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Urban Real Estate Economics

Class 10: February 18, 2015Susan Wachter

Market Value and Appraisal

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Administration and Introduction

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Today’s Class

• Readings:– Appraisal Institute, Understanding the Appraisal

(canvas)– Linneman, Real Estate Finance and Investment:

Risk and Opportunities, (pp. 30-31), Ch. 7 (BP#17), and Ch. 9 (BP#18)

• No readings for Monday’s class – project work due

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Project: Specifics and Deliverables• Initial PowerPoint

– Project Name, Team Members 2/23– Location, concept, draft, Idea/Investment Thesis—Why? 2/25– Feasibility analysis, not necessary to do, do start thinking about it.

• Please upload PowerPoint presentations to canvas.

• If you have fewer than 6 people in your group and would like others or if you have no group please come see me at the end of today’s lecture.

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Today’s Class

1. Administration and Introduction2. Feasibility Analysis3. Valuation Methods4. Appraisal and Market Analysis5. Market Puzzles6. Takeaways

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Feasibility Analysis

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Should you develop a specific site?

• This is your group decision • Depends on market pricing, including price of

inputs—specifically land• You do not want to build or redevelop if the

market will not support your project at a price that rewards your efforts and covers your costs

• How do you know?• Point of feasibility analysis

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Return Target: “cap rate” versus a “build to cap rate”

• A “cap rate” is what you pay for an asset based on it’s earnings and it’s market based. A “build to cap rate” is essentially the return target you earn based on the developer’s cost to deliver an asset.

• A good developer always gets “build to rates” well in excess of market “cap rates” or they lose money.

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Market Cap Rates• Market Cap Rates are estimates of market-clearing yields that real estate

investors are achieving for similar assets in that market

• With a Market Cap Rate and known (or pro forma) NOI, one can calculate current asset Value

• Value = NOI / Cap Rate, or• Cap Rate = NOI / (Cost or Value)

• Cap Rate is essentially inverse of EBITDAx multiple• “Build To” Cap Rate is the return earned on a development

– Build To Cap Rate = annual NOI / “total Project Cost”

• Acquisition Cap Rate is what you buy a specific asset for

– Acquisition Cap Rate = annual NOI / “total Purchase Cost”

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Feasibility Analysis and Rentable Space: Not All Space is Revenue Generating

• You must pay to build the entire building, not just the leasable space

• You incur operating costs for the entire building, not just the leased space

• You recover rents from leased space, which excludes vacant space and non-leasable common space

• To determine whether to build or not, you need to know whether rent from leasable space covers cost of building.

• Use concept of replacement rent to determine feasibility of development/redevelopment project.

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Feasibility Analysis Example

• Land $30 per gross foot• Hard Costs $90 per gross foot• Soft Costs $30 per gross foot• Total Cost Gross $150 per gross foot

• Rent $30 per leasable foot (per year)• Operating Cost $10 per gross foot• Occupancy 95% of leasable footage• Loss Factor 30% of gross footage

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Replacement Rent• Replacement rent is the rent level needed to justify

building.• Replacement rent per gross foot

– Gross foot includes vacant space and non-leasable common space (loss factor)

Build to Calculation

Replacement Rent per Gross Foot = Build To Cap Rate (Return) * Expected Total Cost + Expected Operating CostsReplacement Rent per Gross Foot = (10%) * ($150) + $10 = $15 + $10 = $25

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Replacement Rent Per Leasable Foot

Replacement Rent Per Leasable Foot

Rent per Leasable Foot = Replacement Rent per Gross*(1/(1-Loss Factor))*(1/(1-Vacancy))Rent per Leasable Foot = $25 * (1/0.7) * (1/0.95) = $37.59

• If rent per gross foot is $25, rent per leasable foot is $37.59.

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NOI vs. SNOI2

Net Operating Income - NOI = Rent per leasable foot – operating costs• In this case, NOI = $25 - $10 = $15

Stabilized NOI – SNOI – term for when the new building is fully rented• In this case, NOI = SNOI = $15

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For your projects: show feasibility through calculating psf construction cost, build to cap rate and compare to market comp leasable

Build to CalculationReplacement Rent per Gross Foot =Build To Cap Rate (Return) * Expected Total Cost + Expected Operating Costs

Replacement Rent per Gross Foot = (10%) * ($150) + $10 = $15 + $10 = $25Replacement Rent Per Leasable Foot

Rent per Leasable Foot = Replacement Rent per Gross* (1/(1-Loss Factor))*(1/(1-Vacancy))

Rent per Leasable Foot = $25 * (1/0.7) * (1/0.95) = $37.59

Compare to market comp rent per leasable foot for your development or redevelopment project

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Does the price, P, exceed the cost to construct, redevelop? Tobin’s Q

• If leasable rent is $37.59, then rent per gross foot is $25 and after operating costs, NOI=$15

• Value of NOI at a 10% cap rate is $150• With construction cost=$150, this is feasible.

• Should you build in that market?• P/Construction Cost = Tobin’s Q• If P = or > Construction Cost, Tobin’s Q = or > 1 Yes

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Should you build/redevelop in this market?

• Ex.: P = $12.5M, rent = $1M, market cap rate = 8, construction cost = $10M

• Price at $12.5 > Construction Cost=$10• If P = or > Construction Cost, Tobin’s Q = or > 1 Yes• Should you build in that market?• Ex.: P = $12.5M, rent = $1M, market cap rate = 8,

construction cost = $10M• Build to cap rate is 10>market cap rate=8 , so yes!

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Would you do this deal?• Total Development Cost is $2.15M• Building is 40,000SF• Gross Building Rent is $5.5PSF• Building Expenses are $0.5PSF• Return target is 10%

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Would you do this deal?• Total Development Cost is $2.15M• Building is 40,000SF• Gross Building Rent is $5.5PSF• Building Expenses are $0.5PSF• Return target is 10%• No. Minimum return to meet target is

$215K per year ($2.15M x 10%). Projected cash flow is only $200K per year [40,000sf x ($5.5psf-$0.5psf)]. It’s not enough.

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Valuation Methods

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Valuation Methods Used in Appraisal

• What are the three accepted valuation methods used in an appraisal?

• Name a fourth method to value real estate.• Why is it important?

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Valuation Methods Used in Appraisal

• What are the three accepted valuation methods used in an appraisal?

• Name a fourth method to value real estate.• Why is it important?

1. Cap Rate2. Comparable Sales (Sales Comparison)3. Discounted Cash Flow (DCF)4. Replacement Cost: replacement is important because it

impacts:a. When developers buildb. What insurers considerc. What analysts use to evaluate market trends

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Sales Comparison• Sales Comparison Valuation Method utilizes recent sales of

comparable properties to estimate value– Sales are shown in price per applicable unit of

measurement– Prices per unit are adjusted to account for significant

differences between the “Subject Property” and each “Comparable” sale

– Adjusted prices per unit are then grossed up by subject size to find overall value

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Sales Comparison – Apartment Complex  Subject Property Comparable Sales

Property Pleasant RunThe Moneyed

VillasApartments at Similar Pines

Mediocre Estates

Sale Price / Proposed Value $10,640,000 $14,000,000 $10,000,000 $10,000,000

Sale Date Proposed June 2011 August 2013 March 2006

Units 160 175 150 200

(Proposed) Price per Unit $66,500 $80,000 $66,667 $50,000

         

Adjustments        

Asset Quality B A B C

Adjustment per Unit $0 ($11,500) $0 $10,000

Location Quality B A- B+ C

Adjustment per Unit $0 ($5,000) ($1,000) $7,500

Amenities B A B- C

Adjustment per Unit $0 ($2,000) $750 $2,000

Market Timing A- C A- A

Adjustment per Unit $0 $5,000 $0 ($3,000)

Total Adjustments per Unit   ($13,500) ($250) $16,500

         

Total Adjusted Price / Unit $66,500 $66,500 $66,417 $66,500

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Replacement Cost Approach• The Cost Approach equates asset value to the construction

cost, less depreciation, plus land value• Often used for:

– Insurance purposes– Non-income producing assets (such as a church)– Recently constructed buildings– Buy vs. build scenarios– Comparison purposes (at time of construction, costs are theoretically

highly correlated to value)– Analysis of market trends

• Cost Approach ignores market cycle• Difficult to understand derived values when there is scarcity

of developable land, assets are old and hence may contain functional or locational obsolescence, or the asset type is not highest and best use

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Replacement Cost Approach• Apartment Complex - 206,160 SF, 1960’s vintage, located in Orlando, FL:

1) Land and Misc costs shown as per square foot of buildable area2) Depreciation is only applied to Total Superstructure Cost (land does not depreciate)

Units/% Cost / Unit Total (000’s)Basic Structure

Base Cost 206,160 SF $44.18 $9,108Exterior Walls 206,160 SF $14.45 $2,979Heating & Cooling 206,160 SF $3.41 $703

Total Basic Structure Cost 206,160 SF $62.04 $12,790Superstructure

Balconies 4,000 SF $29.33 $117Total Superstructure Cost 206,160 SF $62.61 $12,907Miscellaneous

Land1 206,160 SF $8.85 $1,824Misc1 206,160 SF $3.34 $687

Total Miscellaneous 206,160 SF $12.19 $2,514 Estimated Replacement Cost 206,160 SF $74.80 $15,421Less Depreciation

Physical and Functional2 41.3% $5,331Estimated Current Value 206,160 SF $48.94 $10,090

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Discount Cash Flow (“DCF”)• DCF Valuation Method analyzes the net present value (“NPV”)

of the pro forma cash flows of the asset– Purchase Price derived from NPV of cash flows at required Discount Rate– Inversely, a given Purchase Price is used to calculate an IRR– IRR = the Discount Rate at which the NPV of the cash flows equals 0

• Key factors to consider for pro forma include: growth rates, rents, expenses, terminal value, leverage, capital needs, investment timing, etc.

• Required Discount Rate is key factor in analysis, but difficult to determine

• Discount Rate should reflect overall risk of investment– One typical form of risk is leverage – the more leverage, the riskier the

investment– Required Discount Rates for “leveraged” investments are often 300-500

bps higher than “unleveraged” rates to reflect the additional risk

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Terminal Cap Rate

• Need terminal cap rate to capitalize last period’s cash flow

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DCF – Unleveraged ExampleAnnual Pro Forma

Period Acquisition Year 1 Year 2 Year 3 Year 4

Income $1,000 $1,035 $1,071 $1,109

Expenses ($600) ($618) ($637) ($656)

NOI   $400 $417 $435 $453

Purchase Price ($6,500) – – – –

Terminal Value   – – – $7,549Cash Flow to Equity ($6,500) $400 $417 $435 $8,002

Sensitivity Analysis

Exit Cap Rate 5.5% 6.0% 6.5%

Terminal Value $8,235 $7,549 $6,968

IRR at Purchase Price of $6.5 MM 12.1% 10.0% 8.1%

NPV at 8% Discount Rate $7,459 $6,954 $6,527

NPV at 10% Discount Rate $6,969 $6,500 $6,103

NPV at 12% Discount Rate $6,520 $6,084 $5,715

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Appraisal Methods: In Sum• There are 3 methods, each has its uses

1. Replacement cost- use concept to calculate long term equilibrium price and replacement rent– Level needed to spur construction activity

2. Comps- for market price-what is current pricing? how does your building compare?

3. DCF- based on projected cash flows– Appraisers are not allowed to forecast rents by law (in many

states)!4. Appraisers often base value on SNOI/market cap rate

– Market Cap Rates are estimates of market-clearing yields that real estate investors are achieving for similar assets in that market

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Appraisal and Market Analysis

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Appraisal and Market Analysis

• In equilibrium, all appraisal methods give the same value: construction costs=comp=cap rate = DCF

• Markets are not always in equilibrium.• Comps reflect market prices which may not

equal value based on market fundamentals

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Market prices may be wrong, unstable, leading to opportunity

• Why? Expectations based, looking backwards• Marginal buyer is the optimist buyer• The optimistic buyer is financed by banks• Banks, appraisers use market prices for lending• Banks use comps• Lack of short-selling

• Prices may be too low• Why? Expectations based, looking backwards• Lack of capital from banks, financial markets, after

the crash

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Cycles/Appraisal• In equilibrium, all appraisal methods: give the same

value: construction costs= cap rate = comp = dcf• Price does not always equal construction cost! • Comps reflect market prices which may be wrong• 4 phases of cycle: if disequilibrium are they all equal?

No!

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Market Cycle Quadrants

Declining Vacancy New Construction

No Construction

Increasing

Vacancy

Declining Vacancy Increasing

Vacancy

More Com

pletions

New Construction

Phase 1 - Recovery

Phase 2 - Expansion Phase 3 - Hypersupply

Phase 4 - Recession

Demand/Supply Equilibrium Point

Long Term Vacancy Average

Occ

upan

cy

Time

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Cycles/Appraisal• In equilibrium, all appraisal methods give the

same value: construction costs=cap rate =comp = dcf

• 4 phases of cycle: 1. Recession2. Recovery3. Expansion4. Hypersupply

• If disequilibrium are they all equal? No!

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Cycles/Appraisal• Recession => unanticipated demand decreases

– Demand does not increase as anticipated– Supply is excessive => vacancies and rent declines

• Building stops, recovery occurs with demand increase– Rents and effective rents increase faster than inflation until

replacement rent levels are reached– With backward looking expectations, rents are expected to

continue to increase at high rates– Reflected in too low cap rates

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Incorrect Expectations and Cycles

2001 2002 2003 2004 2005 2006 2007

YEAR

EFF

ECTI

VE R

ENT

($)

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RECESSION

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RECOVERY

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The common mistake=> and opportunity

• Market extrapolates rent growth and price growth to continue at recent past rate– Market cap rates reflect these expectations

• What do you do-- grow rents at what rate, to what levels ???

• How do you form your price estimates?• At what rate do you grow your rents?• That will determine your DCF • Also your view of current market cap rates

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• Bad form to grow NOI at extrapolated rate for any extended period unless the market is in equilibrium and growing at the inflation rate and supply is elastic – then grow NOI at inflation.

• Markets are sometimes in equilibrium.• For example, many property markets were in

equilibrium from 1998 to 2001, and were supply elastic.

• If not at equilibrium, need to estimate of equilibrium rents levels and derive growth rate

How Do Cash flows Change Over the Cycle?

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Market Puzzles

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Historic Property Cap RatesHistoric Property Cap Rates 1989-2002

7.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.019

89

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Go

ing

-in

Cap

Rat

e (%

)

Office - CBD Apartment Office - Suburban Industrial - Warehouse Industrial R&D

Source: Real Estate Research Corp.

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Cap Rate By Asset Class

1985.41987.11988.21989.31990.41992.11993.21994.31995.41997.11998.21999.32000.42002.12003.22004.32005.42007.12008.22009.32010.44.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

Office Industrial Multihousing Retail

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Forward Cash Flow Cap Rate Spreads over the 10-year US Treasury

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Market Puzzles: US

• Depopulated cities not just decentralized– Cities still the center of large, growing MSAs– But some US cities are growing, where, why reversal?– Urban population growth in US and world

• Sharp discontinuities in gradients – In current use, rents cover depreciated costs, do not cover

maintenance, upgrade or new building

• Poor live in center of cities in US not elsewhere– Market forces do not predict. If due to market forces, would

be more universal

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Ren

t

Distance

Emergence of new centers as well as growth at Center. Will the center repopulate?

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Ren

t

Distance

?

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Where and How - Urban Growth in US:

• Decentralizing from urban centers to suburbs• Where has growth occurred in the US—new

metro areas• Historically growth in south and west in US• Why?• Result? National markets for firms• Global urban growth, new outcomes

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US Lights at Night

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Urban Growth

• Where will the build out be in the US—existing cites/metros/in new metro areas?

• Growth in industrialized countries, in emerging economies, China, India?

• How do you know which cities will grow?– Projections based on industrial growth and cost

based forecasts• How do you know where new cities will grow?• Infrastructure

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Takeaways

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Global Urbanization: Why?

• Role of low labor costs• Declining transportation costs• Market integration globally• Superstar cities: Role of agglomeration economies

on a global scale?

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Takeaways: -Undervalued Real Estate

• Takeaway: 1-Undervalued Real Estate• Takeaway: 2-Undervalued Real Estate• Takeaway: 3-Undervalued Real Estate• Takeaway: 4-Undervalued Real Estate

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1-Real Estate Not at Highest Use• Highest and best use & “price” discovery• See gaps in the skyline at specific sites• Economic height / redevelopment option• Value creation

– Price of building minus cost to construct• Rent * # floors capitalized minus construction costs

– Residual = land value:– Negotiate with landowner over who gets excess

profits

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2-“Re-pricing” markets

• The rebranding of University City• Expected rent growth up, risk down, cap rate

down in neighborhood that re-prices• City’s can re-price as well, see “detour”

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The Quick-Change Artist: The South of Fifth area in Miami Beach has high-rises along the water

and low-rises in the center.

http://www.nytimes.com/2013/02/17/realestate/a-miami-beach-fla-neighborhood-rises-to-the-height-of-luxury-living-in-just-one-decade.html?hpw

High-end neighborhoods come and go, though few swing from blighted status to the height of luxury living in just one decade. That’s what happened in the South of Fifth Street neighborhood

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3-Urban Growth at New Edges: Land Value where not priced

$ P(d)

d (distance)

raAgricultural Value

Current Location

Value

Future Growth in

Location Value

$228,571

$14,286

$91,429

$334,286

Cap Rates: i = 0.07 and with growth of 2% i=.05

$105,715 = value at edge

20 mi

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MSA Growth and Market Rents

I II

Income growth at center => rent growth throughout

Trans. cost decline => rent growth (except at center), with no population growth

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MSA Growth with Land Value Growth and Rent Growth at New Urban Centers-Elastic S

III

New centers

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Diverging Cap Rates

1970 1980 1990 2000 20060.000

0.020

0.040

0.060

0.080

0.100

Avg Cap Rate by City Type

TurnaroundGrowingDeclining

Year

Cap

Rate

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1970 1980 1990 2000 2006670,000

694,000

718,000

742,000

766,000

790,000San Francisco Population

Year

Popu

latio

n

1970 1980 1990 2000 20060.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07San Francisco Cap Rate

Year

Cap

Rate

1970 1980 1990 2000 2006550,000

570,000

590,000

610,000

630,000

650,000Boston Population

Year

Popu

latio

n

1970 1980 1990 2000 20060.000.010.020.030.040.050.060.070.080.09

Boston Cap Rate

Year

Cap

Rate

1970 1980 1990 2000 20067,000,000

7,280,000

7,560,000

7,840,000

8,120,000

8,400,000New York Population

Year

Popu

latio

n

1970 1980 1990 2000 20060.00

0.01

0.02

0.03

0.04

0.05

0.06New York Cap Rate

Year

Cap

Rate

Boston

New York

Rent Home Price

$ 1,140 $ 783,000

Rent Home Price

$ 1,050 $ 420,000

Rent Home Price

$ 920 $ 482,00003.7

San Francisco6

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Seattle

Denver

Atlanta

1970 1980 1990 2000 2006460,000

484,000

508,000

532,000

556,000

580,000Denver Population

Year

Popu

latio

n

1970 1980 1990 2000 20060.000.010.020.030.040.050.060.070.08

Denver Cap Rate

Year

Cap

Rate

1970 1980 1990 2000 2006480,000

500,000

520,000

540,000

560,000

580,000Seattle Population

Year

Popu

latio

n

1970 1980 1990 2000 20060.000.010.020.030.040.050.060.070.08

Seattle Cap Rate

Year

Cap

Rate

1970 1980 1990 2000 2006 2006 2006390,000

412,000

434,000

456,000

478,000

500,000Atlanta Population

Year

Popu

latio

n

1970 1980 1990 2000 2006 2006 20060.000.010.020.030.040.050.060.070.08

Atlanta Cap Rate

Year

Cap

Rate

Rent Home Price

$ 700 $ 229,000

Rent Home Price

$ 810 $ 434,000

Rent Home Price

$ 640 $ 154,000

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San Antonio

Los Angeles

Jacksonville

1970 1980 1990 2000 20062,700,000

2,940,000

3,180,000

3,420,000

3,660,000

3,900,000Los Angeles

Year

Popu

latio

n

1970 1980 1990 2000 20060.00

0.01

0.02

0.03

0.04

0.05

0.06Los Angleles Cap Rate

Year

Cap

Rate

1970 1980 1990 2000 2006600,000

740,000

880,000

1,020,000

1,160,000

1,300,000San Antonio Population

Year

Popu

latio

n

1970 1980 1990 2000 20060.000.010.020.030.040.050.060.070.080.090.10

San Antonio Cap Rate

Year

Cap

Rate

1970 1980 1990 2000 2006500,000

560,000

620,000

680,000

740,000

800,000Jacksonville Population

Year

Popu

latio

n

1970 1980 1990 2000 20060.00

0.02

0.04

0.06

0.08

0.10

0.12Jacksonville Cap Rate

Year

Cap

Rate

Rent Home Price

$ 910 $ 596,000

Rent Home Price

$ 730 $ 164,000

Rent Home Price

$ 660 $ 93,000

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Future population?

Philadelphia

1970 1980 1990 2000 20061,400,000

1,520,000

1,640,000

1,760,000

1,880,000

2,000,000

Philadelphia Population

Year

Popu

latio

n

1970 1980 1990 2000 20060.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14Philadelphia Cap Rate

YearCa

p Ra

te

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4 - Distressed real estate• After the bubble due to irrational price

expectation formation and/or hypersupply• Market expected rent growth down due to

backward looking expectations• Even as markets stabilize and recover• In recovery phase, after recession, rents and

prices can be expected to increase• Contributing factor, cash crunch, financial

freeze

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4 - Mispricing over the cycle• In expansion, unrealistically high forecasts for future

rents, common mistake is to extrapolate demand growth Overshooting of supply is likely

• Real estate recession results, estimate starts v. existing vacancy

• In recovery from recession, common mistake to extrapolate passed no growth

• Most serious error: Prices extrapolated to continue to increase based on past, leverage up to those prices, cap rates converge and collapse

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Historic Property Cap RatesHistoric Property Cap Rates 1989-2002

7.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.019

89

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Go

ing

-in

Cap

Rat

e (%

)

Office - CBD Apartment Office - Suburban Industrial - Warehouse Industrial R&D

Source: Real Estate Research Corp.

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Last Mispricing Episode• Overpricing Phase

– Mid-1980’s-1989 -- Lack of liquid capital market instruments to short sell. Misaligned incentives and deal-driven pricing caused typical DCF pricing to be systematically too high, rents extrapolated to grow

• Underpricing Phase – Early 1990’s -- Lack of liquid capital market instruments to

buy. Market “surprise” caused traditional sources of capital to withdraw and cap rates to increase. Lack of access to capital for informed buyers. Once again, typical DCF’s resulted in mispricing

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Next Class

• Monday, February 23– No readings for class – work on projects

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