CHAPTER TENCHAPTER TEN

VALUATION OF INCOME PROPERTIES: APPRAISAL AND

THE MARKET FOR CAPITAL

Market ValueMarket Value

• Motivated buyer and seller

• Well informed buyer and seller

• A reasonable time period

• Payment in cash or cash equivalent

• Arms length transaction

Appraisal ProcessAppraisal Process

• Physical and legal identification

• Identify property rights

• Purpose of the appraisal

• Specify effective date of value estimate

• Apply techniques to estimate value

Income ApproachIncome Approach

• GIM

• Direct capitalization method

• Discount present value method

• Note- the first two methods rely on current market transactions

Gross Income MultiplierGross Income Multiplier

• PGI*

• Less V and C

• EGI

• Less OP

• NOI

• GIM= sales price/ gross income*

Capitalization RateCapitalization Rate

• V= NOI/ R

• NOI can be compared with transaction prices to derive R

• Sometime called market extraction method

Operating ExpensesOperating Expenses• Real estate taxes• Insurance• Utilities• Repair and maintenance• Admin. and general• Mgnt. and leasing• Salaries• Reserves• other

Discounted PVDiscounted 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

Simple FormulaSimple 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)

ExampleExample

• 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

Concept of a Capitalization Concept of a Capitalization RateRate

• Capitalization rate (“cap rate”)= NOI1/ value– Ratio of first year income to value

• Rearrange equation: value=NOI1/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 rate=NOI1/ 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

Beyond the Simple FormulaBeyond 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

ExampleExample

• 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?

SolutionSolution• 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%

NPV @12% $1,041,390 *Yr 6 NOI/ terminal cap rate of 120,000/ .10NPV @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

Reversion ValuesReversion Values

• Expected L-T cash flows

• REV9= (NOI10)/ (r-g)

• Directly from sales transaction data

• Resale based on expected change in property values

Highest and Best Use AnalysisHighest and Best Use Analysis

• PV= NOI1/ r-g or NOI1/r

• PV- BLDG cost= land value

Mortgage Equity Mortgage Equity CapitalizationCapitalization

• V= M+E

• DS= NOI1/ DCR

• Calculate M

• Calculate E (PVA + CF)

• PV= M + E

Cap Rates and Market Cap Rates and Market ConditionsConditions

• 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