Chapter 10

1. Chapter 10 Valuation of Income Properties: Appraisal and the Market for Capital

2. Overview • Valuation Fundamentals • Appraisal Process • Sales Comparison Approach • Income Approach • Gross income multiplier (GIM) • Capitalization rate • Discounted cash flow • Highest & Best Use • Mortgage-Equity Capitalization • Cost Approach

3. Valuation Fundamentals • Market Value • Most probable price • Open market and fair sale • Knowledgeable buyer and seller • Arms length transaction • Normal financing

4. Appraisal Process • An appraisal is an estimate of value • It is used as the basis of lending and investing decisions • Appraisal Process: • Physical and legal definitions • Identify property rights to be valued • Specify the purpose of the appraisal • Specify the effective date of value estimate • Gather and analyze market data • Apply techniques to estimate value • Three approaches of appraisal • Sales comparison approach • Income capitalization approach • Cost approach

5. Sales Comparison Approach • Use data from recently sold “comparables” to derive a “subject” market value • Adjust comparable sales price for feature differences • Principles of contribution & substitution • Lump sum adjustments and square foot adjustments • Subjective process

6. Sales Comparison Approach

7. Sales Comparison Approach

8. Income Approach • The value of a property is related to its ability to produce cash flows • Gross income multiplier (GIM) • Capitalization rate • Discounted cash flow

9. Gross Income Multiplier • Determine comparable property GIM as: • Apply GIM to the subject property • If GIM = 6.00x and the subject has gross income = $120,000 then • Value Estimate = 6.00 x $120,000 = $720,000

10. Capitalization Rate • If comparable properties have different operating expenses then instead of GIM, net operating income (NOI) should be used

11. Capitalization Rate – Continued • Capitalization Rate Range: • 0.1320 < R < 0.1377 • The cap rate choice is an educated opinion of the appraiser • Which property is most similar to the subject? • If the subject NOI = $58,000, the value estimate could be: • $58,000 / 0.1320 < V < $58,000 / 0.1377 • $421,205 < V < $439,394 • Care must be taken when determining R

12. Capitalization Rate – Continued • Considerations when determining R • Consider the comparables • Similarity to subject • Physical attributes • Location • Lease terms • Operating efficiency • How is NOI determined? • Stabilized NOI • Nonrecurring capital outlays • Lump sum • Averaged • Was NOI skewed by a one-time outlay?

13. Discounted Present Value • Compute the present value of future cash flows • Forecast NOI and holding period • Select discount rate based on risk and return of comparable investments (r) • Determine reversion value of property

14. Discounted Present Value – Discount Rate

15. Discounted Present Value – Reversion Value • Estimating reversion value • Not an exact science • Method 1: Discount remaining cash flows using a terminal cap rate (RT) • RT = (r – g)  constant positive growth (g) • RT = (r)  growth is zero • RT = (r + g)  growth is a decay rate • Method 2: Estimate RT by adjusting the “going in” cap rate • RT > going in cap rate • This is because as properties age their income generation potential diminish • Method 3: Estimate resale value from expected changes in property value

16. Discounted Present Value – Example • A property has a projected year 1 NOI of $200,000. NOI is projected to grow by 4.00% per year for the following 2 years, then by 2.00% per year for the subsequent 2 years at a 1.00% constant rate afterward. Given a required return of 13.00%, what is the value of the property? • NOI1 = $200,000 • NOI2 = $208,000 • NOI3 = $216,320 • NOI4 = $220,646 • NOI5 = $225,059 • Constant 1.00% growth begins

17. Discounted Present Value – Example • Terminal Value = $1,894,250 • Cash flows: • NOI1 = $200,000 • NOI2 = $208,000 • NOI3 = $216,320 • NOI4 = $220,646 • NOI5 = $225,059 + $1,894,250 • PV @ 13.00% = $1,775,409

18. Highest & Best Use • Land value: The residual land value is the difference between total property value driven by rents and cash flows less cost of constructing an improvement on a given site • Sources of land price volatility • Speculation • Changes in valuation of improvements that can be built on the land • Residual Land Value • PV – Building Cost = Land Value • Step 1: Compute the present value of the estimated cash flows for all alternatives • Step 2: Subtract building cost • Step 3: Select highest value among the alternatives

19. Highest & Best Use – Continued

20. Mortgage-Equity Capitalization • Value = PV of Mortgage Financing + PV of Equity Investment • Steps: • Estimate NOI • Subtract Debt Service from NOI • Subtract Mortgage Balance from Resale Value • Discount Cash Flows • Add Present Value of Cash Flows to Mortgage

21. Mortgage-Equity Capitalization – Continued

22. Mortgage-Equity Capitalization – Continued • PV of total cash flow @ 12.00% = $165,566 • Financing is based on debt coverage ratio (DCR) of 1.20 and first year NOI of $50,000. • Debt service (DS) = $50,000 / 1.20 = $41,667 • Monthly payment = $41,667 / 12 = $3,472 • If the loan rate is 11.00% for 20 year then the loan amount is $336,394 • Property value = $336,394 + $165,566 = $501,960

23. Valuation Fundamentals • Reconciliation of Value Estimates • The sales comparison and income approaches should yield similar value estimates. • Market Conditions Changes on “Going in” Cap Rates • Supply & Demand pressures • Capital market changes • Capital market & spatial market changes

24. Cost Approach • Buyer would not pay more than the value of land plus cost of building the structure • Estimate the construction cost if new • Subtract depreciation • Physical • Functional • External • Add site value