Presentation on theme: "Valuation of Income Properties: Appraisal and the Market for Capital"— Presentation transcript:
1 Valuation of Income Properties: Appraisal and the Market for Capital Lesson by:David Burditt - Ben Kail - Matt Cutter
2 Market ValueThe 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.
3 Appraisal Process Physical and legal identification Identify property rights to be valuedFee simple or leased fee estateSpecify the purpose of the appraisalCondemnation of property, insurance losses, property taxSpecify effective date of value estimateGather and analyze market dataApply techniques to estimate value
4 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.
5 Income Approach Gross Income Multiplier (GIM) Capitalization Rate Sales price / Gross IncomePGI vs. EGICapitalization RateUsed when the comparables have largely differing operating expenses. NOI is used instead.Define cap rates by looking at comparable propertiesCap Rate = NOI / Sale Price of ComparableValue = NOI / Cap Rate
6 DCF Analysis Estimate Reversion Value Forecast NOI Choose a holding period for the investmentSelect a Discount Rate (r)Also known as: required rate of returnThought 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
7 Estimating Reversion Values (A) Developing Terminal Cap Rates Based on Expected Long-Term Cash FlowsUse 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 PriceRT = (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.
8 Estimating Reversion Values (B) Estimating the Terminal Cap Rate Directly from Sales Transactions DataUses 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.
9 Estimating Reversion Values (C) Estimating the Resale Price Based on an Expected Change in Property ValuesAvoids 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.
10 Highest and Best Use Analysis PV= NOI1/ r-g or NOI1/rPV- BLDG cost= land valueExamplePV=$500,000/( )$500,000/.10=$5,000,000Assuming building cost=$4,000,000Land Value=$5,000,000-$4,000,000Land Value=$1,000,000
11 Volatility in Land Prices What causes land price volatility?Investor SpeculationFundamental change or expected change in location
12 Highest and Best Use Analysis OfficeRetailApartmentWarehouseNOI yr 1$500,000$600,000$400,000Return or r13.00%12.00%10.00%Growth or g3.00%4.00%2.00%Building Costs4,000,000
13 Highest and Best Use Analysis Year 1 NOIRImplied Property ValueBuilding CostsImplied Land ValueOffice$500,00010.00%5,000,0004,000,0001,000,000Retail600,0008.00%7,500,0003,500,000Apartment400,0009.00%4,444,444444,444Warehouse
14 Highest and Best Use Analysis The retail project would be the highest and best useA total property value of $7,500,000Implied land value of $3,500,000If the asking price of the land is $1,000,000The can immediately realize value by developing retail site for $1,000,000 and selling for $3,000,000
15 Highest and Best Use Analysis SummaryIt 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.
16 Mortgage Equity Capitalization The previous discount rate was the free and clear discount rate, it does not consider if the property will be financedMortgage Equity Capitalization considers financing affectsV= M+E(V)Value = present value of expected (M) mortgage financing + (E) equity investment made by investors
17 Mortgage Equity Capitalization DS= NOI1/ DCRDS= $50,000/ 1.20 = $41,667Calculate M- The monthly mortgage is $41,667/12 = $3,472.22l assuming a 20 yr term and an 11% rateCalculate E (PVA+CF)PV= M+ E
18 Mortgage Equity Capitalization 123456NOI$50,000$51,500$53,045$54,636$56,275$57,964DS41,667N/ACash flow$8,333$9,833$11,378$12,969$14,608Resale:Resale in year 5$526,945Less mortgage balance$305,495$221,450Total cash flow$236,058
19 Mortgage Equity Capitalization PV= M+ EPV at a 12% discount rate is $167,566PV = $336,394 + $165,566PV = $501,960You can calculate the LTV: $336,394/$501,960 = 67%
20 Cap Rates and Market Conditions Lower cap rates (higher property values) tend to be brought about by:Unanticipated increases in demand relative to supplyUnanticipated decreases in interest ratesBoth of the above
21 Cap Rates and Market Conditions Higher cap rates (lower property values) tend to be brought about by:Unanticipated increases in supply relative to demandUnanticipated increases in interest ratesBoth of the above
22 Word of CautionThe above illustrations were developed under strict assumptions regarding timing and duration of conditions of excess supply and demandTo demonstrate the effects of market conditions on property values and cap ratesNo consideration was given to the possible interaction between changes in any one of these market forces on other market influences
23 In PracticeThe investor must know how to incorporate these relationships into forecastsConsider:Current market supply and demand conditions and how long such conditions will lastThe effects of such conditions on rents and NOIThe future course of interest rates that may be affected by more global, non-real estate specific influences such as global economic growth and inflationary pressuresThe 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
24 Valuation of a Leased Fee Estate Simple EstatesProperties that can be leased at current market rentsLeased Fee EstatesProperties that have existing leases in place that have leases at below or above market rentsWhen considering a property, it is important to investigate whether or not existing leases are present and the contents of such leasesFailure to investigate such cases may result in serious errors when estimating value
25 The Cost ApproachRational 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.
26 The Cost ApproachFor 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.
27 The Cost ApproachTo 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.
29 The Cost Approach: Adjustment of Replacement Cost Estimate Replacement Costs at current pricesLess Repairable DepreciationLess Incurable DepreciationLess Functional & Economic –Locational ObsolescenceAdd in Site Value=Value per Cost Approach
30 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.
31 Oakwood Apartments: Income Approach Inputs:Units:95 Two-bedRent:$1210/monthRent Escalator:3%See Comparables on Page 284 & Excel Spreadsheet
32 Chapter 10 Conclusion Three Approaches to Valuing Real Estate: Sales/Market ApproachIncome Capitalization ApproachCost ApproachThe three approaches are somewhat intertwined.
33 Chapter 10 ConclusionThe 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.
34 Chapter 10 ConclusionAppraisals 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.