Real Estate Valuation Part 1 - Introduction

Background

I've analyzed and valued ("underwritten") billions of dollars of commercial real estate over several market cycles, and while I'm a slow learner, you can learn almost everything I know in about 5 minutes.

Valuing real estate begins with your underwriting, and it all boils down to 10 essential categories of revenues and expenses. Each of the 10 could be its own post, but this is real estate- not rocket science, so we'll go over each one quickly and drill down further another time.

These are the essential building blocks of how real estate is underwritten, from the single family home rental to the duplex, three flat, or triple decker, all the way to the large, institutional, class A Multifamily asset. Let's start with..

High Level: CASH FLOW (is king)

Real estate is primarily valued based on its cash flow. There are other factors, but valuing based on a cash flow stream is the base-case, 'vanilla' standard idea. We're either valuing the cash flow it makes this year, or the cash flow it could be making next year.

The first step to determining the value of a property is to understand its annual cash flow, for last year and for next year. In real estate, we have two cash flows we focus most on:

-Historical - last year's performance, the historical statement,

-Pro Forma - our best guess of next year's income is called a Pro Forma.

Put plainly, a Pro Forma is Revenues minus routine Expenses, which results in our yearly Net Operating Income.

We use that Net Operating Income with a specific multiplier in order to arrive at our value. Our multiplier is really a division by a percentage, e.g. 5% cap rate means our $1M NOI divided by our 5% cap rate means our value is 20x our NOI, or $20M.

Our NOI divided by our Purchase Price is our cap rate (capitalization rate), the percentage yield you can expect on your money. The appropriate NOI at a reasonable cap rate is the number one method to value commercial real estate.

Once you have your underwritten NOI, and applied the appropriate cap rate (multiplier) you have the foundation of your answer to "How much should I pay?".

Now that you know WHY we would want to determine the Pro Forma NOI, we will walk through the 10 basic steps of underwriting a deal.

Key Terms:

• Historical Statment
• Pro Forma Statement
• Net Operating Income (NOI)
• Cap Rate