Key Insights into Valuing Companies in the Real Estate Sector
The Consistency of Data and Trends
The real estate sector encompasses a variety of activities, limited only by the imagination, including: selling, leasing, management, development, appraisal, title services, and investment. When valuing businesses linked to the real estate market, whether directly or indirectly, it is essential to examine both the risk and the cash flow generating ability of each company. The co-authors of this article share essential aspects appraisers must consider in these valuation engagements.
The real estate sector encompasses a variety of activities, limited only by the imagination, including: selling, leasing, management, development, appraisal, title services, and investment. When valuing businesses linked to the real estate market, whether directly or indirectly, it is essential to examine both the risk and the cash flow generating ability of each company. Additional elements to consider are the company type, economic conditions, industry trends, and unique value drivers for each business entity. Â
From the valuation perspective, it is vital to understand the type and operating dynamics of each real estate business to determine the most appropriate valuation method to use. For example, a title company is an operating business that generates income by providing title services and insurance to customers; therefore, the income approach would be appropriate to value this type of business. On the other hand, a real estate holding company is generally considered a non-operating entity. Although real estate holding companies may generate moderate levels of cash flows, typically, the value of the underlying real estate property far exceeds the companyâ€™s income-generating ability. Because the company’s fair market value cannot fall below the market value of its underlying holdings (i.e., real estate), the companyâ€™s value is derived using the adjusted net asset value method under the asset approach.
Overall, a wide array of business activities exists in the real estate sector. Despite the diversity, however, most companies in the real estate sector are influenced by the same macroeconomic factors, such as supply and demand for real estate, GDP per capita consumption growth rate, term structure of interest rates, unemployment rates, demographic characteristics, government policy, economic cycle, and inflation. The COVID-19 pandemic created unique circumstances that fueled considerable demand and profitability in the real estate industry. The limited supply of houses on the market was further exacerbated by the mortgage forbearance enacted by the government. This prevented any significant wave of foreclosures as well as a reduction in natural turnover in the housing marking, further tightening the supply. Pair that with historically low-interest rates and several injections of stimulus money from the government created a frenzy in the real estate market. This period was quite rosy for the real estate industry, with many businesses achieving record revenue and profitability. According to the Q2 2022 DealStats Value Index, private real estate companies were selling at an EBITDA multiple of 7.7x in 2020, compared to an EBITDA multiple of 4.0x in 2019.
Our current economic environment is characterized by rampant inflation, rising interest rates, and soaring energy prices. The real estate industry is particularly sensitive to interest rate changes because much of the real estate industry is leveraged through mortgage and investment loans. Due to the 30-year fixed-rate mortgage rise, sales volumes are anticipated to decrease. The Federal Reserveâ€™s recent interest rate hikes indicate further increases to the 30-year fixed-rate mortgage. According to the Wall Street Journal, as of October 2022, the 30-year fixed rate mortgage sits at 7.93%, up from 2.77% approximately a year ago. Not only will these interest rate hikes affect mortgage rates, but they will also impact the cost of capital. When using the income approach, developing a reasonable market-based discount rate is essential.
Real estate brokerages and agencies are prominent players in the real estate sector. If you have ever bought or sold a home, chances are you have worked with a real estate agency. These companies act as intermediaries for buying, selling, and renting residential or commercial properties. The residential market is comprised of single-family homes, attached homes, and individual apartments, whereas the commercial market includes office buildings, retail space, and warehouses. Agencies and brokerages tend to be highly competitive, and they compete based on reputation, ability to network with other professionals and prospective clients, effective marketing and advertising campaigns, and service quality. Real estate agencies and brokerages rely on sales volume to generate revenue; therefore, it is critical for these companies to be located in close proximity to highly active real estate markets with the potential for high population growth. For that reason, location is a key value driver for this type of business.
The real estate sector also includes property management. Companies within this industry are responsible for various activities, including: rent collection, trash removal, security, writing and executing leases, repairs, and maintenance. Property managers oversee all types of properties ranging from apartment complexes, vacation rentals, mobile home parks, and office buildings. Property management companies have overlapping value drivers like a brand name, but the value will also depend on the type of property being managed. The property type will determine if the companyâ€™s cash flows will be cyclical (for a vacation rental) or recurring (for an apartment complex). The volatility of cash flows will impact the risk and value of these businesses.
Vacation rental property management has increased in popularity, partly due to the success of Airbnb. This peer-to-peer renting company has spawned competing companies such as Vrbo, HomeToGo, and Vacasa. Airbnb has around seven million listings worldwide, ranging from traditional homes and condos to unique, non-traditional options such as RVs, treehouses, caves, and castles. Properties hosted on the Airbnb platform can be considered commercial properties since they are structured as income-producing real estate businesses.
To value a vacation rental management company, under the income approach to valuation, it is necessary to project or forecast the rental income of the underlying properties. This can be calculated based on the estimated daily rate and occupancy rate. Several tools are available to research and understand pricing dynamics for Airbnb properties, including AirDNA. AirDNA allows users to conduct in-depth analysis and market research to price their short-term rentals. Management companies charge anywhere between 20%â€“50% of their hosting property revenue. Operating expenses such as utilities, tax, cleaning, and maintenance must also be factored in. Other valuation considerations include seasonality, competitive pricing, reviews, and location.
Other players in the real estate sector include real estate developers who are responsible for the financing and building of development projects such as housing developments or apartment complexes. Real estate appraisers, title companies, and mortgage brokers are also essential for real estate transactions.
Additionally, investment opportunities include real estate investment trusts (REITs). A REIT can be used as a diversified investment vehicle comprised of income-producing real estate, such as offices, apartment buildings, and warehouses, that provide a return to investors through dividend income.
On a smaller scale, the house flipping business is a risker option. Assuming sufficient resources exist, investors can purchase a property, rehab it, then sell it for a profit or wholesale it. This space has several franchises (such as Home Vestors) available to purchase to cap the risk. Typically, these franchises provide a two-week training program, use of their proprietary software to perform a cost/benefit analysis on a property, and assist with lead generation and marketing campaigns.
Several key trends have emerged, and each one of those trends will have varying impacts on the value of real estate companies, whether directly or indirectly. First, there have been new migration trends within the United States. Many people have opted to move from cities to suburbs. This was in part accelerated by COVID-19. The rise in home prices and rents in populous cities forced people to move to more affordable areas. Second, since COVID-19, large parts of the population have been relocating to the Sun Belt region of the United States. In addition to the appeal of warmer weather down south, many young adults are attracted to the southern region due to lower taxes. According to PwCâ€™s Emerging Trends in Real Estate 2022, eight out of the ten top-ranked real estate markets in the United States were in the Sun Belt region, including Phoenix, Nashville, and Austin. Real estate companies in these areas are forecasted to perform well compared to companies that operate in slower markets like Flint, East Stroudsburg, and Detroit. Booming markets offer higher growth potential. Real estate companies in these markets with higher growth opportunities are valued higher by investors and buyers because their expected rate of return tends to be higher. Overall, companies will be valued differently based on their geographic markets.
The new migration trends have caused further supply constraints in certain markets, bolstering home prices even more. According to Zillow, the average home price in the United States was about $354,000 in August 2022, that is up 19.8% from one year ago. Some of the previously mentioned markets are seeing more dramatic increases. Nashville, TN, saw a 30.7% increase in home prices from last year, with the average home costing $455,000. While rising interest rates and mortgage rates are anticipated to cool the property market, inventory in these booming markets is still tight, which may keep housing prices elevated for longer than expected. During the pandemic, the real estate markets acted more like an auction, where a home would have several offers and sell in a few days, even though historically, it takes about 90 days to sell a house. These conditions have been favorable for real estate companies as sales volume and profitability have reached all-time highs. As the trend in home prices and interest rates develop, it may start to paint a different picture of profitability for these real estate companies and, in turn, their underlying business value.
In addition to migration and housing price trends, the real estate sector is also seeing a change in technological trends. Many homebuyers now prefer to use online platforms, such as Zillow and Redfin, to do their house hunting and mortgage pricing. A homebuyer demographic has shifted to 37% Millennials, 24% Gen X, and 18% Young Baby Boomers. To maintain value, real estate companies will need to adapt to the customers’ technological preferences, such as smart home upgrades to apartments and houses. Leveraging technology, such as customer relationship management (CRM) solutions, can also save time, cut costs, and improve customer experience. By staying up-to-date on the latest technology trends, companies will reduce their risk of customer attrition and obsolescence to competitors. When companies have less perceived risk, buyers are willing to pay a higher price for the company.
The performance and value of real estate companies are inherently cyclical in nature and may fluctuate with the overall health of the economy, as evidenced by the historical trends of the sectorâ€™s market multiples. Market multiples can be used as a reasonable benchmark to value companies. Sales multiples derive the value of a business based on revenue, whereas EBITDA multiples provide a more wholistic view of the company by including operating aspects of the business. An analysis of the sales and EBITDA multiples trends for the real estate, rental, and leasing industry shows that from 2012 to 2022, the median sales multiple ranged from 0.62x to 0.76x. Despite some volatility within the sales multiple, this multiple has remained relatively stable over the past decade. The EBITDA multiples within the industry ranged from 2.4x to 7.7x through the period 2012 to 2021.
The real estate market is the bedrock of our economy. It is one of the most critical sectorsâ€”each of us encounters it daily. Although the value may experience some fluctuations from time to time, one of the best investments in our land is land (and other businesses that support or relate to it), or as Mark Twain eloquently noted: â€śBuy land, they’re not making it anymore.”
 Median Selling Price/Nets Sales (Private Targets), DealStats Value Index 2Q 2022.
 Median Selling Price/ EBITDA (Private Targets), DealStats Value Index 2Q 2022.
Nataliya Kalava CVA, ABV, MAFF, is the founder and managing director of American Valuations. She has over 12 years of experience in the field of finance. Ms. Kalava has prepared, overseen, or contributed to hundreds of valuations for purposes related to gift and estate tax planning, management planning, transaction (M&A), SBA valuations, financial reporting, and litigation, among others. She greatly enjoys working with business owners to address ownership transition challenges and opportunities. Ms. Kalava is the co-founder and managing member at NAMBRI Technologies LLC www.nambri.com and she serves on the Board of Directors for the Business Transition Council of Tampa Bay, a not-for-profit organization https://btctampa.com.
Brianna McKown is the Senior Financial Analyst at American Valuations. She has valued various companies ranging from small businesses to large corporations for purposes related to gift and estate tax planning, sale, litigation, and SBA financing purposes. These valuations span across several industries, including but not limited to: construction services, manufacturing, professional services companies, and retail businesses.