In a fund past its term the NAV appraises assets the manager has already decided to sell. The price is the cash the sales will return, and when.
Value a real estate fund interest in wind-down as the cash the disposal plan will return, discounted at your target return: sale prices below appraisal, selling costs, debt repaid, fees and wind-up costs, year by year. On an illustrative fund with €96.0 million of NAV and three assets to sell over three years, a 20 per cent interest reported at €19.20 million is worth €13.99 million at a 13 per cent return, 72.9 per cent of NAV. Leverage turns an average 7.94 per cent haircut on the buildings into 14.9 per cent of NAV.
Worked in full in The Real Estate Secondaries Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Funds past their term are a large part of the real estate secondary market: the manager has extensions, the investors want their money back, and the remaining assets are often the ones that did not sell in the good years. The NAV of such a fund is an appraisal of assets the manager has already decided to sell. The price question is therefore what the sales will produce and when, not what the assets are worth to a long-term holder.
| Asset | Appraisal | Sale year | Haircut to appraisal | Debt allocated |
|---|---|---|---|---|
| Office, Frankfurt | 70.0 | 1 | 5% | 31.11 |
| Retail park | 60.0 | 2 | 8% | 26.67 |
| Business park | 50.0 | 3 | 12% | 22.22 |
| Gross asset value | 180.0 | 7.94% | 80.0 |
| Input | Value |
|---|---|
| Other net liabilities, settled at the end | 4.0 |
| NAV (180.0 less 80.0 less 4.0) | 96.0 |
| Net income yield on appraisal / interest rate on debt | 5.5% / 5% |
| Selling costs, % of price | 1.5% |
| Management fee in extension, % of NAV | 0.75% |
| Fixed fund costs a year / wind-up costs | 0.6 / 1.0 |
| Interest bought / buyer's target return | 20% / 13% |
Cash flowt = net income − interest − fees − fund costs + Σ sales × (1 − haircut) × (1 − costs) − debt repaid
Value of the interest = stake × Σ cash flowt ÷ (1 + r)t
In Excel, with the fund's yearly cash flows in C10:E10: =20%*NPV(13%,C10:E10). Debt is allocated to assets in proportion to appraisal and repaid from each sale.
Year 1: the remaining assets earn 9.90 of net income against 4.00 of interest, so 5.90 before fees and fund costs. The Frankfurt office sells at 66.50, 5 per cent below its appraisal, nets 65.50 after costs and repays 31.11 of debt. The fund distributes 38.97. Year 2 brings 30.28 from the retail park, and year 3, after the 4.0 of other liabilities and 1.0 of wind-up costs, 16.98.
| Line | Fund |
|---|---|
| Reported NAV | 96.00 |
| Haircuts to appraisal on sale | -14.30 |
| Selling costs | -2.49 |
| Net income after interest, three years | 11.14 |
| Management fees | -1.33 |
| Fixed fund costs | -1.80 |
| Wind-up costs | -1.00 |
| Total cash returned | 86.23 |
The fund returns 86.23 undiscounted, 89.8 per cent of NAV. Discounted at 13 per cent the cash flows are worth 69.97, 72.9 per cent of NAV, a discount of 27.1 per cent. For the 20 per cent interest: NAV €19.20 million, cash €17.25 million, value €13.99 million.
The 27.1 points split into 10.2 points of leakage, money that never arrives, and 16.9 points of time, money that arrives later than a NAV implies. The leakage is dominated by the haircuts: 14.30 on the buildings is 7.94 per cent of gross value but 14.9 per cent of NAV, because the fund is geared at 44.4 per cent loan-to-value and every euro of shortfall comes out of equity. It is the same gearing that sets how much cap rate expansion a secondary discount absorbs. Income over the wind-down, 11.14, more than covers the fees and costs, but not the haircuts.
A haircut to appraisal is not a view that the appraiser is wrong. Assets left at the end of a fund's life are sold on a timetable, to buyers who know it, and the appraisal assumes a willing seller with no deadline. For how much an appraisal can lag the market, see how to unsmooth appraisal-based returns.
| Haircuts | On plan | One year late | Two years late |
|---|---|---|---|
| None (sold at appraisal) | 84.2% | 78.7% | 73.9% |
| Base case, 7.94% average | 72.9% | 68.7% | 65.0% |
| 1.5 times, 11.92% average | 67.2% | 63.7% | 60.6% |
Even at appraisal and on plan, the interest is worth 84.2 per cent of NAV to a 13 per cent buyer, because three years of a low-yielding run-off cannot earn 13 per cent on NAV. Each year of delay costs between 3.7 and 5.5 points. At a 10 per cent target the base case is worth 76.3 per cent of NAV; at 16 per cent, 69.8.
The common mistake is to price a wind-down fund at a market discount read from a survey, as if it were a mid-life fund. The discount on a tail-end interest is mostly arithmetic: sale haircuts magnified by leverage, fixed costs on a shrinking base, and the time to the last sale. Model the disposal plan asset by asset and the discount follows. Fixed costs bite harder as NAV shrinks, the point made for buyout funds in why tail-end secondaries trade at deeper discounts.
Value = stake × PV of the disposal plan's cash flows. Here a 20 per cent interest at €19.20 million of NAV is worth €13.99 million, 72.9 per cent: 10.2 points lost to haircuts, costs and fees, 16.9 to time. The book prices the same interest from the tape, asset by asset, as a second road to the reported NAV; the free workbook for this case carries both roads and the exit-yield sensitivity as live formulas.
Because sale shortfalls come out of equity while debt is repaid in full. With 80.0 of debt on 180.0 of assets, haircuts averaging 7.94 per cent on gross value cost 14.30, which is 14.9 per cent of a 96.0 NAV. At 44.4 per cent loan-to-value every point lost on the buildings costs about 1.9 points of NAV.
At a 13 per cent target, each year that every sale slips costs roughly four points of NAV in the base case, because income at a 5.5 per cent yield after interest and fees cannot earn the buyer's return. Illustratively, the interest falls from 72.9 per cent of NAV on plan to 68.7 one year late and 65.0 two years late.
Not to a buyer who needs a market return. Even with no haircut and sales on plan, an illustrative three-year run-off returns 100.32 on a 96.0 NAV but is worth 84.2 per cent of NAV at 13 per cent. The low running yield over the wind-down, not the sale prices, explains the gap.
This article is one calculation from The Real Estate Secondaries Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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