Due Diligence, Valuation, and Indexes

Alternative Investments 11 min readModule 3 of 3Save

What you'll learn

LOS 31.d
Explain the due diligence process and valuation approaches for real estate investments.
LOS 31.e
Discuss real estate investment indexes, including their construction and potential biases.

Real estate investors normally perform due diligence to confirm the facts and conditions that might affect the value of a property. Due diligence includes the following:

Market review and outlook. Investors can aggregate real estate transaction prices (and possibly lease prices) from the internet, based on standardized criteria such as size, location, age, condition, and amenities. Investors can use this data to estimate the value of a specific property.

That estimate should take the current phase of the real estate cycle into consideration.

Current lease review and future lease outlook. Here, the investor examines the rental rates and estimates of rent prices going forward, as well as lease expiration dates, vacancy expectations, and the history of rent payments and delinquencies. Forecasts of lease income should also incorporate commission expenses for new leases and the cost of improvements (amortized over the life of the lease) needed to attract future tenants.

Financial review. The investor should confirm operating expenses using evidence such as utility and tax bills, and review maintenance spending to determine if the seller has deferred maintenance to inflate NOI. The investor should ensure that the cash flow statement supports the accrual accounting figures.

Documentation review. A title review (normally required by the mortgage lender) should be conducted to ensure a clean title, free of any liens or ownership disputes. Investors should also check that tax payments are up to date, and whether any restrictions conflict with their intended use of the property.

Property inspection and service agreements. The investor should have a property survey performed to ensure it is free of encroachments or other legal issues. Physical, engineering, and environmental inspections may also be used to identify potential problems with the property.

Analyzing service and maintenance agreements (e.g., frequency and cost of repairs) can help an investor identify ongoing problems.

Valuation Approaches

Several different valuation approaches exist for real estate. The most appropriate methodology for a particular property will depend on its characteristics, as well as factors such as market conditions and data availability. An appraiser can arrive at a more reliable estimate of a property’s value by combining and averaging approaches.

Cost Approach

The logic behind the cost approach is that a buyer is unlikely to pay more for a property than it would cost to purchase similar land and construct a comparable building.

The cost approach involves estimating the market value of the land, estimating the replacement cost of the building (including developer’s profit), and then adjusting for depreciation and obsolescence. The cost approach is often used for unusual properties, or properties where comparable transactions are limited.

Sales Comparison Approach

The premise of the sales comparison approach is that the purchase price should be close to what other buyers have paid for similar properties in the current market. Ideally, the comparable real estate would be identical to the subject property, though in practice, this is rare. Differences may relate to size, age, location, property condition, and market conditions at the time of sale.

These mismatches can be addressed by adjusting the sale prices of the comparable properties to reflect their differences from the subject property: the values of comparable transactions are adjusted upward (downward) for undesirable (desirable) differences. In this way, we revalue the comparable as if it were like the subject property.

Worked example: Sales comparison approach

An appraiser has been asked to estimate the value of a warehouse and has collected the following information:

Unit of comparison	Subject property	Comparable 1	Comparable 2	Comparable 3
Size, in square feet	30,000	40,000	20,000	35,000
Age, in years	5	9	4	5
Physical condition	Average	Good	Average	Poor
Location	Prime	Prime	Secondary	Prime
Sale date, months ago		6	18	12
Sales price		$9,000,000	$4,500,000	$8,000,000

The appraiser’s adjustments are based on the following:

Each adjustment is based on the unadjusted sales price of the comparable.

Properties depreciate at 2% per annum. Because Comparable 1 is four years older than the subject, an upward adjustment of $720,000 is made [$9,000,000 × 2% × 4 years].

Condition adjustment. Good: +5%, average: none; poor: −5%. Because Comparable 1 is in better condition than the subject, a downward adjustment of $450,000 is made [$9,000,000 × 5%].

Similarly, an upward adjustment is made for Comparable 3 in the amount of $400,000 [$8,000,000 × 5%].

Location adjustment. Prime: none, secondary: 10%. Because both Comparable 1 and the subject are in a prime location, no adjustment is made.

Over the past 24 months, sales prices have been appreciating 0.5% per month. Because Comparable 1 was sold six months ago, an upward adjustment of $270,000 is made [$9,000,000 × 0.5% × 6 months].

Solution

Once the adjustments are made for all of the comparable transactions, the adjusted sales price per square foot of the comparable transactions are averaged and applied to the subject property as follows:

Adjustments	Subject property	Comparable 1	Comparable 2	Comparable 3
Sales price		$9,000,000	$4,500,000	$8,000,000
Age		+720,000	−90,000	None
Condition		−450,000	None	+400,000
Location		None	+450,000	None
Sale date		+270,000	+405,000	+480,000
Adjusted sales price		$9,540,000	5,265,000	$8,880,000
Size in square feet	30,000	40,000	20,000	35,000
Adjusted sales price per SF		$238.50	$263.25	$253.71
Average sales price per SF	$251.82
Estimated value	$7,554,600

The sales comparison approach is most useful when multiple similar properties have sold recently. This is often the case with single family homes, but when the market is weak, transactions tend to be fewer. Even in an active market, transactions may be limited for more specialized property types, such as regional malls and hospitals.

The sales comparison approach assumes that comparable transactions represent the current market. However, the results of this method can be skewed by a period of irrational pricing, such as a market bubble.

Income Approach

The premise of the income approach is that a property’s value is equal to the present value of its future cash flows. The rate of return that a buyer requires to invest in the subject property is used to compute this value. Examples of the income approach include the direct capitalization method and the discounted cash flow valuation method.

Under the direct capitalization method, value is calculated by capitalizing the first year NOI of the property using a capitalization rate known as the going in cap rate.

The capitalization rate, or cap rate, is related to the discount rate, but they are not the same. The discount rate represents the required rate of return and can be thought of as the risk free rate plus a risk premium.

If NOI and value are expected to grow at a constant rate, the cap rate is lower than the discount rate:

cap rate = discount rate - growth rate

The cap rate can be applied to produce a valuation:

value = \frac{estimated NOI}{cap rate}

Worked example: Valuation using the direct capitalization method

Suppose that NOI for an office building is expected to be $175,000, and an appropriate cap rate has been estimated as 8%. Estimate the value of the property using the direct capitalization method.

Solution

V_{0} = \frac{NOI _{1}}{cap rate} = \frac{$175 , 000}{8%} = $2, 187, 500

With the discounted cash flow method, value is based on the present value of the property’s future cash flows (again, based on NOI) using an appropriate discount rate. A terminal value is used to represent the present value of the property’s final cash flows to infinity. Terminal value is estimated as a perpetuity capitalized using the terminal cap rate.

Discounted cash flow valuation can be used to estimate value as follows:

value = t = 1 \sum n \frac{NOI _{t}}{( 1 + r ) ^{t}} + \frac{TV _{n}}{( 1 + r ) ^{n}}

where:

TV_{n} = \frac{NOI _{n + 1}}{terminal cap rate}

$r$ = required rate of return

$n$ = holding period

Worked example: Valuation using the discounted cash flow method

Suppose that we are considering an investment in an office building with a holding period of three years. It is expected that the NOI for the first year will be $2 million, and that NOI will grow at 5% per year for the next two years, after which time it will grow at 3% forever. Assume a required rate of return of 8%.

Estimate the value of the property using the discounted cash flow method.

Solution

NOI_{1} = $2 million (given)

NOI_{2} = 2.00 \times ($1.05 m) = $2.10 million

NOI_{3} = 2.10 \times ($1.05 m) = $2.205 million

NOI_{4} = 2.205 \times ($1.03 m) = $2.2712 million

Terminal cap rate = 8% - 3% = 5%

TV_{3} = $2.2712 m /0.05 = $45.424 million

Using the BA II PLUS financial calculator:

CF0 = 0, CF1 = 2, CF2 = 2.10, CF3 = (2.205 + 45.424) = 47.627

I = 8

Compute NPV → This equals $41.46 million.

Recall that the cap rate is applied to a property’s first year NOI. An analyst should adjust the subject property’s NOI if, due to some temporary situation, it is unrepresentative of similar properties. For example, suppose a property is temporarily experiencing high vacancy during a major renovation.

In this case, the first year NOI should be recalculated as if the renovation was complete. This stabilized NOI or normalized NOI is then capitalized, and the loss in value from the temporary decline in NOI is subtracted to arrive at the value of the property.

Real estate indexes have several uses:

To track the performance of the real estate asset class

To serve as a benchmark to evaluate investment managers

To underpin index based investment products such as ETFs

Investors should be aware of how the indexes are constructed, as well as their limitations. For example, the observed low correlation of real estate to other asset classes may be partly attributable to the way an index is constructed and the frequency of updates to the index. Private real estate investment indexes are based on property metrics and are usually not investable.

There are two types of real estate investment indexes: appraisal based indexes and transaction based indexes.

Appraisal Based Indexes

Because real estate transactions involving one particular property occur only infrequently, indexes have been developed that instead use appraised values. Appraisal based indexes combine valuations of individual properties to measure the market overall. One popular appraisal based index in the United States from the National Council of Real Estate Investment Fiduciaries (NCREIF) is the NCREIF Property Index (NPI).

Members of the NCREIF (mainly investment managers and pension fund sponsors) submit appraisal data quarterly, and the NCREIF calculates the return as follows:

return = \frac{NOI - capital expenditures + ( ending market value - beginning market value )}{beginning market value}

The value of the index is then computed based on value weighted returns of the individual properties.

Earlier, we defined cap rate as NOI divided by the beginning market value of the property. This is the current yield (or income return) of the property and is one component of the index return equation. The remaining components of the equation contribute the capital return.

To achieve a positive capital return, the property’s market value must increase by more than the associated capital expenditures.

Indexes allow investors to compare real estate performance with those of other asset classes. A real estate index can also be used by investors to benchmark real estate returns. However, a major drawback is that the income component of index return does not represent actual cash flows to investors (like REIT distributions do).

The Global Real Estate Fund Index (GREFI) is a capitalization weighted index, published quarterly, that includes local currency return and incorporates prices going back to 2009. The index combines data from the NCREIF, the European Association for Investors in Non Listed Real Estate Vehicles (INREV), and the Asian Association for Investors in Non Listed Real Estate Vehicles (ANREV).

Appraisal Lag

Changes in appraisal based indexes tend to lag changes in actual prices. Because appraisals use past transaction data as inputs, transactions must occur before appraisal prices can be affected. Appraisals are conducted infrequently; thus, a change in property prices may not be reflected in appraised values until the next quarter or longer.

Further, appraisal lag tends to smooth an index, that is, reduce its volatility, much like a moving average does. Because of this smoothing, appraisal lag results in lower calculated correlations with other asset classes.

Appraisal lag can be mitigated by unsmoothing the data. To unsmooth an index, a modified autoregressive model can be applied:

R_{t}^{*} = α R_{t} + (1 - α) R_{t - 1}^{*}

Here, R* is the appraisal based return and R is the actual return. The value of α (0 ≤ α ≤ 1) determines the speed with which the appraisal based return reflects the actual return. A higher α applies more unsmoothing.

Appraisal lag can be avoided by using a transaction based index.

Transaction Based Indexes

Transaction based indexes measure price changes based on actual sales of real estate. Two categories of statistical transaction based indexes have been developed to address the issue of property sales occurring only infrequently: repeat sales indexes and hedonic indexes.

A repeat sales index relies on recurring sales of the same property, which helps to distinguish true price changes from differences between properties. With this kind of index, a change in market conditions can only be measured after a property is sold twice. A regression model is used to allocate the changes in index value to each quarter.

A hedonic index, by comparison, requires only one sale. A regression model is employed to control for differences in property characteristics such as size, age, and location. Once the model is fitted, it can be used to derive estimates of value for a basket of properties periodically.

These data are then used to estimate the returns for that basket.

Public Security Indexes

Bloomberg, FTSE Russell, MSCI, Nikkei (日経), S&P Dow Jones, and Nareit®, among others, produce indexes covering public securities. Indexes such as CMBX exist for real estate debt securities. Some indexes cover equity REITs only, some REOCs only, and some a combination of the two.

Finished this module?

Track your progress across all 171 modules.

Test yourself on Reading 31CFA-style practice questions