Fundamentals of Real Estate

Lecture 14

Spring, 2003

Copyright © Joseph A. Petry

www.cba.uiuc.edu/jpetry/Fin_264_sp03

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Housekeeping

Exam on Wednesday, March 19. Will cover chapters 12, 13, 14 & 17, as well as

regression tools we have reviewed for the project.

Each team needs a unique team number beginning with 1. Please be sure you remember your team’s number.

Project will be available by the end of this week. Will be due Wednesday, April 16th.

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Income Approach Models to Valuation Discounted Cash Flow Analysis Direct Capitalization

Analysis is similar to Investment Analysis, except Perspective is different

– Objective is to obtain an estimate of market value Data is different

– Use data that reflects market conditions, not particulars of a given investor

Valuation by The Income Approach:Chapter 13

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Valuation by The Income Approach:Discounted Cash Flow Analysis

Input Assumptions for Suburban Office Building Example Suburban Office Building Reconstructed Operating StatementInput AssumptionsNumber of units 18 total; 8 on 1st floor, 10 on 2ndAsking price = 885,000$ Contract rents 12 units at 900$ per month

6 units at 700$ per monthProjected rental increases 3% per yearVacancy & collection losses 10% per yearOperating expenses 45% of effective gross income each year

Expected holding period 5 yearsExpected selling price = 1,026,000$ Selling expenses 5% of expected selling priceMortgage financing

Loan-to-value ratio 75% of acquisition priceInterest rate 8%

Maturity 30 years with monthly paymentsUp-front financing costs 3% of loan amount

Discount rate 12%

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Valuation by The Income Approach:Discounted Cash Flow Analysis

Suburban Office Building Reconstructed Operating StatementPotential Gross Income (PGI) 180,000$ Less: Vacancy & collection losses (VC) 18000Effective gross income (EGI) 162,000$ Less: Operating Expenses (OE)

Fixed ExpensesReal estate taxes 15,900$ Insurance 12,000 27,900

Variable ExpensesUtilities 13,900$ Garbage collection 1,000Supplies 4,000Repairs 6,000Maintenance 12,000Management 8,100 45,000$

Total Expenses 72,900$ Net Operating Income (NOI) 89,100$

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Valuation by The Income Approach:Discounted Cash Flow Analysis

Operating Cash Flow From Suburban Office Building ExampleInitial Net Operating Net Sale PV Factor @ Present

Year Investment Income Proceeds 12% Value0 (885,000)$ 1.000000000 (885,000) 1 89,100$ 0.892857143 79,554 2 91,773$ 0.797193878 73,161 3 94,526$ 0.711780248 67,282 4 97,362$ 0.635518078 61,875 5 100,283$ 974,700$ 0.567426856 609,974

Net Present Value 6,846

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Investment Analysis Vs. Valuation Investment analysis you start with a discount rate that

works for you, and analyze the cash-flows accordingly. You make assumptions regarding occupancy, rental rate changes, eventual sale price, loan characteristics, etc. Does the investment analysis end with a positive NPV or exceeding your required rate of return? If yes, buy it.

Valuation takes perspective of the “market”. Assumptions are made not based on special skills, but rather typical or average values derived from the market. Price is the dependent variable--what you are trying to establish. You find “Gross Present Value” of the flows, not “NPV”.

Valuation by The Income Approach:Discounted Cash Flow Analysis

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Valuation by The Income Approach:Discounted Cash Flow Analysis

Assuming the market discount rate was 10.5% instead of the investor’s 12%, an initial valuation would look like this:

Operating Cash Flow From Suburban Office BuildingNet Operating Net Sale PV Factor @ Present

Year Income Proceeds 10.5% Value

1 89,100$ 0.904977376 80,633 2 91,773$ 0.81898405 75,161 3 94,526$ 0.741162036 70,059 4 97,362$ 0.670734875 65,304 5 100,283$ 974,700$ 0.606999887 652,514

Gross Present Value 943,672

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Valuation by The Income Approach:Discounted Cash Flow Analysis

Investment Analysis Vs. Valuation Appraisers will typically get a bit more specific when using

discount rates, by analyzing the BTCF. Divide BTCF into debt & equity, then value each component at

an appropriate “market” discount rate. Use the “initial” valuation (944,000) as the assumed sale price.

Assume typical market loan terms (see below) and the market “equity yield rate” (ye) of 18%, and new sale price of 944,000:

Investor MarketLTV: 75%

80%

Interest Rate: 8.0% 9.5%

Maturity (pay monthly): 30 years 30 years

Up-front financing: 3.0% 2.0%

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Valuation by The Income Approach:Discounted Cash Flow Analysis

Investment Analysis Vs. Valuation Do the intermediate steps to find the BTCF and BTER

columns:

Operating Cash Flow From Suburban Office Building ExampleNet Operating PV Factor @ Present

Year Income BTCF BTER 18.0% Value1 89,100$ 12,898$ 0.847457627 10,931 2 91,773$ 15,571$ 0.71818443 11,183 3 94,526$ 18,325$ 0.608630873 11,153 4 97,362$ 21,160$ 0.515788875 10,914 5 100,283$ 24,081$ 312,825$ 0.437109216 147,265

Net Present Value 191,446

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Valuation by The Income Approach:Discounted Cash Flow Analysis

Investment Analysis Vs. Valuation The value of the property is based upon the present value

of the cash flows of debt, valued at the appropriate discount rate (the rate of interest of the loan), plus the present value of the return to equity, valued at the appropriate discount rate (equity yield rate).

The appraised value of the property in this case is:V0 = Ve + Vd

V0 = $191,446 + $755,200 = $946,646

Using market discount rates, as well as breaking the analysis down further and applying separate discount rates on the debt and equity provided a significant improvement in estimate of market value.

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Valuation by The Income Approach:Direct Capitalization

Direct Capitalization is alternate, common approach

Estimate a property’s value by dividing a one-year estimate of its income by a capitalization rate.

Allows appraisers to rely on summary market evidence without having to project incomes and expenses years into the future.

While the argument can be made that this relies on only one year’s cash flows, and hence is incomplete, there are two reasons why this is not such a problem for an appraiser1. By using actual sales data to come up with a

capitalization rate, future cash flows should be reflected provided that the purchasers did estimate future flows.

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Valuation by The Income Approach:Direct Capitalization

Direct Capitalization is alternate, common approach2. The capitalization rate used can be thought of as “an overall

capitalization rate” in the sense that it can be used to find a market value by using in V=I/R:R = y – gR = Direct capitalization ratey = discount rate, or yield for the overall propertyg = Forecast compound annual growth rate of the NOI and

property value for the remaining economic life or holding period.

Assume NOI of a property is 200,000, the investor required return is 12% and the estimate of NOI and appreciation is 2.5% per year. What is the property worth? How much did incorporating the growth of NOI and property appreciation impact your estimate of value? What if you expect NOI and depreciation of 1% per year?