Chapter 14: Real estate value Real Estate Principles: A Value Approach

Chapter 14: Real
estate value
Real Estate Principles: A Value Approach
Ling and Archer
Outline
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Investment risk
Time-value-of-money
Internal rate of return
Determining the discount rate
Appraisal
Investment and risk; a
classical view
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Investment is about involving costs (cash outflows)
now for the sake of future benefits (cash inflows).
Investment risk is about uncertainty. This
uncertainty comes from two possible sources: (1)
costs can be uncertain, and (2) benefits can be
uncertain.
Examples of uncertain costs: (1) renovating an
aged house frequently leads to cost overrun, and
(2) developing a subdivision may be surprised by
soil contamination.
Question: should high costs, in equilibrium, lead to
high benefits (returns)?
The spectrum of risk (Exhibit 14-10)
Calpers loses big on land deal
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“Calpers, a $244 billion fund, did its first
undeveloped land deal in 1994 and today
has 7 partners for such deals and
investments in more than 12 states.”
Some deals filed for bankruptcy.
“Land can loss value quickly because there
are fewer other ways to generate income
form it.”
Source: WSJ, May 01, 2008.
Developer sells land dirt cheap
to reap tax benefits
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“ Home builder D.R. Horton Inc. is unloading land
across California at big discounts…partly to reap
the tax benefits from selling property at a loss.”
“Horton sold a 4 acre parcel in Escondido, near San
Diego, for $4.4 million, about 25% of what it paid for
the property in 2005.”
“Tax law allows companies to apply losses from
land and other asset sales to past profits and reap a
tax refund…as far back as 2 years.”
Source: WSJ, Oct. 03, 2008.
The spectrum of cost uncertainty
The spectrum of CF uncertainty
Risky hotels
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“Heading into an economic downturn, hotels
are often among the first industries to suffer
as travel slows and room rates weaken.”
“Lodging analyst Smedes Rose estimates
Marriott is trading at 17 times its expected
earnings per share this year. It traded as
high as 30 times a year ago.”
Source: WSJ, Apr. 30, 2008.
Definitions
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Investment-grade (vs. speculative-grade)
properties: commercial properties that are large
(values generally well over $10 million), relatively
new, located in major metropolitan areas, and fully
leased.
Alternatively, properties can be grouped into class
A (new to newer quality construction in prime to
good locations), class B (aging properties in good to
average locations), and class C (older properties
with functional inadequacies and/or marginal
locations)
2 notions of RE values
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Investment value: value to a particular
individual (e.g., NPV): Chapters 18 &
19.
Appraised value: value to a “typical”
investor, or probable selling price:
Chapters 7 & 8.
Investment cash flows
Initial
Cost
Cash Flow
From
Operations
Cash Flow
at Sale
Discounting cash flows
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The fundamental, economic value of a real
investment is the sum of discounted future cash
flows.
A dollar in the future is worth less than a dollar
today. One of the main reasons for this is inflation.
Net present value (NPV): the difference between
fundamental value and initial costs.
If a real estate investment has a positive NPV, the
investment project should be accepted.
Internal rate of return
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In addition to fundamental value,
practitioners often obtain estimates of the
internal rate of return (IRR). The IRR is also
known as the “investment yield” or the “total
yield” in the RE industry.
If the IRR is higher than the required IRR
(the benchmark), the investment project is
accepted.
Cost of equity
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For publicly traded stocks, the cost of equity
is estimated by using an asset pricing
model, say the CAPM.
For private RE investment, it is harder to
infer the cost of equity from public market
data.
One possible way to estimate this required
rate of return is to identify the return
investors could typically earn on real estate
investments of similar risk via a survey.
Going-in IRR
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An investor’s required going-in IRR = risk-free rate
+ required risk premium.
The required risk premium is higher when the
investment has higher risk (risk-return tradeoff).
Investment-grade properties usually require a risk
premium of 4-8%.
Note that the notion of going-IRR is usually stated
as “before-tax.” The reason for being before-tax
because before-tax cash flows are used for
appraisals.
See Exhibit 18-5, p. 493 for range and average
going-in cap rates.
Going-in IRR example
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Suppose that Hill Inc. is thinking about
investing in an investment-grade office
building in Manhattan. The investment
horizon is 10 years. The return for investing
in T-bonds with a maturity of 10 years is 5%.
Given the perceived investment risk, Hill Inc.
estimates that the required risk premium for
investing in this building is 6%. What is the
going-in IRR?
Going-in IRR = risk-free rate + required risk
premium = 5% + 6% = 11%.
Appraisal
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Appraisal provides an estimate of the most
probable selling price of a property. This
estimation provides valuable information to
the seller and potential buyers of the
property.
The ask price and bid prices are often
established around the appraisal value.
Chapters 7 & 8.