How To Value Commercial Property Uk
Investing in commercial real estate can be overwhelming in the best of circumstances, as there are many known and unknown variables that may lead to an investment’s ultimate success. To properly evaluate an investment in commercial real estate, we input the data points of the deal into an excel data model that calculates an estimated return taking into consideration the terms of the debt and equity, the hold period, and the timing and success of the execution of certain events laid out in a business plan for the project. The following details five “gotchas” that every investor may want to look out for to help determine whether an investment has been rigorously underwritten, or whether to take additional care and consideration before proceeding with an investment that may be too good to be true.
1. The Estimated Hold Period is Too Short to Execute on the Expected Business Plan
Investors typically look at the estimated internal rate of return (IRR) to determine the overall time valued return of a particular investment.¹ If a project is anticipated to be held for 5 years, and all other projections remain the same, the investment will increase its actual IRR by selling in less than 5 years, and reduce its actual IRR by selling after more than 5 years.² The project’s return is impacted by the time-value of the investment’s capital outstanding; the less time capital is outstanding, the higher the internal rate of returns are, and the more time capital is outstanding, the lower the internal rate of returns are. If a sponsor wants to make their investment opportunity more attractive to investors, and if they believe that investors will invest more readily in a transaction with a higher IRR, a sponsor could reduce the projected hold period in their model in order to increase the estimated return and entice more investors to invest in the deal.³
Some investors like shorter estimated hold periods and associate shorter hold periods with less risk of changes in the market. A 2-3 year estimated hold period is not necessarily an indication that the sponsor is attempting to inflate the IRR to make their deal more attractive. But the investor may want to determine whether the size and scope of the business plan that the sponsor is planning is reasonable for the estimated time frame presented. If the sponsor is purchasing an asset at a low price (i.e., out of distress), doing only minor upgrades, or only upgrading a portion of the property, it is possible that the sponsor could complete all expected work in 12-18 months and then put the asset on the market. To determine whether the timing of a business plan is reasonable, the investor can question the sponsor about the size of the budget, absorption rates in the market for the subject’s asset type, and the estimated time comparable assets have taken to be marketed and sold.⁴
2. The Exit Cap Rate Used to Underwrite the Exit Price is Unrealistically Low
Another way the estimated IRR may be increased is to increase the property’s sales price at the end of the hold period. Arguably the hardest part of underwriting a commercial real estate investment is to project what the sale price of the asset could be 3, 5, 7 or even 10 years after purchase, and the sale price is estimated by using a capitalization rate applied to the estimated net operating income at the end of the modeled hold period.⁵ The IRR calculation requires the sale price as an input, as the profit or loss made at the sale is a significant part of the investor’s overall return or loss on the project. There are two ways to analyze if the exit cap rate the sponsor uses in their model is reasonable for the subject property:
- Use a higher cap rate at exit than the reality of the market going in: Investors can start by looking at the stabilized going-in cap rate of the market at the time of the purchase of the transaction and see if the sponsor uses an estimated higher cap rate on exit in the model. Because value-add transactions are common for crowdfunding platforms, the going in cap rate of the particular asset may be below market if the property isn’t stabilized, or above market if the property is being bought for a “deal” (i.e., a good price relative to the comparative set), so it’s best to not use the investment’s actual acquisition cap rate.⁶ Rather, a better benchmark to look at is the stabilized market cap rate for the subject property’s asset type in the specific market at the time of purchase, and to stress the transaction by using an exit cap rate that is 25-100 basis points higher for the sale price at the time of exit. Using a higher cap rate reduces the price of the property. Investors typically want to be as conservative as possible with projections by making the assumption that the market will be worse at the time of sale which leads to a lower sale price and have a more conservative impact on estimated returns. It is important to note that this test works when the investment is made in a strong market; if an investment is made during a downturn or depressed period, it may be reasonable to assume that the market will recover and a lower cap rate than the going-in cap rate may be used in the future.
- Use Market Data to Determine A Market Average Exit Cap Rate: A prudent methodology for determining a reasonable exit cap rate is to use a credible data source to pull 10-year cap rate averages for the submarket and use the average cap rate upon exit. In ten years the submarket has likely gone through a real estate cycle, so it will have some years with lower cap rates reflecting the height of the market and some years with higher cap rates reflecting the bottom of the market; by using a 10 year average, the goal is to find a cap rate that is within a reasonable range when projecting the exit price of the asset in that market in the future. This is not an exact science, however, it is one method that may provide a reasonable, and defensible, assumption of value at exit.
Most importantly, if your projected exit cap rate seems “low” relative to the exit cap rates expected in that particular market, you may want to ask the sponsor about their methodology for selecting the exit cap rate to make sure they are not using this input to reverse engineer a more attractive investment for today.
How to Analyze a Commercial Real Estate Deal
Investors are increasingly looking to put capital into commercial real estate. There are many options to choose from: multifamily, office, retail, industrial, hospitality and land development are the major property types to consider. Within each of those property types, investors must then decide whether to invest in Class A, Class B or Class C properties. This decision will depend, at least in part, on whether they’re investing in a primary, secondary or tertiary market.
Feeling overwhelmed yet? You’re not alone! The commercial real estate industry can be a complex web for first-time investors looking to get started.
One way to make the decision-making process easier is by understanding how real estate professionals analyze a commercial real estate deal. There are certain factors that an industry expert will always look at, both at the micro- and macro-level. General market trends, for example, is one of the macro-level factors to consider. But there are many property-specific details that must be analyzed, as well. Each of these factors will influence whether to invest in a commercial real estate deal or not.
Related: Ultimate Guide to Private Equity Real Estate.
Assess general market trends
Someone who’s looking to invest in commercial real estate might learn about a deal in a few different ways. One way is to scour the market and identify deals on your own, something most first-time investors find challenging. Another way is to express interest in investing, and then look for partners who can bring you deals for consideration.
In either case, the first step when evaluating a prospective deal is to consider the general market trends. At a very high level, an investor will want to understand where we are in the market cycle. Market cycles generally last +/- ten years. It can be risky to invest at the market peak, but trying to pin down the market peak can be a fool’s errand. Few can predict when the market will turn with any real certainty. Instead, use market cycle as a rough guide when making investment decisions.
Where we are in any given market cycle will affect all commercial real estate, regardless of specific location.
Therefore, a more useful barometer when analyzing a commercial real estate deal is the hyper-local market trends. For example, let’s say a fund manager is looking for you to invest in a submarket of Houston, Texas. You’ll want to learn more about the drivers of that submarket. Ask questions like:
- Is the population growing or contracting? If the population is growing, who’s moving here and why? Similarly, is the population young and diverse or is it aging?
- What are the area’s major economic drivers? Who are the major employers? How diverse is the local economy? What is the unemployment rate (and is that trending upward or downward)?
- What is the median household income? How much do households spend on rent, on average? How much discretionary income do households have to spend?
Now start to investigate questions that pertain specifically to the property class in question:
- What is the average vacancy rate for properties of this type?
- How much is in the pipeline for new construction of this property type?
- Which buildings would be considered your biggest competitors?
- What would be driving demand for this property type and why?
The answers to these questions will help inform whether or not investing in that property type, in that submarket, is a wise decision. For example, a submarket in which there is a growing, diverse population attracted by an expanding tech economy might be a prime candidate for new multifamily apartment construction, particularly if your analysis finds limited inventory and little in the pipeline for the next 3-5 years.
Want to learn how to invest in private assets and alternative investments?
Read Penn Capital’s guide.
Conduct commercial property analysis
Let’s say you’re convinced to invest in a specific submarket based on a favorable assessment of its general market trends. Now is the time to conduct a commercial property analysis. A commercial property analysis is essentially a comprehensive evaluation of several quantitative (e.g., the numbers) and qualitative (e.g., owner’s motivation to sell) factors that will influence the viability of a particular transaction.
The numbers (years, dates, income, etc.)
Anyone who is considering investing in commercial real estate will want to spend some time getting familiar with a basic pro forma. The pro forma, usually presented in spreadsheet form, will start with an assumed sales price. It will then outline all of the property’s income and operating expenses in detail. It will capture rents collected on a monthly basis. It will account for occasional vacancies. It will have line items built in for routine expenses, such as taxes and insurance. The pro forma will also capture other annual expenses, such as landscaping and snow removal, which may be up to the owner’s discretion.
There are many inputs into a pro forma. These inputs are critically important to understand, as they will help a prospective investor determine their potential return on investment (described in more detail below).
Aside from the pro forma, there are other numbers for an investor to consider, such as the year the property was built, the date it was remodeled (if any), square footage, lot size, number of units, the length of current ownership and more.
Expenses and remodeling
As noted above, the pro forma should account for all known and anticipated expenses. This includes yearly expenses, such as property taxes and insurance. It will also include monthly expenses, such as utilities and property management. These are generally known expenses and can be predicted to hold relatively steady year-over-year assuming the status quo remains.
The pro forma will also want to capture variable operating expenses, such as landscaping and seasonal expenses such as snow removal. For example, a property owner may only pay for snow removal as needed, which can cause the price to go up or down each month depending on average snowfall. During a particularly mild winter, an owner might save hundreds or thousands of dollars on this line item. A look back at the previous five years is a good way to ascertain an average to plug into the pro forma.
The same strategy can be used to account for other operating expenses, such as as-needed repairs and maintenance. This is the budget that usually captures something like a new heating system – an expense that long-term owners are bound to incur, but the timing of the expense may be unknown (and therefore, budgeted for in case needed).
Remodeling is another major line item, assuming the prospective buyers intend to take on any substantial renovations upon sale. Remodeling is usually a significant cost, particularly in value-add projects in which the new owner is looking to reposition the property.
Related: Why Multi Family Class is a Good Real Estate Asset Class
The property history is important for any investor to consider. There are many aspects to property history, ranging from when the property was built to ownership history. You’ll generally want to know:
- When the property was built
- When the major building systems (e.g., the HVAC system, roof, etc.) were installed, and
- How long the current owner has owned the property.
Ownership patterns can be quite telling. For example, if a property tends to turn over frequently, this could be an indication that the asset has historically underperformed.
On that point: performance is another key piece of property history. Performance can be measured by things like current vacancy rates and current rents (as benchmarked against the market average).
Assurance is a somewhat obscure term as it pertains to commercial real estate. Generally speaking, assurance refers to there being some sort of validation that the property is worth pursuing. Assurance could include, for example, strong evidence of demand for that property type.
For example, when Amazon announced it had selected Crystal City in Arlington, VA as the location for its east coast headquarters (dubbed “HQ2”), this was the assurance many needed to invest in local real estate. Amazon announced that it would be bringing 25,000 new jobs to this headquarters, which real estate experts confirmed would drive demand for new multifamily housing.