Case 088Real estate and infrastructureWarm up

A co-living asset has 800 beds at 85% occupancy and Rs 15,000 a bed a month, with opex at 40% of revenue. Value it at a 9% cap rate and test what occupancy the Rs 100 crore asking price needs.

The situation

Kutumb Co-living runs an 800-bed building near an IT park, let to young professionals on monthly contracts at Rs 15,000 a bed. Occupancy has averaged 85% over the last year. Operating costs, including staff, housekeeping, utilities and the property manager's fee, run at 40% of revenue. Comparable operating residential assets have changed hands at a 9% cap rateCapitalisation rate: net operating income divided by value. A 9% cap rate means a buyer pays about 11 times the yearly net operating income..

The owner is asking Rs 100 crore.

Your task

Value the asset at a 9% cap rate on current occupancy, work out the occupancy at which it is worth the asking price, and say what the price is really assuming.

Quick check

At a 9% cap rate, what occupancy makes the building worth Rs 100 crore?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

At 85% occupancy the building is worth about Rs 81.6 crore at a 9% cap rate, and no occupancy makes it worth Rs 100 crore. Revenue is Rs 12.24 crore, NOI Rs 7.34 crore, and that over 9% is Rs 81.6 crore. The asking price needs Rs 9 crore of NOI, which is 104% occupancy, or a 7.3% cap rate at 85%, or rent of about Rs 15,625 a bed. The price is a bet on rent growth or a lower cap rate, not on filling the building.

Step 1How do you value an operating building?

On the income it produces, not the bricks. A paying-guest house is worth what its rooms earn after the cook and the electricity are paid, capitalised at the yield buyers of such houses want. 800 beds at Rs 15,000 a month would earn Rs 14.40 crore a year if full; at 85% that is Rs 12.24 crore; after 40% of opex the net operating incomeRevenue from the property less the costs of running it, before interest, tax and depreciation. It is what a cap rate is applied to. is Rs 7.34 crore; at a 9% cap rate the value is Rs 7.34 over 0.09, about Rs 81.6 crore. That is Rs 10.2 lakh a bed, which is the sanity check a real estate team uses first.

Value at a 9% cap rate against occupancy: the asking price sits above a full building, Rs crore40608010060%70%80%90%100%OccupancynobedsAsking price Rs 100 crore: needs 104% occupancy at 9%85%: value Rs 81.6 croreFull: Rs 96 croreEach point of occupancy is worth about Rs 0.96 crore; the asking price implies a 7.3% cap rate at 85%.
At a 9% cap rate value rises in a straight line with occupancy, to Rs 81.6 crore at 85% and Rs 96 crore with every bed let; the Rs 100 crore asking price sits above the full building and would need 104% occupancy, so it is priced on something other than filling the beds.
Step 2What does the Rs 100 crore price need?

Work the price backwards. Rs 100 crore at 9% is Rs 9 crore of NOI, which at a 60% margin is Rs 15 crore of revenue, and that is 104% of a full building. So occupancy cannot get there. Either the rent must rise to about Rs 15,625 a bed at 85%, a 4% increase, or the buyer must accept a 7.3% cap rate on today's income, or the owner is pricing the building on a plan to add beds. Each point of occupancy is worth about Rs 0.96 crore at 9%, so even the full 15 points between 85% and 100% add only Rs 14.4 crore.

OccupancyRevenue, Rs croreNOI, Rs croreValue at 9%
70%10.086.0567.2
85% (today)12.247.3481.6
100%14.408.6496.0
Asking price Rs 100 crore needs15.009.00104% occupancy
Value moves from Rs 67.2 crore at 70% occupancy to Rs 96.0 crore at 100%, and the Rs 100 crore asking price needs Rs 9 crore of NOI, more than the building can produce at today's rent even with every bed let.
Step 3What is the view, and what would you pay?

Bid on today's income with a plan for tomorrow's. Offer around Rs 82 crore, and if rents in the micro-market have risen since the leases were set, underwrite a rent rise with evidence from new lettings rather than paying the seller for it up front. Occupancy is the operating lever to diligence: 85% on monthly contracts near one IT park means the building empties when one employer moves, so ask for the occupancy by month and by employer. The limit of a cap rate valuation is that it freezes one year's income; a buyer who believes rent grows 5% a year is really using a lower cap rate, and should say which, because 7.3% on an asset that trades at 9% is a 20% premium with a name.

Where candidates lose it

The usual loss is multiplying out the value and stopping, without testing the asking price. The question is designed so the price cannot be reached by occupancy, and a candidate who does not notice that has not asked what the price assumes.

The second is applying the cap rate to revenue rather than net operating income, which roughly doubles the value and hides the whole problem.

What the interviewer asks next

  • The seller says rents will reach Rs 18,000 next year. How much of that would you pay for, and how?
  • The owner can add 100 beds for Rs 5 crore. What does that do to the value, and does it close the gap?
  • Why do operating residential assets trade at higher cap rates than leased offices?

Company names and figures are illustrative.