Valuation of Income Properties: Appraisal and the Market for Capital Lesson by: David Burditt - Ben Kail - Matt Cutter
Market Value • The most probable price which a property should bring in a competitive and open market. • 1. Buyer and seller are typically motivated; • 2. Both parties are well-informed or well-advised; • 3. A reasonable time is allowed for exposure in the open market; • Payment is made in terms of cash in in US dollars or other comparable arrangements; • 5. The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.
Appraisal Process • Physical and legal identification • Identify property rights to be valued • Fee simple or leased fee estate • Specify the purpose of the appraisal • Condemnation of property, insurance losses, property tax • Specify effective date of value estimate • Gather and analyze market data • Apply techniques to estimate value
Sales Comparison Approach • Based on data provided from recent sales of properties highly comparable to the property being appraised. • Comparable properties are adjusted to the subject property. • Positive features that comparables possess relative to the subject property require negative adjustments; • Negative features require positive adjustments. • Valuing properties using this method is a highly subjective process and should be justified with evidence based on recent experience with highly comparable properties.
Income Approach • Gross Income Multiplier (GIM) • Sales price / Gross Income • PGI vs. EGI • Capitalization Rate • Used when the comparables have largely differing operating expenses. NOI is used instead. • Define cap rates by looking at comparable properties • Cap Rate = NOI / Sale Price of Comparable • Value = NOI / Cap Rate
DCF Analysis • Forecast NOI • Choose a holding period for the investment • Select a Discount Rate (r) • Also known as: required rate of return • Thought of as a required return for a real estate investment based on its risk when compared with returns earned competing investments and other capital market benchmarks. • A risk premium for real estate ownership and its attendant risks related to operation and disposition should be included within the discount rate. • Estimate Reversion Value
Estimating Reversion Values • (A) Developing Terminal Cap Rates Based on Expected Long-Term Cash Flows • Use of a Terminal Cap Rate (RT) • If reversion is going to take place in year 9, year 10 NOI will be used to calculate the reversion value. • NOI / RT = Sales Price • RT = (r – g) when avg. long-run growth in NOI is expected to be positive. • RT = (r) when long-run growth in NOI is expected to be level or zero. • RT = (r + g) when avg. long-run growth in NOI is expected to be negative or decline.
Estimating Reversion Values • (B) Estimating the Terminal Cap Rate Directly from Sales Transactions Data • Uses a larger cap rate than the “going in” rate. • Assumes that as properties age and depreciate the production of income declines; therefore, the expected growth in NOI for an older property should be less than that of a new property. • Higher caps on older properties reflects economic depreciation.
Estimating Reversion Values • (C) Estimating the Resale Price Based on an Expected Change in Property Values • Avoids using a terminal cap rate, instead assumes that property values will change at a specified compound rate each year. • The resale price is expressed as a function of the unknown present value. The valuation is based on the premise that the value of the property is equal to the present value of the NOI.
Highest and Best Use Analysis • PV= NOI1/ r-g or NOI1/r • PV- BLDG cost= land value • Example • PV=$500,000/(.13-.03) • $500,000/.10=$5,000,000 • Assuming building cost=$4,000,000 • Land Value=$5,000,000-$4,000,000 • Land Value=$1,000,000
Volatility in Land Prices • What causes land price volatility? • Investor Speculation • Fundamental change or expected change in location
Highest and Best Use Analysis • The retail project would be the highest and best use • A total property value of $7,500,000 • Implied land value of $3,500,000 • If the asking price of the land is $1,000,000 • The can immediately realize value by developing retail site for $1,000,000 and selling for $3,000,000
Highest and Best Use Analysis • Summary • It is the expected use of land and its future income that determines its value. • As developers and investors envision what will bring the highest property value, competition for site and prices paid based on expected site developments will ultimately determine land values.
Mortgage Equity Capitalization • The previous discount rate was the free and clear discount rate, it does not consider if the property will be financed • Mortgage Equity Capitalization considers financing affects • V= M+E • (V)Value = present value of expected (M) mortgage financing + (E) equity investment made by investors
Mortgage Equity Capitalization • DS= NOI1/ DCR • DS= $50,000/ 1.20 = $41,667 • Calculate M- The monthly mortgage is $41,667/12 = $3,472.22l assuming a 20 yr term and an 11% rate • Calculate E (PVA+CF) • PV= M+ E
Mortgage Equity Capitalization • PV= M+ E • PV at a 12% discount rate is $167,566 • PV = $336,394 + $165,566 • PV = $501,960 • You can calculate the LTV: $336,394/$501,960 = 67%
Cap Rates and Market Conditions • Lower cap rates (higher property values) tend to be brought about by: • Unanticipated increases in demand relative to supply • Unanticipated decreases in interest rates • Both of the above
Cap Rates and Market Conditions • Higher cap rates (lower property values) tend to be brought about by: • Unanticipated increases in supply relative to demand • Unanticipated increases in interest rates • Both of the above
Word of Caution • The above illustrations were developed under strict assumptions regarding timing and duration of conditions of excess supply and demand • To demonstrate the effects of market conditions on property values and cap rates • No consideration was given to the possible interaction between changes in any one of these market forces on other market influences
In Practice • The investor must know how to incorporate these relationships into forecasts • Consider: • Current market supply and demand conditions and how long such conditions will last • The effects of such conditions on rents and NOI • The future course of interest rates that may be affected by more global, non-real estate specific influences such as global economic growth and inflationary pressures • The contents of leases that have been executed on the property being evaluated and whether conditions in any of the above will materially affect rents, expenses, and tenant default rates
Valuation of a Leased Fee Estate • Simple Estates • Properties that can be leased at current market rents • Leased Fee Estates • Properties that have existing leases in place that have leases at below or above market rents • When considering a property, it is important to investigate whether or not existing leases are present and the contents of such leases • Failure to investigate such cases may result in serious errors when estimating value
The Cost Approach • Rational of the Cost Approach: Any informed investor would not pay more for a property than it would cost buy the land and build the structure.
The Cost Approach • For new property: The cost approach involves determining the construction cost of the building an improvement and adding the market value of the land. • In the case of an existing building, the appraiser estimates the cost of replacing the building.
The Cost Approach • To use the cost approach to value, an appraiser uses today’s replacement cost of equivalent or identical property as a basis for evaluation. This is the cost to replace the asset with another of similar age, quality, origin, appearance, provenance, and condition, within a reasonable length of time in an appropriate market. • In using this approach, the appraiser reasons that the value of an asset is equal to the amount required to produce another desirable asset of at least equal amount and quality. This approach involves the cost of reproduction, independent of the benefit of having the original asset at hand.
The Cost Approach • See Excel Spreadsheet
The Cost Approach: Adjustment of Replacement Cost Estimate • Replacement Costs at current prices • Less Repairable Depreciation • Less Incurable Depreciation • Less Functional & Economic –Locational Obsolescence • Add in Site Value • =Value per Cost Approach
The Cost Approach • Cost Approach is most effective when: • An improvement is new and depreciation does not present serious complications (effective age compensation). • It is hard to find comparables among unique property types.
Oakwood Apartments: Income Approach • Inputs: See Comparables on Page 284 & Excel Spreadsheet
Chapter 10 Conclusion • Three Approaches to Valuing Real Estate: • Sales/Market Approach • Income Capitalization Approach • Cost Approach • The three approaches are somewhat intertwined.
Chapter 10 Conclusion • The availability and quality of data should always dictate the methods and approaches chosen for valuation. • Perfect data = perfect results; this is never the case, appraisals are always somewhat subjective due to the human factor and imperfect data.
Chapter 10 Conclusion • Appraisals are estimates of market value based on market conditions and information available at the time of the appraisal. • The appraisal should be used as complement, not a substitute for sound underwriting or investment analysis.