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Two excellent questions. They are related, so let me see if I can answer both questions at once.
The idea is this. At any time, an Investor can purchase a “risk-free” and completely liquid asset in the form of a government bond. That government bond will offer some yield-to-maturity that in finance is called the “risk-free rate”. When an investor is deciding whether to make an investment, that risk-free option is always available to him as the safest alternative. Thus, the investor would expect some yield premium to invest in any asset that is riskier than the “risk-free” government bond.
That same principle applies to real estate. Because real estate is riskier than government bonds, the real estate investor would expect the return on a real estate investment to be higher than the yield on a government bond. That is the “risk premium” referred to in the Cornell Real Estate Journal article, and what I was stating when I said: “Compare the assumed cap rate to the prevailing risk-free rate (USTs in the United States) and market discount rates. Know the spread between each and ask yourself, is this appropriate and/or likely to persist?”
As a side note. This “risk premium” is a metric that mostly institutional real estate investors track (see the CBRE Cap Rate Survey for the avg. risk premium by property type and location). If the real estate risk premium (difference between risk free rate and cap rates) narrows, that means real estate investors are willing to take more risk for less return; which is generally due to a greater supply of real estate capital chasing fewer opportunities.
So how does one go about “calculating” the risk premium? In the real world, you don’t! The market sets the risk premium and it’s up to you to decide whether that risk premium is enough. In other words, the market may offer you opportunities to buy at a 6% cap rate, resulting in an 8% unlevered IRR (i.e. the discount rate – see course 2) and it’s up to you whether that’s a sufficient return to justify the commensurate risk. And that decision – whether the return is sufficient – is most often decided by your debt and equity capital sources.
As an example, imagine prevailing cap rates are 4% for your property type and market of choice and you expect to yield a 6% unlevered IRR when taking into account growth. However, you seek out a 60% LTV loan and quotes come back at a 6% interest rate. And when you go to your equity partner, they quote you an 8% preferred return to cover the other 40%. You can thus safely say that the return doesn’t justify the risk, because the capital markets (debt and equity providers) told you so.
With all of that said, in the spirit of teaching what really goes on in the industry, this is not that important in the grand scheme of things! It’s good to know so you understand what’s driving cap rates and discount rates, but it’s not like real estate analysts or associates are using a complex formula to calculate the appropriate risk premium to apply to each deal. The deal tells you the risk premium, and it’s up to you to decide whether that’s sufficient.
Michael goes into this in more depth in course 2 when discussing discount rate, unlevered IRR, PV calculation, and how they are all used in practice.
Thanks again for the great questions!
Some great points Pratik. Allow me to clarify. It is definitely worthwhile for an opportunistic investor to use DCF analysis. My point was, calculating the present value is not possible due to the string of investment cash flows that go out beyond time zero. But the DCF is extremely valuable for calculating IRR, equity multiple, estimating breakeven and stabilization, and host of other risk and return metrics that rely on a projected period of cash flows (we go much deeper into this in courses 3 and 3a).
And thank you for bringing up residual land value calculation! For those who are unfamiliar with the analysis, Residual Land Value Analysis is a method for calculating the value of development land. The most common method is to subtract from the total value of a development, all costs associated with the development, including profit but excluding the cost of the land. The amount left over is the residual land value, or the amount the developer is able to pay for the land given the assumed value of the development, the assumed project costs, and the developer’s desired profit.
What I just described does not require building out a full DCF. However, a more robust way to calculate residual land value is using a DCF. If you’d like to see this in action, I included a residual land value analysis module in my All-in-One that does just this (see below).
How it works is you solve for some target return metric. It may be IRR, Equity Multiple, Net Profit. You could even solve for a risk metric, such as stabilized loan proceeds if your goal was to cash-out refinance at stabilization. And while this isn’t a PV calculation, this particular residual land value analysis method uses the DCF to help you arrive at an appropriate price to pay for the land.
We will not be covering residual land value in the Accelerator, but here are a few resources you can look at:
1) How to calculate residual land value
2) Using the Residual Land Value Module in the All-in-One
As always, thanks for the great question!
Spencer
Hi Pratik,
Spencer here. I’ll let Michael respond as well, but let me offer my two cents.
In my experience development firms do not generally use PV (or NPV) calculations. That’s because the PV calculation is really asking, to achieve an X return (the IRR or discount rate) what do I have to pay today? From a DCF perspective, that involves one big negative cash flow in time zero followed by a string of positive cash flows until the end of the analysis period. The cash flows in an opportunistic investment like development do not model out in that fashion.
I see PV used most often by asset management teams and core investors. They have well-established internal target return assumptions, and will use that target return as a discount rate to understand the value of the investment.
But how do they arrive at that target return assumption (i.e. discount rate)? You have part of the equation, the cost of your equity capital. But if you plan to add leverage, you must also take into account the cost of debt capital. So if you raise equity at a 15% pref and borrow at 6%, your discount rate will be some blend of the two rates plus what you as a sponsor need to earn.
In practice though, there’s no formula that real estate firms use (no, not even WACC). In the real world, it’s much less of a perfect science. Each firm will have their own required/target return depending on the risk profile of the investment, and that will become their discount rate when performing this type of analysis.
Spencer
Hi Pratik,
Spencer here. Fielding this one for Michael.
First off, you are correct that the underlying assumption is that cash flows generated each period are assumed to be re-invested at the IRR rate. While not typical in the real estate industry, if you feel this is overly aggressive you can use the MIRR() function instead of the IRR() or XIRR() function (we’ll discuss both IRR() and XIRR() in course 3a). The MIRR() function offers the option to choose a reinvestment rate for cash flows, different from the IRR rate. For more information, check out this article from McKinsey.
In terms of your question about handling cash flow streams with oscillating positive and negative values. The short answer is, you can’t be confident of an IRR() calculation by Excel when the cash flows change from negative to positive repeatedly. That’s because each time your cash flows change from negative to positive, or from positive to negative, the Excel IRR calculation generates an additional solution .
So what to do when your cash flow stream goes negative to positive to negative repeatedly? I personally ignore IRR in those instances, and instead rely on non time value of money profitability metrics such as Equity Multiple and investment spread (yield-on-cost minus market cap rate).
I can’t speak authoritatively to other solutions to this conundrum, but a quick Google search yields another solution. This article offers MIRR as an alternative for positive-negative-positive cash flows, but I can’t confirm it’s effectiveness as I haven’t used MIRR for this issue.
Great question, by the way!
Spencer
Jim and Jrob,
We feel your frustration about the Quiz start. The issue first popped up overnight and appears to be affecting a handful of people. The challenge on our end is we’re unable to replicate the issue – meaning the quizzes work for our tech team and most of the users, but for a few of you the Start button just doesn’t appear on some quizzes.
The tech team has attempted a couple of fixes throughout the day today, including one a few minutes ago. We can’t test on our end whether the fix works so would you please try the following for us:
1) Open an incognito tab (or open a different browser you don’t typically use),
2) Login in, and see if the Start button is now appearingThen please let us know either way if the latest fix worked. That would be really helpful.
And we apologize for this nuisance. Completing the quiz will not limit your ability to continue with the lectures, but I know it’s frustrating not being able to see if you’ve completed the assignment successfully or not.
Spencer
Hi Kyle – we just sent you an email with a few questions. We’ve had a handful of other people with similar issues on Quizzes. We’re thinking there’s a browser-specific conflict, but we need to isolate it so our tech guys can fix it.
Thanks for your patience!
That’s a keen eye! And quite correct. 995,803 SF of building area would equate to 995,8030 ÷ 370 = 2,691 SF/unit!
Since the net rentable area is (see page 5) 775 SF x 370 = 286,750 SF, either it’s a VERY inefficient building or it’s a typo. I’m going with typo!
We’ll get it fixed and a revised OM saved back to the Accelerator.
Thanks for pointing this out!
Hi John,
Sorry about the trouble here. A second member has reported issues with that quiz as well. Our tech team is working to troubleshoot the issue and get a fixed rolled out.
I’ve gone ahead and increased the number of retakes for the quiz. Please attempt to retake the quiz. If the issue persists, let me know, and then move on for now. Not scoring an 80% on the quiz won’t impact your ability to successfully complete the course.
Appreciate your patience with this while we work on a fix.
Spencer
Hi Matt,
Moving this question to the ‘Accelerator Technical Support’ forum.
The ‘Passing Grade’ column in your Learning Dashboard is meant to let you know what percentage of lectures you must complete in that course to “Finish” the course. It is not your actual grade in that course. Sorry for the confusion!
If you recall from the Guide to Getting Started (https://www.adventuresincre.com/academy/courses/guide-to-getting-started/lessons/accelerator-certificate-of-completion/), to qualify for the Accelerator Certificate of Completion you must:
1) Take all 16 courses in the Accelerator
2) Complete 80% of the lectures in each course
3) Receive a score of at least 80% on select quizzesI added a note to clarify that the quizzes that require an 80% score or greater are only in courses: 3a, 4a, 4b, 4c, 4d, 4e, 10, 11, 12. , You are given unlimited tries to pass quizzes that require an 80% passing score.
Our tech team noticed that the ‘Passing Grade’ column in the Learning Dashboard was erroneously stating that you needed a 100% to pass. They corrected the error, but I can see how it created confusion on your end!
I’ve asked them to rename the column to ‘Req’d Grade’.
Thanks for pointing this out!
Spencer
Jim,
Chiming in here. I’ve been told this issue has been resolved. The quiz should now offer retakes and the Learning Dashboard should now update properly.
Let us know if the issue pops back up for you.
And thanks again for pointing this out so we could get it fixed!
Spencer
Slaff,
I wanted to follow up on this issue. We discussed some solutions with our tech team and they’ve added a user caching tool that is meant to store a copy of each Lecture page to your browser. Assuming it works properly, it should help speed up the load time to lectures you’ve already been to.
While not a perfect solution, it will hopefully make the ‘Complete’ button issue you raise a little less of a nuisance and likewise improve the overall experience using the learning tool.
We’re continuing to explore other solutions, but this is one solution our team could quickly implement.
Thanks again for your feedback. Please let us know if you run into other issues and/or you have other suggestions.
Best of luck this week!
Spencer
Hi Josh,
Great question. I would not say that Collection Loss (i.e. Credit Loss) is synonymous with vacancy. The drivers of Collection Loss are quite distinct from the drivers of physical vacancy. However, as was the case with 55 Crescent Apartments and The Foles, I usually assume any risk of Collection Loss is captured by my General Vacancy assumption.
So why not separate Collection Loss out from Vacancy in the cases in this course? This really comes down to how much of a reality Collection Loss is at the property. There are certain properties where delinquency is negligible (e.g. luxury class A property), and so it’s easier to just assume that your General Vacancy assumption captures any credit loss that might occur. On the flip side, if you’re underwriting a property with a persistent delinquency issue, it makes sense to break that out into it’s own line item. That way you can assess how much revenue is lost due to delinquency versus physical vacancy.
I would suggest as a rule of thumb, if you have a clear history of Credit Loss that impacts EGR by more than 1% per year, it would make sense to break it out. Otherwise, it’s cleaner to not separate it.
Thanks for the question,
Spencer
All excellent questions. Perhaps a greater explanation of how actual and general vacancy are used will help to clear up some of the confusion, and in turn answer your questions.
In most cases, you will only see “actual vacancy” in historical operating statements. In reporting what happened at the property in the reporting period, the operator will state the amount of lost rental revenue due to vacant units (i.e. downtime).
So in the case of ‘Crescent Apartments’ you’ll notice that there is Actual Vacancy (under the Rental Revenue section) reported for 2016, 2017, and the T12. Those actual vacancy amounts tell us how much potential rental revenue was lost due to vacancy.
It is thus assumed that there was likewise potential Other Income (i.e. RUBS, Other Income, and Parking Income) lost due to vacancy, but that income is embedded in the respective Other Income line items – at least that is what is most common in industry.
So to further explain this point. Let’s look at the 2016 historical operating statement for Crescent Apartments. In 2016, the property reported 5,309,488 in Potential Rental Revenue (i.e. Market Rent) with (284,036) in Actual Vacancy. That means the property experienced 5.35% vacancy that year. Total Other Income equaled 490,003 in 2016. The 5.35% vacancy is assumed to be embedded in that 490,003 number. So if we assume Other Income sources are directly fixed to occupancy and 490,003 is the total other income at 94.65% occupancy (i.e. 5.35% vacancy), we would then extrapolate that had the property been 100% occupied Total Other Income would have equaled 490,003 ÷ 94.65% = 517,700. That is called in CRE “Grossing Up” a value for vacancy.
But how do we underwrite vacancy – either for rent or for other income? In my experience everyone does it slightly different. In fact, that’s why in the case of Crescent Apartments I had the broker modeling vacancy under the Actual Vacancy line while I modeled it under ‘General Vacancy’. In terms of industry convention, neither is outside the realm of normal.
Generally speaking though, General Vacancy is a Pro Forma (not historical) line item only and is used to adjust Gross Revenue to account for the expected long-term vacancy. Remember, the Pro Forma is meant to reflect a perpetual NOI. If the property has experienced either abnormally high or abnormally low occupancy over the past few years, the General Vacancy line items allows us to smooth the underwritten vacancy to something more sustainable.
So in the case of Crescent Apartments, I hit Rental Revenue with a loss-to-lease factor but left the Actual Vacancy line as 0 (meaning grossed rental revenue up for vacancy, after accounting for a perpetual loss-to-lease). I then modeled Other Income conservatively by not grossing up Other Income line items for actual vacancy. Finally, I hit the Gross Revenue (Rental Revenue + Total Other Income) with a 5% adjustment down via the General Vacancy line to account for long-term vacancy.
Hope that helps clear up your questions!
Spencer
Hi Slaff,
This is good feedback – thank you. I agree with you it’s a nuisance. This is actually something I weighed when we were deciding between a few long lectures vs more short lectures. The upside to the short lectures is it’s a format that fits better with busy schedules. Downside is more lectures to wait to load and more ‘Complete’ buttons that must be pressed.
The inadvertently pressing Next instead of Complete button issue came up during testing/development and unfortunately according to our development team having the ‘Next’ button also act as a ‘Complete’ button created a whole new set of issues. One change we made in response to this was to make the ‘Complete’ button automatically take you to the next lesson. But that’s only if you remember to press Complete rather than Next, which I know is easier said than done!
Either way, we’ll raise this issue again with our tech team and add the feedback to our list of improvement requests we’re receiving from the initial launch group.
Thanks again for the comment – keep them coming!
Spencer
