Two methods are key to this investment strategy.
real estate investors believe that real estate assets have an underlying
intrinsic value that can be determined by analysis and evaluation.
Opportunities for profitable investments arise when the asset’s purchase price
is below its intrinsic value.
investors evaluate an investment’s opportunity by understanding the
relationship between value and price. Thus, the essential task of a successful
real estate value investor is to determine the intrinsic value to capitalize on
inefficient market mispricing.
determining the intrinsic value of real estate investment assets, value
investors use two generally accepted methods: replacement cost and net present
Replacement Cost Method
most commonly recognized by industry professionals, the replacement cost method
can be quite complex to calculate. Often used for new developments, it can
provide a guideline for existing projects, especially in today’s market where
capitalization rates on high-vacancy properties are not useful.
a building’s replacement cost requires gathering construction-related estimates
• hard costs (site, building, parking),
• soft costs (third-party consultants, permits,
• contingency costs (unforeseen events),
• fees (developer, construction, profit),
• marketing and leasing costs, and
• financing costs.
practice is to measure the total cost to replace a building using a cost per
square foot method. For example, it might cost $90 psf to replace a multifamily
property in Tucson, Ariz., or $125 psf to replace an office building in
Atlanta. It really depends on the local market and product type.
assessing replacement cost on an investment asset, contact two or three
reputable developers or contractors who are familiar with your market and
product type to obtain replacement cost estimates. Make sure the cost estimates
are an apples-to-apples comparison.
rule of thumb is to be a buyer of real estate when prices fall below
replacement cost, and a builder of real estate when prices rise above
replacement cost. Therefore, replacement cost is the line in the sand — the
base line to assessing potential value creation opportunities.
Net Present Value Method
method determines a real estate investment asset’s intrinsic value by finding
the present value of future cash flows.
value is properly calculated as the sum of current and future cash flows with
each dollar of future cash flow appropriately discounted back to take into
account the time value of money. Future cash flows are discounted to present
values using an interest rate that the investor could earn in the next best
alternative investment. This is known as the discount rate.
example, an investor buys a property for $950,000 that has a value creation
opportunity requiring $50,000 of capital improvements. The investor’s total
initial cash investment is $1 million.
part of the value creation strategy, the investor plans to renovate the
property by painting and landscaping and to upgrade the resident profile by
adding some unique services and amenities. With the new look and upgraded
resident profile, the investor expects to raise rents.
will take 12 months to stabilize the property. So, in year one, there is no
cash flow because of expected vacancy and down units during the repositioning
process. But in year two, the property is stabilized with higher rents and
occupancy; it generates a $50,000 cash flow. In year three, the property
continues to remain strong with rents slowly increasing and generates a $60,000
year four, the investor receives an unsolicited offer from a real estate agent
to buy the property for $2 million. The investor decides to sell the property.
net sale proceeds, after paying real estate commissions and closing cost, is
$1.75 million. When the sale proceeds are combined with a $50,000 cash flow in
year four, the property generates a $1.8 million cash flow in year four.
investor finds an alternative investment of similar quality and risk yielding 7
percent, creating the discount rate for the NPV calculation.
this simple example, the NPV is $1,465,861. That’s the intrinsic value of this
property assuming the investor successfully executed the value creation
strategy. So, an investor can buy this property for $1 million knowing it has
intrinsic value of $1,465,861.
Key NPV Factors
NPV involves future cash flow, it is critical to forecast accurate assumptions
when modeling a property investment. Here are a few key factors when
strategy. Modeling a stabilized property versus
a high-vacancy property requires different forecasting assumptions. Use
worst-case scenarios to offset potential forecasting and assumptions errors,
especially on properties without a consistent operating history.
rate. The discount rate should reflect
market conditions. An increase in the discount rate in the example from 7
percent to 13 percent would reduce the NPV to $1,185,000.
and expenses. Forecasted income and expenses should
be reasonable and supported by factual data. Forecast lease-up absorption on
vacant properties using market standards. Also, use industry standard expense
benchmarks in model assumptions.
sales price. Use a capitalization rate appropriate
to the asset’s location, class, and product type that conforms to trending
market conditions. Forecasts for capital markets, the local economy, and real
estate fundamentals should reflect a safe cap rate when modeling future sales
sure the assumptions in your modeling are founded on sound and reasonable data
when determining the intrinsic value of a real estate investment. Understanding
the investment strategy, proper discount rate, accurate income and expenses,
and future sales price will improve the accuracy of the intrinsic value end
result. For protection, value-oriented investors insist upon a margin of safety
by buying low in case the intrinsic value calculation was too optimistic.
replacement cost and NPV methods into your financial analysis and modeling will
help uncover more value-oriented real estate investment opportunities. As the general real estate
market improves in the coming years, such opportunities will be harder to
pencil out, so take advantage of today’s opportunities using intrinsic
valuations as your measurement stick.
Haskell is the author of The Inside Game to Real Estate Value Investing
and founder of Value Hound Academy, an online membership community for
value-oriented real estate investors. Contact him at firstname.lastname@example.org.