Friday, April 22, 2011

Understanding Value Creation in Real Estate--by Uncle Sherman (Guest)

In November of 2007, Isthismar, a Dubai based investor, bought 280 Park Avenue, a two tower 1.2 million square foot Class-A office building in Manhattan. They paid $1.2 billion for the building, or around $1,000 per square foot, a new record for a property of this size. A few months later, Isthismar flipped the building to Broadway Partners, a New York-based real estate investment company for $1.35 billion, a small profit. Broadway held the building until this March, when they announced that they were in over their heads and needed a bail-out.


The story is a familiar trope of the last recession—over-funded investors get caught up in a manic market and overpay. “Investors” isn’t really the right term though, since buying without any regard for real estate fundamentals is speculation rather than investment. But how do we know they overpaid? Is this just smarmy 20-20 hindsight? And what are “fundamentals” after all?

Real Estate Fundamentals

Owning real estate as an investment is like owning a car rental business (with very long-lived cars). You lend your car to someone who pays you to borrow it. That’s it. The value of your real estate is the value of the payments you can get when you lend it to someone. Of course many home owners and even some “professionals” don’t pay attention to lending or rental rates. Home owners often estimate value by how much pleasure they’ll get out of a home, or how much they believe they can get when they sell it. “Professionals” sometimes buy buildings for braggadocio, brand image or for the fees they get for investing money. There is nothing wrong with buying on those principles (unless you’ve promised your investors you’d do otherwise), but betting on what the next guy will pay instead of the cash income you’ll get for renting is the definition of speculation.

Real estate investment, as opposed to speculation, is the purchase of a property based on its income potential. Property income has two parts: “yield” or “current income”, meaning the income you expect to receive while owning the property, and “appreciation,” the increase in capitalized value of the expected future income, which you’ll get when you sell the property.

Like any other investment, real estate is risky. You may not be able to lease out your building, or if you do, your lessee may not pay their rent. You might also face non-leasing risks, such as capital risks (problems with the building’s structure), environmental risks, political risks (direct expropriation, an increase in taxes, or a modification of legal use which makes an expected income stream infeasible), technological risks (new technology or change in social habits which render your building obsolete), financing risk (not being able to refinance or repay your loan), and many others. As a result, good real estate investors approach acquisitions not only thinking about the income they’ll get with a property, but the riskiness of that income. After all, the 11% yield you’re buying on a property isn’t worth a whole lot if you stop receiving it when the tenant goes bankrupt in the second year you own the building.

Pricing Real Estate

Real estate investors think about the value of a building both in terms of what income you’d get if you owned it today (a “static” analysis), and what income you’d expect if you owned it a number of years into the future (a “dynamic” analysis).

A static analysis is useful to compare a property against other projects and opportunities with similar risk profiles. The most important number investors use to understand an investment on a static basis is a capitalization rate, or cap rate. Cap rates are the inverse of price/earnings multiples with stocks, although in real estate the convention is to divide “Net Operating Income” or “NOI” into a property’s price. Like earnings, NOI is composed of income (rents, other income) minus expenses (real estate taxes, insurance, property management, and any utilities and maintenance costs that can’t be passed through to tenants). Unlike earnings, NOI may or may not include capital expenditures on the building, depending on the property type. NOI never includes debt service.

Cap rates represent the cash yield in the first year of the investment and don’t take into account future expectations or changes in the asset or income stream. A higher cap rate represents a larger amount of income per the price paid, but if the property is openly marketed, a higher cap rate also suggests that the property’s income stream is riskier than similarly sized income streams of more expensive properties.

Here’s an example. Let’s say I can buy a condo for $100,000 and rent it out for $11,000 a year. Let’s say that all my expenses on the condo are $1,000. My cap rate is $10,000 divided by $100,000 or 10%. Now assume that at the same time I buy my condo, you buy a condo down the hall for $90,000. If you get $9,000 of income, you’re buying at the same cap rate as me, and the market considers your condo and my condo to be similarly risky. But if you get $10,000 of income, you’re buying at a higher cap rate and the market believes your property is more risky than mine. Why? If investors are willing to accept a 10% yield (as I did on my property), and your property receives $10,000 income, and if investors believe your and my properties are equally risky, someone would bid up the price to $100,000. If they do not, then you are paying less for a higher but more risky income stream, hence the higher cap rate.

This example assumes there is market liquidity and market knowledge, and that investors are rationally seeking to optimize the risk-return profile of their investments. These assumptions are not always true, but most real estate investors know what cap rates their competitors are paying for properties, so they are at least aware when they are breaking away from the pack. Breaking away from the pack isn’t necessarily stupid either—the best money is made taking mispriced risks that others won’t.

As opposed to a static analysis, a dynamic analysis of real estate evaluates the estimated income stream over a multi-year horizon using a traditional discount cash flow model. In addition to considering rent changes, vacancy, sales expenses, capital expenditures, and leverage, investors also have to consider changes in interest rates. Over the long term, cap rates are driven by interest rates; the various real estate asset types each have a different spread over “riskless” treasuries. That’s because if cap rates get too close to treasuries, investors can (in principal) shift their money out of real estate and into government bonds, driving cap rates up until the risk/return profile makes sense. Again, this idea assumes more liquidity than probably exists in real estate, and it doesn’t take into account the asset allocation models which drive so many institutional investors today. As a result, cap rates changes may get dislocated from treasuries in the short term, creating investment or sales opportunities. But in the long term, as Ben Graham says, the market is a weighing machine, and cap rates return to proper risk-associated levels.

Common Investor Mistakes

Understanding and modeling real estate income streams or risks is worthy of books, to say nothing of a blog post. There are two points however which non-real estate investors often miss entirely in evaluating real estate investments but which are critical to profitability.

The first is capital expenditures, which for buildings in good repair consist of leasing commissions and tenant improvements (TIs). Buildings with higher capital expenditure requirements relative to their cost (office buildings and restaurants, as opposed to industrial warehouse buildings) suffer disproportionately during periods of high turnover because their cost structure is more variable relative to rollover risk. Although investors across asset classes may conservatively underwrite expected capital expenditures into their purchase price, investors with high cap-ex buildings pay a larger cost for being wrong. This problem is particularly true with TIs.

In most real estate asset types, a building owner gives a tenant a TI allowance to “finish” shell space to the tenant’s preferred specifications. These improvements generally include carpet, painting, or even new walls, among other items. The TI allowance can be given as a cash payment toward contractors, or as a loan amortized into the tenant’s lease. The amount of TIs depends on the market conditions and the product type. In both strong and weak leasing markets, tenants request improvements.

Although they are considered “capital improvements” and can be added to a building’s basis, TIs generally don’t outlast a tenant. This is a critical point--since each new tenant demands new TIs, the more frequently tenants move in and out of a space, the more a landlord has to spend on capital expenditures. The idea seems obvious, but it is often lost in acquisition underwriting, which often models “down” scenarios with low rents rather than with high turnover. In weaker leasing markets where it is harder to fill space and where tenants default more frequently, owners must pay TIs more frequently to keep the space filled, and more generously to attract tenants away from competitive space. And during a down market, an owner must foot this bill while accepting a lower lease rate. As a result, while higher TI asset classes may look as good on paper and perform as well in “up” markets, they are much more risky in down markets.

The second issue that non-sophisticated investors often overlook is the impact of changing interest rates on real estate investments. Interest rates hit the bottom line in a number of ways. First, depending on rates at any time, a significant percentage of commercial real estate loans float at variable rates, and interest rate changes quickly hit the bottom line through debt service. Second, even if owners have the cash to cover mortgage payments, they may incur a “technical default” if their coverage ratio reaches a certain level. A technical default may require acceleration, imposition or other fee consequences. Third, as mentioned above, interest rates ultimately drive cap rates, which play a more significant role in asset value than any other factor.

Buying at a 5% cap rate for example, which many real estate investors are doing today, is risky business. Ten year treasuries historically yield around 5%, and real estate, depending on the asset type, is considered a minimum of 150-200 basis points riskier than treasuries. The tables below are simplified as they do not include traditional deducts for vacancy, sales costs and a number of other items, however they still demonstrate the disproportionate impact of interest and cap rates versus rental increases. Notice that if treasuries go back up to 5% and cap rates go up to 7% or 8%, you don’t even make a 5% return unless you get 5% annual net operating income increases and hold for a minimum of 7-10 years. If interest rates go up to 7% or 8% and cap rates hit 9% or 10%, it’s almost impossible to make your money back unless you hold for 7 to 10 years, even if rents increase at 8%-9% annually for that entire time. Given that current interest rates cannot go lower and that inflation seems poised to strike, buying at a low cap rate seems to have a one-sided risk reward profile.

This is likely the discovery that Broadway Partners made in 280 Park Avenue, which reportedly sold at a cap rate below 4%. When you buy at a historically low cap rate, and cap rates rise even slightly, there is almost no way to escape losing money. Isthismar was equally culpable for speculating, but they managed to flip the building before they got in trouble.

In future posting, I will cover other overlooked phenomena of real estate investing.

IRR Returns

Buying at a

5%

cap

Going out Cap


6%

7%

8%

9%

10%

11%

12%

Annual NOI Inflation

2%

1%

-4%

-7%

-11%

-13%

-15%

-17%

3%

1%

-3%

-7%

-10%

-13%

-15%

-17%

4%

2%

-3%

-6%

-9%

-12%

-14%

-16%

3 Year Hold

5%

3%

-2%

-6%

-9%

-12%

-14%

-16%

6%

3%

-1%

-5%

-8%

-11%

-13%

-15%

7%

4%

-1%

-5%

-8%

-10%

-13%

-15%

8%

5%

0%

-4%

-7%

-10%

-12%

-14%

9%

5%

0%

-3%

-7%

-9%

-12%

-14%

10%

6%

1%

-3%

-6%

-9%

-11%

-13%


6%

7%

8%

9%

10%

11%

12%

2%

3%

1%

-1%

-3%

-5%

-6%

-8%

3%

4%

1%

-1%

-3%

-4%

-6%

-7%

4%

5%

2%

0%

-2%

-3%

-5%

-6%

5 Year Hold

5%

6%

3%

1%

-1%

-3%

-4%

-5%

6%

7%

4%

2%

0%

-2%

-3%

-5%

7%

7%

5%

2%

0%

-1%

-3%

-4%

8%

8%

5%

3%

1%

-1%

-2%

-3%

9%

9%

6%

4%

2%

0%

-1%

-3%

10%

10%

7%

5%

3%

1%

-1%

-2%


6%

7%

8%

9%

10%

11%

12%

2%

5%

3%

1%

0%

-1%

-2%

-3%

3%

5%

4%

2%

1%

0%

-1%

-2%

4%

6%

4%

3%

2%

0%

-1%

-1%

7 Year Hold

5%

7%

5%

4%

2%

1%

0%

-1%

6%

8%

6%

5%

3%

2%

1%

0%

7%

9%

7%

5%

4%

3%

2%

1%

8%

10%

8%

6%

5%

4%

3%

2%

9%

10%

9%

7%

6%

4%

3%

3%

10%

11%

9%

8%

6%

5%

4%

3%


6%

7%

8%

9%

10%

11%

12%

2%

5%

4%

3%

2%

2%

1%

1%

3%

6%

5%

4%

3%

3%

2%

1%

4%

7%

6%

5%

4%

3%

3%

2%

10 Year Hold

5%

8%

7%

6%

5%

4%

4%

3%

6%

9%

8%

7%

6%

5%

5%

4%

7%

10%

9%

8%

7%

6%

5%

5%

8%

11%

10%

9%

8%

7%

6%

6%

9%

12%

10%

9%

9%

8%

7%

7%

10%

13%

11%

10%

9%

9%

8%

7%


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