Real Estate Ch. 8

Describe the conditions under which the use of gross income multipliers to value the subject property is appropriate.

An income multiplier approach to valuation is more appropriate for apartment buildings than for most office, industrial, and retail properties because apartment leases seldom exceed one-year terms. So the lease structure of the property types makes it more or less appropriate to use the income multiplier.

Income Approach: Direct Capitalization

(with an "overall" cap rate) -find value as a multiple of first year net income (NOI) -"multiple" is obtained from sales of comparable properties -similar in spirit to valuing a stock using a price/earnings multiple (market price per share/earnings per share)

Going-out Cap Rate

-"terminal capitalization rate" -the ratio of the estimated NOI in the year following sale to the overall value of the property at the time of sale

Assume a reserve for nonrecurring capex is to be included in the pro forma for the subject property. Explain how an above-line treatment of this exp would differ from a below-line treatment.

-An above-line treatment of CAPX would result in a lower Net Operating Income, which means less tax taken out. -A below-line treatment would be taken out after taxes so you wouldn't get the tax benefit.

DCF vs. Direct Capitalization

-DCF valuation models require: 1. estimate of typical buyer's expected holding period 2. estimates net (annual) CFs over expected holding period, including net income from expected sale of property 3.appraiser to select discount rate (required IRR)

Important Points About Cap Rates

-Direct Capitalization only uses 1st year NOI, but Ro reflects all future CFs -transaction prices of the comparables reflect the value of future CFs -in turn, the cap rates extracted from these sale transactions do so as well

In what situations or for which types of properties might discounted CF analysis be preferred to direct capitalization?

-Direct capitalization relies heavily on comparable transactions, which is sometimes difficult to obtain. The adjustments necessary can be very complex and difficult to quantify. -Also, a lot of commercial real estate is subject to long term leases or even numerous leases with various rental rates and/or rent escalation clauses

Some Sources of Expense Data

-Institute of Real Estate Management (IREM): detailed information on apartments, offices, shopping centers, federally assisted housing & condos, co-ops & planned communities -Building Owners and Managers Association (BOMA): large office buildings -International Council of Shopping Centers (ICSC) -Urban Land Institute (ULI) -Local market participants; other pro formas you have seen -market knowledge is key

Distinguish between levered and unlevered CF. In what sense does the equity investor have a residual claim on the property's CF stream if mortgage financing is employed?

-Levered Cash Flows: the property's net rental income after subtracting any payments due the lender -Unlevered Cash Flows: the expected stream of NOI's and the expected net sales proceeds; represents the income-producing ability of the property before subtracting the portion of the cash flows that must be paid to the lender to service or retire the debt

Other Methods of Estimating Cap Rates

-Mortgage-Equity Cap Rate -Constant Growth Cap Rate

Calculating Effective Gross Income (EGI)

-PGI - VC + MI = EGI

Calculating NOI

-PGI - VC + MI = EGI - OE - CAPEX = NOI -Potenetial gross income - Vacancy & collection loss + Misc. income = Effective gross income - Op. Exp - Capital exp.

Types of Commercial Leases

-Straight Lease: "level" lease payments -Step-up or Graduated Lease: rent increases on a predetermined schedule -Indexed Lease: rent tied to an inflation index; ex. consumer price index -Percentage Lease: rent includes percentage of tenant's sales

Pro Forma

-a five year CF forecast

Cap Rate

-a rate that is used to convert the 1st year NOI (property's overall CF) into an estimate of current market value -Ro is a "cap" rate (a multiple), not a discount or interest rate!, can't be applied to future CFs -also "overall capitalization rate" or "going-in cap rate"

Data on comparable sales can be inadequate due to:

-above or below market leases -differing length of leases and rent escalations--comparable vs subject -differing distributions of op. exp. between landlord and tenant

Appraiser Work/Skills

-develop network of data contacts -be skilled in data analysis and report production -collect, read, and organize data and reports -fight time deadlines

Selecting Cap Rate Estimates

-direct extraction is preferred, but needs 3 or more comparable sales with good information -choice ultimately depends on quality of data available for each type of estimate -reconciliation made by weighting

Is direct capitalization superior to DCF

-fewer explicit assumptions and forecasts are required -implicit assumption: Ro = (NOI1/Selling Price)

Projected stream of NOI is ____________________

-fundamental determinant of property's value

Miscellaneous Income (MI)

-garage rentals and parking fees -laundry and vending machines -clubhouse rentals

Vacancy & Collection Loss (VC)

-historical experience of subject property -competing properties in the market -"natural vacancy" rate: vacancy rate that is expected in a stable or equilibrium market

Problems With Valuation by Direct Capitalization

-inadequate data on comparable sales -differing prices between institutional and private investors for similar properties -result: DCF analysis can be preferable

OE does not include:

-mortgage payments -tax depreciation -capex -income tax -replacement reserves

Capital Expenditures (CAPEX)

-non-recurring expenditures that increase value of structure/prolong its useful life (roof replacement, additions, HVAC replacement, resurfacing of parking areas) -tax motivation for classifying a cash expenditure as an OE (vs CAPEX) if possible (above-line vs below-line)

Operating Expenses (OE)

-ordinary & regular expenditures necessary to keep a property functioning competitively -Fixed: exp's that do not vary with occupancy (at least in the ST); hazard insurance, local property taxes -Variable: exp's that tend to vary with occupancy; utilities, maintenance & supplies

Mortgage-Equity Cap Rate

-problem: can't estimate cap rates w/o actual comparable sales -solution: since income-producing RE has both equity & debt financing, think of the cap rate as a weighted average of equity cap rate & mortgage cap rate -Equity CF, Loan CF, Equity, Equity Cap Rate, Loan Cap Rate, Loan-to-value Ratio

Income Approach: Discounted CF (DCF)

-project net CFs for a standard holding period (say, 10 years) -discount all expected future CFs at required return (IRR) -lots of assumptions

NOI is __________

-property's "dividend" -measures the relationship between current income stream and property price or value -not investor's dividend--ignores future CFs and expected appreciation

NOI must be sufficient to:

-service the mortgage debt AND -provide equity investor with an acceptable return on equity

Potential Gross Income (PGI)

-starting point for calculating NOI -rental income assuming 100% occupancy -sometimes referred to as Potential Gross Revenue (PGR) -important issue: should forecast of PGI be based on contract rent (signed leases) or current market rents?--market rents used more

Contract Rent

-the actual rent being paid under contractual commitments between owners and tenants -may be used to estimate PGI if the property is subject to LT leases to financially reliable tenants at rates above/below market

Net Operating Income

-the projected stabilized income in the next 12 months -different from accounting NOI in that real estate value not tied to individual related to it--their income taxes, etc. -no income taxes, depreciation, debt interest -NOT CF -sometimes referred to as "reconstructed operating stmt" (ROS)

Market Rent

-the rental income the property would most probably command if placed for lease on the open market as of the effective date of appraisal -generally used in PGI

Terminal Value

-the sale price at the end of the expected holding period

Capitalize

-to convert future income into a present value

Direct Capitalization vs. DCF: CAPEX

-using Dir. Cap.-1 yr valuation, CAPEX above the line; most appraisers treat CAPEX as "above line" expense -using DCF-CAPEX either above or below, mostly below; institutional investors usually treat CAPEX as "below line" expense-- NOI - CAPEX = Net CF

The Income Approach

-value=present value of anticipated income -often called "income capitalization" -two types: Direct capitalization, Discounted CF

Steps in Direct Capitalization

1. Obtain estimates of cap rates (Ro) from market using "direct market extraction" equation 2. Divide the subject's NOI1 by a weighted average of the abstracted Ro's abstracted from the market to obtain an estimate of value for the subject property

Equity Cap Rate

=BTCF/Equity =Re (equity dividend rate)

Loan Cap Rate

=Loan CF/Loan

Loan-to-value Ratio

=Loan amount/Price =m (mortgage-equity cap rate) =m x Rm + (1-m) x Re

Equity CF

=NOI - Debt Service =Before tax CF (BTCF)

Equity

=Purchase price - Loan

Constant Growth Cap Rate

=Required Total Yield - Expected Appreciation Rate -Total Yield = Cap Rate + Appreciation Rate

Net Sale Proceeds

=Sale Price - Selling Expenses

Why is the market value of RE determined partly by the lender's requirements of equity investors?

A lot of times real estate investments are financed with both debt and equity. Therefore, both the lender and equity required rates of return are relevant.

Effective Gross Income Multiplier

EGIM = (sale price/EGI) -quick indicator of value for smaller rental properties -requires no operating exp. information -critical assumptions: roughly equal op. exp. %'s across subject & comparable properties; assumes market rents are paid -best used for properties with ST leases (apartments & rental houses)

An overall capitalization rate is divided into what type of income or CF to obtain an indicated market value?

NOI

Direct Market Extraction Equation

Ro = (NOI1*/Selling Price)* *from the sale of a comparable property -defining the "market" for comparable selection is critically important

Direct Capitalization Basic Value Equation

V = (NOI1/Ro)

Cap rates in general have ______ since 1996

decreased

The final value estimate produced by one approach is called:

indicated value

The methodology of appraisal differs from that of investment analysis primarily regarding:

point of view and types of data used

What property type probably would not be appropriate for income capitalization?

public school; not farm, warehouse, apartment, shopping center