In a typical commercial real estate investment, there are two sources of investment returns. The first is the periodic income the property produces after all operating expenses are paid – a small but consistent portion of total returns. The second is the profit upon sale of the asset, which is a one time event at the end of the investment holding period. Although it only happens once, this profit can make up a larger portion of the total return than income. The exact amount of profit is dependent upon the property’s residual value at the time of sale.
In this article, we are going to discuss residual value as it relates to commercial properties. We will describe what it is, why it is important, and how it contributes to the total return in a CRE investment transaction. By the end, readers will have a more thorough understanding of this concept and will be able to incorporate this knowledge into their pre-investment due diligence process.
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What is Residual Value?
In a commercial property context, residual value is the value of a property at the end of the investment holding period. Ideally, it is more than the purchase price paid to acquire the property. NOTE: The term “residual value” is also used to discuss the value of an asset at the end of its useful life. This is not the context covered in this article.
For example, suppose a real estate investor purchases a commercial property for $1,000,000. Also suppose that they hold it for 10 years and, at the end of the 10th year, they sell it for $1,750,000. The sales price is the residual value.
Projecting Residual Value
Conceptually, the idea of residual value is simple enough. In practice, projecting it accurately can be much more difficult because analysts must make a number of assumptions that may or may not turn out to be true. The further out the projection, the less accurate residual value estimates tend to be.
But, when estimating potential total returns for a commercial property investment, the residual value makes up a large portion of the investment return so it is critical that it is as accurate as possible. Ultimately, the decision to invest or not is heavily influenced by the residual value estimate.
Calculating Residual Value
Residual valuation is typically calculated prior to making a purchase and it is usually done in one of two ways.
Income Capitalization Method
The first method is known as the income capitalization method. With it, investors create a proforma projection of income and operating expenses over the duration of the planned investment holding period. To complete this task, real estate investors must make certain assumptions about things like interest rates, income growth rates, vacancy rates, property tax growth, and market conditions over a multi-year span. From these figures, Net Operating Income (NOI) is calculated as gross income less expenses.
In the final year of the holding period, a capitalization rate is applied to NOI to determine the residual value. For example, if NOI in the final year is $100,000 and an investor chooses a 7% cap rate, the residual value is estimated to be $1,428,000 ($100,000 / 7%). Typically, the cap rate is chosen based on a combination of recent sales of comparable properties, experience, and assumptions about market conditions at the end of the holding period.
Sales Comparable Valuation Method
The other option to determine market value at the end of the holding period is to use the sales comparison approach. With it, investors look at sales of comparable properties in the same market and calculate a per square foot value they can apply to their own property. For example, if comparable properties sell for an average of $100 PSF and the potential investment has 10,000 square feet, they may safely assume the residual value of the property is $1,000,000.
Again, this valuation methodology requires a set of assumptions about inflation during the holding period and market conditions at the time of sale, both of which can be incredibly difficult to predict.
Residual Value Example
To illustrate the importance of residual value in a commercial real estate transaction, an example is helpful. This example is simplified for the purposes of explaining how residual value works
Suppose an investor considers the purchase of a multifamily property for $1,000,000 with a planned holding period of 5 years. For the sake of simplicity, also assume they pay cash for the property.
To figure out how much of a return they could potentially make, they create a proforma for the entire investment holding period. In each of the 5 years, the property returns $50,000 in cash flow/NOI, which provides a nice consistent return. But, at the end of the holding period, a 4% cap rate is applied to the $50,000 in income to assume a residual value of $1,250,000.
In this example, the property produced $250,000 in total income over the five years and then it produced another $250,000 in profit upon sale of the property. Based on these figures, the investor would calculate their return metrics like Internal Rate of Return and Equity Multiple. Based on the result of these calculations, a decision is made to pursue this opportunity or not.
A Word About Assumptions
In commercial real estate, investment returns are made over the long run. Practically, this means that the plan for most investment properties is to buy them, hold them for 5-10 years while trying to make them more valuable, and then sell them for a profit.
This means the financial model used to calculate returns must incorporate a number of assumptions that have a major impact on the residual/resale value of the property. Some of the major assumptions necessary are:
- Growth: Financial models typically assume some amount of growth in both rental income and operating expenses. Usually 1% – 3% per year.
- Vacancy: There must be some accounting for income lost due to vacant space. Typically 5% – 7% annually over the long term.
- Market Conditions: Real estate market conditions are notoriously difficult to predict, but they have a major impact on the estimated value of the property at the end of the holding period. Modelers need to make assumptions about lender interest rates, absorption rates, and capitalization rates.
- Loan Terms: Finally, assumptions must be made about the terms of the loan used to finance the purchase and how they may change over time. For example interest rates could change or the loan could mature.
The key point here is less about specific assumptions and more about the idea that assumptions have a major impact on the net income and profit ultimately earned in the investment. For example, if investors assume 3% annual growth in rents, but they actually turn out to be 1%, the actual return is going to be significantly less than the modeled return.
For this reason, the best real estate investors often run their model through a range of economic scenarios to make sure the total return will be stable with a wide margin of error for changes in market conditions.
Other Uses of Residual Value
Finally, it is important to note that residual value is discussed in a very specific context in this article – commercial real estate investment. But, there are a number of other avenues where residual value is an important concept – most notably in accounting.
In an accounting context, residual value, sometimes called salvage value, is the remaining value of a fixed asset at the end of its useful life or end of the lease term. Often, this value includes an allocation for depreciation taken by the lessee. While this residual method/residual technique of valuation is very important for the creation of financial statements, it does not impact commercial real estate valuations from a due diligence standpoint.
Summary of Residual Value
In a commercial real estate investment context, residual value is the value of a property at the end of an investment holding period. It usually represents the property’s sale price.
Residual value is important because, if it represents a profit, it is a major contributor to total investment returns.
There are two ways residual value is typically calculated. The first is the direct capitalization method. The second is the sales comparison approach.
In many cases, residual value must be estimated prior to purchase for a time that is five or ten years into the future. So, it typically includes a number of assumptions about things like rent growth and vacancy rates.
Ultimately, the goal of the residual value calculation is to provide an input to the total return metrics to see if an opportunity is worth pursuing or not.
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