This newsletter will cover all things real estate investing with a European focus. For you, it will hopefully be interesting. For me, it’s an outlet to think out loud.
Topics will include summaries of fundamental principles (like this post), primers on interesting sectors (e.g. flexible office, housebuilders), detailed reviews of listed names or situations, vexing questions (e.g. relationship between interest rates and property values), real estate as a financing tool (e.g. securitisations, opco/propco, ground rents) and whatever else seems interesting.
Before we get to the more exciting stuff we should cover some basics.
Comparable transaction approach
Let’s imagine you’re thinking of buying a prime office building in central London let to an investment grade tenant on a 25 year lease paying £10m rent per annum.
You do some research and find that properties with similar characteristics have sold for a 5.0% yield (or ‘cap rate’ in American terms). You decide that means you’re also willing to pay 5.0% or £200m (£10m rent / 5.0%)1.
This is the comparable transaction approach and it is no different to the approach used in multibillion leveraged buyouts through to Mr Smith looking for his next home in Huddersfield.
But the words ‘similar characteristics’ in the explanation above are putting a heavy burden on the English language. There will no perfect comparable2 and you need judgement to adjust the yield accordingly.
Some factors which might lead to a higher (or wider) yield and therefore lower value can include:
Poorer tenant quality - as they might go bust and stop paying your rent
Shorter lease length - as they might leave when the lease expires
Rent above market levels - as you’ll need to cut rent to market levels at lease expiry (also known as being ‘overrented’)
Capex needs - the more capital expenditure to spend the less cash left for you
Location - hopefully an obvious one
Any many others…
The longer your lease and the higher your yield, the more your property value is derived from cashflows rather than residual real estate value3, and the more what you’re buying looks like a bond rather than a property.
Taken to extreme, you can even sell an ‘income strip’ where an investor buys only the rental income over the duration of the lease leaving them with no residual real estate risk.
We talk about ‘yield’ very simplistically above, but there are actually several types:
Cap rate = Net Rent / Property Value
The easiest to understand and US convention. Net rent is referring to any direct property expenses taken out of gross rent (e.g. property taxes).Net Initial Yield (NIY) = Net Rent / (Property Value * (1 + Purchaser’s Costs))
European convention (mostly) where you add purchaser’s costs to get to the yield a buyer actually receives. In the UK, standard purchaser’s costs are 5% stamp duty land tax plus 1.8% general costs for 6.8% total. Most the time people talk about ‘yield’, they are talking about this number.Topped-Up NIY = (Net Rent + Outstanding Rent Frees) / (Property Value * (1 + Purchaser’s Costs))
The same as NIY but the value of any rent temporarily not being paid (as you offered a rent free period as a lease incentive) is added back to rent. Generally a purchaser applies a yield to the topped-up rent and then deducts the value of any outstanding rent free to get to a purchase price (e.g. £100m value less £5m rent that will not be paid during a say 18 month rent free period leads to a £95m purchase price).Reversionary yield = Estimated Rental Value / (Property Value * (1 + Purchaser’s Costs))
The Estimated Rental Value (ERV) is the rent the property would generate if it were fully let today at market rents. If the property is overrented, the reversionary yield will be lower. If the property has high vacancy, the reversionary yield will be higher.Equivalent yield = [Formula too complicated]
The simplest way to understand this is as the time weighted average yield between net initial and reversionary yield (i.e. the yield if you assume full occupancy and rents go to ERV at the next lease event). This is the only yield that takes time into account.
I’m sure you can see why this makes finding the right ‘comparable’ yield even more challenging.
Discounted cashflow approach
You may think the comparable transaction approach is a blunt tool which is self-referential. And you’d be right to some extent because the comparable yield is really downstream of the hallowed discounted cashflow (DCF) approach.
Every asset is worth its cashflows and real estate is no different. In the case of our example office building, you will have a boring cashflow like the one below.
Here you can see you buy the property for £200m or 5% cap rate, collect rent for 5 years which is growing at 2% per annum and then sell it for £221m (equivalent to the same 5% cap rate). Note the cap rate is applied to next year’s rent as that is what the next buyer will benefit from4.
I’ve intentionally not shown any purchase or disposal costs to make the point that entry cap rate plus rental growth is the unlevered IRR (i.e. 5% cap rate + 2% rental growth p.a. = 7% unlevered IRR). This would be equally true if you did everything on a net initial yield basis instead.
Any debt which costs lower than your 7% unlevered IRR will be accretive. As a rule of thumb, if you double your unlevered IRR and subtract your all-in assumed interest rate you get your levered IRR at 50% LTV (e.g. 14% minus 5% all-in rate is 9% levered IRR vs 8.9% actual shown above before fees)5.
If your target unlevered IRR is higher than 7% you would need to pay less for the building (equivalent to a higher yield).
A different buyer may assume a higher rental growth rate or thinks they can sell the property for a 4% cap rate in the future (yield compression). That means they can afford to pay more.
Yield compression has the biggest impact on returns but it can be brave bordering on foolish to assume someone else will be willing to pay more than you were willing to. There are as many justifications for assuming yield compression as there has been money lost. General justifications include that you have been able to buy cheap (like a distressed sale), the fact you will take some risk to stabilise a troubled asset or you expect a certain sector / location will become in vouge.
To conclude…
Another helpful valuation reference point is the replacement cost (i.e. what would it cost to build a similar asset today). Buying below replacement cost gives you some comfort that someone will not build a shiny new building next door and steal all your tenants.
The next post will cover how to value property companies. It can be easy to get lost in the corporate complexities and niche reporting metrics. It’s helpful to remember the value is ultimately in the properties which are valued like all others.
If you’ve learnt anything from the above it’s hopefully that if in doubt, just put a yield on it (to paraphrase Beyoncé who is no stranger to real estate).
You can also take the inverse of 5.0% (1 / 5.0%) to get the equivalent multiple of 20.0x which is the language traditional corporate investors speak in.
A comparable yield should reflect “a transaction at arm’s length involving a willing buyer and a willing seller” to use the special incantation. You can find a good summary of current UK yields in this helpful Knight Frank guide updated monthly.
Residual real estate value is what you’re left with after all the rent has been paid. If you pay £100m for a building and the present value of the rental cashflows are £60m then your residual real estate value is £40m (or 60% of your value is in the rent and 40% in the real estate).
In reality, rent reviews might be every 3-5 years and if it is not contractually agreed (e.g. a fixed uplift or linked to inflation) the next buyer is unlikely to give you full benefit of this.
This rule of thumb becomes less accurate the more exit cap rate differs to entry cap rate. Note most commercial real estate loans in Europe are interest only with a bullet repayment at maturity.