 £0 £0 £178,302,863

Net cash flow £0 £6,500,000 £6,500,000 £7,879,688 £7,879,688 £7,879,688 £7,879,688 £186,182,551

NPV at 7.5% £146,731,169

4. THE MISSING DETAIL

What detail was left out?Mainly costs and fees

Management costs Letting agents fees

Capital expenditure Selling agents fees

Void costs Buying agents fees

Rent review fees Legal fees

Stamp Duty (buying and selling)

For a large assets such as a shopping centre, the cash flow could contain dozens of rows. One for each individual tenant. I’ll expand the cash flow later in order to illustrate some of the issues.

5. THE KEY INPUTS

5.1 FORECASTING RENTS

5.2 FORECASTING SALE PRICES

5.3 FORECASTING DEPRECIATION

5.4 FORECASTING VOID COSTS

5.4 SETTING THE TARGET RATE OF RETURN

Acquisition professional

Asset managerAgentFund ManagerResearcherClient/investor

•Target rate of return•Exit yield - building•Rental growth - building•Market rent•Depreciation - building•Capex•Refurbishment•Redevelopment•Voids, bad debts andmanagement

•Target rate of return•Exit yield - market•Rental growth - market•Market rent•Depreciation - market•Voids

•Target rate of return•Exit yield - building•Rental growth – buildingand market•Market rent•Depreciation – buildingand market•Voids, bad debts andManagement•Capex•Refurbishment•Redevelopment

•Target rate of return•Lot size•Covenant strength•Lease structure•Geographical/sectorpreferences

•Voids, bad debts andmanagement•Capex•Refurbishment•Redevelopment

Garbage In-Garbage Out!

Lots to look at on Moodle.