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Appreciate the comment Peter, but I’m not understanding the question. If you wouldn’t mind clarifying that would be helpful!
When you refer to the ‘original retail statement’, are you referring to the ‘Summary Income Statement Templates’ file found in the ‘Case Study Downloads’ section of lecture 1.6? Or in other words, the summary statement that we use to rollup the detailed statement?
Likewise you mention that “the majority of the categories in the subject detailed statement are not reimbursable”, however all of the operating expense line items in the ‘Detailed Income Statement – Retail‘ file used in the case assignment are reimbursable (the file is found in the ‘Case Study Downloads’ section of lecture 1.6).
You might also take a look at ‘Watch Me Build’ video at the end of the course to get a better understanding of how I go about rolling up the detailed line items to summary line items.
But again, if you wouldn’t mind clarifying the question that will help me better answer the question.
Thanks!
Spencer
Hi bfarbowitz,
We dropped the ball on answering this promptly – sorry for that! This one slipped through the cracks on a busy weekend.
To your question.
I think course 3 will more fully answer this question. But I’ll make two points on this topic and then answer your question.
First, a quick primer on the real estate DCF. The real estate DCF consists of three types of cash flows: ‘Investment Cash Flow’, ‘Operating Cash Flow’, and ‘Reversion Cash Flow’. Without those three cash flows, you cannot properly calculate returns such as IRR. To better understand the concept, think of the real estate DCF in terms of a bond. A bond that yields 10% consists of the following cash flow:
1) Bond purchase (i.e. Investment Cash Flow)
2) Coupon payments paid regularly over the term of the bond at 10% of the face value of the bond (i.e. Operating Cash Flow)
3) Repayment of bond at maturity (i.e. Reversion Cash Flow)To properly calculate the yield, you would need all three cash flows in your analysis.
Which leads me to my second point, which is remembering the key difference between Finance vs Accounting. Accounting is backward looking (i.e. Actual) while Finance is forward looking (i.e. Forecast). Real estate financial modeling is about forecasting the future. All of your analysis is generally forward-looking, even if you rely on the past for assumptions.
So in your DCF, your reversion value – synonymous with that ‘repayment of bond at maturity’ – is essential to calculating returns. Even if you intend to hold an asset (or fund) indefinitely, there must be a reversion value at the end of any analysis period. That reversion value is what you believe you could reasonably sell the asset for at the end of the analysis period, irrespective of whether you plan to sell the asset or not.
So to your question:
“Do you need to consider the FV or cash flow from reversion at exit when calculating the IRR at a given point in time?
For example: If I have a building and I am going to exit my position after 10 years, should I be including the estimated reversion price of the building (or fair value of the asset if it’s a fund) in the year 5 IRR calculation?”
Yes. If you want to calculate the IRR in year five, you would run a five-year DCF. That five year DCF would include a reversion value at the end of year five. And that value would be what you forecast the asset to be worth at that point.
Your DCF would look something like this:
Year 0 – Investment Cash Flow
Year 1 – Operating Cash Flow
Year 2 – Operating Cash Flow
Year 3 – Operating Cash Flow
Year 4 – Operating Cash Flow
Year 5 – Operating Cash Flow + Reversion Cash FlowAnd your IRR calculation, assuming annual periods, would then be an IRR calc of those six net cash flows.
Thanks again for the great question!
Spencer
I’ve since created a lecture on the GP Catch Up concept in our Advanced Concepts course. In that lecture, I share both a catch up to net profit, as shown here, as well as a catch up to a given IRR hurdle. You can find that lecture here:
Hunter – Spencer here, responding for Michael as he’s out of the country this week.
This is an interesting question. The answer is far less nuanced than you might think, especially when you’re NOT coming at it from an academic perspective. In grad school, we learned various “methods” for deriving a cap rate. Everything from comparative analysis (i.e. looking at cap rates on sales of comparable properties) to building an imputed cap rate by adding together tranches of risk (e.g. risk free rate + illiquidity risk + market risk + volatility risk + etc). I remember we even used a method of deriving an imputed cap rate by calculating the weighted average cost of capital and then subtracting out a long-term growth rate.
However, this program is about teaching how concepts are actually used in industry. And in industry, cap rates are much more simple than what you learn in academia/school. There’s not some special formula you can use to come up with the right cap rate. In the real world, a cap rate is simply an assumption, the denominator in your direct cap (i.e. NOI/Cap Rate) formula, used to forecast the value of a stabilized property. And like any other assumption in your model, the cap rate assumption is arrived at by looking at what is actually being achieved at similar properties and using that information to support your assumption.
So to your question, “is there any way of determining the rate for a development property?”. The answer is Yes. By looking at what cap rates other newly developed and stabilized properties are trading for in your market. You get that data either through personal experience and knowledge of trades in your market, data providers such as CoStar/REIS, or through broker contacts. Real estate research firms also put out market cap rate analysis that provides high-level cap rate information (e.g. CBRE Cap Rate Survey), but in industry cap rates are supported (i.e. justified to an investment committee) by actual sales of comparable properties.
Happy to answer any follow up questions to this!
Ironically, I’m putting together a post on the blog side of the website on this very topic! I’ll share the link as a response to this thread when I’m done, but to quickly answer your question: yes, your method is correct.
With that said, allow me to offer some color on property tax incentives in both your DCF and Direct Cap valuation.
Direct Cap.
What’s the first rule of direct cap valuation? Only cap durable cash flows, right? A below market property tax line item is not durable. So the proper way to account for a property tax abatement when doing a direct cap valuation is to:
1) Mark the property taxes to market in your pro forma.
2) Calculate the present value of the future property tax abatement payments. Now what discount rate should you use though? Personally I use the cap rate but this is probably overly conservative and simplistic. Others use the yield on municipal bonds for the jurisdiction guaranteeing the abatement, which also makes sense but interest paid on municipal bonds are free from federal tax (in the U.S.) which means you’d need to calculate the tax yield equivalent for that bond to really get to the proper discount rate. Hence, using the cap rate is a safe and simple alternative.
3) Cap the adjusted NOI by the cap rate and then add the present value of the property tax abatement to the base value to arrive at an adjusted value including the property tax abatement.DCF
You already taught us the method for accounting for a property tax abatement in a DCF valuation. But to restate:
1) Run the DCF, projecting the actual cash flow inclusive of any property tax abatement payments.
2) Adjust the reversion pro forma to include market rate property taxes.
3) Take the present value of the future property tax abatement payments beyond the analysis period, and add that value to the reversion value to get an adjusted reversion value.Really glad you brought this up!
Additional Insights
Here is the link to the blog post mentioned above. The post includes a video and Excel workbook walking you through the logic.
Nick – Yes I’ve seen this done as well, and that practice overstates the returns and is incorrect. Doing so is no different than pricing a bond by including a coupon payment in the initial period with the bond purchase, which would overstate the bond yield and would thus be incorrect.
Another way to conceptualize the time zero concept is to consider daily periods (I apologize for belaboring the point but there may still be people confused about this). You wouldn’t include operating cash flow on the day the property is purchased, correct? Because you don’t own the operating cash flows until the next day. Thus the DCF would look something like:
Day 0: – Acquisition Cost
Day 1: + Operating Cash Flow
Day 2: + Operating Cash Flow
Day 3: + Operating Cash Flow
Day Etc.: + Operating Cash Flow
Day Reversion: + Operating Cash Flow + Reversion Cash FlowREIS and CoStar in the United States use NOI when calculating cap rate. However, as I mentioned above, there may be line items in specific markets included in NOI that aren’t included in other markets.
If you use a data provider, it’s good form to get to know the data provider’s market analyst for your markets. In CoStar for example, on each property page the market analyst’s name and contact information are listed so you can reach out and ask questions about the data. I’ll occasionally call the analysts, especially in markets I’m unfamiliar with, to ask questions about specific properties or submarkets, or how data was collected and is being presented. You’re paying a lot of money for those subscriptions, might was get the most out of it!
I regularly see this question arise as a point of confusion for many and so I’m glad you asked this!
First to the answer and then an explanation. There should never be Operating Cash Flow or Reversion Cash Flow in period (i.e. time) zero; only Investment Cash Flows.
The entire concept of time zero comes from the traditional DCF in finance. Imagine you’re investing in a 10,000 bond with a 10% coupon rate. You purchase the bond in time 0, and then in each time that follows you receive a coupon equal to 10% of the bond’s face value. At the bond maturity, you receive the face value of the bond back (i.e. the residual). Thus the bond looks something like:
End of Period 0: -10,000
End of Period 1: 1,000
End of Period 2: 1,000
End of Period 3 (Maturity): 1,000 + 10,000If you run an IRR on the above cash flow, assuming each period is equal to one year, the result is 10.0% which unsurprisingly is equal to the coupon rate. You wouldn’t think to include the coupon in time zero, because you don’t own the bond in period 0 but rather purchase the bond at the end of period 0 and then receive a coupon at the end of each subsequent period.
So it goes with a real estate DCF. In time zero, you purchase the real estate (or in the case of a development you deploy your first dollar). Operating Cash Flow then begins in period 1 and continues until the end of the analysis period, at which point there is a sale (or residual value). The DCF looks very similar:
End of Period 0: Acquisition (Outflow)
End of Period 1: Operating Cash Flow (Inflow)
End of Period 2: Operating Cash Flow (Inflow)
End of Period 3: Operating Cash Flow (Inflow) + Reversion Cash Flow (Inflow)Again, you wouldn’t think to include operating cash flow in period 0 because you don’t own the asset in period 0 but rather purchase the real estate at the end of period 0.
Thanks again for the great question!
As promised, I’ve added two videos to the Modeling Multiple Tranches of Capital Sources Dynamically lecture.
The first video shows you how to complete the ‘Error Check’ formulas. The second video shows you one way to integrate this module into a full real estate model.
You can find the updated lecture here:
Sorry for the delayed response – both Michael and I have been traveling for the holiday weekend!
You are correct. You likely read this here:
https://www.pircher.com/media/publication/50_SACArticle.pdf
You are also correct that the actual distribution percentages are the same in both cases. But the LP generally prefers the promote to dilute both the GP and LP’s interest. This gives the LP the option to replace the GP, if necessary, and still dilute the prior GP’s share when paying the new GP’s promote.
Not a silly question at all! Generally speaking, in the United States at least, direct cap valuations are derived by capping NOI. There are exceptions to this, but the standard is to cap NOI.
With that said, what matters most is that you’re following market and property type convention. This is because the cap rate you eventual use in your analysis should be based on and/or supported by cap rates at comparable sales. If the comparable cap rates you’re using to support your valuation are based on Net Operating Income, then you should likewise use NOI in your analysis.
Equally as important, is to ensure your NOI contains similar line items as your comparable set. So for instance, if your comp set (i.e. market convention for your property type) includes a capital reserve in the NOI calculation (i.e. capital reserve modeled above the line), then likewise you should follow suit.
Thanks for the great question!
Wisdom,
This is a great question. From a modeling and valuation perspective, there are a couple of ways to handle situations where one or more tenants are in-place at above market rents. Now I should mentioned, why the rent is above market is somewhat unimportant, but you provide a good example of when it might be the case.
How you handle this depends on whether you’re valuing the property using a direct cap or DCF.
Direct Cap.
In the case of a direct cap valuation. What I do is first, in my direct cap pro forma, I mark the tenant’s rent to market. This ensures that I’m not capping the above market rent into perpetuity. Using this adjusted pro forma, I arrive at a direct cap value before accounting for the value of the above market rents.
Next, I calculate the present value of the portion of rent that is above market. This entails modeling how much rent is above market in each period out into the future, and then discounting those cash flows back to the present at some discount rate (e.g. a percent equal to the cap rate). That present value is then added to the direct cap valuation to arrive at an adjusted value.
DCF.
In the case of a 10-year DCF valuation. I would model the rents in-place (i.e. as-is), but then mark the rents to market in the residual pro forma to ensure that I’m not capping the above market rents into perpetuity in the residual value.
If necessary, I may also do a similar present value calculation of any remaining above market rents after the end of the analysis period, and add that amount to the residual value to properly give credit for the additional cash flow.
Thanks again for contributing to this discussion!
Hi Wisdom,
Not sure I fully understand the question. Are you asking, from the perspective of the firm making an acquisition, how to account for in-place rents that are above market due to amortized tenant improvements embedded in their rents?
Spencer
Hi Sunny,
Would you mind sending over your completed Workbook and I’ll take a look? You can send it to [email protected]. Happy to take a look and see where the issue is!
Spencer
