Commercial Investment Real Estate is the magazine of the CCIM Institute, the leading provider of commercial real estate education. CIRE covers market trends, current developments, and business strategies within the commercial real estate field.
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INVESTMENT ANALYSIS Value Play are familiar with your market and product type to obtain replacement cost estimates. Make sure the cost estimates are an applesto-apples comparison. Te rule of thumb is to be a buyer of real estate when prices fall below replacement cost, and a builder of real estate when prices rise above replacement cost. Therefore, replacement cost is the line in the sand — the base line to assessing potential value creation opportunities. v Two methods are key to this investment strategy. by Craig Haskell Value-oriented real estate investors believe that real estate assets have an underlying intrinsic value that can be determined by analysis and evaluation. Opportunities for profitable investments arise when the asset's purchase price is below its intrinsic value. Value investors evaluate an investment's opportunity by understanding the relationship between value and price. Thus, the essential task of a successful real estate value investor is to determine the intrinsic value to capitalize on inefcient market mispricing. In determining the intrinsic value of real estate investment assets, value investors use two generally accepted methods: replacement cost and net present value. Replacement Cost Method While most commonly recognized by industry professionals, the replacement cost method can be quite complex to calculate. Ofen used for new developments, it can provide a guideline for existing projects, especially in today's market where capitalization rates on high-vacancy properties are not useful. 16 January | February | 2013 Determining a building's replacement cost requires gathering construction-related estimates such as: • hard costs (site, building, parking), • sof costs (third-party consultants, permits, and fees), • contingency costs (unforeseen events), • fees (developer, construction, proft), • marketing and leasing costs, and • fnancing costs. Common practice is to measure the total cost to replace a building using a cost per square foot method. For example, it might cost $90 psf to replace a multifamily property in Tucson, Ariz., or $125 psf to replace an ofce building in Atlanta. It really depends on the local market and product type. When assessing replacement cost on an investment asset, contact two or three reputable developers or contractors who Te NPV method determines a real estate investment asset's intrinsic value by fnding the present value of future cash fows. Present value is properly calculated as the sum of current and future cash fows with each dollar of future cash fow appropriately discounted back to take into account the time value of money. Future cash fows are discounted to present values using an interest rate that the investor could earn in the next best alternative investment. Tis is known as the discount rate. For example, an investor buys a property for $950,000 that has a value creation opportunity requiring $50,000 of capital improvements. Te investor's total initial cash investment is $1 million. As part of the value creation strategy, the investor plans to renovate the property by painting and landscaping and to upgrade the resident profle by adding some unique services and amenities. With the new look and upgraded resident profle, the investor expects to raise rents. It will take 12 months to stabilize the property. So, in year one, there is no cash fow because of expected vacancy and down units during the repositioning process. But in year two, the property is stabilized with higher rents and occupancy; it generates a $50,000 cash fow. In year three, the property continues to remain strong with rents slowly increasing and generates a $60,000 cash fow. In year four, the investor receives an unsolicited ofer from a real estate agent to buy the property for $2 million. Te investor decides to sell the property. Te net sale proceeds, afer paying real estate commissions and closing cost, is $1.75 Commercial Investment Real Estate Lisa Blue/Getty Images Net Present Value Method