If you think it’s easy being a CFO, think again. You have internal pressures from the acquisitions and investments team to fund cash quickly, manage liquidity so everyone gets paid, quickly and correctly prepare your real estate valuations, and keep your investors (and auditors) happy. That’s a tall order.
Let’s say that you’re the CFO of a commercial real estate firm. It’s year-end, and you have to review your real estate valuations. You may be overwhelmed by the sheer volume of work. You may be tempted to cut corners. To avoid making mistakes in your haste, here are the 5 things that I’d never do as a CFO: real estate valuations edition.
1) Fail to review valuations
You may think this is an unnecessary mention, but I’ve seen enough CRE firms to know that this is worth mentioning. Depending on the size of your firm, you may not need to perform a detailed review of each valuation model (and roll-up, if a fund). That said, someone at your firm needs to perform a detailed, line-by-line review of each valuation.
They should sanity-check totals. Confirm the accuracy of formulas. Review reasonableness of variables. Determine whether quarterly or yearly changes in valuation make sense.
Ideally, you have at least one person performing an extremely detailed review, and another person performing a more high level “does this all make sense together?” type of review. If you’re the only reviewer, then do a detailed review, sleep on that, and then do a cursory second check.
2) Not support the cap rates used in the income approach
Real estate firms typically use one of the following three methods for valuing their properties:
The most common approach is the income approach. This is also commonly referred to as the DCF, or discounted cash flow, approach.
With the income approach, you predict the next 12 months’ net operating income for each investment. Then, you determine the market cap rate for your investment. Since you have the market cap rate and forward 12 months’ NOI, you can presume to know what the property/portfolio would trade at if it sold today. Calculate the investment’s value by dividing the forward 12 months’ NOI by the cap rate. You’ll need to account for the capital stack, which I’ll address next. For purposes of determining the overall property or portfolio valuation, the two key ingredients are forward 12 months’ NOI and the market cap rate. The market cap rate sounds pretty important, eh?
It is. And that’s why you need to support it. No self-respecting auditor is going to let you sneak by with a host of cap rates for various markets without justifying *why* you chose those cap rates. You can support it with research data services, BOVs or recent transactions from other properties that you’ve recently sold nearby, or other data sources. Regardless, you need to support where you got your market cap rate from and justify why that’s appropriate for your investment.
3) Forget to account for highly liquid assets in your real estate valuations
This one may surprise some of you! If you think about it, the income approach, BOV, and sales comps methods work to determine the current value of the real estate, not taking into account the current cash held by the real estate’s legal entity (or entities). If you have a material amount of cash sitting on your investments’ books, then you better include it in your total valuation of the investment.
4) Apply incorrect or incomplete prepayment penalties
If you have debt on your investment, then you must take into account the debt when valuing your equity. In other words, if you sold the investment today – or whenever you’re valuing it – then you would need to pay off the debt in full. Many commercial real estate loans come with prepayment penalties. Be sure that you account for those by reducing the amount of equity you’d receive by the prepayment penalty you would have to pay.
5) Fail to verify and document the waterfall structure and debt agreements
Now, this one is the most common of all. We often get in a rhythm of checking the box on valuations. Quarter after quarter or year after year, not much often changes for a single investment. The seemingly routine tasks involved in valuation may lead you to become lethargic. I strongly advise you to avoid this with the plague.
The easiest way to improperly value your real estate investment is not to make a mathematical error; it’s to fail to update your waterfall structure or debt information when a change has occurred. Not all changes involve capital transactions; for example, you may have added a GP to the investment who did not put in any cash, but they will receive payment for their “sweat equity” in the waterfall structure.
You also need to ensure that you have documentation of each of these agreements handy. In the likely event that an auditor requests them, you’ll be prepared. Or god forbid, the SEC makes a surprise visit… well, you’d be prepared for that too.
That’s a wrap, folks! I hope that you enjoyed the 5 things that I’d never do as CFO: real estate valuations edition. Let me know if you have any that you’d avoid too. I always love hearing from you.