“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Chapter 15 Valuation Analysis: Income Discounting, Cap Rates and DCF Analysis

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Major Topics  Simple multiplier models of value  The income approach to value  The derivation of a capitalization rate  Overall market rate capitalization  Discounted cash flow analysis  The net present value decision rule  The IRR decision rule

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Introduction  “How much is the asset worth?”  All methods of valuation reflect that the present value of a property is based on the future returns as measured through cash flows discussed in Chapter 15  They are similar in that they are based upon discounting the future returns to the present using some form of model

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Valuation using Multipliers  GRM (Gross Rent Multiplier) = Price / Gross Rent (PGI)  Presumption: “Whatever investors are willing to pay for similar property per dollar of gross rent they should be willing to pay for a subject property”  GRM should be found from comps with:  Similar ages  Similar turnover  Similar growth projections

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner  The most applicable appraisal technique which directly considers the motivations of the typical investor by quantifying the benefits of owning real estate Traditional Income Approach to Value NOI (net operating income) R (capitalization rate) Value =  NOI as used by appraisers is called the stabilized NOI to reflect the longer-term productivity of the property  The projected NOI would normally be the NOI for the upcoming 12 months

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner  Think about cap rates as the inverse of a price earnings multiple  With cap rates, higher rental growth rates and faster price appreciation means cap rates will be lower  Identical to the notion of risk premiums Cap Rates and Price/ Earnings Multipliers

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner  Also think of cap rate as a return “on” and return “of” capital  Return on is the price for providing the capital – example: mortgage interest portion of the monthly payment  The mortgage loan principal paid down is the return “of” capital Cap Rates and Return of Capital Cap Rates and Cost of Capital  Several appraisal variations known as mortgage-equity or band of investment techniques for deriving a cap rate  Identical to weighted cost of capital method

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner  Can affect both appreciation rates and risk  A market becoming over supplied will increase the uncertainty of income which implies higher risk and also reduce rental growth rates - cap rates will move higher  If the market demand is getting stronger with little possibility of new supply, we will see faster rental growth and lower cap rates Market Conditions Matter Property Age and Cap Rates  Older properties tend to have more uncertain repairs and capital improvement expenditures, and tend to be located in lower appreciation areas  Both these factors cause a higher cap rate

Summarized Influences on Cap Rate Valuation FactorImpact on Cap Rate Growth in IncomeFaster growth means a low cap rate and higher value RiskHigher risk means a higher cap rate and lower value Economic obsolescence Shorter economic life means a higher cap rate and lower value Interest Rates or Cost of Capital Higher interest rates imply higher cap rates and lower value Market ConditionsStronger rental market imply lower cap rates and higher values Property AgeOlder properties typically have more risk as a result of greater repair volatility. More risk means higher cap rates and lower values “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Discounted Cash Flow Analysis (DCF)  Total property value = mortgage value + equity value  Cash flows (after tax or before tax) are projected for entire holding period  Projected resale value at end of holding period is calculated by dividing the NOI by the going out cap rate  The required rate of return (rrr) is the discount rate based on long term yield required by the investor  The equity value is derived from the following formula: CF 1 CF 2 CF T Projected Resale CF T Equity Value = PV e = … rrr (1 +rrr) 2 (1 + rrr) T (1 + rrr) T “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

DCF Analysis Example: With and Without Debt Assume no debt. In this case the value of the equity is the value of the property. The subject property is an office building with a single lease. The asking price is $13,453,000. Suppose the present time is the end of the year The building has a 6-year "net lease" which provides the owner with $1,000,000 at the end of each year for the next three years (2003, 2004, 2005). After that, the rent "steps up” to $1,500,000 for the following three years (2006 through 2008), according to the lease. At the end of the sixth year (2008) the property can be expected to be sold for 10 times its then-current rent, or $15,000,000. Thus, the investment is expected to yield $1,000,000 in each of its first three years, $1,500,000 in each of the next two years, and finally $16,500,000 in the sixth year (consisting of the $1,500,000 rental payment plus the $15,000,000 "reversion" or sale proceeds).

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner DCF Analysis Example (Contd.)  Value of the property is found by applying the DCF formula as follows:  If the price were less than this, say, $12 million, the buyer would see an expected (going-in) return greater than 10%

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Discounted Valuation with Mortgage Debt  Identical to previous model Value = Equity + Debt  Keep in mind the lender’s requirements in terms of the minimum debt coverage ratio and the maximum loan to value  Also important to use market rate assumptions for terms of mortgage

Typical Mistakes in DCF Application  GIGO (garbage in, garbage out)  If your case lacks merit, dazzle them with numbers  Excess laziness and Fairytale Worlds “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Is DCF really useful in the Real World?  Just a formality?  Used in evaluating alternatives  Used in checking investment decisions  Loss of credibility due to too much corruption with misinformation “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Capital Budgeting and NPV Rule  NPV decision rule: Maximize the NPV across all mutually exclusive alternatives and never choose an alternative that has an NPV<0 “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Zero NPV deals are OKAY  Zero NPV means that there is no super- normal profit  If both buyer and seller are applying the NPV rule, they both require NPV  0  Hence the deal will be possible only when they accept a NPV=0  A zero NPV deal is “bad” only if it is mutually-exclusive with another deal that has a positive NPV “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

The “Hurdle Rate” version of the Decision Rule Maximize the difference between the project’s expected IRR and required rate of return and never do a deal with an expected IRR less than required rate of return  Required return is the total return including risk premiums reflecting the risks of the investment – referred to as the Hurdle Rate

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner END