Valuation of Real Estate Assets: A Hypothetical Case Study

Valuation of Real Estate Assets: A Hypothetical Case Study

KIRAN KUMAR K V, Faculty-Finance

~~ Beginning of
the Case ~~

Feel Secure Wealth
Managers (FSWM) LLP, a private asset management firm head quartered in Mumbai,
maintains a stock and bond portfolio and also invests in four quadrants of the
real estate market: private equity, public equity, private debt and
public debt
. Each of the four real estate quadrants has a manager
assigned to it. FSWM intends to increase its allocation to real estate. The
Chief Investment Officer (CIO) Gayathri Sheelvant
has scheduled a meeting with the four real estate managers to discuss the
allocation to real estate and to each real estate quadrant. Nithin Milind, who manages the private
equity quadrant, believes his quadrant offers the greatest potential and has
identified three investment properties to consider for acquisition. Selected
information for the three properties is presented in Table-1 below:
Selected Information on Potential Private Equity Real Investments
Property
A
B
C
Property Description
Single Tenant Office
Shopping Centre
Warehouse
Size (Sqmt)
3000
5000
9000
Lease Type
Net
Percentage Gross
Gross
Rental Income pa (at full occupancy)
Rs. 575000
Rs. 610000
Rs. 590000
Other Income
Rs. 27000
Rs. 183000
Rs. 29500
Vacancy and Collection Loss
Rs. 0
Rs. 61000
Rs. 59000
Property Management Fee
Rs. 21500
Rs. 35000
Rs. 22000
Other Operating expenses
Rs. 0
Rs. 234000
Rs. 0
Discount Rate
11.5%
9.25%
11.25%
Growth Rate
2%
0%*
3%
Terminal Cap Rate
11%
Market Value of Land
Rs. 1500000
Rs. 1750000
Rs. 4000000
Replacement Costs
–         
Building Costs
–         
Developer’s Profit
Rs. 8725000
Rs. 410000
Rs. 4500000
Rs. 210000
Rs. 12500000
Rs. 585000
Deterioration – Curable & Incurable
Rs. 4104000
Rs. 1329000
Rs. 8021000
Obsolescence
–         
Functional
–         
Locational
–         
Economic
Rs. 250000
Rs. 500000
Rs. 500000
Rs. 50000
Rs. 200000
Rs. 100000
Rs. 750000
Rs. 1000000
Rs. 1000000
Comparable Adjusted Price per SQMT
–         
Comparable property-1
–         
Comparable property-2
–         
Comparable property-3
Rs. 1750
Rs. 1825
Rs. 1675
Rs. 950
Rs. 1090
Rs. 875
Rs. 730
Rs. 680
Rs. 725
* Assumptions behind above estimates:
Assumption-1: The holding period for each
property is expected to be five years.
Assumption-2: Property B is expected to have
the same net operating income for the holding period due to existing leases,
and a one-time 20% increase in year-6 due to lease rollovers. No further
growth is assumed thereafter.
To prepare for the
upcoming meeting, Nithin has asked
his research analyst Shiju Sunny, for
a valuation of each of these properties under the income, cost and sales
comparison approaches using the above information and the two assumptions. In
reviewing Table-1, Nithin notes the disproportionate
estimated obsolescence charges for Property-C relative to the other properties
and asks Shiju to verify the
reasonableness of these estimates. Nithin
also reminds Shiju that they will
need to conduct proper due diligence. In that regard, Nithin indicates that he is concerned whether a covered parking lot
that was added to Property-A encroaches (is partially located) on adjoining
properties. Nithin would like for Shiju to identify an expert and present
documentation to address her concerns regarding the parking lot.
Shiju
summarily writes down the below tasks for preparing
a report:

  1. Compare the four quadrants and suggest what
    arguments can Nithin put forth to
    demand higher allocation into his quadrant (i.e., private equity) of real
    estate investments.
  2. Rank the three properties in the order of
    highest to lowest owner exposure to risk related to operating expenses.
  3. Determine the value of the properties using
    Direct Capitalization Method
  4. Determine the value of the properties using
    Discounted Cash Flow Method
  5. Determine the value of the properties using Cost
    Approach
  6. Determine the value of the properties using
    Sales Comparison Approach
  7. Give
    an overview of due diligence process to be followed by Shiju for Property-A
~~ End of Case ~~

INSTRUCTOR
REFERENCES:

I.                   
What
courses are intended to be using this case?
The
case can be used as part of courses like Alternative Investments, Portfolio
Management, Financial Modeling and Corporate Valuation.
I.                   
What
models/concepts/theories can be explained through this case?
The
case can be used to demonstrate the below concepts/theories/models/applications:
a)    Real
Estate as Financial Asset – Types (Private Equity, Public equity, Private Debt
& Public Debt)
b)    Types
of Real Estate Properties – Single-family, Multi-family, Office & Other
Commercial Spaces
c)     Types
of leases – Gross Lease, Net Lease and Percentage Lease
d)    Risks
& rewards of investing in real estate
e)    Valuation
of real estate investments using the three approaches – Income, Cost &
Sales Comparison
f)     Process
of Real Estate Due Diligence
I.                   
What
main issue/problem is addressed in this case?
The prime focal point
of this case is the challenges of accommodating heterogenic characteristics of
different types of properties in the valuation process.
I.                   
Teaching
Notes / Solutions

This
case can be best be solved with the use of MS-Excel. Student should be
comfortable in entering the formulas, using functions in spreadsheet. Although,
no major quantitative work is involved, basic financial mathematics knowledge
is essential.

A total of 3
hours/sessions with demonstration would be required, including the case
briefing. It would be ideal to group the students into groups of 3-4 members in
each.
Outline
solutions for solving key issues (Explained question-wise):

1. Compare
the four quadrants and suggest what arguments can Nithin put forth to demand
higher allocation into his quadrant (i.e., private equity) of real estate
investments.
Use the table below to
explain the basic forms of real estate investments:
Equity
Debt
Remarks
Private
Direct investments
in Real Estate. This can be through sole ownership, joint ventures, real
estate limited partnerships, or other forms of commingled funds
Mortgages
Larger investments
Requires property
management expertise
Public
Shares of real estate operating companies and
shares of REITs
Mortgage-backed Securities (residential and
commercial)
Liquid markets
Possible diversification
Remarks
Participate in Value
Appreciation & Income Stream
Similar to bonds
Arguments
for Private Equity in Real Estate:
Private equity in real
estate enable greater decision-making control relative to real estate
investments in the other three quadrants. A private real estate equity investor
or direct owner of real estate has responsibility for management of the real
estate, including maintaining the properties, negotiating leases and collecting
rents. These responsibilities increase the investor’s control in the
decision-making process. Investors in publicly traded REITs or real estate debt
instruments would not typically have significant influence over these
decisions.
2. Rank
the three properties in the order of highest to lowest owner exposure to risk
related to operating expenses. Give a brief description
Types
of Leases:

Gross
Lease

– Owner has to bear/pay the operating expenses
Net
Lease

– Tenant has to bear/pay the operating expenses

Percentage
Lease
– Tenants pay additional rent once their sales
reach a certain level

Risk
Categorization

Owner is exposed to higher risk, in case of Gross Lease when compared to Net
Lease; Owner is also taking higher risk when he accepts Percentage Lease
arrangement.
Ranking
in the given case:
Highest risk – Property
B à
Moderate risk – Property C à
Lowest risk – Property A
3. Determine
the value of the properties using Direct Capitalization Method
 
Three
Approaches to Real Estate Valuation

1) Income
Approach
: Considers what an
investor would pay based on expected rate of return that is commensurate with
the risk of the investment. The value estimated with this approach is
essentially the present value of the expected future income from the property,
including proceeds from resale at the end of a typical investment holding
period.
(a) Direct
Capitalization Method

estimated the value of an income-producing property based on the level and
quality of its net operating income
Capitalisation Rate = Discount rate – Growth
rate

Value
= Net Operating Income / Cap Rate

(b) Discounted
Cash Flow Method
is
different from Direct Capitalisation Method by considering a series of cash
flows and terminal cash flows getting discounted back to present
Value = PV of NOI for
the foreseeable period + PV of terminal period value

2) Cost Approach: Considers what it
would cost to buy the land and construct a new property on the site that has
the same utility or functionality as the property being appraised. Adjustments
are made if the subject property is older or not of a modern design, if it is
not feasible to construct a new property in the current market, or if the
location of the property in not ideal for the current use.
Value
= Replacement Cost of Building – Curable & Incurable Obsolescence + Highest
& Best Use Value of the Land

3) Sales Comparison Approach:
Considers what similar properties transacted for in the current market.
Adjustments are made to reflect differences between the properties, such as
size, location, age and condition of the property and to adjust for differences
in market conditions at the times of sale.
Value
= (Comparable Transaction Value/No. of SQMT or SQFT of the Comp) X (No. of SQMT
or SQFT of Subject Property)

Computation
of Net Operating Income
NOI = Rental Income + Other Income – Vacancy &
Collection Loss – Property Management Costs

Cap
Rate = Discount Rate – Growth Rate

4. Determine
the value of the properties using Discounted Cash Flow Method

5. Determine
the value of the properties using Cost Approach

6.  Determine
the value of the properties using Sales Comparison Approach

7. Give
an overview of due diligence process to be followed by Shiju for Property-A

Due diligence is
conducted to verify other facts and conditions that might affect the value of
the property and that might not have been identified by the appraiser. The
following is an example of items that are usually part of this process
  • Review the leases for the major tenants and
    review the history of rental payments and any defaults or late payments
  • Look at cash flow statements of the previous
    owner for operating expenses and revenues
  • Have an environmental inspection to be sure that
    there are no issues, such as a contaminant material on the site
  • Have physical/engineering inspection to be sure
    that there are no structural issues with the property and to check the
    condition of the building systems, structures, foundation and adequacy of
    utilities
  • Have an attorney or appropriate party review the
    ownership history to be sure that there are no issues related to the seller’s ability
    to transfer free and clear title that is not subject to any previously
    identified liens
  • Review service and maintenance agreements to
    determine whether there are recurring problems
  • Have a property survey to determine whether the
    physical improvements are in the boundary lines of the site and to find out if
    there are any easements that would affect the value
  • Verify that the property is compliant with
    zoning, environmental regulations, parking ratios and so on
  • Verify
    that property taxes, insurance, special assessments and so on have been paid
With regards to
Property-A’s specific issue of potential encroachment of the parking lot, Shiju
should ideally take up an independent property survey and determine whether the
physical improvements, including the covered parking lot, are in the boundary
lines of the site and if there are any easements that would affect the value of
the property.

~~~~~~~~~~~~~~~

Author is a faculty in Finance @ International
School of Management Excellence, Bangalore
(www.isme.in)
feedback: kirankvk@isme.in




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