Real Estate Exam #2

What is a risk premium? Why does such a premium exist between interest rates on mortgages and rates of return earned on equity invested in real estate?

- A risk premium is a higher expected rate of return paid to an investor as compensation for incurring additional risk on a higher risk investment. In general, investors are considered risk averse and must be compensated more for the higher risk of some investments. - This premium exists between mortgage interest rates and returns on equity invested in real estate because the equity investor is assuming more risk than the mortgage lender. The lender assumes less risk because a lender would have first claim on the property should there be a default. If this were not the case, the investor would be better off lending on real estate than investing in it. Y

What is a capitalization rate? What are the different ways of arriving at an overall rate to use for an appraisal?

- An overall rate or overall capitalization rate is the rate on the overall property (debt and equity). - One way of arriving at an overall rate is to use the band of investment approach. This is based on taking into consideration the investment criteria of both the lender and the equity investor involved in a project. This is done by taking a weighted average of the equity dividend rate expected by the investor and the mortgage loan constant (expressed on an annual basis) required by the lender. - Two different ways of arriving at an overall rate are the direct capitalization approach and the present value method.

What is the economic rationale for the sales comparison approach? What information is necessary to use this approach? What does it mean for a property to be comparable?

- The rationale for the market approach (otherwise known as the sales comparison approach), lies in the principle that an informed investor would never pay more for a property than what other investors have recently paid for comparable properties. - The sales comparison approach to valuation is based on data provided from recent sales of properties highly comparable to the property being appraised. - For a property to be comparable, the sale must be an "arm's-length" transaction or a sale between unrelated individuals. Sales should represent normal market transactions with no unusual circumstances, such as foreclosure, sales involving public entities, and so on.

If investors buy properties based on expected future benefits, what is the rationale for appraising a property without making any income or resale price projections?

- Using the direct capitalization approach, this technique is a very simple approach to the valuation of income producing property. The rationale is based on the idea that at any given point in time, the current NOI produced by a property is related to its current market value. - A survey of other transactions including sales prices and NOI (NOI ÷ sales prices) indicates the cap rate that competitive investments have traded for. This survey provides cap rates that indicate what investors are currently paying relative to current income being produced. A parallel in equity securities markets would be earnings yield (or earnings per share ÷ price) or price earnings multiples (price ÷ earnings per share).

What is the relationship between a discount rate (or IRR) and a capitalization rate? What causes differences between them?

A capitalization rate is equal to the difference between the discount rate and the expected growth in income. In other words, changes in income over the economic life of the property are ignored when using a capitalization rate. Y

In general, what effect would a reduction in risk have on "going-in" cap rates? What would this effect be if it occurred at the same time as an unexpected increase in demand? What would the effect on property values be?

A reduction in risk lowers cap rates because expected returns are lower. If this occurred at a time when demand increases, property values would rise significantly because of increases in rents from greater demand and lower cap rates. Y

When may a "terminal" cap rate be lower than a "going-in" cap rate? When may it be higher?

A terminal cap rate may be lower than the going in cap rate if between the present time and end of a holding period interest rates are expected to fall, risk is expected to decline, or demand is expected to increase (thereby producing higher rents and/or appreciation). A higher terminal cap rate would result if the opposite changes in the three situations stated above occurred.

What is meant by a unit of comparison? Why is it important?

A unit of comparison is used in the sales comparison approach to valuation. To the extent that there are differences in size, scale, location, age, and quality of construction between the project being valued and recent sales of comparable properties, adjustments must be made to compensate for such differences. The appraiser must find an appropriate unit of comparison for a given property. Examples are price per square foot for an office building, price per cubic foot for warehouse space, price per bed for hospitals, or price per room for hotels.

Define amortization. List the five types discussed in this chapter.

Amortization is rate at which the process of loan repayment occurs over the loan term. Types of amortization are fully, partially, zero, negative and constant rates of amortization.

What is the difference between base or face rents and effective rents?

Base rents reflect rent that will be paid per rentable square foot of leased space. It does not include additional items such as finish out costs, expense pass throughs and other costs that are included when calculating effective rents.

What factors affect a property's projected NOI?

Expected market rents and vacancy rates Expenses associated with operating the property Nature of any leases on the property

What is meant by partitioning the internal rate of return? Why is this procedure meaningful?

IRR is made up of two components of cash flow: 1. cash flow from operations 2. cash flow from the sale of the investment - Partitioning is done to obtain some idea of the relative weights of these components of return and to get an idea of the timing of the receipt of the largest portion of that return. - Partitioning is meaningful because it helps the investor to determine how much of the return is from annual operating cash flow and how much is from the projected resale cash flow. Operating cash flow is generally more certain than projected resale cash flow. Therefore, the greater the proportion of resale cash flow versus operating cash flow, the greater the risk facing the investor. This could be useful in comparing multiple investments. YYYYY

What is meant by the incremental cost of borrowing additional funds?

The incremental cost of borrowing funds is a measure of what it really costs to obtain additional funds by getting a loan with a higher loan-to-value ratio that has a higher interest rate.

Why do you think appraisers usually use three different approaches when estimating value?

If perfect information was available, then theoretically the same value should result regardless of the methods chosen, be it cost, market, or income capitalization. Even with imperfect information, there should be some correspondence between the three approaches to value, which is the reason appraisal reports will typically contain estimates of value based on at least two approaches to determining value.

What factors would result in a property increasing in value over a holding period?

Inflation: This causes rents as well as the final sale price to be higher. Demand: Increased demand for space may increase value if the supply of space doesn't increase as well.

What are the primary benefits of investing in real estate income property?

Net Income: Dollars left over after collecting rent and paying expenses but before considering taxes and financing costs. Property Sale: Expecting a price increase over a specified holding period increases investor return. Diversification: Reduces overall risk to hold many types of investments. Taxes: Preferential tax benefits. Taxable income is often less than before-tax cash flow.

Is a cap rate the same as an IRR? Which is generally greater? Why?

No. The cap rate is the relationship between the current NOI and present value. The IRR is the return on all future cash flows from the operation and sale of the property. Usually, the IRR is greater than the cap rate. Y

What are positive and negative financial leverage?

Positive leverage occurs when the unlevered IRR is greater than the interest rate paid on the debt. Negative leverage occurs when the unlevered IRR is less than the interest rate paid on the debt. Y

What are some of the potential problems with using a "going-in" capitalization rate that is obtained from previous property sales transactions to value a property being offered for sale today?

Problems occur if properties being used as "comparables" have different lease terms, maturities, and credit quality of tenants. Further, if properties are older, have depreciated, have different functional design, etc. than the subject, problems can occur. In these cases cap rates must be either adjusted to reflect these differences or not used at all.

Why might the market value of a loan differ from its outstanding balance?

The balance of a loan depends on the original contract rate, whereas the market value of the loan depends on the current market interest rate.

What are the primary considerations that should be made when refinancing?

The borrower must determine whether to present value of the savings in monthly payments is greater than the refinancing costs (points, origination fees, costs of (1) appraisal, (2) credit reports, (3) survey, (4) title insurance, (5) closing fees, etc.

What is the economic rationale for the cost approach? Under what conditions would the cost approach tend to give the best value estimate?

The rationale for using the cost approach to valuing (appraising) properties is that any informed buyer of real estate would not pay more for a property than what it would cost to buy the land and build the structure. The cost approach is most reliable where the structure is relatively new and depreciation does not present serious complications.

Discuss the differences between using (1) a terminal cap rate and (2) an appreciation rate in property value when estimating revision values.

The terminal cap rate approach to estimating a reversion value is based on the assumption that in the year of sale, investors will value the property based on the new "going in" cap rate at the time. Estimates of the terminal cap rate are made by adjusting the current or going in cap rate to reflect any depreciation that is likely to occur over the holding period. A risk premium may also be added because the cap rate is being applied to NOI several years in the future which is less certain than the current NOI that a going in cap rate would be applied to. Y

What is meant by depreciation for the cost approach?

There are three categories of depreciation for the cost approach. They are very difficult to determine and, in many cases, require the judgment of appraisers who specialize in such problems. The three categories are as follows: - Physical deterioration. - Functional or structural obsolescence due to the availability of more efficient layout designs and technological changes that reduce operating costs. - External obsolescence that may result from changes outside of the property such as excessive traffic, noise, or pollution.

What is the effective borrowing cost?

This differs from the contract rate because it includes financing fees (points, origination). It differs from the APR because the latter is calculated assuming that the loan is repaid at maturity. When calculating the effective cost, the expected repayment or payoff date must be used. The latter is usually sooner than the maturity date. Y

When estimating the reversion value in the year of sale, why is the terminal cap rate applied to NOI for the year after the holding period?

When we sell a property the price paid by the next investor is an assessment of income for his expected period of ownership. Therefore, for the next investor, or potential buyer, the NOI for his first year of ownership will be the year after we sell the property. This will be the first year of his investment. Y