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Valuation of Income Properties: Appraisal Techniques and Capital Market Insights

This chapter delves into the valuation of income properties, focusing on the appraisal process and market capital dynamics. It highlights the significance of motivated buyers and sellers, the arms-length transaction principle, and the essential components of the appraisal process, including property rights identification and effective date specification. Key valuation methods like the Income Approach, Gross Income Multiplier, and Direct Capitalization Method are explored. Real estate investment essentials, such as operating expenses and discounted cash flow analysis, are also discussed, providing investors with a comprehensive understanding of property valuation.

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Valuation of Income Properties: Appraisal Techniques and Capital Market Insights

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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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