Medical office building syndication is a common investment and alignment strategy. This involves the formation of an entity which possesses real estate so that individual investors may be offered fractional ownership. How these entities are formed, the way in which ownership offering is structured, and control and governance issues can make these entities tricky to value. Two major areas of confusion I find in these type of assignments are 1) Cashflow to rate matching issues and 2) Discounts and premiums
Net Operating Income & Cap Rates
One area of confusion is the difference between commercial real estate valuation and business valuation. Commercial real estate valuation primarily considers effective rental income or net operating income (NOI) as the benefit stream. NOI represents the rental income generated by the property after deducting all operating expenses. It is a form of pre-tax earnings. In commercial real estate this benefit stream is capitalized or discounted with appropriate market rates. NOI is very different from net cashflow to equity as used in an income approach in business valuation. Valuators often neglect to make the appropriate adjustments to the entity-level cashflow or cost of capital. It is critical to match the correct rate to the correct benefit stream. NOI is pre-tax and therefore should use a pre-tax cap rate. Net cashflow to equity is an after tax rate. Also important to consider is the effect of the capital structure and future debt service requirements.
Discounts and Premiums
Syndications can have different sizes of investment blocks, and different rights, restrictions, and governance. Operating agreements and internal buy/sell provisions need to be carefully reviewed and understood in order to properly assess discounts and premiums. A single investor may not have more than a small fractional ownership though they can possess significant rights and control. Restrictions on transfer/sale also are important in assessing marketability discounts. Purchase options and rights of first refusal are common considerations as well. Overall the valuator must fully understand the nature and structure of the investment and use proper inputs in order to reach the appropriate conclusion of value.0