Split the NAV: price the standing assets on a discount, and price the development as the cash it will return, net of the capital still to be called.
Split the NAV in two. Price the standing assets on your usual discount, and price the development as the cash it will return on completion, less the capital still to be called, at a return that reflects construction and letting risk. In an illustrative fund with a development carried at 30.0 of its 100.0 NAV, the development is worth 22.73 to a buyer requiring 15 per cent, and the fund is worth 87.13, a 12.9 per cent discount to NAV, not the 8 per cent that its standing assets alone would justify.
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 →
A fund's NAV usually carries a development at cost to date until it completes. That number says what has been spent. It does not say what the buyer still has to spend, how long it will take, or whether the building will let at the rent in the appraisal. A secondary buyer who applies one blended discount to the whole NAV is pricing the development as if it were a let building, and is also forgetting that the cost to complete arrives as capital calls, funded at par by whoever owns the interest.
| Input | Value |
|---|---|
| Standing portfolio, gross asset value | 120.0 |
| Fund debt | 50.0 |
| Development, carried in NAV at cost to date | 30.0 |
| NAV | 100.0 |
| Completed, let value of the development (appraisal) | 64.0 |
| Buyer's allowance for letting risk on completion | 5% |
| Cost to complete, per the manager | 26.0 |
| Buyer's contingency for overruns | 10% |
| Years to completion, cost spent evenly | 2 |
| Buyer's required return on development risk | 15% |
| Buyer's discount on the standing portfolio's NAV | 8% |
| Share of the fund being bought | 20% |
The cost to complete is funded from undrawn commitments, so it reaches the buyer as capital calls. On the manager's own figures the scheme makes a profit of 8.00 on a total cost of 56.0, 14.3 per cent on cost: a thin margin for a scheme still exposed to construction and letting.
Step 1: the standing assets. 120.0 of property less 50.0 of debt is 70.0 of NAV. At an 8 per cent discount it is worth 64.40.
Step 2: the development's cash flows. The buyer expects the completed building to fetch 64.0 × 95% = 60.80 in two years. The cost to complete with contingency is 26.0 × 1.10 = 28.60, called as 14.30 a year.
Step 3: discount them at the development return.
PV of completed value = 60.80 ÷ 1.152 = 45.97
PV of calls = 14.30 ÷ 1.15 + 14.30 ÷ 1.152 = 23.25
Development value = 45.97 − 23.25 = 22.73, against 30.0 in NAV: a 24.2 per cent discount
In Excel: =GDV*(1-Haircut)/(1+r)^2-PV(r,2,-CTC*(1+Cont)/2)
Step 4: add up and scale to the interest. The fund is worth 64.40 + 22.73 = 87.13, a 12.9 per cent discount to its 100.0 NAV. A 20 per cent interest, reported at 20.00, is worth 17.43, and the buyer must also fund 5.72 of calls, 2.86 a year.
| Component | NAV | Buyer's value | Markdown |
|---|---|---|---|
| Standing portfolio | 70.0 | 64.40 | 5.60 |
| Development | 30.0 | 22.73 | 7.27 |
| Fund | 100.0 | 87.13 | 12.87 |
The development is 30 per cent of the NAV and 56.5 per cent of the discount. A buyer who priced the whole interest at the 8 per cent standing discount would pay 18.40 for the 20 per cent stake, 0.97 too much, and would only find out as the calls came in.
| Overrun allowance | 12% return | 15% return | 18% return |
|---|---|---|---|
| 0% | 26.50 (9.1%) | 24.84 (10.8%) | 23.31 (12.3%) |
| 10% | 24.30 (11.3%) | 22.73 (12.9%) | 21.28 (14.3%) |
| 20% | 22.10 (13.5%) | 20.61 (15.0%) | 19.24 (16.4%) |
Time matters as much as cost. If completion slips to three years with the same total spend, the development falls to 18.21, a loss of 4.52 for one year, and the fund's discount widens to 17.4 per cent. For the development to be worth its 30.0 carrying value at 15 per cent, the completed building would have to fetch 74.13, 15.8 per cent above the appraisal.
Quoting the bid as a percentage of NAV and comparing it with the discounts on funds that hold only let buildings. A 12.9 per cent discount on this fund is not a deeper discount than 8 per cent on a standing fund; it is the same 8 per cent on the let assets plus a proper price for a development that still needs 28.60 of money and two years of luck. The same logic, that capital still to be paid in is bought at par, is set out in how unfunded commitments change a secondary price.
Ask the manager for the development's cost report, the contract sum and what is fixed, the pre-let status and the funding source. If the cost is funded by a development loan rather than calls, deduct the loan instead, and treat the interest on it as part of the cost.
Never apply one discount to a NAV that mixes let buildings with a scheme under construction. Price the standing assets from the tape, price the development as completed value less calls at a development return, and add the two. The book's argument is that a headline discount overstates what a buyer is really paying; the free workbooks for the book take a reported discount apart line by line, and valuing a property fund from the asset tape covers the standing side.
Usually at cost to date until completion, or at a residual value that deducts the cost to complete and a profit allowance from the completed value. Either way, the figure excludes the capital still to be called. In the example the development sits in NAV at 30.0, while the buyer still has to fund 28.60 of cost, including a 10 per cent contingency, before the 64.0 completed value can be realised.
Because the value depends on cost, time and letting that have not happened yet, and because the buyer funds the remaining cost at par through capital calls. At a 15 per cent required return the development in the example is worth 22.73 against 30.0 in NAV, a 24.2 per cent discount, three times the 8 per cent applied to the standing assets.
Discount the same cash flows one year further out. If completion slips from two years to three, the development falls from 22.73 to 18.21 in value, a cost of 4.52 for one year, and the discount on the whole fund rises from 12.9 to 17.4 per cent.
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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