And if you overlook the occasional housing crisis or three, you can see why the real estate market is so essential to all sorts of different industries:
- Utilities: Need to deliver electricity somewhere…
- Consumer Retail: Need to fit those Brooks Brothers suits somewhere…
- Industrials: Need to park your private jet somewhere…
But there’s surprisingly little information out there about what you actually do in a real estate investment banking group – even though lots of people are interested in the field.
We’re going to fix that with an interview from an analyst who networked his way into real estate IB, coming from a non-target state school.
Today’s interviewee has covered lodging, gaming, and home building, and he can tell you all about properties and REITs as well – so let’s get started and learn how the sector is divided, how valuation works, and what you need to know when interview season begins. This interview features valuation and financial analysis commentary provided separately by Suleman Iddrissu.
Laying Down the Foundation
Q: Okay, let’s get started with your story and how you broke in. Were you more interested in investment banking, or in real estate?
A: Sure. I went to a state school and networked quite a bit with alumni to find my role.
It’s incredibly vital to find someone who can sponsor (similar to mentoring, but more like one step above) your entry into an investment banking team, and from there help to look after your progress in terms of assignments.
And in turn, you, as the mentee, need to perform well to ensure that your superior looks great.
When I found myself on a real estate-related team, I thought about getting a real estate license but that sort of background is not necessary from an entry-level standpoint.
So I was definitely more interested in investment banking from the start, and just happened to network my way into a real estate group.
Q: I know we’re not focused on networking here, but any tips on how to stand out?
A: To do well, you just need i) the right attitude, ii) attention to detail, and iii) a real sense of teamwork.
- Attitude: If I give you an assignment at 3AM, will you have a smile on your face the following morning? Or at least not be drooling on your desk?
- Attention to Detail: Are you able to check your own work? If I don’t have time to do all of my own assignments, then I definitely don’t have time to do your assignments.
- Teamwork: Can you anticipate the needs of your teammates? If someone is working on sector pages, and you happen to come across a useful article, will you be able to create a quick 3-point summary so your team doesn’t waste time?
Q: And what other tips do you have on getting in if you can’t use on-campus recruiting? Anything specific to real estate?
A: Here’s how I think about the different recruiting channels, if opportunity were a house and you were looking to “break in”:
- Front Door: On-campus recruiting, applying online, diversity programs, etc…
- Side Door: Networking through alumni and internal referrals.
- Back Door: Taking another role and then transferring internally.
- Window: Volunteering to work for free and then creating a position for yourself.
- Chimney: Help an analyst out on his / her own assignments, so you effectively create an externship. Maybe chip in to do acquisition idea profiles, etc…
- Through the Wall: Get in during a Superday by fostering the right relationships way in advance.
The recruiting process is kind of like dating – it requires getting to know your partner, being accommodating, and not going in with a canned agenda.
I don’t think too much of what I’m saying here is specific to real estate – networking in any area of investment banking is the same.
Here, you just need to be certain that you show passion for the sector to maximize your chances of being placed in our group.
Real Estate 101
Q: That’s good to hear… so let’s jump into what you actually do in a real estate group at a bank. How is it divided?
A: Real estate is one of the broader coverage areas in investment banking, and each sector is quite a bit different:
Real Estate Investment Trusts (REITs): These firms are sort of like private equity firms, but for properties rather than companies. They buy and sell properties, operate and improve them, and sometimes even develop new properties.
REITs might be diversified, or they might focus on a specific sector like commercial, residential, retail, industrial (ex: warehouses), healthcare, and so on; some firms might have a geographic concentration as well.
REITs are required to issue 90% of their taxable income as dividends to avoid corporate-level income tax – and that requirement combined with their constant acquisition and development of new properties results in minimal cash on-hand most of the time.
So they have huge financing needs and need to issue debt and equity constantly just to continue operating.
Home Builders: These firms construct and sell homes, often for particular geographies. A company such as KB Home (NYSE: KBH) might have a particularly strong presence in the Southwestern and Southeastern US.
The properties here may range from single-family to townhomes to condominiums (NB: home builders might be classified under industrials).
Sometimes these firms also offer financing services through a separate arm. You might expect to see similar offerings from construction equipment (Deere and Deere Finance) or even automotive (ex: GM) makers.
Demand for houses is the strongest indicator of where this sector is going – in a poor economy with high unemployment, home building is not a great place to be.
Certain bankers might also cover aggregates, which are related to the materials used in home building or even infrastructure development (NB: companies in this space include Martin Marietta Materials, or Vulcan Materials).
Gaming: They should just call this one “Casinos,” but I guess “Gaming” sounds better.
There are pockets of activity around the globe known for this segment – Las Vegas, Atlantic City, and Macau come to mind (see page 19 here).
The key driver here is how well casinos can keep gamblers inside the casino and spending money (hence all those free bottles when you gamble away your bonus in Vegas…).
Casino operations also include expensive restaurants with some of the best chefs in the world, and elaborate shows with the biggest names in the entertainment (ex: Cirque du Soleil). So then it’s not surprising that the sector often features…
Lodging: Mostlyhotels and resorts (cruise lines sometimes fall under transportation). Pricing, promotion (think Priceline.com or Kayak.com), and the occupancy rates for hotels influence this sector.
The hotels themselves also offer conference/convention/trade show services as another source of revenue (if they’re in a major gaming hub).
Length-of-stay is critical and can be boosted by amenity expansion and upscale hotel additions. Proximity to other major cities is a driver in the Asia market, as is transportation infrastructure (See here for an example of a lodging company’s overview).
Unlike residential or commercial buildings, which feature long-term leases, hotels have “lumpier” and more seasonal revenue – which presents both a challenge and an opportunity.
Q: You discussed REITs above, but how often do you work with individual properties in a real estate IB group?
For example, would you ever be involved with selling or financing the acquisition of a regular apartment building?
A: It depends on the group, but at most large banks the focus is on REITs, the other sectors above, and companies that own chains of hotels and resorts rather than individual properties.
Partially, that’s because individual properties (with some exceptions) are generally not worth enough for us to get deeply involved; also, property sales are more the domain of real estate brokers rather than investment bankers.
Post-financial crisis, I’ve also seen real estate investment banking teams adopt a more principal-oriented approach to the real estate sector. Of course, you should expect the deals to be pretty sizable or notable to get the attention of an investment bank.
And if you look at top REITs, like Vornado (NYSE: VNO), the top leadership is comprised of former financiers and accountants – no real estate brokers or real estate developers.
So while the two fields are arguably similar, they are actually quite different. I’m not saying it’s impossible to go from one to another, but you would be better positioned coming in from a general finance background as opposed to a realty background.
Q: In the other sector interviews, we’ve seen the usual valuation suspects time and time again. How is real estate valuation any different?
A: That’s a really broad question, because valuation depends heavily on the sub-sector. You value a REIT differently from a home building company.
And you value individual properties differently from both of those. For hotels in particular, see Hotel Valuation Techniques By Jan deRoos, Ph.D., and Stephen Rushmore, CHA, MAI.
In general, real estate valuation is different from “normal company” valuation due to the metrics you use, but it’s not quite as different as valuation for banks and insurance firms, for example.
Q: Can you walk us through some of the key metrics then?
A: Sure. For individual properties, Net Operating Income (NOI) is one of the key metrics and is similar to EBITDA for normal companies. NOI is equal to Revenue Minus Operating Expenses Minus Property Taxes, and excludes Depreciation, Amortization, and Corporate-Level Income Taxes.
The NOI divided by the Property Value equals the property’s Cap Rate (also called the Yield in the UK and other regions), which is typically anywhere from 5-10%.
It’s the inverse of valuation multiples: a 20x multiple corresponds to a 5% Cap Rate, and a 10x multiple corresponds to a 10% Cap Rate.
Then on the REIT side, you can sum up all the REIT’s individual properties to get a picture of what the entire firm looks like.
Q: But do you use the same metrics for REITs?
A: Technically, you can calculate NOI and Cap Rates for REITs, but the most important metric by far is Funds from Operations (FFO), which is defined as Net Income + Depreciation & Amortization – Gain / (Loss) on Sale of Real Estate.
The idea is to say, “On a normalized, recurring basis, how much in earnings are we generating?”
Gains and losses are non-recurring, so they’re subtracted; and D&A is extremely large but it’s non-cash and deceptive for real estate because most properties increase in value over time.
That is just the basic idea – you see all sorts of variations, such as Adjusted Funds from Operations (AFFO), where you subtract Maintenance CapEx to more closely approximate cash flow, and then metrics like AFFRO that make other adjustments depending on the industry (e.g. straight-lining of rent).
All REITs break out FFO in their filings, so that’s your best source for the actual numbers.
Dividend yields and dividend payout ratios are also important to analyze for REITs because of the requirement to issue 90% of taxable income as dividends to avoid corporate-level income taxes.
Q: OK, so let’s go through the different methodologies now.
A: Sure… I’ll start with the intrinsic side:
Dividend Analysis (AKA Dividend Discount Model): This approach considers a 5-year projection with discount rates as well as a terminal value calculated either by a multiple or a perpetuity growth approach.
Discounted Cash Flow: Stream of Funds Available for Distribution = FFO – normalized recurring capital expenditures. As you know, this requires determining cost of capital, and discounting streams into present value.
With REITs, DCFs and Dividend Discount Models can often give you similar values because FFO – Recurring CapEx tends to be close to the actual dividends issued.
Net Asset Value: This one is specific to real estate, and it’s different from what you see for oil & gas companies and other types of NAV models.
The idea is that you take the REIT’s projected NOI and divide it by the appropriate Cap Rate (you can go granular and divide this into different regions or property types) to figure out the value of their gross real estate assets.
Then you add in other assets, exclude Accumulated Depreciation, and subtract Liabilities to determine the NAV. You can also calculate NAV Per Share and look at the premium or discount to the company’s current stock price.
Q: That’s a lot of information, but it sounds like NAV is the key methodology that’s a lot different from what you see in other industries.
What about relative valuation and multiples?
Q: Sure. Just like other industries, you can still use public comps and precedent transactions, and sometimes you even see EV / EBITDA multiples used there.
But more common are FFO and AFFO multiples, both of which are Equity Value-based (since you start with net income).
Occasionally, you also see Earnings Before Depreciation and Deferred Taxes (EBDDT).
And then you have the other analyses that pop up when looking at M&A deals: Contribution Analysis (the % of the combined entity that each company in a merger would receive based on their FFO contribution), accretion / dilution analysis, trading analysis (comparing a target stock to a composite index), and even looking at research analyst price targets.
Some firms also use Prospective Buyer Analysis to see if other buyers could execute the transaction without having EPS decline immediately afterward; you’ll see it referred to as Affordability Analysis as well.
Q: Once again, lots of information there – but it sounds like the different multiples are the main point to keep in mind?
A: Pretty much. Again, sometimes you will still see EV / EBITDA used, especially outside of REITs for industries such as home building.
I would also take a look at these Fairness Opinions to see good examples of how banks value real estate firms in real life:
Note how the Gaming valuation uses very standard multiples and methodologies: EV/EBITDA, P/E, and an unlevered DCF. Here’s an example of a confidential information memorandum
If you were to buy a portfolio of real estate properties, you might have to value each property on its own (using Cap Rates and perhaps a type of DCF analysis).
Life in Real Estate
Q: That’s a very helpful explanation of real estate valuation.
What about the popular deal types in the sector? Will you be doing lots of M&A deals, or are financings more common?
A: Capital raisings are far more common, at least for REITs – as mentioned above, they constantly need to raise debt and equity to continue acquiring, developing, and renovating properties. Financings are more common in the other sectors as well.
M&A is not quite as common because there aren’t too many REITs to begin with – it’s not like other industries where there were hundreds or thousands of potential targets, so most acquisitions are of assets (individual properties) instead.
Firms also tend to lack cash and the ability to raise debt (since they’re already heavily leveraged), so 100% stock deals are the most viable option, but those present risk to both parties.
When M&A does happen, geographic presence tends to be a key driver: one firm is strong in the Northeastern US but wants to expand to the Midwest or Southwest, for example.
Deal flow also runs in patterns: if one real estate firm raises capital, a competitive firm will likely do the same. In fact, I had one week where all the biggest REITs raised equity right after one another.
This is not to say that you’ll never get exposed to M&A, but financings are definitely more common here.
Q: So if you like real estate, where would you go work? Are any banks particularly strong in the sector?
A: Real estate, like the financial sector, requires drawing on a large balance sheet because of the high percentage of financing deals.
Expect Bank of America Merrill Lynch and Deutsche Bank to be near the top of the league tables.
Any day of the week, you can use Bloomberg’s <LEAG> command, and click ‘Financial Advisors.’ Click any of the names, and you can see a list of deals done by the firm. Easy!
Q: Finally, some people claim that going into real estate makes your skill set much more specific and limits you to ONLY real estate-related opportunities.
What’s your take on that? Are there good exit opportunities?
A: I think there’s some truth to those claims, but it happens with most industry groups: you tend to get pigeonholed into doing the same thing on the buy-side, regardless of whether you start out in TMT, industrials, or any other group.
So yes, recruiters are more likely to get you interviews with real estate-related groups.
If you want to move elsewhere, you need to demonstrate interest in other areas by researching them, reading sector pages, and reading the articles on this site about other groups, areas, and regions.
In terms of exit opportunities within real estate, REITs are a common destination for analysts; some people also move onto real estate private equity firms or hedge funds.
It’s not quite as common to move into plain vanilla private equity, but sometimes it happens.
Moving into real estate development is rare because the skill sets are totally different and development is much more “brick and mortar” than working with REITs, home building firms, and so on.
Q: Awesome! Thanks for your time. Really enjoyed the chat.
A: No problem – hope it was helpful.