The Three Different Methods for Valuing a Property and Why Discount to Replacement Cost is The Most Important

There are three primary methods for valuing a property. The sales comparison approach, the income capitalization approach and the discount to replacement cost approach. There are many areas of overlap within these three methods, but I’ll try to lay them out individually in the simplest way possible.

Sales Comparison Approach ­– The most commonly used approach, especially in residential real estate, but used extensively in commercial real estate as well. The method is very simple and involves looking at comparable buildings to see what they sold for. There are different metrics for comparison dependent on the real estate asset type. Office buildings are compared on a price per square foot basis. Multifamily buildings are compared on a price per unit basis. Hotels are compared on a price per key (room) basis (this is why hotel rooms in Manhattan are so small – more rooms typically leads to a higher property valuation). All real estate assets are valued off cap rates as well. Cap rates are simply the net operating income (very similar to EBITDA – just think of it as revenue minus expenses before debt) of a property divided by the property value. So, if a property has a NOI of $1MM and it sold for $20MM, the property sold at a 5% cap rate.

Unlike the other metrics listed above, you should be very careful when using cap rates to value a property, as they often change over the course of the hold period. For example, in a value-add deal, cap rates barely even matter. Why is this? Say you are buying a property for a 5% cap rate and plan on extensively renovating it to achieve higher rents. The higher rents will increase your NOI, which will increase your cap rate. Which means that the initial cap rate you are buying at doesn’t really matter at all. What really matters is your stabilized cap rate (yield), which should be very different if you execute your business plan correctly.

The trick with this method is accurately finding the buildings that are most similar to use as a metric for comparison. Location, vintage (age), tenant profile, recent renovations completed, etc. all factor into the decision and must be appropriately accounted for. There is no easy way to explain how to weight each of these factors to come up with accurate sales comps – you can only really learn this from experience.

Income Capitalization Approach – This is typically called the “Income Capitalization Approach”, but I think it’s easier to think about as the “Cash Flow Approach”. Essentially, with this method, you are valuing the property based on the cash flow it is spitting out every year. There are a ton of different ways of doing this – you can value the property based on a cash flow (EBITDA or NOI multiple) and you can value it on an IRR/NPV basis. The way in which you value it really does not matter – you will come to pretty much the same conclusion either way. My firm typically values properties on an IRR basis, so that’s what I’ll focus on.

There are a ton of flaws with the cash flow approach, the most prominent of which relate to the fact that it often assumes both the market conditions and the asset conditions will stay the same. It generally relies on an asset-specific situation, rather than market fundamentals (which is why it is inferior to the discount to replacement cost method, which truly focuses on the market fundamentals of supply and demand).

I don’t want to get into too much depth here, but a few things to be cautious of when projecting out the cash flows:

Make sure your leverage isn’t driving your returns. You should be calculating your leveraged and unleveraged returns separately and there should not be too much of a gap between the two. If the gap is large… you do not have a good investment – all you have is high leverage.

Make sure most of your profit isn’t coming from appreciation on the sale instead of income during the hold period. As a general rule, alarm bells should go off if more than 70% of your profit is coming from appreciation on the sale (obviously there are exceptions to this, especially if it is a heavy value-add deal). There are a couple ways to avoid this. One is to always make sure you are adding at least 100 basis points to your exit cap rate vs your entry cap rate. Another is to check the entry price per square foot vs the exit price per square foot. Is it reasonable? If you are going from $800 PSF to $1500 a square foot over a 3-year time frame… that is probably not reasonable.

Discount To Replacement Cost Approach – Replacement cost is simply how much it would cost to build the property, brand new, from the ground-up. It’s a criminally underrated metric – generally the least common metric that beginners think about, but likely the most important. If you are anything like me when I first started looking at real estate, you probably only care about the cashflow numbers – who cares how much it cost to build as long as it’s making money, right? Wrong. The problem with valuing an asset off cash-flow alone is that you are assuming the market conditions stay the same. This is almost never the case. At the market-level, supply often increases, which (unless followed by a similar increase in demand) gives you less bargaining power over your tenants and generally lowers rents. How does figuring out the replacement cost prevent you from making the mistake of investing in an asset that is poised to have decreasing rents?

Let’s use an example of two separate investments, both in the same market.

Scenario 1: Say you buy an asset for $1,000 per square foot (PSF) and rents are $200 PSF. To make things simple, we will assume that expenses are $100 PSF. That means your NOI is $100 PSF and your initial yield is 10% ($100/$1,000).

Scenario 2: Now let’s assume replacement cost is $1,500 PSF and you decide to build. In this scenario your yield (after years of developing) would be 6.7% ($100 PSF/$1,500), or 3.3% lower than if you had simply bought an existing building.

So, what does this mean? It means that supply will very likely not increase in your market because it makes no sense to build – why would you take on all the risks associated with development (development is the highest risk investment in real estate) for a lower yield than if you bought an asset that already exists? No one is going to do this unless 1. They get some type of government subsidy 2. They are only in it for the development fees (usually 4% of the project cost) 3. They are making a ridiculous high-risk bet that rents will continue to increase during their development period, which will increase their yield.

Markets where you can buy at a discount to replacement cost are the best types of markets to invest in because you can be relatively sure that the market conditions (supply) will not change, which allows you to take one variable out of the equation, so you only have to focus on the asset-level. It also means there is room for the market valuations to grow, because, presumably the difference between the market price PSF and the replacement cost PSF will equalize, meaning your asset will increase in value.

You should be using all of these methods for each investment you look at

It doesn’t need to be a long drawn out process for each one.

The discount to replacement cost method is very simple if you know your market. For example, San Francisco is one of the primary markets my firm invests in. Since I know off the top of my head that ground-up development costs approximately $1,200 per square foot, an alarm bell goes off in my head when I see a property that is more expensive than that. Even if you don’t know your market, all you need to do is figure out the replacement cost from someone who does (lookup market reports, talk to brokers and developers).

Sales comps should be relatively simple as well. A lot of this information is online (visit county websites, Zillow, LoopNet, etc.). If you cannot find the information directly online, see if you can pull market reports from a brokerage (Cushman and Wakefield, CBRE, Colliers etc.). If none of that works, the property is likely being marketed by a specific broker. Call him up and say you are interested in the property. Chat with him for a bit about the property and then ask him for sales comps. Be careful with this, however. Remember that brokers want to sell the building for the highest dollar amount possible and generally do not care if you get ripped off (there are exceptions if you have a good relationship with them). What does this mean? It means that you need to be scrutinizing these comps very carefully. Think of all the reasons why the comps they show you could potentially be misleading. Was the comparable building bought by a 1031 buyer? This means that they were likely rushed (there is strict deadline that 1031 buyers need to hit) and it is possibly that they overpaid out of desperation. If so, the price they paid might not be indicative of a true market price. Was the comparable building bought with foreign capital or through a pension fund? Why does this matter? Pension funds and foreign capital typical have a lower cost of capital (lower required return) and are generally willing to pay up for a property just so they can park their capital. There is a high chance you would not be willing to accept the same return they are. Obviously, the specifics will differ for each deal. If you are starting out doing your first deal, it is highly unlikely that you will be competing with pension fund capital. However, these are the types of questions you should be thinking about in any situation.

The income capitalization approach typically takes the longest as you generally have to model out the full cash flows and it requires serious thought regarding each assumption. It also takes the most amount of skill to project out accurately.

Overall, when used correctly, the methods should all mesh together (an obvious example of this is cap rates, which feature prominently in both the sales comparison approach and the income capitalization approach). The three methods should be used to create one mosaic, from which you create the framework for your decision-making process for each specific deal.