Valuation of Income Properties: Appraisal and the Market for Capital Chapter 10 Valuation of Income Properties: Appraisal and the Market for Capital

Overview Valuation Fundamentals Appraisal Process Sales Comparison Approach Income Approach Gross income multiplier (GIM) Capitalization rate Discounted cash flow Highest & Best Use Mortgage-Equity Capitalization Cost Approach

Valuation Fundamentals Market Value Most probable price Open market and fair sale Knowledgeable buyer and seller Arms length transaction Normal financing

Appraisal Process An appraisal is an estimate of value It is used as the basis of lending and investing decisions Appraisal Process: Physical and legal definitions Identify property rights to be valued Specify the purpose of the appraisal Specify the effective date of value estimate Gather and analyze market data Apply techniques to estimate value Three approaches of appraisal Sales comparison approach Income capitalization approach Cost approach

Sales Comparison Approach Use data from recently sold “comparables” to derive a “subject” market value Adjust comparable sales price for feature differences Principles of contribution & substitution Lump sum adjustments and square foot adjustments Subjective process

Sales Comparison Approach

Sales Comparison Approach

Income Approach The value of a property is related to its ability to produce cash flows Gross income multiplier (GIM) Capitalization rate Discounted cash flow

Gross Income Multiplier Determine comparable property GIM as: Apply GIM to the subject property If GIM = 6.00x and the subject has gross income = $120,000 then Value Estimate = 6.00 x $120,000 = $720,000 1 2 3 Sales Price $600,000 $750,000 $450,000 Gross Income $100,000 $128,000 $74,000 GIM 6.00x 5.86x 6.08x

Capitalization Rate If comparable properties have different operating expenses then instead of GIM, net operating income (NOI) should be used 1 2 3 4 Sales Price $368,500 $425,000 $310,000 $500,000 NOI $50,000 $56,100 $42,700 $68,600 R 0.1357 0.1320 0.1377 0.1372

Capitalization Rate – Continued Capitalization Rate Range: 0.1320 < R < 0.1377 The cap rate choice is an educated opinion of the appraiser Which property is most similar to the subject? If the subject NOI = $58,000, the value estimate could be: $58,000 / 0.1320 < V < $58,000 / 0.1377 $421,205 < V < $439,394 Care must be taken when determining R

Capitalization Rate – Continued Considerations when determining R Consider the comparables Similarity to subject Physical attributes Location Lease terms Operating efficiency How is NOI determined? Stabilized NOI Nonrecurring capital outlays Lump sum Averaged Was NOI skewed by a one-time outlay?

Discounted Present Value Compute the present value of future cash flows Forecast NOI and holding period Select discount rate based on risk and return of comparable investments (r) Determine reversion value of property

Discounted Present Value – Discount Rate

Discounted Present Value – Reversion Value Estimating reversion value Not an exact science Method 1: Discount remaining cash flows using a terminal cap rate (RT) RT = (r – g)  constant positive growth (g) RT = (r)  growth is zero RT = (r + g)  growth is a decay rate Method 2: Estimate RT by adjusting the “going in” cap rate RT > going in cap rate This is because as properties age their income generation potential diminish Method 3: Estimate resale value from expected changes in property value

Discounted Present Value – Example A property has a projected year 1 NOI of $200,000. NOI is projected to grow by 4.00% per year for the following 2 years, then by 2.00% per year for the subsequent 2 years at a 1.00% constant rate afterward. Given a required return of 13.00%, what is the value of the property? NOI1 = $200,000 NOI2 = $208,000 NOI3 = $216,320 NOI4 = $220,646 NOI5 = $225,059 Constant 1.00% growth begins

Discounted Present Value – Example Terminal Value = $1,894,250 Cash flows: NOI1 = $200,000 NOI2 = $208,000 NOI3 = $216,320 NOI4 = $220,646 NOI5 = $225,059 + $1,894,250 PV @ 13.00% = $1,775,409

Highest & Best Use Land value: The residual land value is the difference between total property value driven by rents and cash flows less cost of constructing an improvement on a given site Sources of land price volatility Speculation Changes in valuation of improvements that can be built on the land Residual Land Value PV – Building Cost = Land Value Step 1: Compute the present value of the estimated cash flows for all alternatives Step 2: Subtract building cost Step 3: Select highest value among the alternatives

Highest & Best Use – Continued

Mortgage-Equity Capitalization Value = PV of Mortgage Financing + PV of Equity Investment Steps: Estimate NOI Subtract Debt Service from NOI Subtract Mortgage Balance from Resale Value Discount Cash Flows Add Present Value of Cash Flows to Mortgage

Mortgage-Equity Capitalization – Continued

Mortgage-Equity Capitalization – Continued PV of total cash flow @ 12.00% = $165,566 Financing is based on debt coverage ratio (DCR) of 1.20 and first year NOI of $50,000. Debt service (DS) = $50,000 / 1.20 = $41,667 Monthly payment = $41,667 / 12 = $3,472 If the loan rate is 11.00% for 20 year then the loan amount is $336,394 Property value = $336,394 + $165,566 = $501,960

Valuation Fundamentals Reconciliation of Value Estimates The sales comparison and income approaches should yield similar value estimates. Market Conditions Changes on “Going in” Cap Rates Supply & Demand pressures Capital market changes Capital market & spatial market changes

Cost Approach Buyer would not pay more than the value of land plus cost of building the structure Estimate the construction cost if new Subtract depreciation Physical Functional External Add site value