CHAPTER TEN

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 valueNOI1/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 rateNOI1/ 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 _at_12 1,041,390 Yr 6 NOI/
terminal cap rate of 120,000/ .10
Year 1 2 3 4 5 6
NOI 100,000 100,000 100,000 100,000 100,000 120,000
Resale 1,200,000
Cash Flow 100,000 100,000 100,000 100,000 1,300,000
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 ME
• 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