Real Estate Valuation Midterm
Three primary tools may be employed by investors to minimize their exposure to risk:
-Avoidance and identification of risk through due diligence -Financial tools such as insurance, hedging, and option contracts -Diversification (either into other product types or different locations)
Market Value is the basis of lending decisions given the following conditions:
-Buyer and seller are typically motivated -Parties are well informed/well advised and acting in their best interest -Payment in cash or using traditional financing
Three types of Income Approaches
-Gross Income Multiplier -Direct Capitalization Method -Discount Present Value Method
The Three Appraisal Approaches
1) Sales Comparison 2) Cost 3) Income Capitalization
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.
Why might a lender prefer a loan with a lower interest rate and a participation?
A lender's motivation for making a participation loan includes how risky the loan is perceived relative to a fixed interest rate loan. The lender does not participate in any losses and still receives some minimum interest rate (unless the borrower defaults). Additionally, the participation provides the lender with somewhat of a hedge against unanticipated inflation because the NOI and resale prices for an income property often increase as a result of inflation. To some extent this protects the lender's real rate of return.
What is meant by a participation loan? What does the lender participate in? Why would a lender want to make a participation loan? Why would an investor want to obtain a participation loan?
A participation loan is where in return for a lower stated interest rate on the loan, the lender participates in some way in the income or cash flow from the property. The lender's rate of return depends, in part, on the performance of the property. Participations are highly negotiable and there is no standard way of structuring them. A lender's motivation for making a participation loan includes how risky the loan is perceived relative to a fixed interest rate loan. The lender does not participate in any losses and still receives some minimum interest rate (unless the borrower defaults). Additionally, the participation provides the lender with somewhat of a hedge against unanticipated inflation because the NOI and resale prices for an income property often increase as a result of inflation. To some extent this protects the lender's real rate of return. An investor's motivation is that the participation may be very little or zero for one or more years. This is because the loan is often structured so that the participation is based on income or cash flow above some specified break- even point. During this time period, the borrower will be paying less than would have been paid with a straight loan. This may be quite desirable for the investor since NOI may be lower during the first couple of years of ownership, especially on a new project that is not fully rented.
What is meant by a "real option"?
A real option is an option related to investment in tangible assets like real estate that involves the option to wait to decide whether to invest additional capital based on future economic conditions. Land can be viewed as having the option to invest additional capital in the future to construct a building.
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.
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.
Investing in Core Properties
Acquiring existing, seasoned, relatively low-risk properties that are at least 80% leased Goal to create stable cash flow
What is meant by an effective tax rate? What does it measure?
An effective tax rate is a tax rate that takes into account the effects of depreciation and time value of money. It measures the actual difference between the BTIRR and the ATIRR. This difference is the effective tax rate and can be less than the actual marginal tax rate. This difference is also due to the fact that the interest on the mortgage loan is deductible.
Why might an investor prefer a loan with a lower interest rate and a participation?
An investor's motivation is that the participation may be very little or zero for one or more years. This is because the loan is often structured so that the participation is based on income or cash flow above some specified break- even point. During this time period, the borrower will be paying less than would have been paid with a straight loan. This may be quite desirable for the investor since NOI may be lower during the first couple of years of ownership, especially on a new project that is not fully rented.
What criteria should be used to choose between two financing alternatives?
Assuming the two financing alternatives are for roughly the same amount of funds (so financial risk due to leverage is the same), the alternative with the lowest effective interest cost should be chosen. This alternative should also result in the highest IRR on equity.
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 are some of the types of risk that should be considered when analyzing real estate?
Business Risk Financial Risk Liquidity Risk Inflation Risk Management Risk Interest Rate Risk Legislative Risk Environmental Risk
What is the difference between business risk and financial risk?
Business risk is the risk of loss due to fluctuations in economic activity that affect the variability of income produced by a property. Financial risk (or debt financing referred to as financial leverage) magnifies the business risk. Financial risk increases as the amount of debt increases.
How may the use of leases shift the risk of rising operating expenses from the lessor to the lessee?
CPI Adjustments Net Lease Expense Stop provisions *more risk for lessee will result in a lower negotiated base rent
What types of expenses would property owners pay when operating and maintaining common areas? Give examples for office, retail, and warehouse properties.
Common area are for the benefit of all tenants. An example for office properties would be the lobby area. For retail a good example is enclosed malls where all the area not occupied by the store itself is common area to allow pedestrians to walk from store to store and use for special events. Warehouse properties might have a loading dock that is shared by all tenants. All of these property types might have parking as a common area. The tenants would often pay a pro-rata portion of the operating expenses related to these common areas such as property taxes, insurance, utilities and maintenance.
What are the similarities and differences between an overall rate and an equity dividend rate?
Difference: The overall rate relates the entire NOI to the value of the property. The equity dividend rate relates the BTCF (or equity dividend) in the first year to the initial equity investment. Similarity: Neither one of these is a measure of investment yield because they do not take into account future income from operations or resale of the property at the end of the holding period. Both are based on a single year, usually the first year.
Why should investors be concerned about market rents if they are purchasing a property subject to leases?
Even if the investment is an existing building that has already been leased, the income can be affected when the existing leases expire and are renewed at the market rent at the time.
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 financial leverage? Why is a one-year measure of return on investment inadequate in determining whether positive or negative financial leverage exists?
Financial leverage is defined as benefits that may result to an investor by borrowing money at a rate of interest that is lower than the expected rate of return on total funds invested in a property. To determine whether leverage is positive (favorable) or negative (unfavorable), the investor needs to determine whether the IRR (calculated over the entire holding period) is greater than the cost of borrowed funds. A first-year measure of return such as the overall capitalization rate can not be used because it does not explicitly consider the benefits that accrue to the investor over time from changes in income and value that do not affect the cost of debt.
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?
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?
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.
Contrarian Investing
Investing in properties that are out-of-favor at low prices, believing prices will recover
Growth Investing
Investing in property types that are likely to experience significant appreciation in value
What is an estoppel? Why is it used?
It is a legal document used in many circumstances. In real estate, it is used by prospective investors to determine factual information with tenants, such as amount of any rent owed, improvements promised by the current owners, etc.
What is the significance of a debt coverage ratio?
It is a ratio of the NOI to the mortgage payment that indicates the riskiness of a loan. It is the degree to which the NOI from the property is expected to exceed the mortgage payment. Lenders typically want a debt coverage ratio (DCR) to be at least 1.2.
In what way does leverage increase the riskiness of a loan?
Leverage increases the standard deviation of return regardless of whether it is positive or negative. This means the investment is clearly riskier when leverage is used. Because the NOI does not change when more debt is used, increasing the amount of debt increases the debt service relative to NOI. Therefore, the debt coverage ratio (DCR) may exceed the lender's limits. With higher loan-to- value ratios and declining debt coverage ratios, risk to the lender increases. As a result, the interest rate on additional debt will also increase.
Sales Approach
Look at the market and compare
Investing in Core Properties with a "Value Add" Strategy
Make changes to mgt or make capital improvements Goal to increase rents and outperform competing properties
What is meant by "loss to lease"? Explain.
Many leases reflect market conditions and rents that existed when the lease was executed. Many financial statements estimate gross rental revenue based on (1) all rental space re-leased today at prevailing rents and compare that amount to (2) actual rental revenue based on leases that have been executed at various times in the past. The difference between (1) and (2) is "loss to lease," or the difference between current market rents and rents actually collected based on lease terms with each tenant.
Equity Dividend
NOI-DS, the before tax cash flow from operations
Flat Rent
No rent change over lease term
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.
Indexed Rents
Periodic rent adjustment-CPI Index
The appraisal process is performed by appraisers and others seeking to establish value
Physical and legal identification Identify property rights to be valued Specify the purpose of the appraisal Specify effective date of value estimate Gather and analyze market data Apply techniques to estimate value
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.
Absorbtion
Rate at which homes are selling within a certain time frame
Motivations for Investing in Income Properties
Rate of Return (income above expenses) Price Appreciation Diversification Tax Benefits
Percentage Lease
Rent partially based on sales "Breakpoint"
Value Investing
Research directed toward finding properties that are overlooked by other investors.
Retail Leases
Sales per Rentable Square Foot and Traffic Counts Provisions on operations may include limits on other tenants Anchor and In-Line Tenants Rent Differences Percentage rent lease Breakpoint Overage Common Area Maintenance (CAM)
Property Sector Investing
Selecting a property type that will outperform other property sectors in a specific market
How does the use of scenarios differ from sensitivity analysis?
Sensitivity analysis involves changing one variable at ta time such as the market rent or the vacancy rate. Scenarious involves changing several variables at once for each scenario, e.g., a pessimistic, most likely, and optimistic scenario. For each scenario there might be a different assumption about market rents, vacancy rates, and the resale price because they are interrelated.
Market Timing
Shifting from one property type to another based on the real estate cycle and forecasted economic conditions.
Industrial Property Leases
Similar to office leases More individualized for tenant Term tends to be longer than office leases Tend to be pass-through Premiums & Discounts
Step Up Rents
Specified rent increases at specified times
Development
Strategy involves the acquisition of land, design and construction of building, and a leasing program to reach stable occupancy.
Modified (full service) lease
Tenant pays rent at a lower rate that Gross, but pays for specific expenses Direct "pass-throughs" (i.e., tenant pays electricity) Non-operating expense "pass-throughs" (i.e., tenant pays for insurance)
Gross (full service) leases
Tenant pays rent only Property owner pays all operating expenses
What is the break-even mortgage interest rate (BEIR) in the context of financial leverage? Would you ever expect an investor to pay a break-even interest rate when financing a property? Why or why not?
The BEIR is the maximum interest rate that could be paid on the debt before the leverage becomes unfavorable. It represents the interest rate where the leverage is neutral (neither favorable nor unfavorable). The BEIR remains constant regardless of the amount borrowed (that is 60, 70, or 80 percent of the property value). An equity investor probably would not pay a break-even interest rate when financing a property because the investor just earns the same after-tax rate of return as a lender on the same project. Borrowing at the BEIR provides no risk premium to the investor. Normally, a risk premium is required because the equity investor bears the risk of variations in the performance of the property.
What is the significance of the passive activity loss limitation (PAL) rules for real estate investors?
The PALL rules are important because, in general, passive losses cannot be used to offset income from another category. Because any tax loss from real estate is usually considered a passive loss, it can not be used to offset income from other sources such as active income from salaries and wages or portfolio income from interest or dividends.
How is the gain from the sale of real estate taxed?
The entire taxable gain from the sale of real estate is taxed at the same rate as ordinary income. It is still important to keep track of capital gains/losses and ordinary income gains/losses. This is due to TRA rules for passive investors and properties acquired prior to 1986.
What is meant by equity?
The investor's initial equity in the project is equal to the purchase price less the amount borrowed. The amount of equity an investor has in a property may change over time if the property value and loan balance changes. E.g., if the property value increases and the loan balance is reduced through amortization, the investor's equity increases.
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.
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.
Cost Approach
The rationale is that no informed buyer would pay more for a property than it would cost to build a new one. The Cost Approach is most reliable where the structure is relatively new and depreciation does not present serious complications
What is meant by a tax shelter?
The term "tax shelter" refers to an investment that allows a taxpayer to reduce taxable income. Although most of the tax shelter benefits of real estate were removed by the Tax Reform Act of 1986, depreciation deductions still provide some "shelter" in that they are non-cash deductions that reduce taxable income. Interest deductions on the mortgage also serve to reduce and in a sense shelter taxable income.
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. Using a rate of appreciation to estimate the reversion value is based on the investor's expectation as to trends in property values. This could be a reflection of risk, expected cash flows, interest rates, and returns on other investments such as stocks and bonds.
How do you think expense stops and CPI adjustments in leases affect the riskiness of the lease from the lessor's point of view?
There is less risk for the lessor with expense stops and CPI adjustments in leases. CPI Adjustments: The risk of unexpected inflation is shifted to the lessee. Expense Stops: The risk of increases in expenses is shifted to the lessee while allowing the lessor to retain the benefit of any decrease in expenses.
What are CAM charges?
These are expenses related to common area maintenance of hallways, lobbies, etc. that are usually prorated and passed on to tenants.
What is meant by partitioning the internal rate of return? Why is this procedure meaningful?
To illustrate what is meant by partitioning the IRR, remember that the 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.
What is meant by useable versus rentable space?
Usable space is the area actually occupied by the tenant. Rentable space is usable space plus a share of common area in a property which is included in the load factor.
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).
Office Leases
Variable terms Premium & Discounts Rentable area Usable area Load factor
What is meant by a sale-leaseback? Why would a building investor want to do a sale-leaseback of the land? What is the benefit to the party that purchases the land under a sale-leaseback?
When land is already owned and is then sold to an investor with a simultaneous agreement to lease the land from the party it is sold to, this is called a sale-leaseback of the land. One motivation for the sale-leaseback of the land is that it is a way of obtaining 100 percent financing on the land. A second benefit is that lease payments are 100 percent tax deductible. With a mortgage, only the interest is tax deductible. The investor may deduct the same depreciation charges whether or not the land is owned, since land cannot be depreciated. This results in the same depreciation for a smaller equity investment. The investor may have the option of purchasing the land back at the end of the lease if it is desirable to do so.
What are positive and negative financial leverage? How are returns or losses magnified as the degree of leverage increases? How does leverage on a before-tax basis differ from leverage on an after-tax basis?
When the before-tax or after-tax IRR are higher with debt than without debt, we say that the investment has positive or favorable financial leverage. When returns are lower with debt than without debt we say that the investment has negative or unfavorable 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. Returns and losses are magnified by the greater the amount of debt, the greater the return or loss to the equity investor. Leverage on a before-tax basis differs from leverage on an after-tax basis because interest is tax deductible. Therefore, we must consider the after-tax cost of debt which is different than the before-tax cost of debt.
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.
Do you think taxes affect the value of real estate versus other investments?
Yes. Not all investments are treated alike when it comes to federal income taxes. Thus, taxes must be considered when comparing returns for investments which are not taxed in the same manner. Investments that have the same before-tax return may have quite different after-tax returns.
Recoverables
are expenses incurred by owners for specific expenses identified in a lease such as security, maintenance, utilities, etc. and are pro-rated and billed to tenants.
Pass Throughs
are expenses such as electricity, insurance, and property taxes that are billed directly to tenants on the basis of rentable area that they occupy.
Common Areas
include mallways, parking areas, lobbies, and hallways. Expenses related to these areas are referred to as common area expenses.
