1. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 1 CHAPTER TEN VALUATION OF INCOME PROPERTIES: APPRAISAL AND THE MARKET FOR CAPITAL

2. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 2 Market Value Motivated buyer and seller Well informed buyer and seller A reasonable time period Payment in cash or cash equivalent Arms length transaction

3. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 3 Appraisal Process Physical and legal identification Identify property rights Purpose of the appraisal Specify effective date of value estimate Apply techniques to estimate value

4. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 4 Income Approach GIM Direct capitalization method Discount present value method Note- the first two methods rely on current market transactions

5. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 5 Gross Income Multiplier PGI* Less V and C EGI Less OP NOI GIM= sales price/ gross income*

6. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 6 Capitalization Rate V= NOI/ R NOI can be compared with transaction prices to derive R Sometime called market extraction method

7. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 7 Operating Expenses Real estate taxes Insurance Utilities Repair and maintenance Admin. and general Mgnt. and leasing Salaries Reserves other

8. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 8 Discounted PV Discount rate (r) Required return for a real estate investment based on its risk when compounded with other investments Time period 5, 7, 10 years A forecast of NOI Estimate reversion value

9. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 9 Simple Formula Present value of an increasing annuity Value= NOI 1 / (discount rate- growth rate) –NOI 1 is Net Operating Income (rent less expensive) during the first year of ownership –Discount rate is the required rate of return (IRR) –Growth rate is the expected growth in income Same idea as Gordon Dividend Discount Model (see www.DividendDiscountModel.com) www.DividendDiscountModel.com Simple model assumes income and value will grow at the same rate forever (or until sold)

10. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 10 Example An apartment building is expected to generate NOI of $100,00 the first year. Rents and expenses are expected to grow at 2% per year until sold after 5 years. The value of the property is expected to increase with income. Investors require a 12% rate of return. What is the value? Value= $100,000/ (12%-2%)= $1,000,000

11. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 11 Concept of a Capitalization Rate Capitalization rate (“cap rate”)= NOI 1 / value –Ratio of first year income to value Rearrange equation: value=NOI 1 /cap rate Two ways to think about getting a cap rate: Formula: cap rate= discount rate- growth rate e.g., in previous example, cap rate= 12%-2%= 10% Comparable sales: cap rate=NOI 1 / sale price where the sale price is from comparable properties e.g., another property sold for $1,200,000 and was expected to have NOI the first year of $120,000

12. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 12 Beyond the Simple Formula Project the NOI for each year of a holding period Project resale price at the end of the holding period Discount the NOI and resale to get present value

13. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 13 Example Income is expected to be $100,000 per year for the next 5 years due to existing leases. Starting in year 6 the income is expected to increase to $120,000 due to lease rollovers and increase at 2% per year thereafter. Investors want a 12% return. What is the value?

14. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 14 Solution First estimate resale using cap rate concept –Resale or “terminal” cap rate= 12%-2%= 10% –Apply this to income in year 6 ( first year of ownership to next owner) –Resale= ($120,000)/.10= $1,200,000 Now discount the NOI and resale price –PMT= $100,000 –FV= $1,200,000 –n= 5 –i= 12% Note that the “going in cap rate” would be 100,000/ $1,041,390= 9.6%

15. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 15 NPV @12% $1,041,390 *Yr 6 NOI/ terminal cap rate of 120,000/.10 Year123456 NOI 100,000 120,000 Resale 1,200,000* Cash Flow 100,000 1,300,000

16. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 16 Reversion Values Expected L-T cash flows REV 9 = (NOI 10 )/ (r-g) Directly from sales transaction data Resale based on expected change in property values

17. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 17 Highest and Best Use Analysis PV= NOI 1 / r-g or NOI 1 /r PV- BLDG cost= land value

18. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 18 Mortgage Equity Capitalization V= M+E DS= NOI 1 / DCR Calculate M Calculate E (PVA+CF) PV= M+ E

19. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 19 Cap Rates and Market Conditions Lower cap rates (higher property values) Unanticipated increases in demand relative to supply Higher cap rates (lower property values) Unanticipated increases in supply relative to demand Unanticipated increases in interest rates