"Measuring Value" : Underwriting Distressed Real Estate
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This project focuses on the use of traditional valuation theories and methodologies as they apply to value-add properties. Valuation theories have evolved over time, catering to different industries in the business world ranging from corporate finance to real estate appraisal. This study begins with a literature review of the history and evolution of traditional valuation theories and methodologies. Then, the principles are considered within the context of the real property (i.e.. real estate) asset class. Finally, the real estate valuation methods are applied to two case studies: 1) A distressed mall in Greeley, Colorado, and 2) a small office building in Kalamazoo, Michigan. Traditional valuation theories and methodologies have survived many eras of the constantly evolving business world and have always proved to stay relevant. Though the theories surrounding valuation were formed long ago, the author witnessed their applications every day during his internship at a real estate private equity firm. By constantly asking questions, making mistakes, and applying these value methods repeatedly, he came to appreciate their true power in the world of investment real estate. This project begins with a literature review introducing the traditional valuation methodologies in the real estate asset class: the income approach, the sales comparison approach (market approach), and the cost approach. These real property valuation methodologies closely mirror valuation principles utilized in business practices outside of the real estate industry, such as mergers and acquisitions in corporate finance. This project emphasizes the flexibility of these real property valuation methodologies by demonstrating their uses on two property types, both differing in property classification and size. Important figures highlighted in this study include the net present value (NPV). internal rate of return (IRR), debt-service coverage ratio (DSCR), pro forma net operating income (pro forma NOI), the discount rate (required rate of return), and the capitalization rate (cap rate). The connection section of this study introduces the real estate industry by breaking down how real properties are measured, graded, governed, and classified. Once a solid foundation of the real property asset class is developed, this project then delves into the world of real estate private equity. It attempts to expose how value practitioners, or underwriters, work through the comprehensive real property due diligence process before implementing the income, market, and cost approaches to real property valuation. Depreciating commercial real estate market conditions, further worsened by the financial crisis of 2008. have led to an increasing amount of opportunistic funds opened by real estate investment firms. The real estate private equity industry is built on identifying arbitrage opportunities in particular commercial real property and commercial mortgage backed security (CMBS) markets to fill their funds. These firms attempt to purchase distressed assets at discounts to their actual values. This project highlights not only traditional valuation theories and methodologies associated with the real property asset class, but also the premise of "value" as it relates to future benefits, or income, and risk, or the required rate of return. At the end of this project, it will be clear that value is only meaningful in the context of risk-adjusted returns. The due diligence process, which involves analyzing both the facts about an investment property and the strength of assumptions, requires intensive quantitative and qualitative analyses to uncover and analyze an investment's risks and opportunities. In the application section of this project, the first case study focuses on a shopping mall encumbered by a nonperforming commercial mortgage backed security loan, while the second case study is centered on a small office building in a stagnant office market. Whether the property is subject to borrowers in default or a sluggish market, this project communicates that risks such as these must be taken into consideration when analyzing these real property investments through traditional valuation methodologies.