Valuation of Real Estate Assets: A Hypothetical

Case Study
~~ Beginning of the Case ~~

Feel Secure Wealth Managers (FSWM) LLP, a private asset

management firm head quartered in Mumbai, maintains a stock
and bond portfolio and also invests in four quadrants of the real
estate market: private equity, public equity, private debt and
public debt. Each of the four real estate quadrants has a
manager assigned to it. FSWM intends to increase its allocation
to real estate. The Chief Investment Officer (CIO) Gayathri
Sheelvant has scheduled a meeting with the four real estate
managers to discuss the allocation to real estate and to each
real estate quadrant. Nithin Milind, who manages the private
equity quadrant, believes his quadrant offers the greatest
potential and has identified three investment properties to
consider for acquisition. Selected information for the three
properties is presented in Table-1 below:

Selected Information on Potential Private Equity Real Investments

Property
A B
Property Description Single Tenant Office Shoppin
Size (Sqmt) 3000 50
Lease Type Net Percenta
Rental Income pa (at full occupancy) Rs. 575000 Rs. 61
Other Income Rs. 27000 Rs. 18
Vacancy and Collection Loss Rs. 0 Rs. 6
Property Management Fee Rs. 21500 Rs. 3
Other Operating expenses Rs. 0 Rs. 23
Discount Rate 11.5% 9.2
Growth Rate 2% 0%
Terminal Cap Rate 11
Market Value of Land Rs. 1500000 Rs. 17
 Replacement Costs
[if !supportLists]- [endif]Building Costs Rs. 8725000 Rs. 45
[if !supportLists]- [endif]Developers Profit Rs. 410000 Rs. 21
Deterioration Curable & Incurable Rs. 4104000 Rs. 13
Obsolescence
[if !supportLists]- [endif]Functional Rs. 250000 Rs. 5
[if !supportLists]- [endif]Locational Rs. 500000 Rs. 20
[if !supportLists]- [endif]Economic Rs. 500000 Rs. 10
Comparable Adjusted Price per SQMT
[if !supportLists]- [endif]Comparable Rs. 1750 Rs.
property-1 Rs. 1825 Rs. 1
[if !supportLists]- [endif]Comparable Rs. 1675 Rs.
property-2
[if !supportLists]- [endif]Comparable
property-3
* Assumptions behind above estimates:
Assumption-1: The holding period for each property is expected to be five yea
Assumption-2: Property B is expected to have the same net operating incom
existing leases, and a one-time 20% increase in year-6 due to lease rollov
thereafter.
To prepare for the upcoming meeting, Nithin has asked his
research analyst Shiju Sunny, for a valuation of each of these
properties under the income, cost and sales comparison
approaches using the above information and the two
assumptions. In reviewing Table-1, Nithin notes the
disproportionate estimated obsolescence charges for Property-C
relative to the other properties and asks Shiju to verify the
reasonableness of these estimates. Nithin also reminds Shiju that
they will need to conduct proper due diligence. In that regard,
Nithin indicates that he is concerned whether a covered parking
lot that was added to Property-A encroaches (is partially
located) on adjoining properties. Nithin would like for Shiju to
identify an expert and present documentation to address her
concerns regarding the parking lot.

Shiju summarily writes down the below tasks for preparing a

report:
1 Compare the four quadrants and suggest what arguments can
Nithin put forth to demand higher allocation into his
quadrant (i.e., private equity) of real estate investments.
2 Rank the three properties in the order of highest to lowest
owner exposure to risk related to operating expenses.
3 Determine the value of the properties using Direct
Capitalization Method
4 Determine the value of the properties using Discounted Cash
Flow Method
5 Determine the value of the properties using Cost Approach
6 Determine the value of the properties using Sales Comparison
Approach
7 Give an overview of due diligence process to be followed by
Shiju for Property-A
~~ End of Case ~~

INSTRUCTOR REFERENCES:

[if !supportLists]I. [endif]What courses are intended to be

using this case?
The case can be used as part of courses like Alternative
Investments, Portfolio Management, Financial Modeling and
Corporate Valuation.

[if !supportLists]I. [endif]What models/concepts/theories

can be explained through this case?
The case can be used to demonstrate the below
concepts/theories/models/applications:
[if !supportLists]a) [endif]Real Estate as Financial Asset Types
(Private Equity, Public equity, Private Debt & Public Debt)
[if !supportLists]b) [endif]Types of Real Estate Properties
Single-family, Multi-family, Office & Other Commercial Spaces
[if !supportLists]c) [endif]Types of leases Gross Lease, Net
Lease and Percentage Lease
[if !supportLists]d) [endif]Risks & rewards of investing in real
estate
[if !supportLists]e) [endif]Valuation of real estate investments
using the three approaches Income, Cost & Sales Comparison

[if !supportLists]f) [endif]Process of Real Estate Due Diligence

[if !supportLists]I. [endif]What main issue/problem is

addressed in this case?

The prime focal point of this case is the challenges of

accommodating heterogenic characteristics of different types of
properties in the valuation process.

[if !supportLists]I. [endif]Teaching Notes / Solutions

This case can be best be solved with the use of MS-Excel. Student
should be comfortable in entering the formulas, using functions in
spreadsheet. Although, no major quantitative work is involved,
basic financial mathematics knowledge is essential.

A total of 3 hours/sessions with demonstration would be

required, including the case briefing. It would be ideal to group
the students into groups of 3-4 members in each.

Outline solutions for solving key issues (Explained question-wise):

1. Compare the four quadrants and suggest what arguments can

Nithin put forth to demand higher allocation into his quadrant (i.e.,
private equity) of real estate investments.
Use the table below to explain the basic forms of real estate
investments:
Equity Debt
P Direct investments in Real Estate. This can be through sole Mortgages
r ownership, joint ventures, real estate limited partnerships, or
i other forms of commingled funds
v
a
t
e
P Shares of real estate operating companies and shares of REITs Mortgage-
u Securities
b and comme
 l
i
c
R Participate in Value Appreciation & Income Stream Similar to b
e
m
a
r
k
s
Arguments for Private Equity in Real Estate:
Private equity in real estate enable greater decision-making
control relative to real estate investments in the other three
quadrants. A private real estate equity investor or direct owner
of real estate has responsibility for management of the real
estate, including maintaining the properties, negotiating leases
and collecting rents. These responsibilities increase the investors
control in the decision-making process. Investors in publicly
traded REITs or real estate debt instruments would not typically
have significant influence over these decisions.

2. Rank the three properties in the order of highest to lowest owner

exposure to risk related to operating expenses. Give a brief
description
Types of Leases:

Gross Lease Owner has to bear/pay the operating expenses

Net Lease Tenant has to bear/pay the operating expenses
Percentage Lease Tenants pay additional rent once their sales
reach a certain level

Risk Categorization Owner is exposed to higher risk, in case of

Gross Lease when compared to Net Lease; Owner is also taking
higher risk when he accepts Percentage Lease arrangement.

Ranking in the given case:

Highest risk Property B Moderate risk Property C
Lowest risk Property A
3. Determine the value of the properties using Direct Capitalization
Method

Three Approaches to Real Estate Valuation

1) Income Approach: Considers what an investor would pay

based on expected rate of return that is commensurate with the
risk of the investment. The value estimated with this approach is
essentially the present value of the expected future income from
the property, including proceeds from resale at the end of a
typical investment holding period.

(a) Direct Capitalization Method estimated the value of an

income-producing property based on the level and quality of its
net operating income
Capitalisation Rate = Discount rate Growth rate
Value = Net Operating Income / Cap Rate

(b) Discounted Cash Flow Method is different from Direct

Capitalisation Method by considering a series of cash flows and
terminal cash flows getting discounted back to present
Value = PV of NOI for the foreseeable period + PV of terminal
period value

2) Cost Approach: Considers what it would cost to buy the land

and construct a new property on the site that has the same utility
or functionality as the property being appraised. Adjustments
are made if the subject property is older or not of a modern
design, if it is not feasible to construct a new property in the
current market, or if the location of the property in not ideal for
the current use.
Value = Replacement Cost of Building Curable & Incurable
Obsolescence + Highest & Best Use Value of the Land

3) Sales Comparison Approach: Considers what similar properties

transacted for in the current market. Adjustments are made to
reflect differences between the properties, such as size, location,
age and condition of the property and to adjust for differences
in market conditions at the times of sale.
Value = (Comparable Transaction Value/No. of SQMT or SQFT
of the Comp) X (No. of SQMT or SQFT of Subject Property)

Computation of Net Operating Income

NOI = Rental Income + Other Income Vacancy & Collection
Loss Property Management Costs
Cap Rate = Discount Rate Growth Rate

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4. Determine the value of the properties using Discounted Cash

Flow Method

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5. Determine the value of the properties using Cost Approach

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6. [endif]Determine the value of the properties using Sales

Comparison Approach

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7. Give an overview of due diligence process to be followed

by Shiju for Property-A

Due diligence is conducted to verify other facts and conditions

that might affect the value of the property and that might not
have been identified by the appraiser. The following is an
example of items that are usually part of this process

Review the leases for the major tenants and review the history of
rental payments and any defaults or late payments
 Look at cash flow statements of the previous owner for operating
expenses and revenues
Have an environmental inspection to be sure that there are no issues,
such as a contaminant material on the site
Have physical/engineering inspection to be sure that there are no
structural issues with the property and to check the condition of
the building systems, structures, foundation and adequacy of
utilities
Have an attorney or appropriate party review the ownership history to
be sure that there are no issues related to the sellers ability to
transfer free and clear title that is not subject to any previously
identified liens
Review service and maintenance agreements to determine whether
there are recurring problems
Have a property survey to determine whether the physical
improvements are in the boundary lines of the site and to find out
if there are any easements that would affect the value
Verify that the property is compliant with zoning, environmental
regulations, parking ratios and so on
Verify that property taxes, insurance, special assessments and so on
have been paid
With regards to Property-As specific issue of potential
encroachment of the parking lot, Shiju should ideally take up an
independent property survey and determine whether the
physical improvements, including the covered parking lot, are in
the boundary lines of the site and if there are any easements
that would affect the value of the property.

Thnaks
Suman