Running the Numbers

At their core, valuations are estimates of the present value of future cash flows. But amid industry jargon and specifics, that simple idea often gets lost. It occurs to me the realm of athletics can lend some insight into the strengths and weaknesses of our different approaches.

Picture this: Instead of dissecting property valuations, we're betting on a marathon's outcome.

Direct Capitalization: The Sprinter's Gaze

The Direct Capitalization method is based on a single year of rental income. It then extrapolates that single year endlessly into the future. This method uses the same formula as a bond with no maturity date (perpetuity), which partially explains the affinity for long leases with creditworthy tenants.?

In our marathon analogy, that’s akin to an observer at Mile 1 marking a runner's time and ambitiously projecting a finish. If the runner maintains a predictable pace, this method shines. That first mile offers insights extrapolatable over the next 25.2 miles to the finish line.

But if we expect our property’s cash flows to be lumpy from tenant turnovers, capital investments and void periods—if our marathon route includes a long incline and our runner starts strong but finds himself a little under-trained—the Direct Capitalization method is no longer an accurate tool.?

DCF: The Coach

Enter Discounted Cash Flow, our seasoned coach, equipped with previous race statistics, training information, and knowledge of impending racecourse challenges. The Coach takes note of the Mile 1 time, integrates all of the other variables, and predicts the race’s progression.?

That long incline from Mile 12 to 15? We think that will slow our runner’s pace to 12-minute miles. Plus we know the runner is a little under-trained, so we expect our runner’s pace to slow to 10-minute miles after the incline.

By accounting for each segment and totalling them up, the Discounted Cash Flow provides us with a much more accurate estimate that factors in all of our known information.

But how do we factor in unknown information? What if the dynamics of race change and now we need to make a wager under completely different circumstances?

The Marathon Becomes a Relay

Let’s say a race that is historically known for its solo runners has now become a relay. To make it even harder to predict, the relay teams have been randomized and the runners can hand off the baton whenever they want.

This relay twist mirrors the intricacies of flexible leasing: the landlord sees the race's onset clearly but grapples with the unfolding relay’s uncertainties. How does one bet responsibly on such a race's outcome?

The ReturnSuite Method

Our seasoned DCF coach, traditionally reliant on the consistency of a single runner, now faces hurdles: multiple runners, with varying capabilities and unpredictable baton exchanges. The DCF coach might try taking the average runner’s split for each portion of the race. Sadly, the math wouldn’t work (if it did, it would be accidental).

While presumably most of the runners will have trained for the race and will fall close to the average pace, there will be some elite runners–and even more in bulky costumes. In a race with so much potential variability, we need to let go of being exactly right and become comfortable with being approximately right. How can we do that?

One way might be to have each runner write their expected pace on their race bib and place it in a pile. We could then build a fantasy relay team by randomly drawing five of the bibs.

But the odds of our race-day team performing exactly the same as our fantasy team is about as likely as the DCF coach being exactly right: almost zero. We’re only looking at one of the many possible scenarios.

The ReturnSuite Method is to repeat the random draw thousands of times, recording each of the results. The result of this process will be a range of potential outcomes, some more probable than the others. Graphing these outcomes will give us a probability density.

This information can now be used to make a wide assortment of wagers:

• We have less than a 5% chance of our team running slower than 4:25
• We can be 70% confident our relay team will run between 4:10 and 2:50
• We can be 98% confident that no team will run faster than 2:30

The exact same idea can be applied to flexible real estate, but rather than running paces, we can estimate the probabilities of cash flows, valuations, occupancy levels, etc.

These new tools can be used to estimate not only the return of an investment, but also the risk profile associated with that investment. We may expect a valuation to be $2.2 million, but it’s useful also to know that we can be 95% confident the valuation won’t drop below $1.1 million.?

Is this a good investment? Depends on what is being invested and how sensitive you are to losses. A pension fund concerned about long-term capital preservation may only be willing to pay $1.8 million for the property, while a value-add fund may be willing to invest $2.1 million for the opportunity to earn the upside.

As commercial real estate enters into a world with more potential variability, we need to recognize that the race and the bets we are being asked to place have changed.?

We are all losing the luxury of the traditional long-distance race, which means we are also losing the traditional tools we have used to place wagers on these races. If we want to make intelligent decisions in this flexible new world, we’re going to have to show up with more than just a stopwatch.

Post Script

Last weekend I attended the 2nd annual Canadian Civil Live. Organized by a group of civic-minded YouTubers, the event can best be summarized as equal parts pub quiz, group discussion, fan appreciation and networking. It was a lot of fun and a great chance to chat with people about real estate adjacent topics like transportation, zoning, urbanism and municipal politics.

If any of these topics interest you, I’d recommend subscribing to their channels - I’ll put a summary of their channels along with their Twitter links in the comments section.