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Chapter 10

Valuation of Income Properties: Appraisal and the

Marketfor Capital

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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

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Valuation Fundamentals

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

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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

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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

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Sales Comparison Approach

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Sales Comparison Approach

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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

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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

Income Gross

Price SalesGIM

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

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Capitalization Rate If comparable properties have different

operating expenses then instead of GIM, net operating income (NOI) should be used

R

NOIValue

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

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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

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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?

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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

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Discounted Present Value – Discount Rate

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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

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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

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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

250,894,1$

0.010.13

$227,3100.011$225,059

gr

NOI Value Terminal 6

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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

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Highest & Best Use – Continued

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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

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Mortgage-Equity Capitalization – Continued

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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

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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

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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