Understanding Real Estate Valuations With A Financial Model
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Valuation models in real estate relate to two types of financial modeling: Real estate development and real estate investment. Both model types have its particular challenges which we will cover here.
Real Estate Development Cash Flow Model
Developing real estate requires both extensive technical and financial expertise by the developer. The developer will want to use a financial model to evaluate if his real estate property development project is financial feasible or not. Normally, these types of models focus on an investment case analysis as basis for an investment decision. The structure of such models more or less is the following:
+ Revenues from the sale of real estate
- Construction costs
- Land costs
- Marketing
- Transaction costs incl. legal, brokers, due diligence, etc.
- Financing costs
- Taxes
= Profit
The easy version of this analysis is a simple profit and loss calculation from a developer’s point of view. Here the main valuation question lies in the estimation of the revenues from the sale of the real estate, which comes down to a market value assessment of the fully finished real estate. This calculation is quick and easy to do but there one or two shortfalls to this approach.
In case the project requires a lot of time to be developed, the project actually might show a profit but because the profit in reality only can be realized upon completion several years down the road, the developer needs to find out if the project covers the opportunity costs of his capital. This is normally done with an Internal Rate of Return (IRR) calculation which is not possible to do with the easy version of this calculation. The second point are the financing costs. Without knowing the required debt drawdown and repayment schedule, it is very difficult to get the financing costs right.
This brings us to the more sophisticated version of this approach which uses the project’s timing schedule to project revenues and costs over the duration of the development project. For this, the developer needs to use additional assumptions such as:
- Construction period (in years)
- Split of the sales revenues (% off-plan sales vs % sales upon completion)
- Debt drawdown and repayment schedule
- Reworked interest calculation
- Payment schedule for the land
- Payment schedule for all costs
This will lead in a detailed cash flow projection over the next year. Now the developer has a clearer picture of the timing of the cash flows, can better evaluate how much funding he really needs and when, and now is able to calculate the project and equity IRR of this project.
The key metrics for investment decisions here are the projects net profit, project IRR, equity IRR and equity multiple. Important to note here is that the whole calculation bases on the exit valuation of the developed real estate and a correct assessment of all the costs of the project. The exit valuation of the real estate needs to be based on comparable sales prices of similar properties and should also consider the market gross capitalization rates on the rental income in case the real estate can be rented easily. A DCF valuation of the finished property in most cases is not needed due to the assumption that CAPEX for a newly developed property should be next to zero and also a finished property should be able to be rented at a certain occupancy rate. This makes the valuation of real estate a bit easier.
Real Estate Investment Model
The second main type of financial models in real estate is the real estate investment model focused on the acquisition and the holding period of an already existing property. During the holding period an investor also might want to invest in the property so that is able to rent it at a higher price later one. As a conservative investor, you want to ensure that the exit value of the property will be at least equal to all the costs spent before. The main valuation check here to do is the following:
Selling price of the property in the future
- Costs of all improvement works
- Acquisition price of the property today
- Transaction costs spent today
- Share of capital gain taxes
= Net gain on the sale of the property
For commercial properties and residential properties (except he luxury segment) the valuation question in the future and today comes down to the rental yields yield of the properties in relation to the valuation. The property valuation can also be done via the Discounted Cash Flow valuation which is more relevant in case there are a lot of capital expenditures expected in the next few years. Real buyers will also want to speak to the bank and get their view on the valuation since they normally know the market and comparable real estate prices very well. Doing this analysis well, will allow you to narrow it further down, where a reasonable valuation range of the property should lie within.
Real Estate Financial Modelling
Modeling in real estate on a very basic level is about discovering the current value of the future stream of cash flows from a real estate asset. This is mostly done with the DCF analysis and allows you to correctly include all factors affecting the value of the property, including expected vacancies and capital expenditures. A DCF analysis therefore allows you to substantiate a capitalization rate estimation of a property in respect to its net income and come up with an argumentation why the value should be higher or lower than an anticipated cap rate. Checkout some of the real estate financial modeling examples.
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