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Return, Income, Value and Capitalization

Return, Income, Value and Capitalization

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Return, Income, Value and Capitalization

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  1. Return, Income, Value and Capitalization • Learning objectives: • Understand the meaning of investment decision making. • Understand the role of the appraisal function in real estate investing. • Examine the appraisal process using capitalization methods.

  2. 9 Points of (Ascending) Main Importance • Any property is a potential investment by virtue of the income producing capability of real estate. • Income potential of real estate is measured using the net operating income (NOI). • NOI is a function of market rents (+), vacancies (-) and operating expenses (-).

  3. 9 Points of (Ascending) Main Importance • Expenses are classified as fixed (property taxes, insurance, hard repairs/maintenance, marketing) or variable (utilities, management/operation, soft repairs/maintenance). • Leases are the (legal) mechanisms that specify the division of tenancy and ownership rights of a real property. • Leases also stipulate the direction and magnitude of cash flows (revenues and costs) to and from landlords and tenants.

  4. 9 Points of (Ascending) Main Importance • Cash flows are adjusted for risks originating from the uncertainty in the above revenues and costs. • Such risks are associated with variations in rent due to lease provisions (step-up/% revenue), concessions (grace, tenant improvements) and options (equity participation, renewal, first refusal, relocation, term flexibility) that arise from the economic forces affecting real estate.

  5. 9 Points of (Ascending) Main Importance • The risk-adjusted expected revenues and costs associated with a real property’s cash flows result in estimates of the economic value for a property. • Likewise, the estimate of the economic present discounted value of a property can be used to infer cash flows and/or return characteristics of a real estate investment.

  6. The Nature of Real Estate Returns • Real estate returns originate from the income generated by sharing tenancy rights of a property. • For this reason, it is of preliminary importance to calculate a property’s “yield” potential, to compare real estate with competing investment alternatives.

  7. The Capitalization (CAP) Rate • The CAP rate is a measure of the estimated first year yield for an income generating property. CAP = NOI ÷ value • Because the CAP rate is a function of NOI and value, it incorporates features of both, return and risks associated with a property.

  8. Identify property and ownership distribution Specify purpose of appraisal Specify effective date(s) of estimated value Obtain and analyze market data Estimate value The Appraisal Function and the Cap Rate • The appraisal process:

  9. The Appraisal Function and the Cap Rate • Income capitalization approach: CAP = NOI ÷ value Value = NOI ÷ CAP

  10. NOI = ? • Estimate from market demand and supply analysis (in feasibility study). • Estimate from rental history of the property (when one exists or is available), with proper adjustments in marketing strategy and costs.

  11. CAP Rate = ? • Should be derived from what investors are receiving from and paying for comparable properties in the market for the specific property under evaluation. • If you can estimate rents, prices, operating expenses and vacancy rates for relevant (comparable) properties, then you can arrive at CAP rate estimate.

  12. The CAP Rate and Efficient Markets • If investment markets are efficient, there should be no arbitrage across different investments = the risk-adjusted time value of money is the same across all investments. CAP = r – gi

  13. The CAP Rate and Efficient Markets • If investment opportunities occur in efficient markets the CAP rate should be equal to the risk adjusted required rate of return on investments, r, minus a factor accounting for value appreciation, gi. • Alternatively, r = CAP + gi. The discount rate = current yield + capital gain = required rate of return.

  14. Mortgage + Equity Value Capitalization • V = M + E • M = LTV*V • E = PDV(BTCF) + PDV(price) – PDV(balance on mortgage) • PDV(BTCF) = PDV(NOI) – PDV(DS)

  15. Mortgage + Equity Value Capitalization • V = LTV*V + PDV(NOI) – PDV(DS) + PDV(price) – PDV(balance on mortgage) • V = k*V + PDV(NOI) • V = PDV(NOI)/(1-k) • CAP = 1-k • ‘k’ is the depreciated cumulative fraction of the property’s value used during the holding period by the current investor.