Ah, reality TV.
Donald Trump might have moved on to other ventures since he made his fortune in real estate, but that doesn’t mean you should abandon your dreams of becoming a real estate guru.
Before diving in, though, you need to learn about the field, how properties get constructed, and how real estate investment trusts (REITs) work.
In other words, real estate financial modeling.
Read on, and you might just be on your way to becoming the next Donald Trump.
If you’re reading this, I’ll assume that you know what a property is.
Broadly speaking, “property” refers to land, buildings, or factories that are worth something – but for real estate modeling specifically, “property” means “a building that earns revenue and profit and can be bought and sold.”
Examples: apartment buildings, homes, offices, hotels, storage facilities, and healthcare facilities such as nursing homes.
Real property can be divided into a few categories:
The business models, typical profit margins, and valuations of each segment differ.
For example, hotels have much less predictable revenue streams since each customer only books a room for a few nights, while apartments often have year-long leases and office and retail spaces often have multi-year leases.
Right above individual properties, you have real estate investment trusts (REITs), which are companies that buy, sell, and operate dozens, hundreds, or thousands of properties.
They’re like private equity firms, but for properties rather than companies.
And they operate the same way as PE firms do: they raise money from investors and then acquire properties using a combination of debt and equity, operate and improve the properties over time, and eventually sell them.
Equity REITs do what I described above and acquire entire properties, while mortgage REITs just buy and sell mortgages; hybrid REITs do both of those. Equity REITs are far more common than the latter two categories.
And then you can divide REITs by the property type they focus on: residential, hotel, office, storage, and so on.
Let’s start by walking through individual property modeling: how you think about building an entire apartment, office, or hotel, and then how to estimate the expenses, revenue, and the sale price.
Property modeling gets very involved and there’s a lot of jargon along the way – this article just an introduction and a quick reference for you, so I’m not going to write 50,000 words here on all the nuances.
(If you want to “go deep”, you should consider investing in our full Real Estate Financial Modeling Course.)
Think of real estate financial modeling as “startup meets leveraged buyout”:
Compared to normal financial modeling, here are the key differences:
First, you need to figure out how big your property is. You measure this in square feet or square meters, and occasionally in other units like acres (43,560 square feet) or hectares (10,000 square meters).
Once you figure out how big the block of land will be, you have to take into account that the entire area will not be rentable: only a small portion will be.
So you calculate the gross area and rentable area (usually a percentage of the gross area, based on local zoning requirements), and then figure out how much everything will cost to develop.
There are 5 big categories of expenses with properties:
Once you’ve estimated all these items, you can come up with a rough estimate of how much the property will cost to develop.
Then, you deliver that estimate to your investors. The two main sources of funding for property development are equity (cash) and debt.
Within equity, there’s developer equity – what you, the developer of the property are throwing in – and then 3rd party investor equity – what other investors are contributing to get a percentage of your property.
Developer equity tends to be a much smaller percentage than 3rd party investor equity, and altogether both forms of equity take up a minority (often 20 – 30%) of the total funding.
Similar to the leverage ratio in an LBO model (video), you use the Loan-to-Cost (LTC) Ratio from similar developments in the market to figure out what percentages of debt and equity makes sense.
Normally you start off with the assumption that the total debt and equity required equals the Hard Costs + Soft Costs + Land Acquisition Costs + FF&E + TIs.
But once you go in and complete more of the model, you also need to add in capitalized interest and the operating deficit (i.e. how much the property loses before it starts turning a profit) to the total funds required.
They say real estate is “Location, location, location” but real estate development is “Timing, timing, timing” (and location).
Once you’ve figured out the total costs, next you need to divide the construction into phases.
The three most common phases are pre-construction, construction, and post-construction, and they may last anywhere from 1-2 years (divided into months in your model) each depending on the complexity of the development.
Then, once you have a rough sketch for how much in development costs you’ll incur each month in your timeline you can begin thinking about revenue, operating expenses, and property taxes.
Revenue categories depend on the type of property: for hotels, you’d look at the Average Daily Rate (ADR) times the number of rooms times the average occupancy rate (and then look at other sources such as food & beverages, events, telecom, etc.).
But for offices or retail, you’d just estimate the rate per square foot or per square meter, multiply by the rentable area, and then multiply by the occupancy rate.
For apartments, there are two big revenue sources: monthly rent and monthly parking fees.
To estimate monthly rent, you would look at the rentable area of the property, figure out how much space you need for an individual apartment unit, and then determine how much to charge tenants.
Let’s say you have an apartment complex with 200 units, each of which is 50 square meters (~538 square feet). In a big city, you might get $2,500 per month for that, which gives you $6 million in rental income (200 * $2,500 * 12).
You could calculate parking revenue by estimating how many parking spots are required for each unit, and then the monthly rates for each spot.
But wait: it’s not quite as simple as adding these two numbers to calculate total revenue. You also have to net a vacancy allowance against this number to reflect the fact that not all your units will be filled at all times. A typical number might be in the 5-10% range.
Once you’ve done that, you can calculate annual net revenue.
Then you need to calculate the operating expenses (maintaining the property, paying for insurance, utilities, and so on depending on the lease terms) and the property taxes (based on the zoning regulations in the area).
Usually you estimate these on a per square foot or per square meter basis, based on similar properties in the area.
Then you can take the net revenue and subtract operating expenses and property taxes to get…
The net operating income (NOI) of the property.
NOI is similar to EBITDA for normal companies, because it:
Net operating income gets a bit muddy when it comes to capital expenditures (CapEx).
Some people do include maintenance CapEx – what it costs to maintain your property in its current condition – but it is never correct to include items like acquisitions, developments, or renovations because those represent growth in the property.
So, bottom-line: you need to dig in and figure out how the person calculated NOI and whether or not they’ve subtracted maintenance CapEx.
Once you have the Net Operating Income (NOI), you can calculate the Capitalization Rate, also known as Cap Rate, or Yield in some countries (such as the UK):
So let’s say your new apartment complex will generate $6 million in annual net operating income, and you want to sell it for $100 million. The cap rate there would be 6%.
Cap rates are the inverse of valuation multiples, because a higher cap rate means that the property is worth less; a 10% cap rate corresponds to a 10x multiple, but a 5% cap rate corresponds to a 20x multiple.
Generally you see cap rates between 5% and 10% across all property types, with lower cap rates in big cities and higher cap rates in the middle of nowhere.
OK, so now you’ve got the estimated monthly development expenses and your monthly NOI based on the net revenue minus operating expenses and property taxes.
So now you need to calculate how much funding you need to construct the property and operate it until it reaches profitability.
Once you’ve done that, you gradually draw on equity until you’ve hit the maximum allowed number (based on investor demand and what they’re willing to pay), and then you start drawing on debt until you no longer need funding and the project reaches profitability.
When drawing on the debt, you also need to capitalize the interest payments until you have enough cash flow to pay interest in cash – so that number will add to the total funds required in the beginning, creating a circular reference.
For a real-world example of this, here’s a free video tutorial on Equity and Debt Draws and Optional Debt Repayment in an office development.
Just like in a leveraged buyout model, you assume that the property is sold at the end of the period you’re looking at – normally around 5 years – and you base this selling price on the cap rate for similar properties in the area and what your NOI is in year 5.
Let’s look at some specific numbers and put everything together:
So the sale price of the property would be $8 million / 7%, or approximately $114 million.
But you’ve also drawn on $60 million of debt, which needs to be repaid – so that brings your net proceeds down to $54 million (we’re ignoring selling and transfer fees here).
So, what happens when you invest $20 million in year 1 and then earn $54 million back in year 5?
Using Excel, you can enter -20, then 0, another 0, another 0, and finally 54 and then use the IRR function to get your answer: it’s a return of approximately 28%, which is very good by anyone’s standards.
In real life, property developments often have much lower returns because sale prices and cap rates are unpredictable; projects also tend to run over-budget and behind on schedule.
So now you understand the basics of how property development works. We’re in “crash-course” mode here so we’re moving onto the next topic: how properties and REITs are connected.
Luckily, it’s pretty simple: a real estate investment trust (REIT) owns dozens, hundreds, or thousands of properties.
They can then do 4 things with these properties:
So when you project a REIT, you use the cap rates, NOI, and property values of entire property segments to estimate what happens in each category above.
Rental income across all the properties becomes the REIT’s revenue, and then the operating expenses and property taxes of all the properties become (part of) the REIT’s expenses.
Other key expenses include corporate overhead and G&A, depreciation (ignored at the property-level, but extremely important at the corporate level), and interest expense (REITs need lots of debt to buy properties).
Then, all the property itself shows up on the REIT’s balance sheet as an asset, and line items like development, acquisitions, maintenance CapEx, and the sale of real estate assets show up on the cash flow statement under Cash Flow from Investing (CFI).
So How Do REITs Work, Exactly?
That’s how properties and REITs are connected, but there are a bunch of other requirements for REITs:
These are the requirements for US-based REITs; they differ by country but they generally follow the guidelines above, sometimes with slightly different numbers.
Now, think about what the above requirements mean: REITs need massive amounts of funding because they need expensive real estate assets on their balance sheets… but they must give up 90% of their profits each year in the form of dividends.
So they can never save up a huge amount of cash on their balance sheets.
Instead, they must rely on constantly raising debt and equity and selling properties to properly fund their operations.
As we move through a REIT’s financial statements, keep in mind the points above on a REIT being comprised of individual properties, the lack of corporate income taxes, and the constant need to raise funds via debt and equity.
Just as with banks, insurance firms, and oil & gas, the income statement looks the most different for REITs, followed by the balance sheet and then the cash flow statement.
Here’s what a REIT’s income statement might look like, from Revenue at the top to Net Income at the bottom:
To get a real-world example of a REIT’s financial statements, click here to see the historical statements of AvalonBay (a residential REIT).
Unlike a traditional company’s balance sheet, a REIT’s balance sheet is split into Real Estate Assets and Other Assets on the Assets side.
The other side is more traditional, with categories for Liabilities and Shareholders’ Equity.
Here are the most common items on the Assets side in each category:
The Accumulated Depreciation number tends to be massive, which creates problems for our valuation, as you’ll see later on.
Also, note how the Real Estate Assets are not separated into the categories you might expect – Existing Properties, Developed Properties, Acquired Properties, etc.
It would make our lives easier if they were, but REITs must follow GAAP / IFRS conventions for asset categories on their balance sheets.
Now, onto the other side:
Redeemable Noncontrolling Interests go beyond the scope of this tutorial, but refer to the REIT’s option to repurchase part of the corporate partnership structure from investors.
The cash flow statement is very standard: start with net income, add back non-cash charges such as depreciation, amortization, and stock-based compensation, and then take into account changes in operating assets and liabilities to calculate cash flow from operations.
Cash Flow from Investing for REITs refers to anything related to their Real Estate Assets: development, acquisitions, capital expenditures, and selling property, land, and so on.
Cash Flow from Financing includes all the normal items: raising and paying off debt and preferred stock, issuing stock, buying back stock, and issuing dividends (huge for REITs).
To get a flavor for how some of this works, click here to view a free sample lesson on how to model dispositions and discontinued operations for AvalonBay.
Let’s start with operating and valuation metrics that are not meaningful for REITs:
So rather than the metrics above, there are two new important metrics you need to know when analyzing REITs:
With FFO, you are approximating how much the REIT can actually issue in dividends on a recurring basis from year to year.
D&A is always non-cash and does not affect its dividend-issuing capacity, so you add it back; losses and gains are assumed to be non-recurring, so you also exclude those.
The only issue with FFO is that you’re not taking into account the CapEx required to maintain all your properties, which is why AFFO exists.
Many analysts argue that AFFO better represents how much in potential dividends a REIT can issue on an ongoing basis, because they must maintain their properties no matter what else they do.
Then there are a few other metrics to know: for example, you can calculate Net Operating Income (NOI) for the entire REIT by summing up the NOI of all its properties, and you can also calculate the REIT’s Cap Rate by dividing its NOI by the gross real estate asset value on its balance sheet.
Dividend Payout Ratios (Dividends / Net Income) are also important to track because a REIT must pay out at least 90% at all times to avoid corporate income taxes.
Sometimes you also calculate Dividends / FFO or Dividends / AFFO and call those “Payout Ratios,” under the argument that FFO and AFFO are better metrics for how much in dividends a REIT can really issue.
Click here to see a real-world example of how AvalonBay calculates FFO in its filings (see page 2 of the PDF).
Just as with other industries, the formula is the same here: familiar methodologies with different metrics and multiples, and then a few new techniques.
So you still use public comps and precedent transactions, and you can even use a DCF to value a REIT if you want, though that’s not very common.
For the public comps and precedent transactions, the key metrics are FFO and AFFO and the corresponding valuation multiples are Equity Value / FFO and Equity Value / AFFO (sometimes you see these calculated as Price Per Share / FFO Per Share and Price Per Share / AFFO Per Share).
You usually screen for comparables and transactions based on gross real estate assets rather than metrics like revenue or EBITDA, and you may do another cut based on REIT sub-industry (residential, hotels, offices, etc.).
There is usually a correlation between FFO and AFFO multiples and the Cap Rate of the REIT – a lower Cap Rate means that the REIT’s portfolio is worth more, which (theoretically) means that they should have higher valuation multiples, and vice versa.
Sometimes you also calculate the FFO Yield (1 / FFO) and the AFFO Yield (1 / AFFO) and compare those to the Cap Rate of the REIT’s entire portfolio to see whether the public markets are valuing it correctly.
Remember the point above about Book Value not being a great metric for REITs due to their high Accumulated Depreciation balances?
You can fix that and value a REIT using its balance sheet with the Net Asset Value (NAV) model.
This is a different NAV model than what you see for oil & gas companies, or for insurance firms (confusing, I know).
Here’s the basic idea:
As you can see, the mechanics of a NAV model are not difficult: you’re just modifying balance sheet values and picking Cap Rates.
What is difficult is determining how to modify everything and the specific Cap Rates to use in the first place.
The theory behind a NAV model is that private markets, at least for real estate, are often more efficient than the public markets – so the prevailing Cap Rates by property and geography can be more accurate than the public market valuation of a REIT.
That’s a nice theory, but picking the appropriate Cap Rates is difficult and time-consuming and you need knowledge of the local real estate markets, or access to brokers and developers in those markets, to do any of this.
Assuming you can actually pick the Cap Rates and value everything else on the balance sheet properly, you can then compare the NAV Per Share to the REIT’s current stock price to see whether it’s trading at a discount, premium, or at about the right level.
Replacement Cost, also known as Replacement Value, is another real estate-specific valuation methodology.
Just like the NAV model, the idea is simple: you look at the gross area of your property and estimate how much it would cost to re-construct the entire property today, based on the Hard Costs, Soft Costs, Land Acquisition Costs, FF&E, and TIs per square foot or per square meter.
So let’s say you add up all of those and it comes out to $750.00 per square foot. But the asking price for the property is $800.00 per square foot.
In that case, it would seem that the property is slightly overvalued since you could theoretically construct a new, identical property for less than the asking price.
However, that logic doesn’t exactly hold up in the real world because constructing a new property is risky and time-consuming, often runs over-budget and behind-schedule, and you can’t build the new property in the same exact location – so there are no guarantees that it will be worth as much.
So Replacement Cost is used as more of a “sanity check” than anything else. You use it to see whether the asking price of a property roughly makes sense rather than as a strict valuation methodology.
And while you can technically apply it to REITs as well, it’s mostly used for individual properties due to the time-consuming nature of the analysis and the inability to get good estimates of the expense per square foot or per square meter in different regions.
Now for the easy part.
Just as with merger and LBO models in other industries, there’s nothing mechanically different about either one for REITs: you still combine the 3 statements and allocate the purchase price in a merger model, and you still use a combination of debt and equity and then sell the company after 3-5 years in an LBO model.
The differences relate to purchase methods and the viability of deals rather than the mechanics.
With a merger model, for example, it’s nearly impossible for a REIT to use much cash or debt – they have little cash due to the “issue 90% of taxable income as dividends” requirement and they tend to be highly leveraged already – so 100% stock deals are extremely common.
Just like normal companies, REITs are motivated to merge to reduce costs and earn more revenue, but often they are also geographically motivated: two competing REITs in one region, for example, might decide to join forces and gain more pricing power so they can raise rents and avoid competing with each other.
And then there are a bunch of smaller differences: no corporate income taxes when calculating accretion / dilution, asset write-ups perhaps based on Cap Rates instead, and accretion / dilution of metrics such as FFO Per Share, AFFO Per Share, and Dividends Per Share in addition to the standard EPS.
REIT LBO models are not terribly common in normal economic times because REITs are highly leveraged by nature; it’s hard to realize a good return if the company already has a high debt load.
They are still more common than oil & gas or commodities-related LBOs because rental income is a much more stable than revenue earned from volatile commodity prices.
But in general, it’s tough to realize a great IRR solely through “financial engineering” – adding on additional debt – unless the PE firm in question also has plans to improve the REIT’s properties or operations in some way.
That was quite long, but we’ve actually just scratched the surface of real estate and REITs.
And you may not be Donald Trump quite yet, but if you’ve made it this far you’re more than prepared to dominate your interviews and land offers in real estate investment banking groups, real estate PE, and even at that REIT you’ve been eyeing.
Remember the key real estate development terms outlined above, the most important REIT metrics, and the NAV model and you’ll be ahead of 90% of the competition.
Good luck, and let me know when you have your own tower (or two)!
P.S. To get the full scoop on real estate, click here to check out the full Real Estate Financial Modeling Course.