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When we go back to critical thinking, we have to consider what the property is. Is it a retail building, a motel, a hotel or a stadium? What is it and what does that mean? What is it worth? To who? What is their risk preference? What is their opportunity cost? By setting our discount rate and asking these questions, the total implication on value can be calculated, where the implication on value, very easily, is the series of cash flows that you apply your required rate of return to, to get back to the value today.

A pro forma valuation is basically taking a series of future cash flows, or a single lump sum of future cashflow, applying a discount rate of return to it to arrive back to the present value or the value of the property. What is it? Why? To whom? What is the implication of value? Therefore, what is the value? That’s it. That is the process of critical thinking to evaluate a property.

Once you do that, you can go into the critical thinking of how to design it, whether you need a permit it and how easy that will be for this property. You may need to lease it, ok well how easy is that going to be? Maybe you have to build up a skyscraper, well, how much is that going to cost? How easy or risky is that? There are all of these factors playing into the risk component of setting your return, together with the time value of money and together with the opportunity costs. Those three components always go into setting your discount rate of return.

That is how simple it is to value something. To continue with the theme of simplicity, let me share now how there are always two ways to evaluate commercial real estate.

1. The dollar value in total dollars or per square foot
2. The yield or rate of return, most commonly the Cap Rate

If a building is worth $10 million today, the other way to describe the value is based on the discount rate of return, that the property is worth a 5% Cap Rate. The Cap Rate equates to:

The recurring Annual Net Operating Income

Divided by

The dollar Property Value.

= Cap Rate

Annual Net Operating Income over value is the capitalization, but really those are two ways of saying the same thing. This is because they validate each other.

A building may sound expensive if its $10 million… but why is it $10 million? Well, it may be that it generates a 5% per cent annual return on value, meaning if you buy it for $10 million today, you will earn 5% annually on an all cash basis. If we go back to what that cap rate is based on opportunity costs – buying this building and earning 5% versus buying a bond online – what is the better deal? Where else could you be getting a 5% capital rate of return and would it be easier or harder to do? Is it riskier to do 5% here versus going elsewhere to get 5%?

The beauty of commercial real estate is that you always have two ways to say the value of something. We have the dollar value of $10 million and we have the cap rate of 5%. Value is, of course, subjective. Who’s buying the property? Is it somebody who is rich that doesn’t need to put a loan on it?

Read the next article for an example of how a property may be valued differently by two people…

Finance principles are a category of mental models used when assembling a pro forma. These include the time value of money, which is effectively how the value of a dollar today is worth more than the value of a dollar tomorrow. The difference in that value is what’s called the discount rate, which accounts for both the risk and the time value of money.

There are different discount rates applied to different investment instruments, but in general, they all say the same thing. There are several explanations for why this is the case, but if you are going from $1 dollar today to a dollar tomorrow, the dollar today is worth more based on time, value, and investment return on the $1 dollar if its invested over this single day. The investment return for investing in an alternative during this 1 day is termed your opportunity cost of your capital. Based on first principles, what you call the discount rate is the rate you assign to future cash flows, to convert them to be the present value of those cash flows based on this time value of money, the associated risk or probability of actually earning those cash flows and your opportunity cost of capital. You may be valuing a series of cash flows over time or a single lump sum cash flow later and you want to understand and to assign the discount rate to that.

Well what helps you to understand what should be the discount rate?

If you’re buying a piece of raw land on the beaten path, you have to get government and local permits to even put in utilities. In this example, you might evaluate that the land today is worth X, but with the new building built on the land, the building tomorrow is worth Y. The discount rate, together with the time value of money, factors in the risk associated with achieving the proposed value.

Well, what are your alternatives? What else could you do to get that same discount / rate of return? Your calculated discount rate establishes the market cap, for a raw piece of land the rate of return could be 20%, but if it’s not happening for 10 years, what is the value of that deal today? We can use the discount rate to get to the present value, which allows us to compare this rate to other alternatives. For example, what would the rate of return be if we were just buying a bond on the public market? If the bond’s rate of return is 10% which would pay out in five years, where would you prefer to invest the capital? Looking at the two values, if the land has a 20% rate of return but the bond is worth more today and it is lower risk, you would ask yourself which of the two deals you prefer. You may prefer the 5%.

These principles are really important in setting your target return, which factors in the time value of money, the opportunity cost of that money – meaning the alternative returns that money can get – and then the risk associated with achieving it. These are the three components of setting your rate of return and embody 80% of finance principles for commercial real estate investing.

Read next… “Valuation Principles that Incorporate Financial Tools and Critical Thinking”

The pro forma is a financial valuation analysis framework that basically tells you what the property is worth based on whatever you’re going to do to it, or in our case, the property business plan. The pro forma is the central decision-making machine for any real estate project, it is your playbook.

With the pro forma as our guide we can go back out to the real world after we establish the initial valuation framework. We can now talk to our architect about how much space can be physically developed, what can be done to this existing vacant box, based on our intentions and the size layout to be converted into housing, or to instead be repositioned into retail to office and how that would work. The architect can tell us how much square footage that we would have available, plus how much rentable square footage can feasibly and functionally fit, and everything else that we may need to consider for the site feasibility. We might need to get permits from the city, for example, which the architect can tell us based on the design. We then plug this information back into our pro forma and see what it comes to. Does that help our value? At what rates?

We then conduct a study of the leasing market by talking to brokers and research leasing data. If we’re taking a vacant retail space and converting it to an office, what would be the rental value of the office space? And if that rent is higher and makes it feasible, let’s put that into our pro forma to see if the returns are higher or lower..

But wait. We have the design and we have an understanding of the market… but how much is this going to cost? Well, once we have a general sketch from our architect, we then take it to our general contractor or our construction manager and say, “Hey, how much is it going to cost to convert this vacant retail space to office?” From there, they will give us some costs and then we plug that back into our pro forma to look at the new value forecast to again ask ourselves the feasibility of the project. Based on these assumptions, we now know what the what is, the why, and we can come up with the value. It’s a beautiful thing.

What I teach, and what we are experts in, are pro formas, effectively, because the pro forma incorporates and considers all of these factors collectively based on the real world.

Am I going to teach you how to be a good architect to design a space? No. Am I going to teach you how to be a good contractor to build the space? No, but am I going to teach you how to take all of these ingredients and put it into the soup. This is multi-disciplinary. As the developer, or as the lead investor you are the conductor of the orchestra. If your contractor is playing the drums, you want to make sure you’re pulling the best out of them on the drums, but you’re never going to play the drums yourself. This is the same with the violinists, the architect, the percussionists and the broker. Your role is to pull all of these pieces together to be able to make an informed decision on the perceived value of the project.

The last part is money. From your pro forma, how are you going to go and get this money? Well, there are two sources of money: equity and debt. The capital stack is how much equity and how much debt equates to the total cost of the project, which is basically what are the sources of funding and how do they stack up together. Venture capitalists call this the cap table, in real estate, we call this the capital stack.

Your project involves buying a piece of property, spending money to design it, build it and lease it. These are your total costs and are the factors that reflect the total uses of the capital. Therefore, your total sources of capital should always equal your total uses of capital.

Read next… “Finance Principles and Tools for Building a Pro forma”

Investing, developing and managing commercial real estate is all about critical thinking by continually asking: “What is it? Why? And then what are these resulting implications its value? This mental model is indeed critical (pun intended) to evaluating property value.

If you look at a building or a piece of land, well, what is it? You might just say it’s a car wash with minimart building, but it could also be seen as housing complex or hotel redevelopment, etc based on what the interested purchaser believes is its highest and best use.

What is your rationale for what you believe the ‘what’ is? From there, what is the implication on value? Is the value of that property, as a vacant retail strip center, higher or lower than its value based on redeveloping it to a housing complex? The what and the why, and the implications on value are the mental models within critical thinking in investing in commercial real estate. A big part of the “Why” is “To Who?” In other words, a private investor seeking to simply buy and hold the retail center will differ in why the view value to be higher or lower than a hotel or housing complex developer. Therefore, the “Why” includes “to who?” in rationalizing the property value.

This critical thinking framework is further driven by the fact that real estate requires input and involvement of multiple disciplines. this is one of the reasons why I enjoy real estate so much. In my role as a developer, investor and a manager of an investment company I get to be involved in and manage a fun variety of disciplines. I may host a group of leasing brokers at a property to talk to them about the vacant space and what they view to be the opportunity on behalf of their prospective tenants. Before that, I might be on a call with my architect to talk about how we can improve a couple of areas in the site plan to be more efficient for the flow of circulation. To do that, I will consult with our attorney regarding refinance of our value creation plan with a group of our investors and how that legal structure will work.

And so just right there you are talking to an attorney, a broker, an architect, and then after all of this, I have to go and talk to our construction team about whether or not we can make a change to the design. What will that do to the budget? And then in turn, what does that have as an implication back into the value?

Read next… “Pro forma Financial Valuation Analysis”

I have the honor and pleasure of teaching finance for real estate investment and development at the undergrad and graduate school real estate programs at the University of Southern California. I don’t use a textbook. Instead, I work to provide real-life tools, financial concepts and applications for “financial underwriting” to determine the value of an income or development property. This post series will equip investors on the mindset and fundamental building blocks toward value add investing in commercial and residential real estate. From there, in future series we will go in depth into our simple value-add investment valuation approach with real life examples.

At my day job at BrandView Capital, we specialize in valuing property on the basis of purchasing and adding value to it through renovation and leasing, or all the way through redeveloping it and/or converting it to mixed-use. Mixed-use property simply means a property has multiple uses that can potentially earn income. The potential for converting a single-use property, whether occupied or vacant, may or may not be visible to both the trained and untrained eyes.

When you look at a building, you may consider the value of the property by taking it at face value. Sure, that’s one indication of value, but what if you could build on top of a building and that could provide additional value for what is there? What if there was excess land behind it, what would that mean for the value of the property? We look for value where others don’t see it as easily as a basis for our investment decisions.

At BrandView, we are so focused on what can be value. What is there today and what can be there in the future in terms of potential value. This requires a very strong understanding of how to apply critical thinking, to identify the what and the why for a property, based on what its implication on value.

Read next… “Critical Thinking: The What, the Why and Implications on Property Investment Value”