12 Things Investors Should Consider When Valuing an Investment Sales Transaction
As an investor, it's essential to understand that a property’s value is driven by information. From market data and macroeconomic influences down to the rent roll and accurate expense figures. The more information available to evaluate, the better an investor can underwrite an investment sales transaction. It's one of many types of commercial real estate transactions but follows a unique method of project evaluation.
After years of structuring investment sales, talking with hundreds of investors, and underwriting deals as both an advisor and personal investor, I’ve uncovered some best practices to consider when analyzing a project. This isn't exhaustive, but I've distilled those lessons learned into a list of 12 key items that need to be examined when valuing an investment sales transaction.
1. Rental Income
Rental income is important for a couple of reasons. Of course, it represents the top-line growth figure. But it’s also a great barometer to assess whether gross collected rents are in line with market averages.
It can even highlight how efficiently a property is being managed. Comparing actual collections against the gross scheduled rent can uncover management inefficiencies or signal that tenants may not be paying rent in full.
Remember that focusing too heavily on rental income can be deceiving. Depending on how a property's underlying leases are structured, that top-line figure can net some property expenses but include others.
2. The Capital Stack
The capital stack comprises the layers of financing invested in a real estate project, so debt is just one piece of the equation. And although this may not impact the market's perception of a property's value, it certainly affects how much an investor can pay for it.
For instance, your philosophy may be to add as much leverage to a transaction as possible, let's say 80%. But so much debt implies that monthly debt service (mortgage payments) will be higher. And when lenders underwrite a property to determine if they'll lend on it, they consider a property's debt service coverage ratio (DSCR). In layman’s terms, rental income after expenses needs to be higher than monthly debt obligations.
You might be able to bridge gaps in the capital stack through an equity placement or some form of alternative debt financing. Still, these are generally more expensive than traditional options. So, ultimately, a commercial investment property may only be worth what an investor can reasonably fundraise for a project.
This may or may not be the fair market value.
Real estate holds value to an investor at its core because of the underlying leases that produce periodic cash flows. A vacant building has intrinsic value because of the economic law of scarcity – but more than likely, an operating company would see greater value in an empty property than an investor would.
So, knowing that an investor derives benefit from a property because of those cash flows, understanding the leases and what makes leases valuable is an important consideration when valuing investment sales. There are several characteristics to consider:
- The type of lease: There are several types of commercial real estate leases that delineate the responsibilities of both the landlord and tenant. And depending on the structure of the lease arrangement, an investor can have varying levels of financial, maintenance and management responsibilities, ultimately affecting a property’s value.
- Length & probability: When assessing the risk of a piece of investment real estate, the timing, length, and likelihood of cash inflows are significant considerations. A 10-year corporately guaranteed lease is worth more to an investor than a 5-year lease with a mom & pop operation that hasn't signed a personal guarantee.
- Rent escalators: Rent escalators have recently come under the spotlight as inflation concerns ramp up. They are provisions that adjust the annual base rent over a fixed period. These increases can either be a pre-determined percentage or tied to CPI – and help keep the rental rate on pace with inflation.
- Extension options: Lease extension options give a tenant the ability to continue leasing space before the expiration of their original lease term. As an investor, options place the space in limbo – a 5-year lease with two 5-year options is not the same as a 15-year lease and can’t be valued as such.
A commercial lease is no better than the tenant on the other side of it. And tenants with solid credit, robust business plans, and a track record of success are hugely valuable to an investor. These businesses are more likely to meet their financial obligations and properly maintain and take care of their space.
A property's tenant mix can be a means of diversifying risk within a property. Economic disruptions disproportionally impact different types of businesses, and tenants in various industries are better diversified. They may be more valuable to an investor.
The number of tenants in a property should also be a consideration. Some investment groups have successfully acquired single-tenant real estate – which is great if that tenant is near riskless. But the more space a single tenant occupies, the greater the possible risk in a default or vacancy event.
5. Deferred Maintenance
Maintenance and repairs that have been postponed for whatever reason fall into the category of deferred maintenance. As an investor, deferred maintenance can be problematic for several reasons. First, repairs cost money. Capital expenditures and upfit expenses need to be accounted for in property underwriting.
The second issue is that repairs take time. And some maintenance may even require that rental be units be vacant. This lost revenue, coupled with the property's associated carrying costs, would ultimately impact the project's bottom line. So, to properly value an investment sales transaction, an investor should have a solid understanding of any deferred maintenance responsibilities.
6. Class & Position of a Property
There is a concept in real estate known as property class. It's an industry term that helps the real estate community quickly communicate the quality of an asset-based on its "position" relative to its peers. For instance, a class A property generally represents the highest quality and newest assets in the most desirable locations. While a class C property may be older, carry more deferred maintenance issues, and need updating to remain current.
As an investor, it's essential to understand the nuances between these property classifications. Each class of property reflects a different risk profile and, ultimately, a different kind of tenant. Class A facilities are generally traded on the lowest margins but demand the highest rental rates and highest quality tenants.
Investors may be compensated for the acquisition of class B and C properties, though. For instance, an investor could clean up and retrofit a class C building in hopes of “repositioning” that real estate to attract higher quality tenants. Ultimately, those value-add risks and rewards need to be assessed as part of an investor’s property valuation.
Expense management begins with what type of lease arrangements are in place. Net leases that pass costs off to the tenant will help a landlord better manage expenses. But beyond the existing lease, there are ways for an investor to determine if the owner is effectively controlling costs – and if not, where there might be room for improvement.
It's relatively easy for an investor to determine what it costs to run certain types of buildings on a regional average per square foot basis – utility, labor, and service costs are generally localized. Property managers also keep active records on expense data for various property types. It's important to assess whether a property's expenses make sense from a market average perspective.
Turnover and re-let expenses can also be a substantial cost that investors should keep an eye on. Are quality tenants staying past their initial term? Does the property experience high turnover, or does space sit vacant for longer than the market average? Analyzing cost data can give insight into management efficiency and possible unrealized property value.
8. Financial Metrics
Accurately projecting an investment property’s financial performance all starts with a proforma. But a proforma is only worth as much as the underlying data and assumptions that make it up – and they can be manipulated to paint a more optimistic picture than reality would suggest. They can also be time-consuming.
An alternative approach is using financial metrics – these can serve as a litmus test before a full property underwriting. Every investor should have a grasp of several metrics that can tell them pretty quickly whether an opportunity is worth taking a closer look at:
- Gross rent multiplier (GRM): Think P/E ratio regarding stocks, GRM serves as a quick ratio to filter out investment opportunities (GRM = Price/Gross potential rent)
- Debt service coverage ratio (DSCR): A metric used primarily by lenders, DSCR measures a property’s ability to cover debt obligations through rental income (DSCR = Net operating income/Debt service)
- Net present value (NPV) & Internal rate of return (IRR): Slightly more involved than alternative benchmarks – NPV measures the present value of all net cash flows over the life of a project. IRR is the estimated rate of return, given a set of cash flows, for a property over its life or a pre-determined hold period
- Cash on cash return: This benchmark measures the annual return based on cash invested in a property. It’s calculated on a pre-tax basis and helps project return on cash when debt financing is also used for a property acquisition (Cash on cash return = Cash flow (pre-tax)/Cash invested)
- Capitalization rate: Capitalization rate, or cap rate, is a ratio that measures the net income a property produces concerning its purchase price. Generally, the higher the cap rate, the higher the expected returns (Cap rate = Net operating income/Property sales price)
- Operating expense ratio (OER): The OER measures the cost of operating a property compared to a property’s income. It’s effective when compared to similar properties to determine expense management efficiency (OER = expenses (less depreciation)/Gross revenue)
9. Market Comparable Data
Financial metrics and benchmarks are great, but they are all relative and ultimately market-dependent. A 4 cap in New York can't be compared to a 4 cap in Des Moines, Iowa. So as an investor, it's necessary to be aware of individual market tendencies and base investment decisions on other properties in the market. There are several comparable indices to be mindful of:
- Lease rates: Rental rates are market and product-type driven. You shouldn’t use 2nd generational restaurant lease rates as a benchmark to assess whether the office property you’re underwriting is properly rented.
- Vacancy rates: Average vacancy rates depend on property class, the submarket, existing management, rental rates, and macroeconomic factors. Every financial analysis should include vacancy allowance, and comparable properties in a given submarket should drive that.
- Replacement cost: Cap rates can often be misleading - a property may be under-rented and offer substantial upside through a reposition or hand on management. Or rental rates could be artificially above-market – I've seen sale-leasebacks executed at higher than market rates to try and drive up the sales price. A property's replacement cost should serve as a litmus test to qualify whether a sales price per square foot makes sense compared to replicating the property.
10. Regional and Macroeconomic Trends
From federal reserve policy and government regulations to changing domestic migration patterns and the evolution of workplace strategy. Most investors focus strictly on location, location, location.
And while that's important for sure, what do the macroeconomic trends signal about the health of specific industries, or even the real estate market as a whole? Even though real estate is a locally driven product, it's necessary to weigh the impacts of greater market forces on property values.
On a more local note, access to quality debt and equity sources is very market-driven. Institutional capital and private equity chase yield – so rapidly growing markets experiencing price dislocation are a prime target for idle cash. And lenders want to get in on the action, too, so they’re also chasing opportunities in these markets – giving investors more access to financing.
There’s a theory known as highest and best use that suggests that every piece of real estate offers a distinct maximum utility, depending on the end-user. This concept is crucial because it means that a site may be more profitable under different conditions and uses. As an investor, even having a cursory understanding of what drives the highest and best use, you can take advantage of finding misallocated resources and mispriced real estate.
Keep in mind that the economic law of scarcity plays a role in the value of an investment sales transaction. And finite real estate inputs, like land, mean that it’s also beholden to this law. So as in-migration ramps up in certain regions around the U.S., and property and land become scarcer, the value will increase. Investment sales are driven as much by today's performance as they are by future appreciation and possible performance tomorrow.
12. Owner's Motivation
All the analysis in the world doesn’t replace the need for emotional intelligence. An investment sales deal is as much about crunching the numbers as it is about understanding the person on the other side of the transaction.
Is anonymity important to the owner – so are they happy transacting off-market? Maybe they are motivated by trying to reduce their tax liability. Is the seller strictly trying to put the most cash in their pocket?
It’s easy to get lost in the numbers. But by focusing on the living, breathing individual on the other side of the negotiation table, it’s much more likely that you’ll strike a successful deal.