Real Estate

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

2. 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.

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

6. 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

7. 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.

8. 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.

9. 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.

10. 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

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

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

13. Highest and Best Use
Analysis
Use Year 1
NOI
R Implied
Property
Value
Building
Costs
Implied
Land
Value
Office $500,000 10.00% 5,000,000 4,000,000 1,000,000
Retail 600,000 8.00% 7,500,000 4,000,000 3,500,000
Apartment 400,000 9.00% 4,444,444 4,000,000 444,444
Warehous
e
400,000 8.00% 5,000,000 4,000,000 1,000,000

14. 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

15. 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.

16. 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

17. 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

18. 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
$526,945
Less
mortgage
balance
$305,495
Cash flow $221,450
Total
cash flow
$8,333 $9,833 $11,378 $12,969 $236,058

19. 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%

20. 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

21. 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

22. 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

23. 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

24. Valuation of a Leased Fee
Estate
 Simple Estates
 Properties that can be leased at current market rents
 Leased Fee Estates
 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

25. 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.

26. 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.

27. 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.

28. The Cost Approach
• See Excel
Spreadsheet

29. 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

30. The Cost Approach
 Cost Approach is most effective when:
1. An improvement is new and
depreciation does not present serious
complications (effective age
compensation).
2. It is hard to find comparables among
unique property types.

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

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

33. 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.

34. 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.