Realty Reality Check — Overestimating Property Returns

During a workshop or seminar I often field over a dozen business ideas that are seeking advice on funding to staff resourcing to manufacturing guidance but I often find that these ideas are not even properly vetted at their foundation. A quick back-of-the envelope analysis often suggests these ideas are not as feasible as they may assumed to be and frequently founders take off to the races without thinking things through. One cannot and should not take for granted even a copied and tested idea to be viable for one entrepreneur simply because another entrepreneur has apparently achieved financial success executing it.

Recently, I spoke with a real estate startup who I found to be significantly overestimating their business model’s financial viability and I arrived at that conclusion in under 10 minutes of Q&A. The purpose of this article is to share some basic techniques and steps on how to quickly evaluate financial viability of an idea at first glance and to set following discussions closer to reality and related risks. This saves everyone a ton of time, energy and even money in the long run.

Commercial developer

We are so used to relating startups with mobile app developers that we sometimes pause for a second when the development is more traditional and more of the brick-and-mortar kind. In Pakistan, the real estate boom has been underway for nearly a decade with population growth from urbanization, migration and overall rise in middle income families. Riding the wave of real estate development, this particular startup comprising of four young entrepreneurs and friends, decided to jump into the arena. As I was listening to their needs and request for assistance with executing the business model, I realized I wasn’t exactly so sure of the base business model itself that was going to promise disproportionately high returns expected by the young team. I veered the conversation to first test the business model assumptions.

Here is how the discussion went:

StartUp (SU): We want to build a 3-storey commercial plaza with approximately 5,000 square feet of Gross Leasable Area (GLA). We want to rent the shops and then perhaps sell the complex.

Saud Masud (SM): Is that around 8–10 shops?

SU: 10 shops to be exact.

SM: How much rent do you think this entire property will generate annually?

SU: Around Rs. 10 million for the year.

SM: OK. What is your expectation for selling the property?

SU: Any plaza generating Rs. 10 million a year in guaranteed rental cash flow, should be worth at least 8–10x that annual rent, no? Maybe we sell it in a couple of years post launch.

SM: Lets take this one step at a time. What is the expected monthly rent per square foot?

SU: We haven’t calculated per square foot. Its about Rs. 75,000 per month in the adjacent plaza for a similar size shop.

SM: Assuming your average shop is 500 square feet (5,000 square feet divided by 10 shops) and average monthly rent is Rs. 75,000, your rental rate would be Rs. 150 per square foot (Rs. 75,000 divided by 500 square feet).

SU: Is that good?

SM: Its not good or bad. Its market. What is your occupancy rate expectation?

SU: 100%. Demand is solid.

SM: Just physically looking at two plazas in your neighborhood and the “shop available for rent” signs, it seems vacancy rates are around 10%, maybe even 20%.

SU: silence

SM: I suggest we assume 20% vacancy rate (i.e. 80% occupancy rate), which means only 8 out of 10 shops may be rented in one year. This means your entire property would generate Rs. 600,000 per month in rent (8 shops x Rs. 150/sqft x 500 sqft) or monthly rental rate of Rs. 120/sqft (Rs. 600,000 divided by 5,000 sqft). So your assumption of Rs. 10 million in annual rent may be a bit optimistic. Its closer to Rs. 7.2 million as per our approach.

SU: OK, not thrilled but OK.

SM: What is your estimate for average monthly expenses per shop.

SU: Roughly Rs. 20,000. That includes all operating expenses including maintenance, repairs, janitorial staff, marketing, utilities, etc.

SM: Alright. That translates into Rs. 40/sqft in monthly expenses. Remember your average monthly rental rate is Rs. 120/sqft. This leaves you with monthly pretax NOI (Net Operating Income) of Rs. 80/sqft. In other words, your total monthly income collected for the property is Rs. 400,000 and annual NOI is Rs. 4,800,000.

SU: Frankly, we were expecting a bit more income.

SM: Fair enough. Lets keep going. For a market like Pakistan, to arrive at property value (NOI/cap rate), we should typically apply a high capitalization rate (cap rate) of between 10% and 15%. Assuming a lower cap rate of 10%, the estimated market value of the property is Rs. 48,000,000 (Rs. 4,800,000 divided by 10%) while a higher cap rate would result in a lower market value of Rs. 32,000,000 (Rs. 4,800,000 divided by 15%).

SU: silence

SM: You suggested a property generating Rs. 10 million in rental should be worth 8–10x its annual rent. That would put your property value expectations at Rs. 80–100 million. We, instead, are arriving at Rs. 32–48 million here. Notice, the value is based off 8–10x annual NOI not rent.

SU: silence

SM: How much is the land acquisition cost in total?

SU: Rs. 25,000,000 for 1,667 sqft area. We will build 3 storeys here for a total of 5,000 sqft.

SM: You should assume around Rs. 2,500/sqft in total construction costs or Rs. 12,500,000 (i.e. Rs. 2,500/sqft x 5,000 sqft). This would roughly make total property development costs add up to Rs. 37,500,000 (i.e. Rs. 25,000,000 + Rs. 12,500,000).

SU: So you are saying our total investment of Rs. 37.5 million may yield a property valued between Rs. 32 million and Rs. 48 million? We could actually lose money?

SM: Precisely! Back-of-the-envelope suggests you are off on monthly rental expectations by more than Rs. 230,000, i.e. by almost 30% and estimated value for the property by almost 50%. You can clearly improve on these first glance estimates by increasing occupancy rates and raising rents given newer property while simultaneously negotiating better construction materials and labor sourcing.

SU: This is no where near our planned returns. We assumed we could probably extract 2–3x our investment in the first couple of years.

Details of the step-by-step high level assessment of the opportunity are as follows:

by Saud Masud, Vector Partners

Sensitivity

Assuming the key model input drivers are tested in the 10% band:

  • Given all else being equal a 10% points increase in occupancy rate, i.e. from 80% to 90% would increase Annual NOI from Rs. 4.8 million to Rs. 5.7 million (+19%). Similarly, a 10% points decline in occupancy rate would lead to a 19% decrease in Annual NOI.
  • Given all else being equal a 10% increase in average monthly rent, i.e. from Rs. 75,000 to Rs. 82,500 will increase Annual NOI from Rs. 4.8 million to Rs. 5.52 million (+15%). Similarly, a 10% decrease in average monthly rent would lead to a 15% decrease in Annual NOI.
  • Given all else being equal, a 10% increase in monthly operating expenses, i.e. from Rs. 20,000 to Rs. 22,000 would decrease Annual NOI from 4.8 million to Rs. 4.56 million (-5%). Similarly, a 10% decrease in monthly operating expenses would lead to a 5% increase in Annual NOI.

Theoretically, all three levers should be pushed simultaneously, i.e. improve occupancy rate and monthly rent while bringing down expenses. The real world challenge is that occupancy rates are highly sensitive to rental rates and may require higher than expected advertising and marketing expenses to reach optimal levels. To better understand the cross-sensitivties of these drivers of value a detailed feasibility study would have to be conducted.

Same Model, Different Investment Risk

When I probed the SU team further on why they were so eager to pursue this business model in the first place, their response was “because so and so had made a killing building, renting and selling previously — he made 10x his investment.” What they failed to mention was that the developer who had executed this business pan had done it a while back and had three things going for him:

  1. He already owned the land at far lower rates and only started developing when he saw commercial build-out momentum picking up around him. That was seven years ago. Now the neighborhood was overcrowded and frankly suffocating.
  2. He had leverage. He took advantage of low lending rates by pledging his other properties and borrowed up to 80% of his total development cost.
  3. Probably the most important factor — timing. He was able to achieve 90% occupancy rates within the first year of launch given the upturn in commercial property demand. A major highway was also being linked to this area, which helped shoot up both property values and rents.

So, yes, the inspiring case study would have likely done very well for himself given low capital investment, leverage and near perfect market timing. But it becomes a challenge for second, third and fourth market movers when low-hanging fruit has all been taken up.

Therefore, all business models especially ones that are knowingly entering a saturated space must proceed with caution. Doesn’t mean there isn’t a feasible opportunity available but it is very likely it is not as shiny and bright as you might think. A quick walk-though as the one above should reveal glimpses of a reality check that may help re-calibrate expectations in advance of jumping into the opportunity with sleeves fully rolled up.