1. Chapter 15 Valuation Analysis: Income Discounting and Cap Rates

2. Major Topics Simple multiplier models of value The income approach to value The derivation of a capitalization rate Overall market rate capitalization

3. Value Value of any asset = PV of expected future CFs Estimating expected future CFs? Holding period? Financing terms? Simplifications Capitalize: to convert future income into a present value Gross Rent Multiplier Capitalization Rate

4. Reconstructed Operating Statement PGIPotential Gross Income - VacVacancy Allowance + MIMiscellaneous Income = EGIEffective Gross Income - OEOperating Expenses - NOINet Operating Income NOI EBITDA

5. Gross Rent (PGI) Multiplier GRM (Gross Rent Multiplier) = Price / Gross Rent (PGI) Quick indicator of value for smaller rental properties Presumption: Whatever investors are willing to pay for similar property per dollar of gross rent they should be willing to pay for a subject property GRM should be found from comps with: Similar ages, turnover, growth projections

6. GRM Example PGI = $162K Value of subject = 5.53 x PGI = 5.53 x $162,000 = $895,860 Comparable A B C Recent sale price $876,400 $986,900 $776,300 Potential gross income $158,200 $175,300 $143,500 GRM (sale price / PGI) 5.54 5.63 5.41 Average GRM = = 5.53

7. Capitalization Rate Cap Rate = NOI 1 P 0 Similar to reciprocal of PE Ratio (P 0 EPS 1 ), except pre-tax Why do PE ratios differ across stocks? Cap Rates should be similar for similar properties

8. Cap Rates and Required Return P 0 = D 1 ÷ (r – g) Flip and solve for r: r = D 1 / P 0 + g g = expected growth; expected cap gain yield D 1 / P 0 = Dividend yield Flip again: D 1 / P 0 = r – g Cap rate D 1 / P 0 = r – g What influences cap rates?

9. Economic conditions Market conditions S & D of/for similar properties Type of property Age of property

10. Valuation FactorImpact on Cap Rate Growth in IncomeFaster growth means a low cap rate and higher value RiskHigher risk means a higher cap rate and lower value Economic obsolescence Shorter economic life means a higher cap rate and lower value Interest Rates or Cost of Capital Higher interest rates imply higher cap rates and lower value Market ConditionsStronger rental market imply lower cap rates and higher values Property AgeOlder properties typically have more risk as a result of greater repair volatility. More risk means higher cap rates and lower values Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

11. Sources of Cap Rates RealtyRates.com: www.realtyrates.com www.realtyrates.com Other appraisers and market participants

12. Capitalization Rate If we know market Cap Rate, and we estimate NOI 1, we have an estimate of market value of property. Buying apartment complex: Cap Rate on San Marcos apartments = 8% Expect NOI 1 to be $85,000. How much to bid?

13. Capitalization Rate Cap Rate = NOI 1 V 0 V 0 = NOI 1 Cap Rate V 0 = $85,000 0.08 V 0 = $1,062,500 Austin market: rents increase faster what should change? Lower expected inflation what should change?

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