Case 085Real assets and private marketsCore
A resort's income swings between Rs 4 crore and Rs 30 crore a year. How would you value it, and how do you avoid penalising the volatility twice?
1The situation
A real estate fund is looking at Konkan Sands Resort, a beach property whose income depends on tourist seasons, monsoon timing and air connections. Its net operating income, after running costs but before financing, is about Rs 30 crore in a good year, Rs 18 crore in a normal year and Rs 4 crore in a bad year. The fund's analysts put the chances at 25%, 50% and 25%.
Stable, fully let commercial property in the region trades at a capitalisation rateNet operating income divided by the property value; a higher cap rate means a lower price for the same income. of about 8%. Resorts with swinging income have traded about 1.5 points higher.
2Your task
What is the resort worth, which income figure do you use, and how do you make sure the volatility is priced only once?
Quick check
Which income figure belongs in the valuation?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
About Rs 184 crore: the probability-weighted income of Rs 17.5 crore at a 9.5% cap rate. The volatility is priced once, in the 1.5 point cap rate premium. The same value comes from haircutting income to a certainty equivalent of Rs 14.74 crore and using the calm 8% rate. Doing both gives Rs 155 crore, 16% too low; using the normal year at 8% gives Rs 225 crore, 22% too high.
Step 1Which income do you put in the numerator?
A mango orchard owner does not value the land on this year's bumper crop or on last year's failed one; a buyer pays for the average crop, less something for the worry. The income that belongs in the valuation is the realistic mean across years: 25% x 30 + 50% x 18 + 25% x 4 = Rs 17.5 crore. Note that it is below the normal year, because the bad year falls further below normal (14 crore) than the good year rises above it (12 crore). A candidate who uses Rs 18 crore has quietly assumed the downside away.
Step 2Where does the volatility go?
Into one place only. The income swings with a standard deviation of about Rs 9.2 crore, over half its mean, so a buyer rightly wants a higher return than on a fully let office. That extra return is the 1.5 point cap rate premium: Rs 17.5 crore at 9.5% gives Rs 184.2 crore. The equivalent route haircuts the income to a certainty equivalentThe sure amount a buyer would accept instead of an uncertain one; the gap between the two is the price of the risk. of Rs 14.74 crore and uses the calm 8% rate. Both give the same answer because they price the same risk, once.
Step 3How does the double penalty creep in?
Usually through two teams each being prudent. The analyst trims the income for bad seasons, and the valuer, seeing a resort, adds a premium to the cap rate. Haircut income of Rs 14.74 crore at 9.5% gives Rs 155 crore, a 16% discount that exists only because the same risk was counted twice. A fund that does this loses every auction for good but volatile assets and does not know why. The opposite error, the normal year at the calm office rate, gives Rs 225 crore and overpays by 22%.
| Route | Income, Rs crore | Cap rate | Value, Rs crore | Verdict |
|---|---|---|---|---|
| Mean income, risk in the cap rate | 17.50 | 9.5% | 184.2 | priced once |
| Certainty equivalent, calm cap rate | 14.74 | 8.0% | 184.2 | priced once |
| Haircut income and higher cap rate | 14.74 | 9.5% | 155.1 | priced twice |
| Normal year, calm cap rate | 18.00 | 8.0% | 225.0 | not priced |
Step 4What else would you check before bidding?
Two things the single number hides. A lender sizes debt on the bad year, not the mean, so a resort carries less borrowing than an office of the same value, which lowers the equity return a buyer can reach. And the 25/50/25 split is itself an estimate; ten years of monthly occupancy would tell you whether bad years cluster. Say the limit: the 1.5 point premium should come from comparable resort sales, and if those are few, state that the value is a range, not a point.
Where candidates lose it
The common loss is picking one scenario, usually the normal year because it feels like the middle, and applying a cap rate to it. That ignores that the downside is deeper than the upside, which is exactly what unpredictable income means.
The second, from candidates trying to sound careful, is haircutting the income and raising the cap rate. Each step alone is sound; together they discount the same risk twice.
What the interviewer asks next
- How much would you lend against Konkan Sands if the bank wants 1.4 times cover in a bad year?
- The good-year probability rises to 40%. What is the value now?
- Would you rather value this resort on a ten-year cash flow model than a cap rate? Why?
Asked at Nuveen, Multifamily, Chicago, 2023 (Wall Street Oasis): Walk me through how you would assess the value of a property if the income stream is unpredictable?
Company names and figures are illustrative.