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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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