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CHAPTER TEN. VALUATION OF INCOME PROPERTIES: APPRAISAL AND THE MARKET FOR CAPITAL. Market Value. Motivated buyer and seller Well informed buyer and seller A reasonable time period Payment in cash or cash equivalent Arms length transaction. Appraisal Process. - PowerPoint PPT Presentation
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Market ValueMarket Value
• Motivated buyer and seller
• Well informed buyer and seller
• A reasonable time period
• Payment in cash or cash equivalent
• Arms length transaction
Appraisal ProcessAppraisal Process
• Physical and legal identification
• Identify property rights
• Purpose of the appraisal
• Specify effective date of value estimate
• Apply techniques to estimate value
Income ApproachIncome Approach
• GIM
• Direct capitalization method
• Discount present value method
• Note- the first two methods rely on current market transactions
Gross Income MultiplierGross Income Multiplier
• PGI*
• Less V and C
• EGI
• Less OP
• NOI
• GIM= sales price/ gross income*
Capitalization RateCapitalization Rate
• V= NOI/ R
• NOI can be compared with transaction prices to derive R
• Sometime called market extraction method
Operating ExpensesOperating Expenses• Real estate taxes• Insurance• Utilities• Repair and maintenance• Admin. and general• Mgnt. and leasing• Salaries• Reserves• other
Discounted PVDiscounted PV
• Discount rate (r)
• Required return for a real estate investment based on its risk when compounded with other investments
• Time period 5, 7, 10 years
• A forecast of NOI
• Estimate reversion value
Simple FormulaSimple Formula• Present value of an increasing annuity• Value= NOI1/ (discount rate- growth rate)
– NOI1 is Net Operating Income (rent less expensive) during the first year of ownership
– Discount rate is the required rate of return (IRR)– Growth rate is the expected growth in income
• Same idea as Gordon Dividend Discount Model (see www.DividendDiscountModel.com)
• Simple model assumes income and value will grow at the same rate forever (or until sold)
ExampleExample
• An apartment building is expected to generate NOI of $100,00 the first year. Rents and expenses are expected to grow at 2% per year until sold after 5 years. The value of the property is expected to increase with income. Investors require a 12% rate of return. What is the value?
• Value= $100,000/ (12%-2%)= $1,000,000
Concept of a Capitalization Concept of a Capitalization RateRate
• Capitalization rate (“cap rate”)= NOI1/ value– Ratio of first year income to value
• Rearrange equation: value=NOI1/cap rate
• Two ways to think about getting a cap rate:• Formula: cap rate= discount rate- growth rate e.g., in
previous example, cap rate= 12%-2%= 10%
• Comparable sales: cap rate=NOI1/ sale price where the sale price is from comparable properties e.g., another property sold for $1,200,000 and was expected to have NOI the first year of $120,000
Beyond the Simple FormulaBeyond the Simple Formula
• Project the NOI for each year of a holding period
• Project resale price at the end of the holding period
• Discount the NOI and resale to get present value
ExampleExample
• Income is expected to be $100,000 per year for the next 5 years due to existing leases. Starting in year 6 the income is expected to increase to $120,000 due to lease rollovers and increase at 2% per year thereafter. Investors want a 12% return. What is the value?
SolutionSolution• First estimate resale using cap rate concept
– Resale or “terminal” cap rate= 12%-2%= 10%– Apply this to income in year 6 ( first year of
ownership to next owner) – Resale= ($120,000)/ .10= $1,200,000
• Now discount the NOI and resale price– PMT= $100,000– FV= $1,200,000– n= 5– i= 12%
• Note that the “going in cap rate” would be 100,000/ $1,041,390= 9.6%
NPV @12% $1,041,390 *Yr 6 NOI/ terminal cap rate of 120,000/ .10NPV @12% $1,041,390 *Yr 6 NOI/ terminal cap rate of 120,000/ .10
Year 1 2 3 4 5 6
NOI 100,000 100,000 100,000 100,000 100,000 120,000
Resale 1,200,000*
Cash Flow
100,000 100,000 100,000 100,000 1,300,000
Reversion ValuesReversion Values
• Expected L-T cash flows
• REV9= (NOI10)/ (r-g)
• Directly from sales transaction data
• Resale based on expected change in property values
Highest and Best Use AnalysisHighest and Best Use Analysis
• PV= NOI1/ r-g or NOI1/r
• PV- BLDG cost= land value
Mortgage Equity Mortgage Equity CapitalizationCapitalization
• V= M+E
• DS= NOI1/ DCR
• Calculate M
• Calculate E (PVA + CF)
• PV= M + E