On Commercial Real Estate – Pt. 2

In the first part of this series, I wanted to show how CRE values could be derived and the effects of assumptions like cap rates had on that process. I want to expand on that post a bit, by using net present value (NPV) analysis in deciding whether or not it’s a good idea to invest in the property. The NPV formula is given below:

In essence, the formula states NPV is the sum of our discounted after-tax cash flows and our discounted after-tax equity return (we have to get our invested capital back) minus the initial investment. If our initial investment is greater than the sum of our discounted after-tax cash flows and discounted after-tax equity return, we don’t make the investment. The rule is to only do investments where the NPV is greater than 0.

To jog our memories, we were looking at a commercial property that had $550K in NOI, a return of 12% (that’s after-tax), and we’ll assume a net operating income growth rate of 4.5% and a holding period of 5 years. We’re also going to assume we’ll sell the property for $4.5MM at the end of the holding period. But to make our investment decision, we need more data. Specifically, we need the following:

  • Tax rate
  • Equity contribution/Debt contribution
  • Interest rate on the debt
  • Purchase price

I have all of these factors as well as some other extraneous ones (capital gains, etc.) contained in this spreadsheet I posted out on Scribd:

The main toggles that drive NPV analysis? Growth rate of NOI and discount rate used in the calculation. But some of the other inputs like depreciation will factor into the decision as well. The pitfall to avoid is being overly optimistic in your NOI growth, and also your discount rate. It’s better to err on the side of higher discount rates and lower growth rates because a higher discount rate is a tougher hurdle for projects to satisfy. You expect to get a return on your money, and using higher discount rates force investors to have discipline regarding the projects they invest in. There are fewer projects that can clear a 15% discount rate than projects that can clear a 10-11%. Using lower growth rates is also a conservative practice as well, because if you factor in high growth rates into your analysis, you have very little room for error in terms of gaining return via high NOI growth or capital gains. So while the project had a positive NPV with a 4.5% growth rate and 12% required return after taxes, if I boosted the required return to 15 or 20% it will not be a good investment if I calculate a negative NPV. One other thing to think about with big projects is the possibility that once your project goes online, you could cannibalize the rent rates and growth rates you need to make the project pay off. So there’s definitely a balance that needs to be struck.

So the bottom line is mood and sentiment can tell you a lot about how the market is pricing in return expectations. When the mood is positive, growth expectations go up, required returns may get lax and everyone just assumes you have to chase it. When mood is negative, no investment looks good enough regardless of what the after-tax return might be. The key is to stay focused on quality investments that meet relatively stringent return requirements, yet don’t need gangbuster growth to develop a positive NPV.

So whether it’s sales/sq. ft. for a shopping center, RevPAR for hotels, rent rates for office buildings, using NPV analysis can help separate good, bad, and ugly CRE investments.

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Filed under finance, macro, Markets

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