Rationale: -Value of a property is the present value of its anticipated income. Often called "income capitalization" -Capitalize: to convert future income into a present value
Two Approaches to Income Valuation
Direct capitalization (with an "overall" rate) Discount all future cash flows at required yield (discount rate)
Direct capitalization (with an "overall" rate)
Find value as a multiple of first year net income (NOI) "Multiplier" is obtained from sales of comparable properties Similar in spirit to valuing a stock using price/earnings multiple
Discounted cash flow (DCF)
Project net cash flows for a standard holding period (say, 10 years). Discount all future CFs at required yield (discount rate)
DCF models require:
1. an estimate of the expected holding period of the typical buyer 2. estimates of net cash flows over the entire expected holding period, including the net income from sale 3. the appraiser to select the appropriate yield (required IRR) at which to discount all future cash flows.
Potential gross income:
Rental income assuming 100% occupancy
Types of Commercial Leases
Straight lease Step-up or graduated lease Indexed lease Percentage lease
"Level" lease payments
Step-up or graduated lease
Rent increases on a predetermined schedule
Rent tied to an inflation index: Consumer Price Index, Union wage index, etc.
Rent includes percentage of tenant's sales
VC-vacancy & collection loss is based on:
Historical experience of subject property Competing properties in the market "Natural vacancy" rate:
"Natural vacancy" rate
Vacancy rate that is expected in a stable or equilibrium market
Net Operating Income
PGI Potential Gross Income -VC Vacancy & Collection Loss + MI Miscellaneous Income = EGI Effective Gross Income -OE Operating Expenses -CAPX Capital Expenditures = NOI Net Operating Income
Ordinary & regular expenditures necessary to keep a property functioning competitively.
Expenses that do not vary with occupancy. -insurance -property taxes
Expenses that vary with occupancy. -Utilities -Maintenance & supplies -Trash and garbage removal
Operating Expenses does not include
Mortgage payments Tax depreciation Capital expenditures
Capital Expenditures (CAPX)
Expenditures that materially increase value of structure or prolong its life: -Roof replacement -Additions -HVAC Replacement -Resurfacing of parking areas -Tenant improvements
Most appraisers treat CAPX as "above line" expense
Above Line: EGI - OE - CAPX = NOI
Institutional investors usually treat CAPX as "below line" expense.
Below Line: EGI - OE = NOI CAPX = Net Cash Flow
Institute of Real Estate Management (IREM): www.irem.org
Detailed information on apartments, offices, shopping centers, federally assisted housing and condominiums, co-ops and planned communities.
Building Owners and Managers Association (BOMA): www.boma.org
Large office buildings
Net Operating Income
NOI is property's "dividend" -Why is it not investor's dividend? Projected stream of NOI is fundamental determinant of value NOI must be sufficient to -service the mtg debt and -provide equity investor with an acceptable return on equity Be careful of NOI vs. NCF
Basic value equation:
V = NOI/R
Warning!!!!!!! Ro is a "cap" rate Ro is NOT a discount rate!!!!
Steps in Direct Capitalization
1. Obtain estimates of cap rates, Ro,, from the market using the "direct market extraction" equation: R = NOI/Selling Price 2. Divide the subject's NOI1 by a weighted average of the abstracted Ros to obtain an estimate of value for the subject
Overall rate of capitalization, or "going-in" cap rate. A ratio of initial cash flow to value Not a yield/discount rate.
Direct capitalization only uses first year NOI, but Ro reflects all future cash flows:
Transaction prices of the comparables reflect the value of future cash flows. In turn, the cap rates extracted from these purchases do so as well.
Effective Gross Income Multiplier
EGIM = Sale price ÷ Effective gross income Quick indicator of value for smaller rental properties Requires no operating expense information Critical assumptions Roughly equal operating expense percentages across properties Assumes market rents are paid Best used for properties with short-term leases (apartments & rental houses)
Problems with Valuation by Direct Capitalization
Inadequate data on comparable sales due to: Differing prices between institutional and private investors for similar properties Result: Discounted cash flow (DCF) analysis can be preferable
Inadequate data on
Above- or below-market leases Differing length of leases and rent escalations Differing distributions of operating expenses between landlord and tenant
Is direct capitalization using Ro superior to valuation by DCF?
Fewer explicit assumptions and forecasts are required What implicit assumption are you making?
Work of Appraiser Requires Analytical AND People Skills
Develop network of data contacts Collect, read, interpret, and organize data and reports Be skilled in data analysis and report production Fight time deadlines
Alternate Methods of Estimating Cap Rates: Mortgage-Equity Rate:
Problem: Cannot estimate cap rates without actual sales Solution 1: Since income-producing real estate has both equity and debt financing, think of the cap rate as a weighted average of equity cap rate and mortgage cap rate Equity cash flow = NOI - Debt service = Before tax cash flow = BTCF Loan cash flow = Monthly payment x 12
= Purchase price - Loan
Equity cap rate
= BTCF ÷ Equity = Re (equity dividend rate)
Loan cap rate
= Loan cash flow ÷ loan = Rm (Loan constant)
= Loan amount ÷ Price = m (Mortgage-equity cap rate) = m x Rm + (1−m) x Re
Recall one-year total yield example: rat
Total yield = Cap rate + Appreciation rate => Cap rate = Total yield - Appreciation rat
Selecting Among Different Cap Rate Estimates
Direct extraction is preferred, but needs three or more comparables with good information Choice ultimately depends on quality of data available for each type of estimate Reconciliation made by weighting