In the process of valuing an investment, be it a real estate, a piece of land or even a business, special attention needs to be given to the valuation methodologies that the assets are valued based on. The valuation methodology and the input assumptions can lead to very different results depending on how it is adopted and applied. It is crucial to always remember that valuation is all about assumptions which entail lots of (human) judgements and as such can be easily manipulated.
As far as the valuation of real estate is concerned, there are 3 very commonly used methodologies used by professional valuers. The 3 methods are: 1) Income Capitalisation Method 2) Discounted Cash Flow Method (“DCF”) 3) Direct Comparison Approach. In today’s article, I will be sharing my knowledge on the above 3 valuation methodologies and the key inputs and outputs to look out for.
Real Estate Valuation Introduction
To begin, let me set the context first before diving into the knitty gritty details. In a real estate valuation exercise, there is always an output i.e. the ultimate value of a real estate asset and inputs i.e. net property income generated from the real estate and the discount rate that is applied. I believe the idea of the output is very straightforward so I will go straight into explaining what Net Property Income and Discount Rate are.
Net Property Income (NPI)
Net Property Income refers to the income generated by the asset netted off with any costs incurred to generate the income. In the case of running a retail mall, the NPI would be equivalent to the rental income received from the tenants minus the property expenses such as electricity and utilities, marketing expenses, staff costs (including the cost of hiring customer service officers and staff in the management office) and property taxes.
Discount rate takes into account the “riskiness of an asset”. Just like what finance courses typically teach about the concept of discount rate, discount rate is associated with risk i.e. a higher discount rate = higher risk. In the context of real estate, different assets have different risk characteristics. For example, an office tower in the Central Business District (CBD) of Singapore should command a lower discount rate relative to an equivalent office tower in the suburbs of Earthquake prone Manila. One can argue that Singapore is free from earthquakes and the office tower’s more strategic location in the CBD of Singapore means that it is always more in demand than an equivalent office tower in an earthquake prone suburban area of Manila.
Armed with the knowledge of what NPI and Discount Rates are, I will now share how these inputs fit into the various valuation methodologies.
Method 1: Income Capitalisation Method
As the name of the method suggests, this method requires “capitalising the income” to obtain a valuation. This is where I will introduce another terminology called capitalisation rate (cap rate). Capitalisation rate is a form of discount rate. As such, the idea of the capitalisation rate is to capture the riskiness of the asset that is being valued. Before I explain how this method works, please take a look at the following formula which is essentially what the income capitalisation method is all about.
Notice that both NPI and cap rate, r are both inputs in the above formula. Both the inputs are observable in the market. NPI can be easily calculated based on the NPI formula I have shared in the introduction while the cap rate, r is typically derived from comparable transactions that have occurred near to the subject asset. Notice that we can swap the positions of “Value of Asset” and “r” such that we can derive the cap rates of comparable properties that have transacted. The implicit assumption here is that assets located within the same area should have the same risk characteristics.
In the next step, I will share how to apply this formula and also give an intuitive explanation of what this valuation method is all about.
Example: Assuming that a valuer is trying to value an asset with an NPI of $2 million. In addition, the valuer knows that a comparable asset next to the subject property has an NPI of $5 million and was only recently transacted for $100 million dollars.
Referencing the workings above, the valuer will need to back out the cap rate based on the available information that he/she has on the neighbouring asset. With this derived cap rate and the NPI of the subject property, the valuer can then derive the value of the subject asset.
With a better understanding of how the income capitalisation method functions, I will now share various ways that can be used to boost the valuation of an asset and more importantly how REIT managers use this knowledge to maximise unitholders’ returns. Let’s take reference from the equation in red above. Mathematically, to increase the left hand side i.e to increase value of an asset, one can either increase the numerator i.e. boost the NPI or decrease the denominator i.e. compress the cap rate.
In the case of a REIT, it is the job of the asset manager to “sweat the asset” and drive up the NPI. This is often done through Asset Enhancement Initiatives (AEIs) where the asset manager plans and executes refurbishment works to the property to maximise its value. This will then enable the property to fetch a higher rent (and hence NPI), thereby boosting the valuation of the asset. This factor is something that the asset manager has a strong influence over. Other methods include constantly refreshing the tenant mix so as to maximise the amount of rental income generated.
As for the case of decreasing/compressing the cap rates, it is less straightforward. Cap rates are often determined by market forces and not within the control of a REIT manager. Looking at the above set of equations, it is not difficult to see that the implied cap rate is not within the control of a party as the comparable transaction that is used to derive the implied cap rate is executed by other market participants. This is where the knowledge and expertise of the investments team in a REIT is required. Cap rate movements are often tied to the interest rates movement in the wider macro-economy and a bunch of other factors such as the desirability of the location in which the asset is located. I will not be going in depth into this in this article and will share more about the factors influencing cap rates in a separate article. In a nutshell, a good investment professional should ideally be able to read the market cycle and acquire a property when the cap rates are high and exit/sell the property when the cap rates have compressed.
The income capitalisation method is one of the most commonly used valuation methodologies given its simplistic nature. If you have been following my explanation, you would have realised that only 2 inputs are needed, NPI and cap rate. The downside of such a simplistic method is that it is often not robust enough. The shortcoming is that the numerator in the income capitalisation method formula represents the expected NPI of the property in the next 1 year and it does not account for and project what the NPI might look like in year 2, year 3 and so on. To overcome this challenge, there is another valuation method known as the Discounted Cash Flow method (“DCF”) that addresses this shortcoming.
Method 2: Discounted Cash Flow Method (“DCF”)
The basis of the income capitalisation method and Discounted Cash Flow Method is very similar in nature as both involves using the same sets of inputs i.e. Net Property Income and Discount Rates. Hence, I will keep this section short as I believe this portion will be a breeze if you had understood my explanation on the income capitalisation method. Despite both their similarities, there are still some key differences. I have created the following two diagrams for illustration purposes.
The key difference is the fact that the Income Capitalisation Method formula implicitly assumes that the NPI received today will be the same for all future periods. In contrast, the DCF method allows the valuer to individually forecast the cash flows for each period before adding a terminal value that is calculated based on the income capitalisation method. In short, DCF is a more robust version of the income capitalisation method as it offers the added flexibility of being able to individually forecast cash flows for different periods. Taking reference from the chart for the DCF method above, I am forecasting the individual annual NPI for periods 1 to 6. From period 7 and onwards, I will forecast a single NPI figure and capitalise it using a cap rate just like how I would do it under the income capitalisation method. For readers who have studied finance, you might point out that it is possible to forecast a growth at a constant rate g in the NPI from period 7 and onwards using the Gordon Growth Model (GGM). I have decided to leave the GGM portion out since this is a Valuation 101 article but for those of you who wish to challenge yourself, you can click on the hyperlink to find out what GGM is.
The above 2 methods covered so far will seem very technical for readers who do not have any finance background but I hope that my simplified explanation is useful for you. For the third and final valuation methodology, it is thankfully not technical at all and I am very sure it is a method that many of you have unknowingly applied if you had had to hunt for a home.
Method 3: Direct Comparison Method
This method of valuation is unofficially (in my dictionary) called the “per square foot/ metre valuation method”. For this method, I believe that a picture speaks more than a thousand words so I have created a self explanatory diagram that I hope will be easy to understand.
If you had ever gone for house hunting before, you would be familiar with this method of valuation. In the context of Singapore, when you are buying a house, the property agent will often quote you the price of the property on a “per square foot” basis. And when you are comparing the different properties that are available to you, you tend to compare them based on their “per square foot” prices. Does this ring a bell now?
For those that are still unsure about what I am talking about, the key for this method of valuation is to collate a list of comparable properties that have been transacted in the market recently. More importantly, these comparable properties must share similar (if not the same) characteristics as the subject property that is being valued. Characteristics include but is not limited to factors such as location, age, condition, size and type of use. The value of the subject property can then be derived based on the “per square foot” rate calculated from the transacted price and size of these comparable properties.
Out of the 3 valuation methods, the direct comparison method is probably the simplest and least technical. However, this method of valuation is often not the preferred method of valuation for professional valuers when valuing a commercial asset. The direct comparison method is often used for the valuation of residential properties while commercial assets such as hotels, offices and retail malls are typically valued using the Income Capitalisation Method and DCF method.
Before I end this article, I would like to say a final word. The valuation of an asset is only as good as the assumptions used!