1. Real Estate Value
Real Estate Principles: A Value Approach

2. Outline
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Investment risk
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Time­value­of­money
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Internal rate of return
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Determining the discount rate
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Appraisal

3. Investment and risk: A classical view
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Investment is about involving costs (cash outflows)
now for the sake of future benefits (cash inflows).
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Investment risk is about uncertainty. This
uncertainty comes from two possible sources: (1)
costs can be uncertain, and (2) benefits can be
uncertain.
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Examples of uncertain costs: (1) renovating an aged
house frequently leads to cost overrun, and (2)
developing a subdivision may be surprised by soil
contamination.
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Question: should high costs, in equilibrium, lead to
high benefits (returns)?

4. The spectrum of risk (Exhibit 14-10)

5. Calpers loses big on land deal
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“Calpers, a $244 billion fund, did its first
undeveloped land deal in 1994 and today has 7
partners for such deals and investments in more
than 12 states.”
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Some deals filed for bankruptcy.
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“Land can loss value quickly because there are fewer
other ways to generate income form it.”
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Source: WSJ, May 01, 2008.

6. The spectrum of cost uncertainty

7. The spectrum of CF uncertainty

8. Risky hotels
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“Heading into an economic downturn, hotels are
often among the first industries to suffer as travel
slows and room rates weaken.”
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“Lodging analyst Smedes Rose estimates Marriott is
trading at 17 times its expected earnings per share
this year. It traded as high as 30 times a year ago.”
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Source: WSJ, Apr. 30, 2008.

9. Definitions
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Investment­grade (vs. speculative­grade) properties:
commercial properties that are large (values
generally well over $10 million), relatively new,
located in major metropolitan areas, and fully
leased.
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Alternatively, properties can be grouped into class A
(new to newer quality construction in prime to good
locations), class B (aging properties in good to
average locations), and class C (older properties
with functional inadequacies and/or marginal
locations)

10. 2 notions of RE values
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Investment value: value to a particular individual
(e.g., NPV): Chapters 18 & 19.
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Appraised value: value to a “typical” investor, or
probable selling price: Chapters 7 & 8.

11. Investment cash flows
Cash Flow
at Sale
Cash Flow
From
Operations
Initial
Cost

12. Discounting cash flows
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The fundamental, economic value of a real
investment is the sum of discounted future cash
flows.
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A dollar in the future is worth less than a dollar
today. One of the main reasons for this is inflation.
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Net present value (NPV): the difference between
fundamental value and initial costs.
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If a real estate investment has a positive NPV, the
investment project should be accepted.

13. Internal rate of return
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In addition to fundamental value, practitioners often
obtain estimates of the internal rate of return (IRR).
The IRR is also known as the “investment yield” or
the “total yield” in the RE industry.
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If the IRR is higher than the required IRR (the
benchmark), the investment project is accepted.

14. Cost of equity
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For publicly traded stocks, the cost of equity is
estimated by using an asset pricing model, say the
CAPM.
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For private RE investment, it is harder to infer the
cost of equity from public market data.
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One possible way to estimate this required rate of
return is to identify the return investors could
typically earn on real estate investments of similar
risk via a survey.

15. Going-in IRR
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An investor’s required going­in IRR = risk­free rate
+ required risk premium.
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The required risk premium is higher when the
investment has higher risk (risk­return tradeoff).
Investment­grade properties usually require a risk
premium of 4­8%.
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Note that the notion of going­IRR is usually stated as
“before­tax.” The reason for being before­tax
because before­tax cash flows are used for
appraisals.
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See Exhibit 18­5, p. 493 for range and average
going­in cap rates.

16. Going-in IRR example
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Suppose that Hill Inc. is thinking about investing in
an investment­grade office building in Manhattan.
The investment horizon is 10 years. The return for
investing in T­bonds with a maturity of 10 years is
5%. Given the perceived investment risk, Hill Inc.
estimates that the required risk premium for
investing in this building is 6%. What is the going­
in IRR?
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Going­in IRR = risk­free rate + required risk
premium = 5% + 6% = 11%.

17. Appraisal
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Appraisal provides an estimate of the most
probable selling price of a property. This
estimation provides valuable information to the
seller and potential buyers of the property.
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The ask price and bid prices are often established
around the appraisal value.

18. Thank You...
Michael S Robinson Utah(CEO and President)
Phone No: 1-916-473-4155
Fax : 877-866-1906
Email : mike@solarwavehawaii.com
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Sacramento, CA 95824
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