Real Estate Private Equity Model: Integrating a Cost Segregation Study

As an REPE analyst, you will build very complex real estate private equity models and be responsible for their accuracy and completeness. Depending on the firm you work for, your model may take into account the tax effects on investment returns. If so, you may want to consider a cost segregation study for property acquisitions.

What is a Cost Segregation Study?

A cost segregation study is a detailed analysis of a property that breaks down the value of a building into different components in order to apply various GAAP or Tax depreciation schedules. As a quick real estate investment case study, if your firm purchased a stabilized office property for $20,000,000, a cost segregation study might break down that value into several components, as follows:

• Land Value: $2,500,000
• Parking Lot: $500,000
• Building Structure: $13,000,000
• Heating and Cooling System: $1,500,000
• Conveying Systems: $250,000
• Tenant Finishes: $2,250,000

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 Cooling Systems (10 years), Conveying Systems (20 years), Tenant Finishes (remaining lease term).

Why This Matters to Your Model

In most cases your model (and likely your accounting department) will simply make a blanket assumption on how to depreciate an asset. Often times the land is assumed to make up 10-20% of the purchase price, and the remaining 80-90% is simply depreciated over 39 years. You can quickly do the math and see that a shorter depreciation schedule results in less tax liability. In fact, do the math, head over to the Forum at LeveragedBreakdowns.com, and share your results with the community!

When initially 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 can use the reports from similar properties to make assumptions for your model. If your firm does not typically use them, but you want to recommend it, you will have to make some assumptions on your own, based on a little research. Much of the information you will need on the cost of different building components can be found in the Cost Approach of an appraisal. You can then cross-reference that with GAAP or Tax depreciation schedules to make an educated guess for your model.

Who Can Prepare A Cost Segregation Study?

These 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 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.

Building a great real estate private equity investment model takes practice and patience. 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!