Commercial Real Estate Valuation
The motivation for entering the commercial real estate market as an investor is usually cash flow driven; this differentiates the impetus for owning owner occupied commercial real estate as a place to conduct one's primary business or buying a home which represents an abode for one's family, pride of ownership and a place to create memories for the future. The complexity, risk and illiquidity of one's capital during the acquisition and management stages of ownership which only becomes liquid at disposition or cash out -refinance warrants a premium to compensate the investor for taking the risk with his / her capital under the arduous conditions of structuring the most effective capital budgeting use of equity / debt in relation to market unpredictability and local market instability. To accomplish this objective a discount cash flow analysis can be prudent in determining the most effective allocation of capital in a deal or if the deal is worth consummating in line with the due diligence findings. The investor is essentially buying an income stream; commercial real estate as an asset class has the added advantages of asset appreciation (usually), debt reduction from the income generated to pay down the debt (mortgage) and tax write offs inclusive of depreciation expense which reduces taxable income and increases cash flow. A Pro Forma is usually prepared for the projected holding period reflective of expected revenue and expenses under current ownership if a refinance or new ownership if it's an acquisition. The investor then makes a determination what discount rate he / she thinks is acceptable to justify and compensate the risk of tying up capital commensurate with project risk, risk premium, the cost of debt and the local and general economy.
Discount cash flow analysis used in commercial real estate is synonymous with discounted cash flow methods of capital budgeting. The Net Present Value (NPV) and Internal Rate of Return (IRR) are used to determine the feasibility of a project. The NPV method discounts the future cash inflow at the investors cost of capital to determine the present value of the investment. This is then compared to the present cost of making the investment. The Internal Rate of Return (IRR) determines the return that equates the present value of the cash inflows and the cash outflows of the investment. This return is then compared to the cost of capital necessary to make the investment. An alternative method of determining value which is used in the income approach to valuation is using the current net operating income (NOI) of a project or the investors expected net operating income under new management and dividing this number by a capitalization rate (cap rate) which factors a safe rate of return eg five years US treasury note plus a risk premium for the project, etc., a hurdle rate to justify the investment and provide a valuation on the property.
Value = net operating Income / cap rate
The net present value method has been referred in the two previous paragraphs under the Discount Cash Flow Analysis general description and implementation. Internal rate of return is another method used by many investors to help decide if a real estate project is worth pursuing. The object is to calculate an overall return on investment (ROI). This is accomplished by using the current operations of the property and project their future returns. This rate calculates the dollar invested, when invested and gives a return based on when the cash flows and the anticipated resale cash flow proceeds are received. This yardstick also can calculate the return after taxes. This return can then be used to compare various investment opportunities. However, this method uses assumptions and is only as good as the assumptions used "garbage in, garbage out". Therefore the astute investor must project multiple possible outcomes including high, moderate and low returns synonymous with best-case, most likely and worst-case scenarios.
Individual investors and business entities reliance and preference of specific valuation models and methodologies can sometimes be traced to experience, industry standards and what is compatible with the investment objective. Many times multiple methods are used eg the Net Present Value and Internal Rate of Return are used to analyze the financial feasibility of a real estate deal to see if it meets the applicable investment standards determined by the investing principals. However, most practitioners place more reliance on one specific method and use others as secondary instruments supportive or unsupportive of the primary method. In the event the investment meets or exceeds the desired yield via multiple methods, if all other facets of the deal are supported by the due diligence it will be pursued and consummated if there is a meeting of the minds between the buyer and seller.