1. TOPIC 3
CALCULATING THE INVESTMENT VALUE
OF REAL ESTATE ASSETS: THE PROCESS
AND CORE INFORMATION NEEDS
2. 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
3. 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
4. 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 .
5. 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
7. 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
8. 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
£7,500,000
•
•
•
Rent is
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
per annum
•
How much (7)? The existing owner wants
rate of return of 7.5%
£150,000,000 for it.
10. Here goes
Year
Year 0
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
£0
Rental income
Year 1
£6,500,000
£6,500,000
£7,879,688
£7,879,688
£7,879,688
£7,879,688
£7,879,688
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.
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
Total revenues from rental income and sale price
PV @ 7.5%
1.0000
0.9302
0.8653
0.8050
0.7488
0.6966
0.6480
0.6028
£0
£6,046,512
£5,624,662
£6,342,838
£5,900,314
£5,488,664
£5,105,734
£112,222,445
(1+i)-n
DCF
PV factor * Net Cash Flow
GPV
£146,731,169
This the sum of the discounted cash
flows.
It is how much the investor should pay
if they require a 7.5% return
11. As you should realise, if they pay the £150 million, they
won’t receive their target rate of return of 7.5% per
annum.
Cost
-£150,000,000
Rental income
£0
Sale receipts
£0
£0
£6,500,000
£0
£0
£6,500,000
£0
£0
£7,879,688
£0
£0
£7,879,688
£0
£0
£7,879,688
£0
£0
£7,879,688
£0
£0
£7,879,688
£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%
IRR
-£3,268,831
7.12%
The IRR is below the target
rate of return and the NPV
is negative
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
Sale receipts
£0
£0
£6,500,000
£0
£6,500,000
£0
£7,879,688
£0
£7,879,688
£0
£7,879,688
£0
£7,879,688
£0
£7,879,688
£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
14. 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.
