Friday, July 8, 2016

Using Price Per Square Foot as a Valuation Metric

Recently my company hired a new senior level acquisitions person with about 30 years of experience to head up our general office division. I work under a few different VP level acquisitions guys and each has their own style, own types of deals they like and key in on different valuation metrics. Some lean heavily on IRR to evaluate their deals. Others use net cash flow, others focus on the going in cap rate to measure their deals, and others yet, like this new senior level acquisition person at my company, really focus on price per square foot--the going in amount and exit amount.

I've never really thought of price per square foot as a very relevant valuation metric, to be honest. so it was a little weird seeing such a seasoned pro rely on it. The reason I've never found it all that relevant is because in pure finance type thinking, it's basically useless. Finance, at its most basic level, says that an asset is worth the stream of cash flows that it will generate while you own it, discounted based on a specified rate. In that sense, the purest, most financially sound method of valuing a property is to project the cash flow it will generate and then discount the cash flows with your desired rate of return, sum up the present values of those cash flows, and that's what the asset's worth. Nowhere in that process does price per square foot factor in.

Of course there's some issues with using the discounted cash flow method to value a property, the primary reason being estimating your cost of capital or cost of equity for a project is actually very, very challenging. That's why IRR is so popular. It's basically using the same method as the discounted cash flow method, but instead of feeding a discount rate into a calculation, IRR just spits out a percentage that you can use to compare investments without feeding it a discount rate.

Back to price per square foot. I've always looked at price per square foot as a gut check, secondary metric that helps justify the purchase price calculated from a DCF or IRR. For example, I'd calculate a purchase price based on a needed IRR. Then I'd take that purchase price, divide it by the property square footage to arrive at a price per square foot. Then it's just a matter of finding comparable sales and seeing what price per square foot they traded at. If the comparables are relatively close to what I calculated, great. If they're way far off, maybe it's worth taking a look at the pro forma again to see if there's a misguided assumption baked in.

This senior level acquisitions guy, for the most part, doesn't need all of that fancy ARGUS / excel pro forma wizardry to arrive at a valuation of a property. A broker will pitch him a deal, he'll think about it for a few minutes, and then do the following type of back-of-the-envelope calculation. He'll say, okay, properties in this market, fully stabilized, are worth $300 per square foot. Then he'll say, this property is for sale for $175 per square foot. However, to stabilize the property, it'll cost $50 per square foot in capex, another $40 per square foot over the whole property in TI's, and maybe another $10 per square foot in leasing commission costs over the whole property. In this scenario, we'd be into the project for a total of $275 per square foot. If we sell at $325 per square foot, that leaves the company a profit of $50 per square foot. If the property is 100,000 square feet, then the total profit we make is $5M.

Then he does one more calculation. He analyzes if that's enough profit for the risk level of the deal and the amount of company time it'll take to successfully execute the project. I have no clue what exactly goes into that part of his analysis, but sometimes $5M is enough profit to justify a deal, and other times it's not. Overall, it's been interesting to him operate and it gave me a new way to think about real estate valuation. Do I think it's better? No, but then again, I'm a total finance nerd and don't have 30 years of experience. In general, I think my generation is of real estate professionals is much more analytically oriented and prefers that type of heavy lifting analysis, but that's another post for another day.

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