Valuing real estate portfolios on an individual property basis typically requires significant appraisal work coupled with substantial appraisal fees. For estate tax filings and gift planning, such fees may constitute an onerous expenditure by the estate or client. Historically, in order to provide liability protection, each individual property was held within a separate legal entity and required a separate appraisal for gift and estate related valuations. The advent (and increasing usage) of Series LLCs allows owners to hold multiple real estate properties within a single legal entity, while still insulating for liability. In situations where numerous properties are held within a single legal entity, valuing the portfolio collectively may provide a supportable and cost-effective solution for gift and estate tax planning and compliance.
Valuing any individual parcel of real estate consists of utilizing a cost, sales comparison, or income capitalization approach (or some combination). The same holds true for portfolios of real estate, with the approaches applied in one of two methods:
Individual Property Valuation
The former method provides the most detailed analysis of a portfolio. In valuing each property individually, every property is inspected, analyzed, and valued based upon its unique location, characteristics, tenant make-up, and financial prospects. After aggregating the value of these properties, the application of a discount or premium should be considered.
Estimating Discounts/Premiums to the Portfolio
It is possible that the value of a portfolio of properties exceeds the aggregate individual property values due to the benefits (and hence increased cash flows) resulting from operating cost efficiencies or synergies of management. In addition to increased cash flows, a portfolio of properties may command a premium to the aggregate value of the underlying properties due to the cost savings in fees (e.g., attorney, brokerage, etc.) and time associated with constructing a portfolio through piecemeal acquisition. Portfolios may also possess premiums deriving from any reduction of risk due to property type or geographic diversification.
By contrast, certain situations may command a discount to the aggregate underlying asset value such as when a portfolio lacks efficiencies, synergies, or diversification. Discounts may also be appropriate if the portfolio is perceived as being poorly constructed. A poorly constructed portfolio exists when demand for the individual properties exceeds demand for the portfolio as a whole (often due to a lack of diversification). However, such situations may be perceived differently by various investors in the marketplace. For example, an undiversified portfolio may be seen by certain investors as focused and acting as a “pure play” vehicle for a particular market/asset class.
CoStar Group, Inc. (“CoStar”) provides data for the quantification of portfolio discounts or premiums. The following chart details the percentage difference in median price per square foot for portfolio sales versus individual property sales, by asset class, between January 2007 and June 2010.2 Based on our analysis of these sales, the sale of a group of properties as a portfolio resulted in a discount to the aggregate individual property value. The discounts existed despite the fact that the portfolios researched were comprised of similar property types and appeared to possess economies of scale, synergies of management, and geographic dispersion.
As illustrated, retail portfolios experienced the largest discount compared to individually sold assets. This discount approximated 33%, while the industrial and office asset classes reflected portfolio discounts of 16% and 23%, respectively. Notably, multi-family real estate demonstrated the smallest discount: approximately 2%. These results correspond with the nature of the properties relative to overall price volatility. That is, the lower the asset class price volatility, the lower the portfolio discount observed. For example, multi-family rent rolls tend to be stable since the asset class, by its nature, lacks anchor tenants (the loss of which may dramatically alter occupancy). In addition, any growth in expenses tends to be fairly stable and consistent. Accordingly, a lower overall portfolio discount is warranted relative to other asset classes.
Several conclusions can be drawn from the market-based evidence presented by this graph. First, the magnitude of discounts for any particular portfolio may be significant (potentially 30% or more). Second, on average, discounts are indeed sizeable (through all asset classes, overall discounts averaged 23%). However, as the range of discounts underscores, care must be taken in determining whether a discount or premium is appropriate. Since every portfolio is unique in its property characteristics and geographic dispersion, each must be analyzed individually to determine its relationship to properties sold individually.
Additional evidence is available by an examination of capitalization rates by asset classes. Capitalization rates are determined by comparing the price paid to the underlying net operating income. A comparison of portfolio capitalization rates versus that of individual properties may also suggest whether or not a portfolio discount or premium is applicable. That is, all else being equal, the higher the capitalization rate, the lower the price and thus the greater the discount.
The following chart illustrates average capitalization rates for portfolio versus single-property sales for certain asset classes between January 2007 and June 2010.3
As indicated, capitalization rates for portfolio sales of all asset classes, with the exception of industrial, are higher than individual property sales from that of their respective asset class. The capitalization rates for office and retail portfolios were approximately 45 basis points higher than individual property sales, while multi-family portfolios were 15 basis points higher.
While industrial portfolios demonstrated a lower capitalization rate of 43 basis points, this departure may result from a timing issue with the data accumulation. With industrial real estate, a greater proportion of portfolio sales (relative to individual property sales) occurred during 2007 and the first half of 2008. Therefore, the lower capitalization rates may merely result from portfolio sales data collected during a span of significant appreciation in real estate prices. In fact, if only the past 24 months were analyzed, capitalization rates for industrial portfolio sales were 189 basis points higher than individual sales.
Portfolio Property Valuation
Similar to the valuation of an individual property, portfolios can be valued collectively by comparison to sales of similar portfolios in the market. Details of portfolio sales are available from commercial data sources such as CoStar and Real Capital Analytics, Inc.4 In addition, directed Internet searches often provide information regarding transactions of high-profile property portfolios.
Once the universe of portfolio sales is identified, it is vital to understand the economic and geographic characteristics of the individual properties that comprise each portfolio. The critical characteristics include property type, location of the individual assets, tenant profile, physical attributes, and any other factors that may result in one portfolio having a higher overall value than another. This analysis will help to determine which portfolio sales are the best comparison to the subject portfolio.
Once the comparable portfolios are narrowed down to those most similar, and understood at the individual asset level, direct comparison can be made. In a qualitative manner, the portfolio being valued is compared to the portfolios sold on an individual asset level. Such a comparison helps to determine a supportable value per square foot for the subject portfolio. In addition, a comparison of the relative risk profiles of each portfolio will help to narrow down the appropriate capitalization rate that will be applied to the portfolio’s net operating income.
Another possible source for support of a portfolio capitalization rate is the publicly traded REIT market. If we compare the net asset value (NAV) of a certain REIT to its net operating income, the result will be the capitalization rate associated with that REIT. Since a REIT has some characteristics of a portfolio, the indicated capitalization rates are helpful. However, this data is considered secondary support due to differences between a REIT and a privately held portfolio. Significant differences often include liquidity issues, levels of professional management, reinvestment requirements, etc.
Traditionally, gift and estate planning involving real estate portfolios required expensive appraisals of each underlying property. Valuing the entire portfolio collectively may provide a more cost-effective solution while the possible existence of a portfolio discount may create substantial tax savings.
Also contributing to this article:
Jeffrey G. Pelegrin
Christopher P. Casey
1 A derivation of valuing each individual property may include a sampling technique whereby some of the properties are valued independently and the values of non-individually valued properties are inferred. Situations whereby such a technique is warranted include the valuation of numerous similar properties or when the inferred property values may be immaterial to the overall portfolio value.
2 Only arm’s-length transactions were studied to derive the discounts noted. In total, 299 portfolios were compared to over 4,600 individual property sales.