REE 4313 Exam 1 Chapter 10

functional obsolescence

due to the availability of more efficient layout designs and technological changes that reduce operating costs

appraisal process

1 ascertain physical and legal id of the property 2 identify prop rights to be valued 3 specify purpose of appraisal 4 specify effective date of value estimate 5 gather and analyze market data 6 apply techniques to estimate value

cap rate

NOI / transaction price

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.

unlevered cash flow from operations =

PGI - Vac and Coll losses + Misc Inc + Reimbursed Exp = EGI - Op Exp = NOI - Cap exp = Cash flow - ADS = BTCF

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.

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

If investors buy properties based on expected future benefits, what is the rationale for appraising a property based on current cap rates 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).

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.

effective age

age based on wear and tear and utility

replacement cost

amount paid to replace in current time

cost approach

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

sales comp approach

based on data provided from recent sales of properties highly comparable to the property being appraised

income approach

based on the principle that the value of a property is related to its ability to produce cash flow

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

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.

physical deterioration

depreciation due to wear and tear, maintenance

residual land value

difference between the total property value, which is driven by rents and cash flows, and the cost of constructing an improvement on a given site

unit of comparison

ex: number of apartment units in an apartment building and number of cubic feet in a warehouse

Under what conditions should financing be explicitly considered when estimating the value of a property?

mortgage-equity capitalization method. With this method, the value of a property can be estimated by explicitly taking into consideration the requirements of the mortgage lender and equity investor, hence the term "mortgage-equity capitalization".

leased fee estates

ownership interest in a leased property

What is meant by depreciation in the cost approach?

physical deterioration, functional and external obsolescence,

fee simple estate

property owner has full enjoyment of property, they can basically do whatever

mortgage equity cap

pv = mortgage financing + equity investment

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?

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.

reversion value

resale price

external obsolescence

result from changes outside of the property such as excessive traffic, noise, or pollution.

what makes a comparable property

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.

gross income multipliers

sales price / gross income

which should be greater, terminal cap rate or going in cap rate

terminal

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

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.

dcf is

value = pv of expected cash flows

cash flow from sale =

Sales price - selling exp = net sale price - outstanding mortgage balance = before tax equity reversion

discount rate

required return for a real estate investment based on its risk when compared with returns earned on competing investments and other capital market benchmarks

direct cap rate is

value = noi / Ro