A New Approach to Estimate the Return on the Equity in the Mortgage-Equity Valuation Technique
In my previous newsletters, I describe the virtues of utilizing the mortgage-equity technique when valuing hotels and other types of income properties. This newsletter will explain how to determine the return on the equity component which is based more on the transaction market rather than the financial market. My approach will probably surprise you.
In summary, the mortgage-equity method is superior to an unleveraged discounted cash flow analysis because it not only reflects the investment rationale of both the equity investor and lender, but its accuracy is significantly enhanced through the use of easy-to-obtain and up-to-the-minute mortgage data.
As real estate appraisers, we need to put our feet into the shoes of typical buyers and employ the same procedures they use to establish their purchase price. Most buyers we have observed start with a projection of Net Income Before Debt Service (NIBDS). They then determine how much they can borrow and the terms of the financing through the utilization of a loan-to-value ratio, a debt coverage ratio, or debt yield. This allows them to calculate the amount of annual debt service along with the yearly equity income (equity dividends). At the end of their holding period, buyers estimate the proceeds from a sale of the hotel and deduct the outstanding mortgage balance and selling expenses (equity residual). They then discount the annual equity dividends along with the equity residual to the present value using an equity yield to determine how much equity they can invest. The total of the mortgage component and equity component establishes what a buyer can pay for the property. Other than some all-cash institutional buyers who purchase properties with no debt, most real estate investors specifically consider the cost of financing in their purchase decisions.
In my previous newsletters, I have shown that the mortgage information is usually highly accurate and can be obtained easily from published sources using a regression formula (see my previous newsletter - “How to Value a Hotel- A Complete Guide to the Hotel Valuation Methodology” - https://howtovalueahotel.com/).
The equity yield, on the other hand, can be somewhat subjective since it requires data not as readily available. Good appraisers should be having ongoing conversations with investors about their equity return requirements. In addition, appraisers can derive equity yields from sales transactions of properties appraised at the time of sale by hypothesizing market-rate debt and solving for the equity IRR.
In this newsletter, I will focus on the derivation of the equity component of the mortgage-equity technique. To keep it simple, I will illustrate the process by using the band of investment method (utilizing an equity dividend) rather than a discounted cash flow (which utilizes an equity yield). Both methods will produce the same results. From now on I will use the term “equity return” rather than equity dividend or equity yield.
In simple terms, the derivation of the equity return has little to do with things most appraisers consider like the cost of capital, risk, illiquidity, type of asset, and other financial and economic data. Rather the equity return reflects market demand for a particular hotel asset where demand represents the number of buyers actually looking to purchase that hotel. If many potential buyers are looking to purchase a particular hotel, equity returns will be lower. If few buyers are looking to purchase a particular hotel, equity returns will be higher.
To illustrate how this works, let’s assume you want to purchase a particular hotel and you will be using the mortgage-equity valuation technique to establish your purchase price. You first need to evaluate the market dynamics and financial performance of the hotel in order to project its future Net Income Before Debt Service (NIBDS). Using this information you then work with your lender to determine how much you can borrow and what the annual debt service will be. Lastly, you need to determine what equity return you would like to have. With this information, you can estimate YOUR value of this hotel and how to start the bidding process.
Let’s use some numbers:
Your projection of the future Net Income Before Debt Service is $2,000,000.
Your lender is willing to lend you 75% of your value using an interest rate of 8% and a 25-year amortization which makes the mortgage constant 9.3%.
Based on the equity return requirements of your investors- you would like to achieve a cash-on-cash equity return of 10%. A good starting point for establishing a return on equity is to assume it needs to be higher than the interest rate on the debt component.
Using a band of investment the capitalization rate can be established using the weighted average cost of capital as follows:
Dividing the NIBDS of $2,000,000 by the cap rate of .094 produces YOUR value of $21,177,000.
$2,000,000/.094 = $21,177,000
Proof of Value:
The $21,177,000 value can be proved by showing that each component receives its desired return. The mortgage represents 75% of the total value or $15,883,000. The mortgage constant is .093. Multiplying the amount of the mortgage times the mortgage constant produces a debt service of $1,471,000. The equity component is 25% of the total value or $5,294,000. Multiplying the amount of the equity times the 10% equity return requirement produces an equity dividend of $529,000. Adding the debt service plus the equity dividend totals $2,000,000 which is the projected NIBDS proving that each component does receive its desired return.
The $21,177,000 is therefore the price you would be happy to pay since it provides the desired return to both the lender and equity investors.
Now you are ready to enter the bidding process by submitting an opening bid. Of course, it would be better to achieve higher returns so your opening bid will probably be less than $21,177,000.
Since it is likely that the cost of your mortgage financing will stay the same you only need to adjust your desired equity return upward. Let’s now price your bid using an equity return of 17.5%. Employing the same band of investment method and only adjusting the equity return up to 17.5% produces the following valuation:
$2,000,000/.113 = $17,666,000
You then submit this opening bid and after several days the broker gets back to you and says, Your bid is way out of the ballpark and you need to come up with a higher bid.
At this point, you have two options available to increase your bid- you can either increase the projection of NIBDS or decrease your equity dividend requirement. The cost of your debt capital is probably not going to change. Assume you don’t feel comfortable increasing your NIBDS, so you bring your equity return down to .10. This produces the $21,177,000 shown in the first band of investment example (see above) which you submit to the broker.
Now at this point, if you are either the only bidder or if you are offering the highest price- you will probably be the buyer.
However, let’s assume there are other bidders, and your $21,177,000 was declined- what can you do now?
Again, you have the same two options to increase your bid- either increase your projection of NIBDS or reduce your equity dividend.
At this point, you evaluate your projected NIBDS and conclude that it is very optimistic and cannot reasonably be increased. Therefore, your only option is to further lower your equity return requirement.
Now here is my point- if you want to stay in the bidding and lower your equity return requirement your decision has nothing to do with the cost of capital, risk, illiquidity, type of asset, and other financial and economic data- it is merely the reality of the transaction market when there are many parties interested in purchasing this hotel. Therefore, to be the successful bidder offering the highest price you either need to be more optimistic about the projected NIBDS or have the lowest cost of capital (debt and equity), or a combination of both. In appraisal terms- this represents Market Value.
In this example keeping your projected NIBDS at $2,000,000 and using a .05 equity dividend your value would be $24,400,000. The highest you could bid assuming you were satisfied with a 0% equity dividend would be $28,800,000.
As you can see in an actual market, the equity return (either an equity dividend or equity yield) ultimately determines whether you are the winner or loser in the bidding process. If you are in a “buyer’s market” with few or no other bidders- you can adjust your equity return upward. On the other hand, if you are in a “seller’s market” with many bidders you will need to adjust your equity return downward to be the successful buyer.
As you can see, the equity return (dividend or yield) is based more on the transaction market rather than the financial market.
To obtain a free copy of my Mortgage-Equity Appraisal Software contact me at [email protected].
Stephen Rushmore
Creator of the Hotel Valuation Methodology and Founder of HVS
Hotel Valuation Software
