1. Valuation of Income Properties: Appraisal and the Market for Capital
Chapter 10
Valuation of Income Properties: Appraisal and the Market
for Capital

2. Overview Valuation Fundamentals Appraisal Process
Sales Comparison Approach
Income Approach
Gross income multiplier (GIM)
Capitalization rate
Discounted cash flow
Highest & Best Use
Mortgage-Equity Capitalization
Cost Approach

3. Valuation Fundamentals
Market Value
Most probable price
Open market and fair sale
Knowledgeable buyer and seller
Arms length transaction
Normal financing

4. Appraisal Process An appraisal is an estimate of value
It is used as the basis of lending and investing decisions
Appraisal Process:
Physical and legal definitions
Identify property rights to be valued
Specify the purpose of the appraisal
Specify the effective date of value estimate
Gather and analyze market data
Apply techniques to estimate value
Three approaches of appraisal
Sales comparison approach
Income capitalization approach
Cost approach

5. Sales Comparison Approach
Use data from recently sold “comparables” to derive a “subject” market value
Adjust comparable sales price for feature differences
Principles of contribution & substitution
Lump sum adjustments and square foot adjustments
Subjective process

6. Sales Comparison Approach

7. Sales Comparison Approach

8. Income Approach
The value of a property is related to its ability to produce cash flows
Gross income multiplier (GIM)
Capitalization rate
Discounted cash flow

9. Gross Income Multiplier
Determine comparable property GIM as:
Apply GIM to the subject property
If GIM = 6.00x and the subject has gross income = $120,000 then
Value Estimate = 6.00 x $120,000 = $720,000 1 2 3
Sales Price
$600,000
$750,000
$450,000
Gross Income
$100,000
$128,000
$74,000
GIM
6.00x
5.86x
6.08x

10. Capitalization Rate
If comparable properties have different operating expenses then instead of GIM, net operating income (NOI) should be used 1 2 3 4
Sales Price
$368,500
$425,000
$310,000
$500,000
NOI
$50,000
$56,100
$42,700
$68,600 R
0.1357
0.1320
0.1377
0.1372

11. Capitalization Rate – Continued
Capitalization Rate Range:
< R <
The cap rate choice is an educated opinion of the appraiser
Which property is most similar to the subject?
If the subject NOI = $58,000, the value estimate could be:
$58,000 / < V < $58,000 /
$421,205 < V < $439,394
Care must be taken when determining R

12. Capitalization Rate – Continued
Considerations when determining R
Consider the comparables
Similarity to subject
Physical attributes
Location
Lease terms
Operating efficiency
How is NOI determined?
Stabilized NOI
Nonrecurring capital outlays
Lump sum
Averaged
Was NOI skewed by a one-time outlay?

13. Discounted Present Value
Compute the present value of future cash flows
Forecast NOI and holding period
Select discount rate based on risk and return of comparable investments (r)
Determine reversion value of property

14. Discounted Present Value – Discount Rate

15. Discounted Present Value – Reversion Value
Estimating reversion value
Not an exact science
Method 1: Discount remaining cash flows using a terminal cap rate (RT)
RT = (r – g)  constant positive growth (g)
RT = (r)  growth is zero
RT = (r + g)  growth is a decay rate
Method 2: Estimate RT by adjusting the “going in” cap rate
RT > going in cap rate
This is because as properties age their income generation potential diminish
Method 3: Estimate resale value from expected changes in property value

16. Discounted Present Value – Example
A property has a projected year 1 NOI of $200,000. NOI is projected to grow by 4.00% per year for the following 2 years, then by 2.00% per year for the subsequent 2 years at a 1.00% constant rate afterward. Given a required return of 13.00%, what is the value of the property?
NOI1 = $200,000
NOI2 = $208,000
NOI3 = $216,320
NOI4 = $220,646
NOI5 = $225,059
Constant 1.00% growth begins

17. Discounted Present Value – Example
Terminal Value = $1,894,250
Cash flows:
NOI1 = $200,000
NOI2 = $208,000
NOI3 = $216,320
NOI4 = $220,646
NOI5 = $225,059 + $1,894,250
% = $1,775,409

18. Highest & Best Use
Land value: The residual land value is the difference between total property value driven by rents and cash flows less cost of constructing an improvement on a given site
Sources of land price volatility
Speculation
Changes in valuation of improvements that can be built on the land
Residual Land Value
PV – Building Cost = Land Value
Step 1: Compute the present value of the estimated cash flows for all alternatives
Step 2: Subtract building cost
Step 3: Select highest value among the alternatives

19. Highest & Best Use – Continued

20. Mortgage-Equity Capitalization
Value = PV of Mortgage Financing + PV of Equity Investment
Steps:
Estimate NOI
Subtract Debt Service from NOI
Subtract Mortgage Balance from Resale Value
Discount Cash Flows
Add Present Value of Cash Flows to Mortgage

21. Mortgage-Equity Capitalization – Continued

22. Mortgage-Equity Capitalization – Continued
PV of total cash 12.00% = $165,566
Financing is based on debt coverage ratio (DCR) of 1.20 and first year NOI of $50,000.
Debt service (DS) = $50,000 / 1.20 = $41,667
Monthly payment = $41,667 / 12 = $3,472
If the loan rate is 11.00% for 20 year then the loan amount is $336,394
Property value = $336,394 + $165,566 = $501,960

23. Valuation Fundamentals
Reconciliation of Value Estimates
The sales comparison and income approaches should yield similar value estimates.
Market Conditions Changes on “Going in” Cap Rates
Supply & Demand pressures
Capital market changes
Capital market & spatial market changes

24. Cost Approach
Buyer would not pay more than the value of land plus cost of building the structure
Estimate the construction cost if new
Subtract depreciation
Physical
Functional
External
Add site value