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The valuation bubble in commercial real estate (CRE) made it all too apparent that many industry professionals either did not have a good grasp of fundamental real estate valuation techniques or chose to ignore the basic precepts of smart investing. This type of speculative investing that occurred during 2005 to 2007 and continues in some sectors affects you directly as you will often be outbid on commercial real estate assets. Buying assets at a fair price is absolutely critical to your success in making money and achieving the proper Risk Adjusted Yield on your investment. While institutional investors often overpay for assets in an effort to deploy capital, it is imperative that you do not follow their folly. The good news is that valuing an asset can be relatively simple.1 You are simply looking at the revenues and expenses related to the property and determining a realistic net operating income, net income and cash flow from operations. If the cash flow from operations provides a sufficient Risk Adjusted Yield on your cash investment, then your pricing is fair.
The pricing of risk is determined by global capital markets and the heterogeneous investment characteristics of the asset.
Yet and this is important the valuation mistakes frequently made in the industry are now legendary! Billions and billions of dollars were lost by the Wall Street investors who ignored the fundamental rules to pricing commercial real estate we discuss below. I. Risk Adjusted Yield Proper valuation begins with an understanding of the appropriate Risk Adjusted Yield you should be seeking in a real estate investment. In other words, what percentage yield do you need on a cash-oncash or internal rate of return (IRR) basis? This Risk Adjusted Yield will vary depending on how much risk is involved in producing that return. Low levels of risk are associated with low potential returns, whereas high levels of risk are associated with high potential returns. The least risky investment is U.S. Treasuries. If you can invest in a 5-Year U.S. Treasury note yielding 2%, you can be certain that you will receive your interest payments and the principal at the end of the term. Other investments are riskier and along with the higher rates of return they afford, you have increased risk of losing your investment. For example, investing in a publically traded REIT will provide you with dividend yields and the prospects of stock price volatility. The question you need to answer is how much greater return over Treasuries is needed to invest in an asset class. Your investment yield needs a risk premium to the risk-free rate of U.S. Treasuries to compensate you for the potential of losing money. In other words, the risk premium is how much more you need to make in a risky investment as compared to a risk-free investment. Risk Adjusted Yield is a combination of the risk-free rate of U.S. Treasuries and a risk premium. Mathematically this is shown as: Risk Adjusted Yield = Treasury Rate + Risk Premium for the Investment
One note: this article is about how to value a commercial real estate property and not about how to select the right asset to buy. In other words, we are discussing valuation techniques and not how to choose a property. If you buy the wrong asset or in the wrong location, even at a great price, it may still fare poorly. 1 Odessa Realty Investments, LLC
You should never pay the seller for upside that is likely to result primarily due to your expertise in managing the asset.
Importantly, once you have a strong sense of the proper returns for a given investment, valuing an asset can be relatively simple. If the net cash flow provides a sufficient Risk Adjusted Yield on your cash investment, then you are paying a fair price. The complications in determining commercial real estate cash flows are relatively limited when compared to doing the same for operating companies such as Apple, General Electric or Citibank. Commercial real estate rightfully has a significant position in any investment portfolio due to its operational simplicity, tax advantages, and inflation-hedging characteristics. Avoiding over paying for an asset, however, is instrumental in achieving the requisite investor returns.
October 2010
The author, Dan Pryor, is a partner at Odessa Realty Investments, LLC. Mr. Pryor has twenty-two years of cumulative experience in real estate investing and investment banking. He has dirt experience in numerous aspects of real estate, including acquisitions restructurings, repositioning, and property management. His past investments and property management include office, multifamily, retail, recreational and medical properties. Mr. Pryor also has an institutional financial background as an investment banker with Lehman Brothers and Salomon Smith Barney (now Citigroup). Mr. Pryor graduated from Middlebury College and the Yale School of Management (MBA).