Thinking about the components of value

Lately, have been thinking about what we mean when we say, for example, that we’re earning a 7% unlevered return on a property.

The math is pretty obvious: Say we invest $2MM in a property between acquisition and renovation (assume this is cash and that there is no mortgage). If we generate $140k / year in net operating income (eg profit), then we are making $140,000 / $2,000,000 = 7%.

But that’s not really a fair reflection of what’s going on, right?

First of all, to even get your money back, you’d need to wait $2,000,000 / $140,0000 = 14 years. And that assumes nothing goes wrong that requires you to put more capital into the building (like needing a new roof).

Second of all, land in a big, growing city like LA tends to appreciate, no matter what’s on it. It’s not really fair to ascribe it no value in your estimate of returns.

So, I’ve been kind of groping for a new way of thinking about these deals and here’s where I’m coming out.

Take the example above. Assume you bought the property for $1.5MM (before spending $500k  to renovate). Assume further that a review of the transactions for comparable pieces of land leads you to ascribe a value of $750k to the land… implying a value of $750k on the structure.

Now you can break the deal in two:

  • You’re getting $140k in cashflow on your $750k+500k = $1.25MM investment in the structure, or a yield of 11.2%
  • You’re speculating on LA multifamily land which you bought for $750k and which ought to grow in value at a rate exceeding inflation

I think if you consider deals in this way, it has the effect of bringing out the actual components of value (the land vs. the business operating on the land), rather than muddling them all together.