real estate valuation. real estate valuation: market comparison approach

Real Estate Valuation

Introduction

Definitions of Market Value:

1. The market value of a property is the present value of future expectedbenefits discounted at the market rate.

2. “The most probable selling price in cash, or terms equivalent to cash,or in other precisely revealed terms, for which the appraised propertywill sell in a competitive market under all conditions requisite to a fairsale, with the buyer and seller each acting prudently, knowledgeably,and for self-interest, and assuming that neither is under undue duress.”(The Appraisal of Real Estate, American Institute of Real EstateAppraisers)


Introduction

The Appraisal Institute definition assumes:

1. the buyer and seller are motivated by self-interest;

2. the buyer and seller are well informed and are acting prudently;

3. the property is exposed for a reasonable amount of time; and

4. payment is made in cash, or its equivalent.


Introduction

I. Techniques Used to Estimate Market Value

A. Market Comparison

B. Cost Approach

C. Income Approach

1. Overall Capitalization

2. Discounted Cash Flow Valuation

Real Estate Valuation:Market Comparison Approach

Steps in the Market Comparison Approach

1. Find similar properties that recently sold: comparables

2. Identify key characteristics of subject and comparable properties

3. Adjust sales prices of comparables for differences in key characteristics

a. non-market financing termsb. non-real estate itemsc. sales dated. amenities

4. Estimate value of subject property by taking the weighted average ofadjusted comparable sales prices.



What are key property characteristics for:

1. Multifamily properties (e.g. apartments)?

2. Office properties?

3. Retail properties?

4. Industrial/warehouse properties?

5. Single family homes?

6. Raw land?



Making adjustments for differences:

1. Non-market financing terms: PV of the difference betweenmarket and contractual cash flows discounted at the market rate.

2. Non-real estate terms: market value of the commodity

3. Sales date: rate of change in real estate prices between salesdate and current period.

4. Amenities: implicit price of the characteristic

Price the comparables as if they were the same as the subject property.



Estimate the market value of the subject property by taking theweighted average of the adjusted comparable property prices.

The weights reflect the appraiser’s confidence in the estimated prices.

Adjustments are made with error, so properties

with numerous adjustments receive a low weight

with few adjustments receive a high weight


Example of Market Comparison Approach

Estimate the value of the following garden apartment property using themarket comparison approach to value. The subject property has 150 unitsand is located in the Fair Oaks area of Dallas, TX. The property was builtin 1979, has 122,500 square feet of leasable area, and is 92% occupied.The improvements occupy 5.83 acres for a density of 25.71 units per acre(upa). Subject property amenities include a swimming pool, clubhouse,laundry room, and tennis court.

You have obtained market data for two comparable properties. The Manoron the Park is a 108 unit garden apartment complex located at the southwestcorner of Park Lane and Valley Meadow Road. This property has 112,896square feet of leasable space, was built in 1965, and is currently 92%occupied. The improvements occupy 4.134 acres for a density of 26.1 upa.The property sold six months ago for $1,470,000. Property amenities



include a swimming pool, clubhouse, and covered parking. The secondcomparable is a 132 unit garden apartment complex located on thesouthwest side of Royal Lane, 160 feet southeast of Abrams Road. FoxHollow has 87,776 square feet of rentable space, was built in 1978 and iscurrently 85% occupied. The improvements occupy 2.907 acres for adensity of 45.41 upa. The property sold three months ago for $1,900,000.Property amenities include a swimming pool, clubhouse, laundry room,tennis court, and exercise room. In addition, the sell took back a $500,000second loan at 7% annual interest with monthly payments for 25 years whenthe market rate for this type of loan was 9%.

Estimate the market value of the subject property using the marketcomparison approach to value if property values are increasing at an annualrate of 3% . The amenity adjustments are provided in the following tables.



Characteristic Adjustment Subject Manor FoxProperty on the Park Hollow

Sales Price $1,470,000 $1,900,000

Financing PV of Cfs market market -$78,895 Adj. Price @ mkt. rate $1,470,000 $1,821,105

Other terms none none

Sales date 3%/12 per mo. current 6 mos. ago 3 mos. ago Adj. Price $1,492,188 $1,834,797



Characteristic Adjustment Subject Manor FoxProperty on the Park Hollow

Adjusted Price $1,492,188 $1,834,797Characteristics

Age 0.5% /year 1979 + 107,917 + 9,174Laundry $25,000 yes + 25,000 0Tennis $60,000 yes + 60,000 0Covered Park $750/unit no - 81,000 0Exercise Rm. $40,000 no 0 - 40,000

Adjusted Price $1,604,105 $1,803,971Unit Price $ 14,853 $ 13,666

Market Value of Subject = ( 0.4 x $14,853 + 0.6 x $13,666 ) x 150= $ 14,141 x 150 = $ 2,121,150

Real Estate Valuation:Cost Approach

Introduction

The cost approach estimates property by adding

1. raw land acquisition costs

2. site development costs

3. depreciated improvement reproduction costs

Real Estate Valuation:Cost ApproachSite Development Costs

Site development costs consist of:

(1) earthwork;

(2) utility installation (e.g. natural gas, water, electricity, sewer);

(3) roads and walks;

(4) landscaping and irrigation; and

(5) other non-structural site improvements (e.g. fences and gates, streetfurnishings (i.e. benches, planters), swimming pools, pool decks,tennis courts, basketball courts, play areas, mail kiosks, etc.)


Improvement Cost

Improvement Costs consist of:

1. Indirect costs (e.g. architectural plans, landscape/irrigation designs,soil reports, surveys, environmental reports, construction periodinterest).

2. Direct construction costs: costs of building materials and labor

a. Reproduction Cost: the cost of building an exact replica

b. Replacement Cost: the cost of building an improvementthat provides the same services

Real Estate Valuation:Cost ApproachReproduction Cost New

1. Quantity survey method: detailed inventory of all materials andequipment used to construct the improvement

2. Unit in place method: based on unit prices for various buildingcomponents

3. Construction cost indices: applies base unit cost estimates to thegross area of the improvement and adds/subtracts for differences.

Construction cost services available from:Marshall and SwiftDodge Building Cost Services/McGraw Hill Information ServicesBoeck Building Valuation


Depreciation

Three types:

1. Physical: wear and tear; deterioration over time

2. Functional: loss of value due to design, outdated equipment

3. Economic: loss of value attributable to external factors(e.g. location)

Depreciation is called curable if the cost of the repair is less than the valueadded from making the repair; incurable if the cost exceeds the benefit.


Depreciation

Techniques used to estimate depreciation:

1. Straight line over useful life.

2. Cost to cure

3. PV of rent loss or increase in expense

4. Appraiser’s judgement


Summary

1. Estimate land acquisition cost

2. add estimate of site improvement costs

3. add estimate of reproduction cost new

a. indirect cost

b. direct cost

4. subtract depreciation (if any)

5. Equals property value

Real Estate Valuation:Income Approach

Overall Capitalization

The market value of a property, V, is frequently estimated as:

where NOI = net operating income for the subject property;

R = capitalization rate--the rate used to convert the property’sflow of benefits (income, capital gain, tax benefits) to avalue today.

V = NOI

R


O vera ll C ap ita liza tio n

T he cap ita liza tio n ra te , R , co m es fro m the m arke t.

T o estim ate the m arke t cap ita liza tio n ra te fo r a p articu la r p ro p erty:

1 . find a sim ila r p ro p erty tha t recen tly so ld ;

2 . co m p ute the N O I fo r the co m p arab le p ro p erty;

3 . use the (ad justed ) se l ling p rice o f the co m p arab le fo r va lue , V , andestim ate the o vera ll cap ita liza tio n ra te as:

R = N O I

V


O v e r a l l C a p i t a l i z a t i o n : E x a m p l e

C o m p u t e t h e o v e r a l l c a p i t a l i z a t i o n r a t e f o r t h e a p a r t m e n t p r o p e r t y e x a m i n e de a r l i e r . T h e t r a n s a c t i o n p r i c e o f t h e p r o p e r t y a f t e r t h e c a p i t a l i m p r o v e m e n t s( e . g . v a l u e ) i s $ 4 , 8 5 0 , 0 0 0 a n d t h e f i r s t y e a r ’ s N O I $ 4 9 5 , 2 4 0 . T h ec a p i t a l i z a t i o n r a t e f o r t h i s p r o p e r t y i s :

R = N O I

V =

$ 4 9 5 , 2 4 0

4 , 8 5 0 , 0 0 0 = 1 0 . 2 1 %


Koll National Average Overall Capitalization Rates

Class “A” Property Quarter/Year

4Q/94 4Q/95 3Q/96 4Q/96

Apartment 9.30% 9.10% 8.82% 8.79%

CBD Office 8.90% 8.80% 8.96% 8.95%

Retail 9.40% 9.40% 9.31% 9.25%

Warehouse/ 9.50% 9.30% 9.24% 9.21% Distribution


Relationship Between the Cap Rate and the Discount Rate

In general, the capitalization rate, R, is not equal to the required yield, ordiscount rate, for income property investments. Under some assumptions, itis possible to develop the relationship between the cap rate and the requiredyield. The formula was developed in the 1950s by the appraiser PeteEllwood and assumes:

1. NOI is an annuity (a series of equal payments)

2. the acquisition is finance with fixed rate debt



Under these assumptions, the Ellwood overall capitalization rate is:

R = dbte - m C - b SFF(dbte , N),

where dbte = the required yield on before tax equitym = the loan to value ratio

C = the mortgage coefficient = dbte + P SFF(dbte,N) - fb = the rate of appreciation/depreciation in the market value

of the property over the holding period.SFF= sinking fund factor computed at the equity yield rate over

the holding periodP = the proportion of the loan repaid over the holding period;f = annual mortgage constant



For an all cash acquisition (e.g. m = 0):

R = dbte - b SFF(dbte , N),

1. the cap rate will equal the discount rate only when there is noexpected change in the value of the property (e.g. b = 0).

2. if b > 0, then the cap rate will be less than the before tax requiredyield on equity by the amount b SFF(dbte, N). This termannualizes the total increase in property value that occurs over theexpected holding period.



The Ellwood formula also helps us understand the relationship betweeninterest rates and capitalization rates. Suppose income property investorscompute their required before tax equity yields by adding 400 basis pointsto the before tax cost of debt. That is, if interest rates are 9% then investorsdiscount expected before tax equity cash flows at 13%. The Ellwoodcapitalization rate for a property that is held for five years, financed with an80% loan with monthly payment for 30 years, and expected to appreciate1.5% per year is:

R = dbte - m C - b SFF(dbte , N)

= .13 - .8 0.03981 - 0.07728 0.1543 = 8.623%



If interest rates fall by 100 basis points to 8%, then investors discount beforetax equity cash flows at 12% and the capitalization rate is:

R = 0.12 - 0.8 0.03971 - 0.07728 0.1574 = 7.607%

So if interest rates fall by 100 basis points, the cap rate fall by 101.6 basispoints.

What happens to property values? For a property with NOI = $100,000:

@ 9% debt, V = $ 100,000/0.08623 = $1,159,689@ 8% debt, V = $100,000/0.07607 = $1,314,579

A $154,890 increase (13.36%) in property value.


Discounted Cash Flow (DCF) Valuation

Estimate market value by adding the present value of all expectedfuture cash flows.

Assumes the holding period cash flows can be estimated

1. Operating period cash flowsa. NOIb. Before Tax Equity Cash Flowsc. After Tax Equity Cash Flows

2. Future expected selling price

Assumes the required yield is known (or can be estimated).


B e f o r e D e b t , B e f o r e T a x D C F

w h e r e N C F t = e x p e c t e d N e t C a s h F l o w i n y e a r t ;

d p = r e q u i r e d y i e l d o n e x p e c t e d p r o p e r t y c a s h f l o w s ;

N = l e n g t h o f t h e h o l d i n g p e r i o d

V a l u e =

N C F

1 + d +

N e t S a l e s P r o c e e d s

1 + d

t

pt = 1

NN

p

t N


Example of Before Debt, Before Tax Valuation

Estimate the market value of the following property:

First year’s NCF is $100,000

NCF is expected to increase 4% per year

The property value is expected to appreciate 3% per year

The property will be held for three years

The required yield for property cash flows is 13%


E xam p le o f B efo re D eb t, B efo re T ax V alua tio n

V alu e = $ 10 0 ,0 00

(1 .1 3 ) +

$ 10 4 ,0 00

(1 .1 3 ) +

$ 10 8 ,1 60

(1 .1 3 ) +

(1 .0 3 ) V alu e

(1 .1 3 )

= $2 44 ,90 3 + 1 .09 27 3 V alu e

(1 .1 3 )

= $2 44 ,90 3 + 0 .7 57 31 V alu e

0 .24 26 9 V alu e = $2 44 ,90 3 ; an d V alue = $1 ,00 9 ,1 1 9 ; R = 9 .9 1%

1 2 3

3

3

3


A f t e r D e b t , B e f o r e T a x D C F

w h e r e B T C F O t = e x p e c t e d b e f o r e t a x c a s h f l o w s f r o m o p e r a t i o n s ;

B T C F R N = e x p e c t e d b e f o r e t a x c a s h f l o w f r o m r e v e r s i o n ;

d b t e = r e q u i r e d y i e l d o n b e f o r e t a x e q u i t y c a s h f l o w s ;


V a l u e = P V o f D e b t +

B T C F O

1 + d +

B T C F R

1 + dt

b t et = 1

NN

b t e

t N


A f t e r D e b t , A f t e r T a x D C F

w h e r e A T C F O t = e x p e c t e d a f t e r t a x c a s h f l o w s f r o m o p e r a t i o n s ;

A T C F R N = e x p e c t e d a f t e r t a x c a s h f l o w f r o m r e v e r s i o n ;

d a t e = r e q u i r e d y i e l d o n a f t e r t a x e q u i t y c a s h f l o w s ;


V a l u e = P V o f D e b t +

A T C F O

1 + d +

A T C F R

1 + dt

a t et = 1

NN

a t e

t N

Real Estate Valuation: Income Approach Office Property Example

Estimate the market value of the following office property. Theproperty has 100,000 net rentable square feet (nrsf). The currentmarket rent for office space is $12.00 per square foot (psf). Theproperty will also provide $100,000 in non rental income during thefirst year of operation. Vacancy losses are 4% of gross potentialincome and collection losses are 2% of gross potential income.

The first year’s variable expenses total $260,000 and the firstyear’s fixed expenses total $170,000. The property also requires$200,000 in capital improvements during the first year of operations.Income and expenses are expected to increase 2% per year for theentire 4 year holding period. In addition, expenses in excess of theexpense stop will be reimbursed. The expense stop is the first year’spro-forma per square foot expense.


The equity investor will finance 75% of the purchase pricewith a 9.0% fixed annual interest rate, 25 year, monthlypayment loan. Financing costs amount to 2% of the loanamount and the borrower must pay a 3% prepayment penalty ifthe loan is repaid within seven years.

The investor expects to hold the property for four years.The future selling price is estimated by capitalizing the fifthyear’s NOI at 10%. The investor will have to pay a 2% salescommission at the time of sale in four years.

Discount future expected property cash flows at 11%annually and expected (before tax) equity cash flows at 13%.


Year: 1 2 3 4REVENUES and EXPENSES:Gross Rental Revenue 1,200,000 1,224,000 1,248,480 1,273,450 less Vacancy Loss -48,000 -48,960 -49,939 -50,938 less Loss to Lease 0 0 0 0 less Collection Loss -24,000 -24,480 -24,970 -25,469Total Net Rental Income 1,128,000 1,150,560 1,173,571 1,197,043 plus Reimbursables 0 8,817 17,810 26,983 plus Other Income 100,000 102,000 104,040 106,121 Reimbursables + Other 100,000 110,817 121,850 133,103Gross Effective Income 1,228,000 1,261,377 1,295,421 1,330,146


Expenses and Net Operating Income

Year: 1 2 3 4REVENUES and EXPENSES:Gross Effective Income 1,228,000 1,261,377 1,295,421 1,330,146less OPERATING EXPENSES: Variable Expenses -260,000 -265,200 -270,504 -275,914 Fixed Expenses -170,000 -173,400 -176,868 -180,405Total Operating Expenses -430,000 -438,600 -447,372 -456,319NET OPERATING INCOME 798,000 822,777 848,049 873,827


Net Cash Flow before Disposition

NET OPERATING INCOME 798,000 822,777 848,049 873,827less Capital Expenses -200,000 0 0 0NCF Before Dispositions 598,000 822,777 848,049 873,827


Disposition Cash Flow

Estimated Selling Price 9,001,197 less Selling Costs -180,024Net Sales Proceeds 8,821,173


Property (Unlevered) Value

006,213,8$

11.1

173,821,8827,873

11.1

049,848

11.1

777,822

11.1

000,598Value

4

32


Before Tax (Levered) Value

How would you estimate the levered value of the property?

The loan is for 75% of the price, but you don’t know the price.

This is what computers are for.


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