As a real estate private equity analyst, you will build complex LBO models and be responsible for their completeness and accuracy. Depending on your employer or the specific fund, your model may take into account the effects of taxes on investment returns. If so, you may want to consider a cost segregation study for acquisitions.
What is a Cost Segregation Study?
A cost segregation study is an analysis of a property that breaks down the value of a building into different components in order to apply various GAAP or IRS depreciation schedules. As a quick real estate investment case study, if your firm purchased a stabilized multifamily property for $20,000,000, a cost segregation study might break down that value into several components, as follows:
- Land Value: $3,000,000
- Parking Lot: $500,000
- Building Structure: $12,500,000
- Conveying Systems: $350,000
- Heating and Cooling System: $1,500,000
- Tenant Finishes: $2,150,000
Breaking the purchase price down into the different component values allows each to be depreciated differently. Using our example, the components could be depreciated as follows: Land Value (not depreciable), Parking Lot (15 years), Building Structure (39 years), Heating and Conveying Systems (20 years), Cooling Systems (10 years), Tenant Finishes (remaining lease term).
Why This Matters to Your Model
In most instances your model (and possibly your accounting department) will simply make a blanket assumption on how to depreciate a property. Many times land is assumed to make up 10-20% of the purchase price, and the remaining 80-90% is depreciated over 39 years. You can quickly do the math and see that a shorter depreciation schedule results in less tax liability in the early years. In fact, do the math, head over to the Forum at Leveraged Breakdowns, and share your results with the community!
When modeling an acquisition, you will not have the cost segregation report in order to create your first run. If your firm typically utilizes cost segregation, you could use the reports from similar properties to make reasonable assumptions for your model. If your firm hasn’t used them but you want to recommend it, you will have to make some assumptions on your own, based on a little research. One helpful source is the Cost Approach of an appraisal, which contains much of the information you will need. You can then cross-reference that with GAAP or IRS depreciation schedules to make an educated guesstimate for your model. This analysis may be how you convince management to pay for such a study.
Who Can Prepare A Cost Segregation Study?
Cost segregation studies are performed by qualified firms or individuals who meet the requirements stipulated by the IRS. These individuals often have property appraisal experience, or most importantly, an engineering and construction background. Many of the larger accounting firms have specialists that can complete such a study, but there are many independent contractors or boutique firms that specialize in it as well. Our experience is that the boutique firms tend to be less expensive.
Building a flexible and reliable real estate private equity investment model takes patience and practice. You can find plenty of opportunities to learn more about building models at LeveragedBreakdowns.com. You will find courses, forums, articles, and actual real estate investment case studies to help you on your journey to a REPE career. Check it out today!