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A set of securities which can be logically grouped together based on their characteristics (risk, return etc.) is known as an Asset Class. Typically securities are grouped into 4 asset classes:

  • Equities (stocks)
  • Fixed income (bonds, debentures etc.)
  • Cash equivalents (money market instruments)
  • Alternative investments (derivatives, commodities, real estate etc.)

Real estate is a unique asset category within alternative investments because of its peculiar characteristics:

Real estate is a lumpy investment

The size of the smallest unit of real estate is much bigger compared to other asset classes e.g. it might not be practically possible to buy 10 square feet of an apartment or a piece of land. While this is true, Real Estate Investment Trusts (REITs) help in reducing the lumpiness and enable participation of small investors, to a certain extent.

Real estate investments are illiquid.

The number of real estate transactions is low because:

    • large ticket sizes of the transactions
    • high amounts of taxes (depending on the country)
    • absence of efficient market places for real estate (similar to stock exchanges)
    • long periods required for construction of buildings (varying from a few months to a few years depending on the complexity and sizes of the buildings)
    • legal procedures such as formal agreements of sale which needs to be registered with the local government

    The pricing of real estate can vary significantly due to local or at times hyper local factors.

    While stock prices tend to be affected by overall economic scenario, industry specific and business/company specific events, prices of real estate may also depend on hyper-local factors. E.g. the location of next big shopping mall or office complex or the next metro station in the proximity to the property can significantly affect the prices apart from the other factors mentioned above.

    Real estate can provide shelter and can generate rental/ lease income.

    Trivial but important characteristic, that none of the other investments allow right of ownership of a place where anyone can take shelter. Real estate can generate significant rental/ lease income which can help in maintaining certain level of liquidity. The rental income generated from real estate is comparable to the dividend income from equity or interest income from bonds.

    Real estate is peculiar in many ways but that is also likely to help with benefits of reducing risk through diversification. When it comes to valuation of real estate, these peculiarities would have to be considered for the purpose of valuation. The impact of various factors on the cash-flows needs to be incorporated appropriately in the financial model. To better appreciate the pricing dynamics of real estate, it would be useful to understand how a real estate developer would go about pricing smaller units within a project. Following generic process can be used as a guideline for real estate modeling.

    Land area and construction area

    Based on the requirements of construction area, a suitable land parcel would have to be located and the rights of construction on that land would have to be obtained. The land requirements would also have to consider the requirements for various amenities and basic infrastructure needs. The land may be purchased or acquired on a long term lease basis.

    Estimating Capex Schedule

    The project is typically planned in different phases and the cost of construction for each of the phases is estimated based on the plan and assumed inflation. Based on the capex requirements, funds would be planned to be met through various means such as available cash, equity or debt.

    Accounting for interest during construction

    During the phase of construction, cash-inflows are minimal and cash outflows are high. If the funds are raised through debt, the interest on the debt would also have to be raised and considered to be a part of the project cost.

    Estimating Operating Expenses

    Apart from the capital expenditure, there would also be certain operational expenses, at least in the initial few years. These are also included in the cash flow projections. As and when the property is occupied by buyers or tenants, the operational expenses towards maintenance may be passed on by the developer, at times with a mark-up.

    Estimating Revenues

    Based on assessment of various demand and supply factors, selling prices and sales volumes are projected. In case of commercial properties, typically lease revenues are estimated instead of revenues from sales. As and when the property is occupied by buyers or tenants, the operational expenses towards maintenance may be passed on by the developer, at times with a mark-up. This also adds up to the revenues.

    Cash-flow analysis

    Based on all the estimates above, projected net cash-flows are derived and are used for calculating the project IRR (indicator of financial health of overall project) and equity IRR (indicator of returns realizable by the equity investors).

    Scenario analysis/ Sensitivity Analysis

    This is the stage of final assessment of all the inputs (assumptions) and various risks (variations in outputs such as IRRs). At this stage, key inputs such as costs and selling prices for the project are assessed from the project viability point of view.

    Awareness of this process can help the investors in analyzing and estimating the right price for any real estate investment. The same process of valuation can be followed by the buyers, sellers, and the intermediaries such as brokers or even investment bankers. The amount of time and resources spent on the process of real estate valuation would depend on:

    • Size of the proposed investment
    • Amount of time available depending on demand/supply dynamics
    • Regulatory requirements
    • Communication requirements of investors (equity/debt)

    Quick Summary
    For real estate valuation, it’s critical to assess all the important factors which are specific to real estate but it would also be important to decide upon the amount of time and resources that needs to be spent on the valuation.
    Happy Real Estate Modeling and Investing!