Risk Adjusted Yield and Valuing CRE

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1 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 1 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

2 So how do you determine your required risk premium for a commercial real estate asset? Historically, risk premiums for institutional quality real estate assets ( A buildings) were about 4.5% to 6.5% above the risk-free rate. Immediately prior to the bubble years, in 2003, A buildings were acquired with risk premiums of about 4.5%. In 2007, at the height of the bubble, the premium was trending at about 0.5% to 2%. Recognize that the 4.5% risk premium in 2003 was for institutional quality A properties. Properties that you assign B and C rankings should have another 2%-3% and 4%-5% added to the risk premium, respectively. And if your property needs to be repositioned or has leasing challenges, further increase the risk premium. It is possible to have risk premiums in the teens and twenties. Looking at a concrete example, if you are acquiring a B building and expected a 10-year ownership period, you would add the equivalent duration 10-year Treasury yield of, say, 2.5%, to the standard risk premium of 4.5% and another 2.5% for the B categorization. Your Risk Adjusted Yield is 9.5%. Inputting numbers into the equation cited above, you get: Risk Adjusted Yield for B Building (9.5%) = Treasury Rate (2.5%) + Risk Premium (7%) This is the yield your investment needs on either a cash-on-cash basis (our recommended strategy which we discuss below) or on a project IRR basis. However, a 10-Year Treasury rate of 2.5% is low by historical standards. In 2000 and 1990, the rates were at When a theory works in approximately 6% and 8%, respectively. When rates go back up practice, it just might work in with the return of inflation, so will the Risk Adjusted Yield. (Note: we discuss commercial real estate and the inflation threat theory. elsewhere.) When you sell your property, the buyer may be requiring a higher return than you, which will inversely affect the value of your property. Thus, if 10-Year Treasuries are at 6% in ten years when you sell the B asset discussed in the preceding paragraph, a buyer would need a 13% return, all other factors held constant. While is appears probable that the risk free rate will increase, this does not necessarily mean your asset will lose value as presumably higher rents and cash flow will increase the value of the property. Yet, the exit valuation will be impacted by higher rates. Accordingly, it is problematic to use current Treasury yields for your calculation of a Risk Adjusted Yield. We sometimes hedge this risk by adding 1%-2% the Treasury yield assumed for our valuation purposes. Again citing the B asset example discussed above, our Risk Adjusted Yield would be approximately 11% if we hedge with an additional 1.5% for the possibility of rising Treasury yields. The determined Risk Adjusted Yield might be adjusted up or down depending on the asset and its potential for upside. If we loved the story, we might stretch a wee bit on valuation, or alternatively might hold out for a higher yield if we were less enamored. The numbers cited herein need to be adjusted for the particulars of your investment. Revenue and cash flow growth has a meaningful impact on Risk Adjusted Yield. If the asset has sustainable and highly probable annual cash flow growth, perhaps due to bumps in rent specified by in place leases, then a lower Risk Adjusted Yield can be justified. We are sticklers for valuing assets based on cash-on-cash returns in the early years, but highly-probable bumps in revenue and increased cash flow may warrant lower initial yields. You should never pay the seller for upside that is likely to result primarily due to your expertise in managing the asset. 2 Odessa Realty Investments, LLC

3 Forecasting cash flow growth is a highly problematic, albeit essential, component of valuing a property. For academics in finance and Wall Street practitioners, cash flow growth estimates are a legitimate part of valuation. Yet, it requires predicting the future and as baseball legend Casey Stengel said, Never make predictions, especially about the future. The Wall Street money that drastically overpaid for assets during recent years relied partially on cash flow growth assumptions to support their faulty investment conclusions. Financial models that rely on internal rates of returns for the investment analysis are great in theory and horrible in practice. Anyone can tinker with assumptions about the future operating margins, capitalization rates and growth rates to justify a purchase price. Even worse is relying on the Greater Fool Theory which assumes that a greater fool will come along and buy the asset at a higher price. That works during an economic bubble, but when the music stops, guess who is looking for a chair? Leverage, or the amount of debt you have on the asset, is a key factor in determining the riskiness of your equity investment. If you have a low loan-to-value ratio, say 50%, the risk of the asset not paying the monthly interest and amortization payments is less than if this ratio is, for example, 80% or above. A relatively large loan as a percentage of the property s value means you have invested less capital, but the chances of you losing the property increases if the property has cash flow problems. Liquidity and control are two key concepts in assessing the risk premium you require over a riskfree investment. Investing in the stock of a large publically traded REIT enables you to sell your stock for cash immediately. However, you will have no control over how the REIT manages its affairs. Investors pay a premium for liquidity and also pay a premium for control. While liquidity is of huge import to investors, the premiums for liquidity and control generally are not that differentiated. Your desire to own, manage and grow a private asset may offset your need to quickly monetize your investment in this asset. It is important to note that in this article we are addressing pre-tax yields. Real estate has attractive tax features, but so do various alternative investments such as tax-free municipal bonds. One should always compare the after-tax yield of an investment to alternative opportunities. For example, taxes on dividends are currently 15%. A 9% dividend yield on your asset will result in a 7.7% after-tax yield. What if the tax rate on dividends was increased to 40%? Then, the after-tax yield would be 5.4%, and alternative investments such as municipal bonds might be more compelling. With this example, you can see how your real estate investments can lose value with changes in the tax code as the next buyer would require greater returns. To summarize, properly buying an asset requires the fundamental discipline of Risk Adjusted Yield. It is imperative that your investment offers a cash flow or IRR yield that is compelling, on a risk adjusted basis. Underestimating the risk premium or relying on unreasonable growth expectations will significantly increase the risk that your property loses value or gains insufficient value during the holding period. II. Focus on Cash-on-Cash Returns We are believers in cash-on-cash returns. Simply stated, how much money are you putting in your pocket at the end of every year, counting all expenses, capital expenditures and a very healthy contribution to the reserve fund? As one old-timer told us: Ebit, Shmeebit. I know how much money is in my wallet. Properly valuing a property is best done by looking primarily at the yield you expect to receive in year 1 of owning the property. Returning to our hypothetical purchase of a B building requiring a 9.5% Risk Adjusted Yield, our primary objective is to have a 9.5% return on the entire amount invested into the 3 Odessa Realty Investments, LLC

4 property. The initial investment amount would be inclusive of equity, closing costs and any initial capital expenditure requirements. If the building can provide a net cash flow or dividend yield of 9.5% on the initial investment, then this would be a fairly valued building and we would proceed with the acquisition. Mathematically this is shown as: Cash-on-Cash Returns (9.5%) = Net Cash Flow / Total Initial Investment As mentioned above, there are many valid reasons to increase or decrease your Risk Adjusted Yield for a particular property. If the property has a phenomenal location and fits your business plan exceedingly well, in certain circumstances you may feel justified in looking out several years for the proper yield. In these situations you may be paying the seller for a bit of the upside and accept that premise knowing that you have a jewel of an asset. Contrastingly, if the building is subject to major improvements and leasing efforts, a higher Risk Adjusted Yield is required. If the property is empty and we need to carry the building, plus pay broker fees and tenant improvements to lease the property, we add these amounts to the initial investment. And we expect a higher yield based on the free cash flow projected for the property when it is stabilized. Depending on the asset class, we often require a projected 15% to 25% cash-on-cash return for assets that involve substantial physical work and lease up. As stated previously, we are not big fans of discounted cash flow analyses to value a property as these are highly subjective and prone to operator error. In DCF s, future cash flows are expressed in a present-day yield known as the internal rate of return. The hypothetical IRR result is a true yield rate, which can be directly compared to other before tax, unleveraged return rates such as stock and bond yields. The challenge is perfectly predicting the future cash flows associated with an asset, particularly the asset s valuation in the terminal year. Terminal valuations are often over weighted in determining project IRRs. We are sometimes bemused by the fact that DCFs are relied upon so widely in the industry. While we look at DCF valuations for all acquisitions, we rarely give them much weight in our final decision making process. Nothing is more assuring than knowing your initial investment will most likely receive an appropriate dividend satisfying your Risk Adjusted Yield requirements in year 1. A high yielding IRR analysis with assumptions made for the next ten years works in the classroom, but not in reality. As we like to say, When a theory works in practice, it just might work in theory. III. Conclusion Buying an asset at the right price has a tremendous impact on the success of your investment. Paying too high of a price and relying on unrealistic growth assumptions to rationalize a purchase will inevitably lead to a loss of investment. The bubble years of reflected the herd mentality of smart Wall Street investors who booked fees, paid bonuses, and professed a belief that rental growth would soon legitimize their purchase prices. Fundamental valuation begins with an understanding of the percentage return you should be seeking in a real estate asset, given the risks associated with that investment. The quality of the asset (location in particular!) is the largest single determinant in determining your investment return. Your yield is heavily influenced by Treasury rates, illiquidity, mortgage interest rates and leverage. Additional key factors include property supply and demand dynamics, capital markets trends, and returns in alternative investments such as bonds or equities. Thus, the pricing of risk is determined by global capital markets and the heterogeneous investment characteristics of the asset. 4 Odessa Realty Investments, LLC

5 We are conservative investors and spend considerable time on each asset purchase to evaluate the risks associated with each asset. At times it is challenging to ignore the irrational exuberance in the market place and stick to fundamental investment principles. Investor sentiment erodes the practical use of DCF models for valuation purposes. Maintaining a focus on cashon-cash returns is helpful as this analysis is focused on the now and possible. 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). 5 Odessa Realty Investments, LLC