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Introduction
This post continues our series on the real estate private equity M&A process, a common arc within any real estate private equity career path. You might expect questions relevant to this article during a real estate investment case study, so we recommend you pay close attention. At this point, we know that a company is worth buying if its net asset value (NAV) is meaningfully above the current share price. To know NAV, simplistically put, you need to know the value of the debt and the gross value of the assets. You subtract the value of the debt from the gross value of the assets, and you get the NAV. Again -- if the NAV per share is meaningfully greater than the stock price, then the company is a good buy. Congratulations, investor! Debt Principal is Straightforward, Asset Value not so Much Figuring out the principal due on outstanding debt is pretty easy. It’s a contractual principal balance, so you can pretty quickly figure it out in a matter of minutes. Every public company reports this, and any private company for sale will tell you this and give you all supporting legal documents. Where the magic comes into play is figuring out the value of the assets. How do you know the true value of an office building on 5th Avenue and 42nd Street in Manhattan? Extrinsic Asset Valuation: Sales Comps Well, the trite answer is any building is worth the most that somebody will pay you for it. To figure out how much somebody will pay us for a building, we approach the question both extrinsically and intrinsically. Extrinsically, we look to see how much similar buildings nearby have sold for on a per-square-foot basis. If our building is brand new with quality tenants, and other brand new buildings with quality tenants have sold for $1,850 PSF, then our building is probably worth something similar to buyers. Extrinsic valuation is pretty straightforward too, you just go to a website like CoStar or Real Capital Analytics where this data is aggregated, or even the local news. Intrinsic valuation is a bit trickier. Intrinsic Asset Valuation: Discounted Cash Flows Intrinsically, we value the building by discounting future cash flows. We look to the future cash flows this office building is likely to produce over the next ten years. We then cap a future sale ten years out, and discount all future operational cash flows and that future sale back at an applicable unlevered discount rate. We dive into the nuances of discount rates in our course Breaking Down REPE, but a good proxy for the unlevered discount rate you might see core office buyers solve for would be whatever is the prevailing cap rate in the market. So if core office buildings are selling for 5.0% cap rates, we’d probably use a 5.0% discount rate to NPV those future cash flows. The NPV of those cash flows results in the price we’d be willing to pay. This approach is called the NPV approach. The inverse is a hurdle rate valuation, which is basically the exact same analysis, except you figure out whatever price you need to pay in order to achieve that discount rate you’re targeting (aka the hurdle rate). If this sounds like the same thing, it’s because it pretty much is. Side note: if the terms discount rate and NPV are a foreign language to you, you should take a few hours out of your day to run through our REPE Starter Kit where we cut to the chase to explain relevant financial jargon as efficiently as possible. Your Extrinsic and Intrinsic Valuations Should Triangulate We like having several valuation methodologies because it allows us to build a “valuation football field.” A football field is just a sideways bar chart that shows the valuations implied by multiple approaches. If you value the asset with several methodologies, you’d hope they all say more or less the same thing so you can triangulate an appropriate range. So if you’ve done your analysis correctly, the result of your discounted cash flow analyses should land somewhere close to your sales comps of $1,850 PSF. No single methodology will be perfect, but if each methodology you employ gets to a similar answer, then your pricing expectations are robust. Learn with Leveraged Breakdowns Leveraged Breakdowns exists to help outsiders take their first steps on their real estate private equity career path. Check out our blog for a trove of free information written by mega fund insiders who remember how hard it was to break into this tough industry. Though we offer premium technical content such as our REPE Starter Kit, we also offer free resources such as our open real estate investment case study challenge.
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