How to value real estate- DCF basics
The Discounted Cash Flow method and the Direct Capitalization method are the fundamental tools for valuing real estate investments and I will use that to inform the discussion today.
The Discounted Cash Flow (DCF) valuation method attempts to account for all future cash flows from an investment and discount them to a present value. So to make that more concrete, let’s say I buy a building today. I can assume I will get rent every year for the life of the building, and also assume that I will have to pay expenses over the same period. The difference of the rent income and the expenses is my profit. But as everyone knows, a dollar of profit today is a lot more valuable than a dollar of profit in the future, so we have to discount the future cash flows to today’s value using the time value of money. We also can’t be certain that we will continue to receive rent in the future, so we should also discount the future cash flows to reflect this uncertainty.
The DCF is the best theoretical way to value real estate, but it is somewhat more complex than the direct capitalization method I will focus on today. Direct capitalization generally captures nearly all of the important nuance of DCF, but does so in a much easier-to-understand formula. Therefore, I will focus on capitalization today. But if you want to understand more about the differences between capitalization and DCF, please see this article or email me.
The direct capitalization method involves taking the current net operating income (NOI) of a building and capitalizing (multiplying it by a large number- generally between 10 and 20) to reflect the face that this income will continue into the future
So the direct capialization valuation method works like this:
- To calculate NOI, we simply add up all of the revenues (rent and other revenue) and then subtract all of the operating expenses (management fee, utilities, etc). It’s important to note that we only subtract operating expenses, so we don’t subtract things like taxes or interest payments. Although obviously important, these expenses don’t factor into NOI.
- We then take the NOI and divide it by a capitalization rate. The capitalization rate is a percentage that takes into account 3 things: NOI will continue indefinitely into the future and in many cases grow over time; future NOI needs to be discounted to today’s value; future NOIs need to be discounted for risk and uncertainty. Capitalization rates are generally between 5 and 10%, but can be lower or higher depending on circumstances.
So then, the value of a building is roughly equal to:
Other valuation methods
Of course, DCF and direct capitalization are not the only valuation methodologies. Another extremely useful type of valuation tool is comparables. Comparables involves taking two or more similar assets and comparing their values. If, for example, we wanted to value Prosper Center, we could use the value of the neighboring Kerry Center as a proxy. For example, Prosper Center and Kerry Center should have similar capitalization rates. Of course we’d have to do slight tweaks to account for variations, for example, but their valuation should be in the same ballpark (although as I will show Prosper should have a lower cap rate since it's green and Kerry is not).
Comparables is a very good way of valuing marketable assets, but I will leave this valuation method aside and focus primarily on DCF today.
Another valuation method often used by real estate developers is simple payback period. Simple payback period measures how many years it takes to recoup an investment. One knock on many green systems is that they have a long payback period. Since many developers usually have a limit on their desired payback period, say 5 years, they often will not make investments that have longer investments.
While it may be true that some green building systems have long payback periods, this totally misses the point in my mind. Simple payback period makes no sense as a rigorous valuation tool for several reasons. First and most importantly, payback period has no concept of revenues. For example, imagine an investment that required $1 today, and then made no revenues for the first 5 years, but made $1,000,000 in the 6th year. If a developer were to strictly use the simple payback period with a 5 year limit, they would miss this clearly profitable investment. This may be an extreme example, but captures a serious flaw in the simple payback period method of valuation. For this reason, I do not consider the simple payback method to be a useful method of valuation. While it generally is true that investments with short paybacks have good returns, it is not necessarily true that investments with longer payback periods do not have good returns.
Therefore I will ignore simple payback entirely and focus instead on direct capitalization today.
How green building drives increased building value
One more time, direct capitalization works like this:
As we can see from this equation, in order to maximize value, we need to maximize revenue, minimize costs, and minimize the cap rate. Green building helps do all three of these things, and in turn increases building value.
(Note: for this discussion, I will assume that we are talking about an office building, where tenants rent the building on a gross lease, i.e. one monthly payment from the tenant to the landlord that covers utilities, maintenance, insurance, and taxes in addition to rent. Other lease structures, such as triple net, are more common, but the green valuation issues remain the same. Please email me or use the comments box for any questions that relate to different lease structures and I will be happy to respond.)
The first way green buildings increase building value is through lower operating costs.
Obviously, a green building that uses less energy will have lower utility bills. Since LEED rated buildings on average use 33% less energy than regular buildings, this means utility costs are about 33% lower. Since utilities account for ~25 to 30% of an office building’s operating expenses, this adds up to big value. Smaller water and waste bills also make for better economics.
Green buildings can also lower other less-obvious expenses. For example, the Fireman’s Fund, a leading insurance company, offers lower insurance rates for LEED certified buildings. Other possible cost saving measures for green buildings include lower interest rates through green banks (although again this doesn’t affect NOI, only returns to the owner) and lower maintenance costs thanks to smaller systems and better commissioning processes.
The result is less operating expenses for green real estate, which means higher building value.
Green buildings also benefit from higher revenue, primarily through increased rents.
Several recent surveys and studies show that green buildings command higher rents. A study by economists for the Berkeley Program on Housing and Urban Policy showed that green buildings on average rent for 2-6% more than their non-green counterparts, after controlling for other variables like location and building age. This green premium even exists in China, where a recent JLL report shows that nearly 70% of high-end real estate tenants are willing to pay more for green real estate.
Why do green buildings command these premium rents? Two reasons primarily. First, workers in green buildings are more productive than workers in brown buildings. Thanks to more daylighting, higher air ventilation rates, improved indoor air quality, and other attributes of green real estate, occupants of green buildings tend to be more comfortable and more productive. The US Green Building Council website links to numerous studies showing that productivity in green buildings is higher. Since green real estate space is more productive than regular brown space, tenants are willing to pay more for the productivity benefits. This productivity-driven rent premium for green buildings will continue, as brown buildings just cannot match the many productivity-boosting benefits of green buildings.
Second, the supply of green buildings is low relative to demand, meaning the large and growing number of companies who want to occupy green space need to pay a premium to get access to the limited supply. This likely will not persist much longer, since the supply of green buildings will expand dramatically. However, what we will see then is a switch, whereby brown buildings actually require a rent discount in order to lure tenants away from the abundant supply of green buildings. So this will also guarantee continuing premium rents over brown buildings.
Since higher rents means more NOI, higher rents therefore drive higher value for green buildings.
Lower cap rate
The capitalization rate is essentially a measure of the future outlook of the property. This includes both expected growth in NOI as well as the perceived risk of future NOI. On both accounts, green buildings do better and therefore should receive lower cap rates.
Let’s first look at expected growth of NOI. As more and more companies demand green real estate and are willing to pay more for the productivity benefits, I think it’s safe to say that we can expect rents and NOI at green buildings to grow faster than those at brown buildings. Or conversely, when green building becomes the norm, very few tenants will be willing to pay the same price for brown real estate, meaning negative rent growth for many brown properties. The result is still faster NOI growth for green buildings, and therefore lower cap rates.
Green buildings are also less risky than their brown counterparts. Since green buildings use more advanced building techniques and are more likely to satisfy the needs of tomorrow’s tenants, there is less risk of functional obsolescence for green buildings. Moreover, thanks to lower environmental impact, green buildings also face less regulatory risk. The result? Again, lower cap rates for green buildings.
Green buildings have higher value
So let’s take these results and run through a quick thought experiment. Let’s start with a hypothetical building with rent of $1,500,000, expenses of $500,000 and a cap rate of 10%. Now what happens when we take the same building but assume it’s green? Well now rents will be 2-6% higher, utilities will be 33% lower, and I'll assume the cap rate will be lower by 0.5 - 1%. As we can see from my calculations below, we get a big value increase.
At the low end, we should expect green buildings to be worth 12% more, and at the high end, green buildings could be worth as much as 25% more than their brown counterparts. Of course this is just a hypothetical example, but the takeaway is clear nonetheless: green buildings are more valuable.
What does this mean for developers and owners?
For developers, I think this means build green from the start. Even for developers who build to sell immediately upon completion, green building is still compelling. The purchaser of the building will have an interest in owning for the longer-term, and should be willing to pay more for green. So even if developers don’t believe the 12% valuation premium example that I laid out above, it seems they can easily get 5+% for all of the reasons I described. This means as long as that developers can hold the cost premium for green below this 5%, they will be making more money than they otherwise would by building brown. If a developer can build green at 5% but get a 10+% valuation increase, well, now the developer is really doing well financially (not to mention socially and environmentally). As more developers start to understand green building economics, I think building green will become increasingly more profitable and eventually become the only way to build.
For owners, I think this means retrofitting to green standards right now. As my hypothetical calculations showed, the benefits of retrofitting and getting green certification are huge. Not only will the building benefit from higher rent, lower operating costs, better corporate image, less risk, etc etc, but it will most likely pay for itself through immediately increased building value. For example, if a building owner could perform a large retrofit on a building for 10% of the building value, the investment would immediately pay for itself thanks to higher post-retrofit building value. Although increased building value isn’t exactly the same as cash in hand for the building owner, the increased building value provides significant security for this investment in energy efficiency and green features.
The bottom line is that green building makes sense for the bottom line. As more and more developers, owners and tenants realize this, I expect to see green building become the norm for those who can afford to pay for the green benefits, particularly those in Class A office buildings, luxury apartments and international quality industrial facilities. The trick then will be to figure out how to make green building economics translate into something that works for those other sectors of the market that I’ve been talking about so much recently. Stay tuned for my next post for some initial ideas on how to use these green building economics to make green building affordable- and widespread.