Two common ways to value commercial real estate
During my 30+ years in commercial real estate I’ve come to realize there are two common ways investors value properties. Many savvy real estate investors have a fairly simple analysis, an almost “back of the napkin” approach to making purchase decisions. And it works well for them. They value properties based on a combination of a big picture, “30,000-foot view” of the property and gut instinct.
And then there are some investors I’ve worked with who like to “get in the weeds.” They enjoy the process of getting as much data as possible to make an informed decision. This is my personality bent too. I want to make sure I’m not missing some arcane but important detail that will make my purchase decision a no brainer.
IRR assumes way too much
Where I differ from most of my fellow detail oriented investors is on the best approach to analyzing a property. As a CCIM designee I have been trained in Internal Rates of Return (IRR) and Net Present Value (NPV) valuation methods. But over time I realized that approach assumes way too many variables you have no answer to when you purchase the property, such as:
- How much are rents going to increase over time?
- How long will you hold the property?
- What will be the rate of inflation over the holding period?
- What will be the cap rate at the time you sell the property?
These questions are all unknowns. In fact, they are unknowable. And yet all of these assumptions have to be made in order to determine an IRR. It’s a classic example of GIGO (garbage in, garbage out). I’ve listened to CCIM instructors tell their students that you should buy the property with the highest IRR when one property had a 14.19% IRR and the other had a 14.23% IRR. Really?
A simpler, better approach than using IRR
Though I enjoy gathering and analyzing as many details as possible, my approach is much simpler than doing an IRR calculation. My property valuation method is based on knowable assumptions or at least reasonably educated guesses such as:
- What will I offer for the property in an as-is condition?
- What is needed to renovate the property and how much will it cost?
- When the improvements are completed what will be the new market rents?
- How long will it take me to achieve stabilized occupancy?
- What type of financing should I get? A perm loan with a holdback for repairs? Or a full-blown bridge loan followed by a competitive non-recourse loan?
All of these assumptions are at the very least educated guesses, if not very knowable inputs. Once it’s modeled up, I focus in on a before-tax return-on-equity in the first year of stabilized operation. If it’s in the 5% or better range then I know it will do well over time.
Two examples of poor outcomes using IRR
Now some of you are probably thinking, “this guy is just intimidated by the sophistication of the IRR method.” Nope, I actually enjoy doing an IRR calculation. It’s so analytical. I love it. I just don’t believe it provides the best approach to making a buy/no-buy decision. It reminds me of the Mark Twain saying, “There are liars, damned liars and then there are statisticians.” Here are two examples of what I mean:
- Depending on your assumptions, you can get whatever IRR you want to get. If it’s not high enough to justify purchasing the property, then increase your annual rent growth by another 1% or lower your sales cap rate in year 10 by 50 basis points. Thirty years ago, as a financial analyst for a syndicator that was my job. I played with the numbers until I got the desired return my boss wanted for our investor presentations.
- In my opinion cash flow is king. But you can use an IRR calculation to justify purchasing a property having little or no annual cash flow but a higher IRR by inflating the sales price in year 10 over a property that has generous cash flows over the holding period. Sorry, I would rather choose the property with the good cash flow and slightly lower IRR than the property with little cash flow and higher IRR. Wouldn’t you?
Use IRR at time of sale, not for purchases
Now that the IRR aficionados have labeled me an IRR Neanderthal, I must confess that I do use a before-tax IRR calculation after I’ve sold a property. Because at that point all the variables are known. I know:
- How much equity was required when I purchased the property
- My annual owner distributions
- The number of years I owned the property
- The amount of cash or 1031 equity I received at closing when I sold the property
Knowing those 4 things, I can then run an accurate IRR calculation. The properties I’ve sold have had an IRR as low as 7% and as high as 28%. But I calculate an IRR calculation after the property is sold, not before because there are way too many unknowns.
If you would like to learn the specifics of how I analyze a property purchase, I would encourage you to listen to a short two-minute video presentation on my website. Click this link to listen to the video. Make sure to download the worksheet below the video for FREE.
Give me your thoughts. What approach do you use to value your real estate purchases?