Valuation of Income Properties: Appraisal and the Market for Capital

Valuation of Income Properties: Appraisal and the Market for Capital Lesson by: David Burditt - Ben Kail - Matt Cutter

Market Value The 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.

Appraisal Process Physical and legal identification Identify property rights to be valued Specify the purpose of the appraisal Fee simple or leased fee estate Condemnation of property, insurance losses, property tax Specify effective date of value estimate Gather and analyze market data Apply techniques to estimate value

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.

Income Approach Gross Income Multiplier (GIM) Sales price / Gross Income PGI vs. EGI Capitalization Rate Used when the comparables have largely differing operating expenses. NOI is used instead. Define cap rates by looking at comparable properties Cap Rate NOI / Sale Price of Comparable Value NOI / Cap Rate

DCF Analysis Forecast NOI Choose a holding period for the investment Select a Discount Rate (r) Also known as: required rate of return Thought 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

Estimating Reversion Values (A) Developing Terminal Cap Rates Based on Expected Long-Term Cash Flows Use 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 Price RT (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.

Estimating Reversion Values (B) Estimating the Terminal Cap Rate Directly from Sales Transactions Data Uses 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.

Estimating Reversion Values (C) Estimating the Resale Price Based on an Expected Change in Property Values Avoids 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.

Highest and Best Use Analysis PV NOI1/ r-g or NOI1/r PV- BLDG cost land value Example PV 500,000/(.13-.03) 500,000/.10 5,000,000 Assuming building cost 4,000,000 Land Value 5,000,000- 4,000,000 Land Value 1,000,000

Volatility in Land Prices What causes land price volatility? Investor Speculation Fundamental change or expected change in location

Highest and Best Use Analysis Office Retail Apartmen Warehouse t NOI yr 1 500,000 600,000 400,000 400,000 Return or r 13.00% 12.00% 12.00% 10.00% Growth or 3.00% g 4.00% 3.00% 2.00% Building Costs 4,000,000 4,000,000 4,000,000 4,000,000

Highest and Best Use Analysis Use Year 1 NOI R Implied Propert y Value Building Costs Implied Land Value Office 500,000 10.00% 5,000,00 0 4,000,00 0 1,000,00 0 Retail 600,000 8.00% 7,500,00 0 4,000,00 0 3,500,00 0 Apartme nt 400,000 9.00% 4,444,44 4 4,000,00 0 444,444 Warehou se 400,000 8.00% 5,000,00 0 4,000,00 0 1,000,00 0

Highest and Best Use Analysis The retail project would be the highest and best use A total property value of 7,500,000 Implied land value of 3,500,000 If the asking price of the land is 1,000,000 The can immediately realize value by developing retail site for 1,000,000 and selling for 3,000,000

Highest and Best Use Analysis Summary It 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.

Mortgage Equity Capitalization The previous discount rate was the free and clear discount rate, it does not consider if the property will be financed Mortgage Equity Capitalization considers financing affects V M E (V)Value present value of expected (M) mortgage financing (E) equity investment made by investors

Mortgage Equity Capitalization DS NOI1/ DCR DS 50,000/ 1.20 41,667 Calculate M- The monthly mortgage is 41,667/12 3,472.22l assuming a 20 yr term and an 11% rate Calculate E (PVA CF) PV M E

Mortgage Equity Capitalization 1 2 3 4 5 6 NOI 50,000 51,500 53,045 54,636 56,275 57,964 DS 41,667 41,667 41,667 41,667 41,667 N/A Cash flow 8,333 9,833 11,378 12,969 14,608 Resale: Resale in year 5 526,94 5 Less mortgag e balance 305,49 5 Cash flow 221,45 0 Total cash 8,333 9,833 11,378 12,969 236,05 8

Mortgage Equity Capitalization PV M E PV at a 12% discount rate is 167,566 PV 336,394 165,566 PV 501,960 You can calculate the LTV: 336,394/ 501,960 67%

Cap Rates and Market Conditions Lower cap rates (higher property values) tend to be brought about by: Unanticipated increases in demand relative to supply Unanticipated decreases in interest rates Both of the above

Cap Rates and Market Conditions Higher cap rates (lower property values) tend to be brought about by: Unanticipated increases in supply relative to demand Unanticipated increases in interest rates Both of the above

Word of Caution The above illustrations were developed under strict assumptions regarding timing and duration of conditions of excess supply and demand To demonstrate the effects of market conditions on property values and cap rates No consideration was given to the possible interaction between changes in any one of these market forces on other market influences

In Practice The investor must know how to incorporate these relationships into forecasts Consider: Current market supply and demand conditions and how long such conditions will last The effects of such conditions on rents and NOI The future course of interest rates that may be affected by more global, non-real estate specific influences such as global economic growth and inflationary pressures The 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

Valuation of a Leased Fee Estate Simple Estates Leased Fee Estates Properties that can be leased at current market rents Properties that have existing leases in place that have leases at below or above market rents When considering a property, it is important to investigate whether or not existing leases are present and the contents of such leases Failure to investigate such cases may result in serious errors when estimating value

The Cost Approach Rational 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.

The Cost Approach For 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.

The Cost Approach To 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.

The Cost Approach See Excel Spreadsheet

The Cost Approach: Adjustment of Replacement Cost Estimate Replacement Costs at current prices Less Repairable Depreciation Less Incurable Depreciation Less Functional & Economic – Locational Obsolescence Add in Site Value Value per Cost Approach

The Cost Approach 1. 2. 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.

Oakwood Apartments: Income Approach Inputs: Units: Rent: Rent Escalator: See Comparables on Page 284 & Excel Spreadsheet 95 Two-bed 1210/ month 3%

Chapter 10 Conclusion 1. 2. 3. 4. Three Approaches to Valuing Real Estate: Sales/Market Approach Income Capitalization Approach Cost Approach The three approaches are somewhat intertwined.

Chapter 10 Conclusion The 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.

Chapter 10 Conclusion Appraisals 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.