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Constant Growth Perpetuity Question

1,128 Views | 10 Replies | Last: 5 yr ago by 93MarineHorn
93MarineHorn
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Question for you finance/investment gurus: How much could someone sell a constant growth perpetuity that pays out $45k/year and increases annually (set to CPI)? The perpetuity is from a commercial ground lease (it is a share of the lease) to a hotel in downtown Austin. The lease ends in 2114 with the hotel conveying to the owners of the ground lease. Just a ballpark estimate would be greatly appreciated.
Casey TableTennis
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AG
Sounds like the Gordon Growth Model is a good fit here. In addition to the dividend (next year), would need to know the growth rate and required return of the purchaser (or a reasonable proxy).
93MarineHorn
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Forgive my ignorance, but I've never heard of the Gordon growth model. The lease escalates annually based on CPI. I was thinking some sort of retirement fund or university fund would be a good prospective buyer. Some entity that is looking very long term. The buyer would receive $45k/year ($$$ escalated to CPI annually) until 2114. At that time whatever improvements made to the land (the hotel) would revert to the buyer as well (approximately 1/16 share of a hotel in downtown Austin and the land it sits on).
DallasAggie0
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From nearly a hundred years out you really couldn't consider any reversion value there for the hotel (beyond the useful life of the improvements). I'd do a DCF and calculate the NPV using $45k/year and escalate it at 3% with maybe a 4% - 6% discount rate. Credit worthiness and location of the hotel is also a factor.
Casey TableTennis
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AG
If I expect inflation to be 2.5% on avg and want a 10% IRR, I would be willing to pay $600k ($45k / (10% - 2.5%)).

The lower the spread between someone's desired return and expected inflation, in theory the more they will pay.

When looking at it this way, a component of the required return is a risk factor for this investment. Sellers almost always see a lease/property as less risky than the buyer, causing a disconnect in fair value.

This model only works if there truly is no cash outlay needed over time and the growth is fairly constant. I'm assuming no residual value.
FTAco07
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AG
If you have a ground lease in downtown Austin that ends in 2114 then I'm going to assume it's a new construction hotel meaning great collateral that is highly unlikely to default. The 30 year TIP is trading for 90bps right now (the market risk free real return rate). Obviously pricing is going to depend on what the lease document actually says, but if you were selling the entire fee simple interest (full ownership of the land that entitles you to review the ground lease rents) it would probably trade in the low 4% cap rate range (cap rate = annual income/price) for a "typical" and financable lease.

The biggest complication here is trying to sell only a partial interest in the fee simple ownership. That may significantly impact the depth of the buyer pool and pricing depending on structure, controls, etc between fee owners. At only $45k/yr in downtown Austin I'm guessing this is a small minority interest and your buyer pool is only going to be HNW individuals. I don't know your situation, but if you wanted to really maximize current value it would be worth talking to an institutional quality commercial broker and exploring a full sale. There are tons of groups out there today with incredibly low return requirements for long term inflation protected income they know that you otherwise wouldn't have access to.

Long winded, but hope that helps.
93MarineHorn
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Quote:

If you have a ground lease in downtown Austin that ends in 2114 then I'm going to assume it's a new construction hotel meaning great collateral that is highly unlikely to default. The 30 year TIP is trading for 90bps right now (the market risk free real return rate). Obviously pricing is going to depend on what the lease document actually says, but if you were selling the entire fee simple interest (full ownership of the land that entitles you to review the ground lease rents) it would probably trade in the low 4% cap rate range (cap rate = annual income/price) for a "typical" and financable lease.
FTAco07 - Yes, this is new construction to be completed in 2020. I own 1/16th of the ground lease. Would you have any idea of the amount of money I could get if I sold my share? Since there are many unknowns, just a ballpark estimate would be very helpful. I really appreciate you taking the time answer my questions. I'm not familiar with the terms and acronyms (TIP, bps...) you and others are using.
93MarineHorn
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Quote:

If I expect inflation to be 2.5% on avg and want a 10% IRR, I would be willing to pay $600k ($45k / (10% - 2.5%)).

The lower the spread between someone's desired return and expected inflation, in theory the more they will pay.

When looking at it this way, a component of the required return is a risk factor for this investment. Sellers almost always see a lease/property as less risky than the buyer, causing a disconnect in fair value.

This model only works if there truly is no cash outlay needed over time and the growth is fairly constant. I'm assuming no residual value.
Thx, Casey. $600k does seem low to me, and definitely not worth selling at that price. I appreciate you taking the time to explain.
BlackGoldAg2011
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AG
just to add another data point to Casey's, if I personally were evaluating buying this I would pay somewhere in the realm of $500k to $750k for this, depending largely on what the actual terms of the lease and sale would be, as well as what the rest of the ownership interests look like. Those numbers would turn out roughly 5%-9% after tax returns for the buyer depending on their specific tax situation.
93MarineHorn
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Quote:

just to add another data point to Casey's, if I personally were evaluating buying this I would pay somewhere in the realm of $500k to $750k for this, depending largely on what the actual terms of the lease and sale would be, as well as what the rest of the ownership interests look like. Those numbers would turn out roughly 5%-9% after tax returns for the buyer depending on their specific tax situation.
Thx, BlackGold. I really appreciate the info.
FTAco07
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AG
Let me reiterate the caveat that all of my knowledge and experience is in the institutional quality commercial real estate space, not the individual/high net worth arena.

First, the ground lease is more marketable once the hotel is fully built and operational. A developer is more likely to default during construction and that brings in a mess of complications with their lender getting the building built to generate your income stream.

If the full ground lease was being sold, again assuming a typical and financable lease document, you're probably looking at a value in the range of $16-$18MM so your 1/16th would be +/- $1MM based on a 4-4.5% capitalization rate. That said, because of the factors I mentioned earlier with the minority interest and different buyer pool, I wouldn't even begin to speculate what the value of a non-controlling 1/16th interest is worth or who would be the right person to talk to about selling it.

It sounds like you have a nice asset here, and without knowing anything about your financial situation, it may be worth more to you than the open market. Ground leases are a great way to establish and build generational wealth that can be tax advantaged if structured properly.
93MarineHorn
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Quote:

Let me reiterate the caveat that all of my knowledge and experience is in the institutional quality commercial real estate space, not the individual/high net worth arena.

First, the ground lease is more marketable once the hotel is fully built and operational. A developer is more likely to default during construction and that brings in a mess of complications with their lender getting the building built to generate your income stream.

If the full ground lease was being sold, again assuming a typical and financable lease document, you're probably looking at a value in the range of $1.6-$1.8MM so your 1/16th would be +/- $1MM based on a 4-4.5% capitalization rate. That said, because of the factors I mentioned earlier with the minority interest and different buyer pool, I wouldn't even begin to speculate what the value of a non-controlling 1/16th interest is worth or who would be the right person to talk to about selling it.

It sounds like you have a nice asset here, and without knowing anything about your financial situation, it may be worth more to you than the open market. Ground leases are a great way to establish and build generational wealth that can be tax advantaged if structured properly.
Thank you very much for your response! It is very helpful and, yes, I'll probably hold on to the lease for many years/decades. I just wanted to explore another option and you and others have been very helpful in educating me. Thanks Ags!
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