REE Exam Two Chapters 5,7,8,9
Land value depend on quality of their
"Access" to other sites, or the "linkage"
Given the following information, calculate the effective gross income: property: 4 office units, contract rents per unit: $2,500 per month; vacancy and collection losses: 15%; operating expenses: $42,000; capital expenditures: 10%.
$102,000
Suppose that an income-producing property is expected to yield cash flows for the owner of $150,000 in each of the next five years, with cash flows being received at the end of each period. If the opportunity cost of investment is 8% annually and the property can be sold for $1,250,000 at the end of the fifth year, determine the value of the property today.
$1,449,635.50
Financing terms
ex,., below rate financing
Using the following information, determine the location quotient for this industry: percentage of employment in financial services industry within the local community: 15%; percentage of employment in financial services industry for the entire United States: 4.4%.
3.4
Given the following information, calculate the effective gross income multiplier: sale price: $950,000; potential gross income: $250,000; vacancy and collection losses: 15%; and miscellaneous income: $50,000.
3.6
Suppose that you are attempting to value an income-producing property using the direct capitalization approach. Using data from comparable properties, you have determined the overall capitalization rate to be 11.44%. If the projected first-year net operating income (NOI) for the subject property is $44,500, what is the indicated value of the subject using direct capitalization?
$388,986.00
Market conditions
i.e., changes in values since sale of comparable
Market knowledge is
key!!!
Stick analyst's
- Are not concerned about the current value, but future price trend - Simon Property Group (SPG) example in the book
Three Observed Patterns of Urban Form
- Burgess Concentric Circle Model, 1923 - Hoty Sector Model, 1939 - Harris and Ullman Multinuclei model, 1945
Who Uses Market Value Appraisals?
- Buyers - Sellers - Corporate acquisitions, mergers or dissolutions - Courts - Divorces - Eminent domain cases - Settlement of estates - Bankruptcy - Mortgage Lenders (purchase of re-finance)
Idealized Location Pattern of Convenience Goods and Services
- Circles are max market perimeter for each provider - Straight lines demarcate access "ridges" between providers
In a competitive marke
- Close substitutes should sell for similar prices - Properties are different but can share similar characteristics
Transactional Adjustments
- Concern the nature & terms of the deal - Property rights conveyed - If buyer of comparable purchased a different legal estate, should be dropped
Promissory Notes (or just Notes)
- Describes the nature of the Debt - Major elements Amount, term, type of amortization Rate of interest Payments, due dates, and late charges Rights to prepay Demand clause (reference to mortgage paper): Acceleration Due-on-sale
First thing first
- Estimating Net Operating Income To estimate NOI is to construct the operating statement
Bid-rent analysis
- Explains how urban land uses are determined. - Assumes households or firms have one demand for access (single "linkage")
Elements of the Note- Interest Rates
- Fixed rate - Adjustable rate
But real estates are in the private markets...
- Infrequent trade - Expensive trade - high search cost - Slow and frictional trade search cost - Private information - informational inefficiency and asymmetry. - Decentralized, local market trade
Four production factors:
- Labor - Material and energy - Physical capital (machines) - Land (a place to produce)
Must be paid first before they "run away"
- Labor - Material and energy - Physical capital (machines)
The first three are mobile- they can be moved to anywhere the price is the highest
- Labor - Material and energy - Physical capital (machines)
Quality of life
- Leadership - Financial support - Government support (subsides, land use regulation)
Property Adjustments
- Location - Physical characteristics - Economic characteristics (not applied to residences) - Important economic characteristics of income producing properties: operating expenses, lease terms, tenant mix
Structure is
- Modernized - Renovated - Abandoned - Demolished
Market value:
- Most probable selling price, assuming "normal" sale conditions - Buyer and seller are typically motivated and reasonably well informed - Open, fair, competitive trading environment
Multinuceli City: Changing Urban Form
- Multinuceli pattern observed by Harris and Ullman by 1945 - CBD no longer the single center of activity
Selecting Comparable Sales
- Must be properties that prospective buyers would consider substitutes for subject property - Should be arms-length transactions - Fairly negotiated prices that occurred under "normal" conditions
Public market
- No need for buyers & sellers to search for "true" market value of an asset; - It is continuously revealed by transaction prices of perfect substitutes
Accrued Depreciation
- Not tax depreciation - Difference between replacement cost & market value of improvements
Transaction price:
- Price actually paid for a specific property, a function of - market value + negotiation + random noise
Export activities
- Products or services provided to the outside world (most manufacturing; higher education and research, advance health care) - Activities that attract money (retirement, tourism, education) - As goes the base, so goes the city.
Data sources:
- Public record (e.g. county property tax assessor) - Multiple listing service (MLS) - Private vendors (title companies, others) --CoStar for commercial properties - Importance of personal relationships - Fee appraisers are research!
Methods to estimate replacement cost
- Quantity survey method - Cost per square foot or cubic foot - Unit in place
Sequence of adjustments
- Transactional adjustments - Property adjustments
Sequence of Adjustments
- Transactional adjustments 1 st ...in order listed above - Property adjustments 2nd...in no particular order - Caution: mixing dollar & percentage adjustment
Investment value:
- Value to a particular individual (investor) based on real circumstances, skills, reputation, tax status, etc. - Primarily depend on investor's ability to generate income from the property
Urban Real Estate Markets Derive from the Urban Economy:
5 - 6% of US land is in urban areas, but 90% of real estate value is in urban areas. Therefore, real estate is essentially an urban phenomenon.
An apple farmer can produce $1200 worth of apple per acre per year. His production cost (exclusive of transportation) is $800. Given transportation cost being $50/mile, what is the farthest distance he is willing to locate from the CBD?
8 miles
Example: If a property currently value = $100,000 and it is expected to produce NOI= 8,000 by the end of the year, then its cap rate
8,000/100,000 = 8%
The Economic Base Multiplier
1. "Exports" bring dollars into the community 2. Most is respent on local goods and services 3. Some "leaks" through outside expenditures 4. Some "leaks" into savings 5. Total community income is the sum of export dollars plus respent dollars
Location quotient example
1. Compute the percentage of total local employment in a given industry. Example: Suppose education employment is 20% 2. Compute the same percentage for the national economy Suppose education in the national economy is 9% 3. Compute the ratio of location to national percentage Location quotient= 20%/9% - 2.22 >1
What housing attributes seem to matter most?
1. Lot size 2. House size 3. Age 4. Location
Steps in Direct Capitalization
1. Obtain estimates of cap rates, Ro, from market using "direct market extraction" Ro= NOI1/Selling Price 2. Estimate the expected first-year NOI. 3. Divide subject' NOI by a weighted average of the cap rate abstracted from the market to obtain an estimate of value for the subject property
There are mainly two income approaches
1. The direct capitalization approach 2. The Discount Cash Flow (DCF) approach Both approaches require an estimate of the property's expected net operating income (NOI).
So to use the Direct Capitalization approach, we need two pieces of information.
1. The expected first-year NOI, which can be estimated based on the building's current operating data 2. The cap rate -which depends on the investor and the market
Types of accrued depreciation that must be considered:
1.Physical deterioration 2.Functional obsolescence 3.External (economic) obsolescence
Given the following information, determine the value of having an additional bathroom. Assume that the comparable properties are similar in all other attributes besides those listed in the table below.
10,000
Urban hierarchy
A ranking of cities based on their size and functional complexity
Several techniques can be used to obtain an indication of property value. The cost approach to valuation would most likely be used for which of the following properties?
A religious facility
An early model of land use is the concentric ring model of urban form developed by E.W. Burgess. Of the following land uses, which would be closest to the downtown area of the central business district (CBD) according to Burgess's model?
A zone of transition that contains warehousing and other industrial land uses between the downtown area and the residential area
Cities with industry economies may be...
more resistant to downturns due to cost advantage
Non-amortized, interest-only loans;
sometimes called a "bullet" loan
Economic Base
Activities that bring income into a city
Secondary (Local) Activities
Activities that recirculate income in a city (local government, local merchants and services)
Loans with right of prepayment
All "conforming" and FHA/VA loans Home equity credit lines
In markets with perfect competition & investment value revelation,
All transactions take place at true market value
Using Repeat Sales to Adjust for Market Conditions
Application: Derive monthly rates of change from most relevant series, & apply to comparables Use: If comparable use is different from best use of subject, better not use as a comparable
The expected costs to make replacements, alterations, or improvements to a building that materially prolong its life and increase its value is referred to as
Capital expenditures.
CBD
Central Business District
Adjustment to Comparable Sale Prices
Convert characters of each comparable to approximation subject
Reproduction cost:
Cost of an exact physical replica Complication in application?
Replacement cost:
Cost to create something of equal utility (functionality)
Competition for locations with better linkage
Creates the patterns of urban land uses and values.
How Does DCF Differ from Direct Capitalization?
DCF valuation models require: 1. estimate of typical buyer's expected holding period 2. estimates of net (annual) CFs over expected holding period, including net income from expected sale of property 3. appraiser to select discount rate (required IRR)
Effective Gross Income Multiplier
EGIM = sales price / effective gross income Quick indicator of value for smaller rental properties
A city's potential for growth or its susceptibility to decline is determined by a set of economic activities that the city provides for the world beyond its boundaries. Economists refer to this set of activities as a city's
Economic Base
Agglomeration economies:
Efficiencies in production due to multiple local industries - Airport service - Financial services and banking - Communications and media
Industry economies of scale:
Efficiencies of production due to scale of local industry
Cost Approach Procedure
Estimated reproduction cost of improvements − Estimated accrued depreciation = Depreciated cost of building improvements + Estimated value of site = Indicated value by the cost approach Major Assumption?: Cost of creating a property is related to its market value
Fixed:
Expenses that do not vary with occupancy (at least in the short run) Hazard insurance Local property taxes
Variable:
Expenses that tend to vary with occupancy Utilities Maintenance & supplies
The sequence of adjustments to the transaction price of a comparable property would make no difference if all adjustments were dollar adjustments. However, if percentage adjustments are involved then the sequence does matter. In making adjustments to a comparable property to arrive at a final adjusted sales price, the proper sequence for the following adjustments would be
Financing terms, market conditions, location
But the land is...
Fixed
Accrued depreciation is the difference between the current market value of a building and the total cost to reproduce it new. One reason for this difference is related to changes in tastes, preferences, technical innovations, or market standards. This is commonly referred to as
Functional obsolescence
Note: market value may not be
Fundamental value
Cities with agglomeration economies may...
Have long-term advantages: - Incubator for new businesses - Cost advantage for emerging industries
Bid-rent indicates the...
Highest rent the land user is willing to bid (can afford to pay)
Fixed rate
Home loans: monthly charge is 1/12 of stated annual rate Many income property loans: 360-actual interest-daily rate is 1/360 of annual rate; multiplied by the actual days in the month
Which of the following would be categorized as a cause of external obsolescence?
Increased traffic flow due to more intensive use in the local area
Adjustable rate
Index rate: Market-determined rate beyond control of either borrower or lender - U.S Treasury Constant Maturity Rate - Thrift institution Cost of Funds Index - LIBOR - Home mortgage rate index
The growth of the motion picture industry in Los Angeles, the petrochemical industry in Houston, and the software industry in Silicon Valley are all examples of how the growth of an industry within a city can create cost advantages for future growth. Economists refer to this phenomenon as
Industry economies of scale
Teaser rate:
Initial, temporarily reduced interest rate could be below market rate
When calculating the net operating income of a property, it is important to identify any expenses that will be incurred in attempts to maintain the property. All of the following would be considered operating expenses except
Interest expense on mortgage
Land uses are not....
Isolate, they interact
Real estate appraisers generally distinguish among the concepts of market value, investment value, and transaction value. Which of the following statements best describes the concept of market value?
It is an estimate of the most probable selling price of a property in a competitive market.
Land use can only pay with what is...
Leftover (residual) income. The land owner has no choice but to accept what the land user can afford to pay.
Households and firms have many...
Linkages
The demand for access between land uses is considered the gravity that holds a city together. These relationships between land uses are commonly referred to as
Linkages
Interpretation:
Local economy has 2.22 times the normal education employment; excess is presumed to be export employment.
Operating expenses can be divided into two categories: variable and fixed expenses. Which of the following best exemplifies a fixed expense?
Local property taxes
Physical deterioration:
Loss in market value due to aging, decay & ordinary use
External (Economic) obsolescence
Loss in value due to changes beyond property boundaries (neighborhood effects) Increased traffic congestion in area Conversion of residential neighborhood from owner-occupied to rental Environmental issues Decline in desirability/demand from neighborhood Is it hard to estimate accrued depreciation? Yes
Functional obsolescence:
Loss in value due to changes in tastes, preferences, technological innovations, or market standards Examples - Florida homes have low ceilings, older homes no hurricane shutters, older homes have not a lot of bathrooms or storage or closet space
In contrast to base activities, local economic activities (or secondary activities) serve the local business and households that are recirculating the income derived through the city's economic base. In other words, we can distinguish local economic activities from export activities by thinking about whether or not the activity brings money into the city from outside sources. Which of the following activities is not an example of land use for local economic activity?
Manufacturing center
Estimating the market value of real estate is complicated by the unique characteristics of real estate markets. In contrast to stock markets, real estate markets are characterized by all of the following except
Market prices are revealed almost instantaneously to prospective buyers.
In real estate markets, a transaction occurs only when the investment value of the buyer exceeds the investment value of the seller. The buyer's investment value is the ________ that he or she would be willing to pay for a particular property, while the seller's investment value is the ________ that he or she would be willing to accept.
Maximum, Minimum
Effective Gross Income Examples
Miscellaneous income Garage rentals & parking fees Laundry & vending machines Clubhouse rentals
Discount cash Flow (DCF)
Most reliable approach A more sophisticated approach. Objective: to estimate the President value of all expected future cash flows (including CF from sales) based on the investor's required rate of return (the discount rate) Project net CFs for a standard holding period (say, 10 yrs) Discount all expected future cash flows at required return (IRR) Appraiser trying to think like a typical investor!
Net Operating Income
NOI is property's "dividend" Why is it not investor's dividend Projected stream of NOI is fundamental determinant of property's value
For DCF approach
NOI is required for every years
CapRate Ro =
NOI1/Vo
Which of the following measures is considered the fundamental determinant of market value for income-producing properties?
Net Operating Income
Appraisal Assignments Where Cost Approach is Heavily Weighted?
New buildings Insurance appraisals Specialty buildings
In the public market
No need to Estimate Market Value
Traditional common law:
No right of prepayment unless explicitly provided
Capital Expenditures (CAPX)
Non-recurring expenditures that increase value of structure/prolong its useful life: Roof replacement Additions HVAC Replacement Resurfacing of parking areas
For direct capitalization approach
Only first year NOI is necessary
Conditions of sale (arm's length or not?)
Parents sell to daughter
Can result in negative amortization:
Payment short-fall is added to the balance, causing it to be more than initial loan amount
Given the following information, calculate the overall capitalization rate: sale price: $950,000; potential gross income: $250,000; vacancy and collection losses: $50,000; and operating expenses: $50,000.
15.8%
Suppose that an appraiser has just completed her analysis using the cost approach to valuation. She has determined that the market value of the subject property is $400,000. If the added value of the site was $80,000 and accrued depreciation amounted to $50,000, what was the reproduction cost of the building?
270,000
Prepayment penalties
Percentage of outstanding balance Yield maintenance - makeup the "lost return" for the lender Defeasance - replace lost cashflow with equivalent T-bonds
Bankruptcy
Possible threat to lender's ability to foreclose Three forms of bankruptcy Chapter 7: Liquidation Chapter 11: Court supervised "workout" Chapter 13: Wage-earner's proceeding No form of bankruptcy can set aside a mortgage lien Chapter 11 and 13 can result in delays
PGI
Potential gross income - VC- Vacancy & collection loss + MI- Miscellaneous income = EGI - Effective gross income - OE- Operating Expenses - CAPX - Capital expenditures = NOI - Net operating income
The starting point in calculating net operating income is the total annual income the property would produce assuming 100% occupancy and no collection losses. This is commonly referred to as
Potential gross income.
The main difference between mortgage and Deed of Trust is the
Power of Sale (which implies different foreclosure procedure)
The following two documents always go together
Promissory Note (or Note): Details the exact terms of the financial obligation Mortgage (or Deed of Trust): Pledges the property as security for the note Legal paper
Valuation calculations are required when a:
Property acquisition is considered
Private markets
Real estates - Unique properties - no two buildings are identical - Unique locations - Many & varied attributes
Modern statutory case:
Right of prepayment unless explicitly prohibited
While there are several conventional approaches used to estimate the market value of residential real estate (i.e. houses), which of the following is typically considered the most reliable approach?
Sales comparison approach
NOI must be sufficient to
Service the mortgage debt and Provide equity investor with an acceptable return on equity Be careful of NOI versus NCF (net cash flow)
Uniform Standards of Professional Appraisal Practice (USPAP) Steps
Step 1: Identify the Appraisal Problem Step 2: Determine the Required Scope of Work Step 3: Collect Data and Describe Property Step 4: Perform Data Analysis Step 5: Determine Value of Land Step 6: Apply Three Approaches to Valuation Step 7: Reconcile Indicated Values from Three Approaches Step 8: Report Final Value Estimate
Loans with restricted right of prepayment:
Subprime home loans "Jumbo" home loans Most income property mortgage loans
When economists say the land value is of a residual nature, they mean
That the value of location is determined by how much the land users can afford to pay
The magnitude of an economic base multiplier depends upon the amount of money that "leaks" out through expenditures outside of the city limits. All else equal, the economic multiplier tends to be smaller when
The city is less isolated from other cities
Bid-rent curve
The concept that the concentric circles in Burgess's concentric zone model are based on the amount people are willing to pay for land in each zone
Investment decision criteria: A good investment is one that
The investment value > = translation price (or market value)
How does location determine land value?
The residual nature of land value
Estimate value of the site
The value of the site is its Highest and Best Use: Legally permissible, Physically possible, Financially feasible, Maximally productive, i.e, yielding the greatest benefit to an owner
Urban growth is not uniform
There are both emerging and declining nuclei
Even the few transactions of comparable properties that we do observed may not be indicative of value of the "subject" property
Thus... we need an army of "Free appraisers" to estimate the market value of RE assets
A fundamental principle of income approach:
Value = present value of anticipated income
Sales Comparison Approach
Value of RE can be determined by analyzing the sale prices of similar properties
Conversely, if we are looking to buy a property, and expect a property to produce $8,000 net operating income by the end of the first year of our ownership, AND we know other similar buildings in this market all getting 8% cap rates, how much should our building be worth?
Vo = 8,000/8% = 100,000
Bid-rent curve calculation Sale Price 1200 Production 600 TC 60
B-RW=(1200-600)-dx60 (1500-800)-80xd =700-80d (100-700)-20d =300-20d d=300/20 = 15 miles
Better linkage means
Better location and higher value
Recourse loan: Nonrecourse loan:
Borrower is personally liable No personal liability
Expenditures made immediately after purchase
Buyer probably received price concession