November 17th RE 415 Quiz (15,16,17)
Below the line expense
An Expense that is recorded "BELOW" the Net Operating Income line in a reconstructed operating statement and therefore is NOT considered part of the total stabilized operating expenses for the property - tenant improvements and lease concessions are the most common line items recorded below the net operating income line for analytical purposes
Which of the following expenses tends to be the most directly "variable" with occupancy rates?
Answer: Building electrical expenses NOT: property taxes or Insurance
EX: Stabilized multitenant industrial property with contract rents near market rates and few lease expirations in the coming 2-3 years
Both DCF and Direct CAP Approach
If cash returns over the life of an investment are the most important consideration for investors, which of the following valuation methodologies most closely represent this buyer dynamic?
COST APPROACH
Which measure reflects a "current income return" on an investment?
Cap Rate
Expense Stop
(protects landlord) - a clause in a lease that limits a landlord's share of operating expenses -limits the landlord's exposure to the risk of increasing expenses
*Realistic long-term capital expenditure projections for most types of commercial property should average at least 10% to 20% of the NOI or an annual average of about 1-2% of the property value
*Realistic long-term rental growth projections in most commercial properties in most areas of the US should average slightly less than realistic expectations
*Real Estate tends to be a CASH INVESTMENT so investors commonly value properties based on CASH RETURNS rather than accounting net income
*Rely on CONTRACT RENT when estimating the value of the leased fee interest in a property
*The property management fee is usually expressed as a percentage of effective gross income
- Alterations (including major replacements and renovation) may be considered capital expenditures and therefore are not included as a periodic expense under repair and maintenance
Not Cash Flow Pro Forma Items
- Interest Expense -Depreciation -Limited Partner's Preferred Return -Income Taxes
Cautions and Considerations for Direct Cap:
- cap rates "trailing NOI" (historical NOI, year -1) -cap rates on "current NOI" -cap rates on stabilized NOI (not actual year 1) *if not stabilized, DCF is usually the better approach explicitly modeling these issues
Direct Capitalization Weaknesses
- longer term leases -current rents not at market rents - property NOI growth and risk pattern different from other properties from which cap rate data was obtained *Cap Rate is a short hand way of quoting the prices that result from DCF models
What are the negative consequences of the common mistakes in DCF even if the overall value conclusion is reasonable?
- may lead to misallocation of capital across asset classes
Results of Mistakes in DCF
- unrealistic expectations - misallocation of capital -wasted time
Direct Capitalization Approach
- useful method for quoting prices that are independent of scale (ie building size, rent/NOI levels)
Expense Cap
-(protects tenant) - limit's the tenant's exposure to the risk of increasing expenses
Costs of Sale
-Broker's commission -Title insurance -surveys -attorney's fees
When we say that the operating pro forma that we use to value a property should reflect "property level cash flows," what are the implication of being "property level"?
-Disregards ownership structure -Disregards any mortgage payments -Excludes any consideration of the value of the business enterprise that might be operating inthe property
GIM and Operating Expenses
-GIM only looks at Revenue/Income not NET OPERATING INCOME. (ie before subtracting expenses) -GIM only works when buildings have similar operating expense ratios (OER)
When we say that the operating pro forma that we use to value a property should reflect "property level cash flows," what are the implication of specifying "cash flows"?
-Real estate tends to be a cash income investment, so investors commonly value propertiesbased on cash returns rather than accounting net income -The only expenses that are included are those cash payments necessary to keep the propertyin good operating condition
Where/Why is the Gross Income Multiplier Used?
-Small apartments a) gross income often provided on MLS publicly b) many similar properties c) frequent sales -Hotel "Room Revenue Multiplier" a) occupancy + rate can be estimated b) used by less sophisticated investors
Which of the following statements are true regarding the "reversion" in the discounted cash flow approach?
-The goal is to estimate the market sale price at the end of the holding period. -The cost of sales should be considered.
Operating Expenses Main Categories
-Utilities -Repair and Maintenance -Property Taxes -Insurance -Management Expense (Fees) -Administrative and General Expenses
Escalation clause
-a clause in an agreement that provides for the adjustment of a price or rent based on some event or index -helps a landlord offset increases in operating expenses which are passed onto tenants on a pro rata basis through an adjustment to rent
Above the line expense
-an expense that is recorded "above" the net operating income line in a reconstructed operating statement typically developed for valuation purposes and is therefore considered part of the total operating expenses of the property
***WHERE IS DCF MOST APPLICABLE
-cash flows driven by signed leases -non-stabilized properties where the Year 1 NOI is not representative of future income -institutional investment grade assets in larger more sophisticated markets -reliable market evidence supporting assumptions
Management Fee
-common to see rates of 3-6% of EGI
Is GIM Useful?
-if the properties are very similar, use GIM -many studies show that for apartments, GIM was accurate in predicting value -can be realiable/useful for hotels which tend to operate at consistent expense ratios
Property Level
-includes real estate rental income, less direct operating expenses and capital expenditures related to operating of RE - ***without consideration of capital or ownership structure (debt service, interest income taxes) -***excludes consideration of non-cash accounting items (depreciation, amortization) ***excludes business income, personal property (laundry machine revenue), services
Variable Expenses
-operating statements for large properties frequently list many types of variable expenses ex: management, utilities, heat, ac, general payroll, cleaning, decorating, maintenance and repair of structure, grounds and parking area maintenance
Capital Expenditure
-project known/anticipated capital costs -tenant improvements, lease commissions -capital repairs/replacement
Capital Reserve
-reserve for replacement of short-lived capital items -typically use average annual cost or shrinking fund factor
***WHERE IS DCF LEAST APPLICABLE
-stabilized current NOI based on market rents -limited supporting evidence for future assumptions -smaller properties and markets with less transparent market data and assumptions
Proforma
-summary of projected future financial statements typically 5-10 YEARS or expected holding period
Discounted Cash Flow
-takes the long-term perspective approach for investment decision making
Equity Income
-the income that remains after all mortgage debt service is deducted from net operating income
2 Components of Vacancy + Collection Loss
1) Physical vacancy as a loss in income 2) Collection loss due to default by tenants
Typical Mistakes in DCF
1) Rent and Income Growth assumptions are too high (usually rents+income within a given building do not keep pace with inflation) 2) Capital Improvement expenditure projections are too low 3) Terminal Cap Rate Projection is too low 4) Discount Rate (expected return) is too high
Forecasting Multiyear NOI
1) Use fundamental Market Analysis to forecast supply + demand 2) Extrapolate past trends into the future 3) Survey of Market Expectations 4) Assume No Changes 5) Project to Stabilized Condition
DCF Key strengths
1) explicitly models future cash flows where known or can be reasonable forecast 2) Based on "total return" both current income growth 3) More detailed than implicit assumptions in direct cap approach
DCF weaknesses
1) highly dependent upon many unprovable assumptions 2) Projects cash flows beyond a reasonable time period 3) "Market Clearing" assumptions may differ from realistic expectations *cash flow forecasts must be realistic, or "expected case" scenario
There are 4 primary cash flow impacts during the gap in time after a lease expires and before the start of a new lease
1) lease commissions 2) lost rental revenue 3) lost expense reimbursement 4) tenant improvement costs
Developing Reconstructed Operating Statements
1) the income and expense history of the subject property 2) income and expense history of competitive properties, recently signed leases, proposed leases, rejected leases proposals and asking rents for the subject and competitive property
GIM Example:
6 unit: $70/month per apartment (total apt rent = $56,880) Gross Rents = $56,880 Sale Price = $568,000 GIM: $568,000 / $56,880 = 9.9858 or 10
Mortgage Constant Formula
= (Monthly payments * 12) / loan amount
Effective Gross Income
= Potential Gross Income - The Vacancy and Collection Loss Allowance
Net Sale Price
= Sale Price - Selling Costs *selling costs = a percentage of sale price
Expected Sale Price
= the market value of the property at the end of the holding period - market value at the end of the holding period is based on the expected future income of the property
Of the four typical mistakes in using DCF, according to the Geltner Miller text, which one results in a lowering of the value estimate?
A: Discount rate too high
Why do we subtract "cost of sales" from the sale price when doing the DCF approach but not when applying the Direct Cap Approach to estimate market value?
A: cost of sales is one of the investor's expected cash flows during the investment period so they must be considered in a DCF A: Market value reflects the price paid from the buyer to the seller, so these side payments are not relevant when estimating value using the direct cap approach
When estimating the value of the "leased fee" interest in a property, should you rely on contract rent or market rent?
Contract Rent
EX: Income property with leases at ABOVE MARKET RENT expected to expire and roll to market in 2 or 3 years
DCF is clearly more applicable
EX: Stabilized 4 unit apartment property with yearly leases at market, typical of many recently sold 4 unit buildings
Direct CAP is probably more reliable
Which measure reflects a "total return" on an investment?
Discount Rate
Replacement Allowance (items)
Ex: roof covering, carpeting, kitchen bath, laundry, HVAC compressors, elevators, sidewalks, driveways, parking areas
A Cap Rate is sometimes called an "overall rate" (OAR) because it represents the "total" return on an investment (True/False).
FALSE
Landlords seek to maximize rental income, so the "natural vacancy rate" is zero.
FALSE
The big difference between NOI and EBITDA (earnings before interest, taxes and depreciation) is that we subtract property taxes from NOI, but EBITDA is before subtracting property taxes.
FALSE
GIM Additional considerations *if you need to tinker with GIM, you should probably use different approach
Factors that can affect GIM: - inflationary expectations -tax law changes -shifts in supply/demand -property type -regional location -financing
Gross Income Multiplier
GIM= Property Sale Price / Gross Income 3 STEPS: 1) Obtain expected YEAR 1 Gross Income 2) Obtain GIM for similar properties 3) Apply GIM to subject property, where property value = GIM * Gross Income
Are Terminal Cap Rates typically higher or lower than going in cap rates?
Higher
When forecasting future cash flows, which of the following is approaches is considered preferred, or better approach, when sufficient data is available?
Market analysis based on supply and demand expectations and/or extrapolation from recent trends
You confirm a property sold for $10,000,000 at a 6% cap rate, but this cap rate was based on NOI after capital reserves. The capital reserves was 10% of NOI (before reserves). Calculate the cap rate using the "textbook" approach with NOI BEFORE RESERVES
NOI AFTER RESERVES = $600,000 NEW NOI - BEFORE RESERVES NOI = X* .9 = $600,000 $600,000 / .9 = $666,666.6667
Direct Cap Rate Formula
NOI subject Property Year 1 / Cap Rate = Sale Price NOI = Sale Price * Cap Rate
You are valuing a property that is currently self-managed by the current owner. In developing your valuation pro forma, it is acceptable to add a typical 3rd party management fee, but only if you also remove any internal management expenses (say, the property manager's salary) from your pro forma.
TRUE
You confirm that a property sold for a 7% cap rate based on a "trailing" year NOI. Assuming it was a stable property with 3% annual NOI growth, calculate the equivalent cap rate based on year 1 NOI
Trailing NOI: a) 100,000 b) cap rate = 7% c) sale price = $1,428,571.43 Year 1 NOI: a) 100,000*1.03 = 103,000 c) sale price = $1,428,571.43 Cap Rate: 103,000 / 1,428,571.43 = 0.071 or 7.21%
You confirmed a property sold for $10,000,000 at an 8.4% cap rate, which seemed unusually high considering it has a new roof, parking lot and facade. Investigating further, you discovered that the buyer spent $2 million to replace the roof, parking lot and facade immediately after purchase. Adjusting the price to reflect the total capital needed to get the property level to its current condition, what would be the indicated cap rate?
UNADJUSTED: - sale price = $10,000,000 - cap rate = 8.40% - NOI = $840,000 ADJUSTED: - sale price + cap expenditure = $12,000,000 -NOI = $840,000 (NOI/Sale Price =CAP RATE) $840,000 / $12,000,000 = 0.07 or 7%
Management fees are reimbursed under "triple net" leases?
Varies by property and/or local practice
Why don't we consider loan principle repayments as an operating expense in a real estate cash flow pro forma, even though they are actual cash obligations that the equity investor must pay?
We value properties based on the unlevered property level cash flows.
What is the key issue in evaluating whether some income stream should be considered "other income" in an operating pro forma when valuing real estate?
is it payment exclusively for the use of some "space-time unit"?
Gross Lease
landlord pays all operating expenses
Net Lease
tenant pays all expenses
Direct Capitalization
the process of estimating a property's market value by dividing a single-year NOI by a "capitalization" rate
Direct Capitalization Strengths
works when: - stabilize properties with short term leases in stable markets - cap rates can be reliably derived from similar properties with the same income and growth expectations