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CHAPTER TEN

CHAPTER TEN. VALUATION OF INCOME PROPERTIES: APPRAISAL AND THE MARKET FOR CAPITAL. Market Value. Motivated buyer and seller Well informed buyer and seller A reasonable time period Payment in cash or cash equivalent Arms length transaction. Appraisal Process.

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CHAPTER TEN

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  1. CHAPTER TEN VALUATION OF INCOME PROPERTIES: APPRAISAL AND THE MARKET FOR CAPITAL

  2. Market Value • Motivated buyer and seller • Well informed buyer and seller • A reasonable time period • Payment in cash or cash equivalent • Arms length transaction

  3. Appraisal Process • Physical and legal identification • Identify property rights • Purpose of the appraisal • Specify effective date of value estimate • Apply techniques to estimate value

  4. Income Approach • GIM • Direct capitalization method • Discount present value method • Note- the first two methods rely on current market transactions

  5. Gross Income Multiplier • PGI* • Less V and C • EGI • Less OP • NOI • GIM= sales price/ gross income*

  6. Capitalization Rate • V= NOI/ R • NOI can be compared with transaction prices to derive R • Sometime called market extraction method

  7. Operating Expenses • Real estate taxes • Insurance • Utilities • Repair and maintenance • Admin. and general • Mgnt. and leasing • Salaries • Reserves • other

  8. Discounted PV • Discount rate (r) • Required return for a real estate investment based on its risk when compounded with other investments • Time period 5, 7, 10 years • A forecast of NOI • Estimate reversion value

  9. Simple Formula • Present value of an increasing annuity • Value= NOI1/ (discount rate- growth rate) • NOI1 is Net Operating Income (rent less expensive) during the first year of ownership • Discount rate is the required rate of return (IRR) • Growth rate is the expected growth in income • Same idea as Gordon Dividend Discount Model (see www.DividendDiscountModel.com) • Simple model assumes income and value will grow at the same rate forever (or until sold)

  10. Example • An apartment building is expected to generate NOI of $100,00 the first year. Rents and expenses are expected to grow at 2% per year until sold after 5 years. The value of the property is expected to increase with income. Investors require a 12% rate of return. What is the value? • Value= $100,000/ (12%-2%)= $1,000,000

  11. Concept of a Capitalization Rate • Capitalization rate (“cap rate”)= NOI1/ value • Ratio of first year income to value • Rearrange equation: value=NOI1/cap rate • Two ways to think about getting a cap rate: • Formula: cap rate= discount rate- growth rate e.g., in previous example, cap rate= 12%-2%= 10% • Comparable sales: cap rate=NOI1/ sale price where the sale price is from comparable properties e.g., another property sold for $1,200,000 and was expected to have NOI the first year of $120,000

  12. Beyond the Simple Formula • Project the NOI for each year of a holding period • Project resale price at the end of the holding period • Discount the NOI and resale to get present value

  13. Example • Income is expected to be $100,000 per year for the next 5 years due to existing leases. Starting in year 6 the income is expected to increase to $120,000 due to lease rollovers and increase at 2% per year thereafter. Investors want a 12% return. What is the value?

  14. Solution • First estimate resale using cap rate concept • Resale or “terminal” cap rate= 12%-2%= 10% • Apply this to income in year 6 ( first year of ownership to next owner) • Resale= ($120,000)/ .10= $1,200,000 • Now discount the NOI and resale price • PMT= $100,000 • FV= $1,200,000 • n= 5 • i= 12% • Note that the “going in cap rate” would be 100,000/ $1,041,390= 9.6%

  15. NPV @12% $1,041,390 *Yr 6 NOI/ terminal cap rate of 120,000/ .10

  16. Reversion Values • Expected L-T cash flows • REV9= (NOI10)/ (r-g) • Directly from sales transaction data • Resale based on expected change in property values

  17. Highest and Best Use Analysis • PV= NOI1/ r-g or NOI1/r • PV- BLDG cost= land value

  18. Mortgage Equity Capitalization • V= M+E • DS= NOI1/ DCR • Calculate M • Calculate E (PVA + CF) • PV= M + E

  19. Cap Rates and Market Conditions • Lower cap rates (higher property values) • Unanticipated increases in demand relative to supply • Higher cap rates (lower property values) • Unanticipated increases in supply relative to demand • Unanticipated increases in interest rates

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