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Chapter 10. Valuation of Income Properties: Appraisal and the Market for Capital. Overview. Valuation Fundamentals Appraisal Process Sales Comparison Approach Income Approach Gross income multiplier (GIM) Capitalization rate Discounted cash flow Highest & Best Use

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Chapter 10

Chapter 10

Valuation of Income Properties: Appraisal and the Market

for Capital


Overview
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


Valuation fundamentals
Valuation Fundamentals

  • Market Value

    • Most probable price

    • Open market and fair sale

    • Knowledgeable buyer and seller

    • Arms length transaction

    • Normal financing


Appraisal process
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


Sales comparison approach
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




Income approach
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


Gross income multiplier
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


Capitalization rate
Capitalization Rate

  • If comparable properties have different operating expenses then instead of GIM, net operating income (NOI) should be used


Capitalization rate continued
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


Capitalization rate continued1
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?


Discounted present value
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



Discounted present value reversion value
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


Discounted present value example
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


Discounted present value example1
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


Highest best use
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



Mortgage equity capitalization
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



Mortgage equity capitalization continued1
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


Valuation fundamentals1
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


Cost approach
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


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