How PE Firms Value Commercial Real Estate Properties?
Private equity (PE) firms are renowned for their ability to drive returns across different market conditions and asset classes.
One such segment that has long captivated PE giants, is commercial real estate. With its steady cash flows, low borrowing costs, less managerial requirements, and long-term appreciation, there are few other investments better suited for the troves of money that PE firms manage for their clients.
The success of PE firms in commercial real estate is largely a result of their unique approach towards valuations and deal structuring. Such approaches have since transformed the entire ecosystem and everyone in it, from brokers and property managers, to appraisers, lenders, and all others in-between.
This legacy industry has witnessed a shift of epic proportions over the past two decades, with the PE industry playing a key role in it. In this article, we take a look at some of their practices, and how they can be applied by small and medium-sized investors for their own benefit.
The Income Approach
The most common approach when it comes to valuing a commercial real estate property is the income approach. Fairly simple and straightforward, this approach is based on the idea that the value of a property is determined by the income it generates.
This is further divided into two more categories – the direct capitalization method, and the discounted cash flow method.
Direct Capitalization Method
This method is particularly suited for valuing assets that produce a stable income, and includes all types of real estate, industrial facilities, and most importantly commercial real estate.
Under this method, the net operating income generated by a property is divided by the capitalization (cap) rate.
The cap rate is essentially the rate of returns that investors require for a particular property, in order to make it worth the investment. This often depends on the prevailing interest rates and market conditions among other things, as even a 3% cap rate can be quite attractive in certain markets, and conditions.
As an example, assume that a building generates a net operating income of $100.000 per year, and has a cap rate of 6%, its market value would be at nearly $1.7 million ($100,000/6%).
Discounted Cash Flow Method
On properties where the income is expected to fluctuate, a more sophisticated approach to valuations is imperative. The discounted cash flow value method is commonly used for a wide variety of asset classes, including when it comes to ascertaining the fair value of publicly traded stocks.
It is calculated by projecting future cash flows of a property, before discounting these cash flows back to their present values using a discount rate. PE firms often use the weighted average cost of capital as their discount rate, as it accounts for the expected rate of returns for investors.
The purpose of a DCF valuation is to introduce the time value of money when comparing investment opportunities. It works quite well in this regard, although a major drawback is that projecting future cash flows is far from straightforward, and is subject to assumptions that could very well be wrong.
The Market Approach
Another common approach when it comes to valuing commercial real estate is the market approach, which is based on the sales prices of similar properties in the same market.
A rather simple approach, it still remains the preferred option for smaller property investors who might find it hard to project future cash flows, and find the net present value of their properties. This is further divided into two categories – the sales comparison method, and the gross income multiplier method.
Sales Comparison Method
As the name suggests, this method involves identifying similar properties in the same region that have sold recently, and using their sales prices to accurately value the property in question.
Beyond having a thorough understanding of the local market and recent transactions that have taken place, this method requires expertise on finding truly comparable properties, before discounting for size, location, amenities, and other aspects.
While this is far from simple or straightforward, there are plenty of professional appraisers who have since turned it into a precise science. Buyers and sellers are often recommended to work with at least two different appraisers, but in a vast majority of cases, the appraised values are at par.
Gross Income Multiplier Method
A great way to simplify the sales comparison method is by using the gross income multiplier method, which merely views the value of a property based on its gross rental income.
This method merely involves multiplying the gross rental income of a property by the gross income multiplier (GIM), which is derived based on the sales price of similar properties in the surrounding area. For example, if a rental property in the neighborhood just sold for 10 times its annual gross income, the GIM will be 10.
Similarly, if the property in question is currently generating a gross annual income of $1 million, based on the GIM of 10, the fair value of the property can be ascertained at $10 million.
Other Factors Considered By PE Firms
While above-mentioned metrics form the crux of PE commercial real estate valuation, there are a slew of other factors that come under consideration.
This mostly includes various qualitative factors, such as the location, its amenities, growth profile, traffic flow, etc, followed by tenant quality, lease terms, and the overall condition of the property.
Private equity giants, the likes of Blackstone, KKR, and the Carlyle Group have created enormous value in the global commercial real estate markets over the past couple of years.
In the process of generating outsized returns for their investors, the funds have driven large-scale transformations when it comes to price-discovery, transparency, and procedural integrity, in what was once a largely unorganized and haphazard market.
These trends and practices have since spread to other corners, with small investors, agents, and other players benefiting just the same.