With price, value and worth broadly understood, consideration should be given to capital and cost of capital used to acquire real estate.
Cost of capital
All capital, debt or equity, has a cost, with debt generally considered cheaper than equity.
In any (investment) market, debt (and cost of debt) is a vital element, which serves to, inter alia, improve return on (equity) investment.
In broad terms, the start point for the cost of debt is to determine the risk-free rate, which is the rate at which sovereign entities i.e. governments borrow, then add a risk premium for borrower risk and investment risk. In Nigeria, the Nigerian naira risk-free rate would be the yield on Treasury Bills (10% to 12.6%), or for long term borrowing, the yield on 5-year or 10-year bonds (12.8% to 14.69%) whilst the United States dollar risk-free rate would be Nigerian Government Eurobonds (7% to 8%). Borrower risk and investment risk could be upwards of 2% depending on a host of considerations. Assuming a total (borrower and investment) risk premium of c. 2% or 3%, then the cost of long term debt should be no less than c. 15% or 16% in Nigerian naira and c. 9% or 10% in United States dollar.
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Considering central government securities (treasury bills, bonds) are considered risk-free and other investment asset classes are priced (with a risk premium) relative to the risk-free rate, then no asset class should be priced or yield a (total) return lower than the risk-free rate……..unless the investment is seen and accepted to be more secure or less risky than sovereign / government securities. Real estate investment is certainly not considered to be more secure / less risky than government securities even with a very good quality tenant in occupation on a long lease.
In addition, to the extent that debt (priced as explained above) is utilised in the acquisition of real estate investment, then the real estate investment must have total return in excess of the cost of debt i.e. a yield in excess of c. 15% or 16% in Nigerian naira and in excess of c. 9% or 10% in United States dollars to service the debt; and capital growth to compensate for the risk of investment. Otherwise, the investment total return would not suffice to service the interest on the debt never mind amortise the debt and compensate investor.
Note: It is possible, and there could be significant value in buying an asset at an initial yield lower than the cost of debt if the purchaser believes that a reversionary yield in excess of the initial yield can be achieved. The reason for this is likely to be that a rent review is imminent or the asset has high vacancy. The value in a transaction of this nature would be the purchaser’s ability to maximise annual rent at rent review, or minimise vacancy within the asset in the shortest possible time or both. In any event, the purchaser’s key initial objective would be to achieve reversionary yield (in excess of cost of debt) as soon as practically possible.
Back to value
Only when real estate yields (initial and reversionary) are in the range suggested above would real estate as an investment asset class be attractive to retail and institutional investors when compared against other investment asset classes.
When considered from this perspective, the logical conclusion is that real estate assets, with initial yields of c. 5% to c. 9% (i.e. multiples of c. 11 to 20) on Nigerian naira net annual income, are significantly over-valued especially in the absence of real capital growth and reversionary yield to support an attractive total return (which is not based on yield compression).
With real estate yields as explained and determined above, multiples on Nigerian naira net annual income from real estate should be in the range of 6.90 (c. 14.5% yield) to 6.25 (16% yield) in the absence of real capital growth to derive a total return in excess of cost of debt.
The yield could reduce slightly in a market with a deep tenant pool (therefore low vacancy rates) and stable currency. For completeness, real capital growth is based, largely, on increases in rental income over and above prevailing inflation during the hold period of the investment. An asset bought and sold at the same yield but with the benefit of rental income growth over and above prevailing inflation would have the benefit of capital growth and would be likely to derive a positive total return.
The above suggests that real estate asset with a net income of ‘say’ NGN 5 million per annum currently valued and priced at c. NGN 83.33 million based on a yield of 6% is significantly over-valued and should, perhaps, be more appropriately valued and priced at c. NGN 35.5 million based on a yield of 14.5% especially if a rent review is not imminent and real capital growth is not certain.
Over-valuation is one of the reasons real estate financiers are often asked by agnostic investors: ‘why invest in real estate for a yield of x% (without certainty of real capital growth) when an investment in government securities can be made for a yield of 1.5x% or 2x%?
Whilst it could be argued that any difference between price and value of an asset is down to demand and supply and market inefficiency, price, we know, would equal value at transaction completion. The issue of worth, and trying to equate worth to value or price, should not occur nor should it be permitted in any market.
For prudent and competent real estate pricing, consideration should be given to whether an investor/a purchaser would be willing to acquire an asset that yields a total return that is far less than the cost of capital and if, indeed, the cost of capital has been considered, determined and understood.
Should an investor or purchaser be willing to accept a total return less than cost of capital, then, it seems value creation is not the objective of investment and, perhaps, the source of the capital ought to be questioned.
In order to create value within the real estate industry in Nigeria, it is incumbent on all participants in the sector to consider international best practices in real estate asset valuation and pricing and ensure that over-valuation/unjustifiable pricing (based on worth) is avoided.
ADENEKAN ADENIRAN
Adeniran is Principal at FRISIA Partners (www.frisiapartners.com)
