Real Estate Valuation

Introduction

Definitions of Market Value:

1. The market value of a property is the present value of future expected

benefits discounted at the market rate.

2. “The most probable selling price in cash, or terms equivalent to cash,

or in other precisely revealed terms, for which the appraised property
will sell in a competitive market under all conditions requisite to a fair
sale, with the buyer and seller each acting prudently, knowledgeably,
and for self-interest, and assuming that neither is under undue duress.”
(The Appraisal of Real Estate, American Institute of Real Estate
Appraisers)
 Real Estate Valuation

Introduction

The Appraisal Institute definition assumes:

1. the buyer and seller are motivated by self-interest;

2. the buyer and seller are well informed and are acting prudently;

3. the property is exposed for a reasonable amount of time; and

4. payment is made in cash, or its equivalent.

 Real Estate Valuation

Introduction

I. Techniques Used to Estimate Market Value

A. Market Comparison

B. Cost Approach

C. Income Approach

1. Overall Capitalization

2. Discounted Cash Flow Valuation

 Real Estate Valuation:
Market Comparison Approach
Steps in the Market Comparison Approach

1. Find similar properties that recently sold: comparables

2. Identify key characteristics of subject and comparable properties

3. Adjust sales prices of comparables for differences in key characteristics

a. non-market financing terms

b. non-real estate items
c. sales date
d. amenities

4. Estimate value of subject property by taking the weighted average of

adjusted comparable sales prices.
 Real Estate Valuation:
Market Comparison Approach
Steps in the Market Comparison Approach

What are key property characteristics for:

1. Multifamily properties (e.g. apartments)?

2. Office properties?

3. Retail properties?

4. Industrial/warehouse properties?

5. Single family homes?

6. Raw land?
 Real Estate Valuation:
Market Comparison Approach

Steps in the Market Comparison Approach

Making adjustments for differences:

1. Non-market financing terms: PV of the difference between

market and contractual cash flows discounted at the market rate.

2. Non-real estate terms: market value of the commodity

3. Sales date: rate of change in real estate prices between sales

date and current period.

4. Amenities: implicit price of the characteristic

Price the comparables as if they were the same as the subject property.
 Real Estate Valuation:
Market Comparison Approach

Steps in the Market Comparison Approach

Estimate the market value of the subject property by taking the

weighted average of the adjusted comparable property prices.

The weights reflect the appraiser’s confidence in the estimated prices.

Adjustments are made with error, so properties

 with numerous adjustments receive a low weight

 with few adjustments receive a high weight

 Real Estate Valuation:
Market Comparison Approach
Example of Market Comparison Approach

Estimate the value of the following garden apartment property using the
market comparison approach to value. The subject property has 150 units
and is located in the Fair Oaks area of Dallas, TX. The property was built
in 1979, has 122,500 square feet of leasable area, and is 92% occupied.
The improvements occupy 5.83 acres for a density of 25.71 units per acre
(upa). Subject property amenities include a swimming pool, clubhouse,
laundry room, and tennis court.

You have obtained market data for two comparable properties. The Manor
on the Park is a 108 unit garden apartment complex located at the southwest
corner of Park Lane and Valley Meadow Road. This property has 112,896
square feet of leasable space, was built in 1965, and is currently 92%
occupied. The improvements occupy 4.134 acres for a density of 26.1 upa.
The property sold six months ago for $1,470,000. Property amenities
 Real Estate Valuation:
Market Comparison Approach

Example of Market Comparison Approach

include a swimming pool, clubhouse, and covered parking. The second

comparable is a 132 unit garden apartment complex located on the
southwest side of Royal Lane, 160 feet southeast of Abrams Road. Fox
Hollow has 87,776 square feet of rentable space, was built in 1978 and is
currently 85% occupied. The improvements occupy 2.907 acres for a
density of 45.41 upa. The property sold three months ago for $1,900,000.
Property amenities include a swimming pool, clubhouse, laundry room,
tennis court, and exercise room. In addition, the sell took back a $500,000
second loan at 7% annual interest with monthly payments for 25 years when
the market rate for this type of loan was 9%.

Estimate the market value of the subject property using the market
comparison approach to value if property values are increasing at an annual
rate of 3% . The amenity adjustments are provided in the following tables.
 Real Estate Valuation:
Market Comparison Approach

Example of Market Comparison Approach

Characteristic Adjustment Subject Manor Fox

Property on the Park Hollow

Sales Price $1,470,000 $1,900,000

Financing PV of  Cfs market market -$78,895

Adj. Price @ mkt. rate $1,470,000 $1,821,105

Other terms none none

Sales date 3%/12 per mo. current 6 mos. ago 3 mos. ago
Adj. Price $1,492,188 $1,834,797
 Real Estate Valuation:
Market Comparison Approach
Example of Market Comparison Approach

Characteristic Adjustment Subject Manor Fox

Property on the Park Hollow

Adjusted Price $1,492,188 $1,834,797

Characteristics
Age 0.5% /year 1979 + 107,917 + 9,174
Laundry $25,000 yes + 25,000 0
Tennis $60,000 yes + 60,000 0
Covered Park $750/unit no - 81,000 0
Exercise Rm. $40,000 no 0 - 40,000
Adjusted Price $1,604,105 $1,803,971
Unit Price $ 14,853 $ 13,666

Market Value of Subject = ( 0.4 x $14,853 + 0.6 x $13,666 ) x 150

= $ 14,141 x 150 = $ 2,121,150
 Real Estate Valuation:
Cost Approach

Introduction

The cost approach estimates property by adding

1. raw land acquisition costs

2. site development costs

3. depreciated improvement reproduction costs

 Real Estate Valuation:
Cost Approach

Site Development Costs

Site development costs consist of:

(1) earthwork;

(2) utility installation (e.g. natural gas, water, electricity, sewer);

(3) roads and walks;

(4) landscaping and irrigation; and

(5) other non-structural site improvements (e.g. fences and gates, street
furnishings (i.e. benches, planters), swimming pools, pool decks,
tennis courts, basketball courts, play areas, mail kiosks, etc.)
 Real Estate Valuation:
Cost Approach

Improvement Cost

Improvement Costs consist of:

1. Indirect costs (e.g. architectural plans, landscape/irrigation designs,

soil reports, surveys, environmental reports, construction period
interest).

2. Direct construction costs: costs of building materials and labor

a. Reproduction Cost: the cost of building an exact replica

b. Replacement Cost: the cost of building an improvement

that provides the same services
 Real Estate Valuation:
Cost Approach

Reproduction Cost New

1. Quantity survey method: detailed inventory of all materials and

equipment used to construct the improvement

2. Unit in place method: based on unit prices for various building

components

3. Construction cost indices: applies base unit cost estimates to the

gross area of the improvement and adds/subtracts for differences.

Construction cost services available from:

Marshall and Swift
Dodge Building Cost Services/McGraw Hill Information Services
Boeck Building Valuation
 Real Estate Valuation:
Cost Approach

Depreciation

Three types:

1. Physical: wear and tear; deterioration over time

2. Functional: loss of value due to design, outdated equipment

3. Economic: loss of value attributable to external factors

(e.g. location)

Depreciation is called curable if the cost of the repair is less than the value
added from making the repair; incurable if the cost exceeds the benefit.
 Real Estate Valuation:
Cost Approach

Depreciation

Techniques used to estimate depreciation:

1. Straight line over useful life.

2. Cost to cure

3. PV of rent loss or increase in expense

4. Appraiser’s judgement
 Real Estate Valuation:
Cost Approach

Summary

1. Estimate land acquisition cost

2. add estimate of site improvement costs

3. add estimate of reproduction cost new

a. indirect cost

b. direct cost

4. subtract depreciation (if any)

5. Equals property value

 Real Estate Valuation:
Income Approach

Overall Capitalization

The market value of a property, V, is frequently estimated as:

NOI
V =
R
where NOI = net operating income for the subject property;

R = capitalization rate--the rate used to convert the property’s

flow of benefits (income, capital gain, tax benefits) to a
value today.
 Real Estate Valuation:
Income Approach

O verall C ap italizatio n

T he cap italizatio n rate, R , co m es fro m the m arket.

T o estim ate the m arket cap italizatio n rate fo r a p articular pro p erty:

1. find a sim ilar p ro p erty that recently so ld ;

2. co m p ute the N O I fo r the co m p arab le pro p erty;

3. use the (ad justed ) selling p rice o f the co m p arab le fo r value, V , and
estim ate the o verall cap italizatio n rate as:

NOI
R =
V
 Real Estate Valuation:
Income Approach

O v e ra ll C a p ita liz a tio n : E x a m p le

C o m p u te th e o v e ra ll c a p ita liz a tio n ra te fo r th e a p a rtm e n t p ro p e rty e x a m in e d

e a rlie r. T h e tra n s a c tio n p ric e o f th e p ro p e rty a fte r th e c a p ita l im p ro v e m e n ts
( e .g . v a lu e ) is $ 4 ,8 5 0 ,0 0 0 a n d th e fir s t y e a r ’s N O I $ 4 9 5 ,2 4 0 . T h e
c a p ita liz a tio n ra te fo r th is p ro p e rty is :

N O I $ 4 9 5 ,2 4 0
R = = = 1 0 .2 1 %
V 4 ,8 5 0 ,0 0 0
 Real Estate Valuation:
Income Approach

Koll National Average Overall Capitalization Rates

Class “A” Property Quarter/Year

4Q/94 4Q/95 3Q/96 4Q/96

Apartment 9.30% 9.10% 8.82% 8.79%

CBD Office 8.90% 8.80% 8.96% 8.95%

Retail 9.40% 9.40% 9.31% 9.25%

Warehouse/ 9.50% 9.30% 9.24% 9.21%

Distribution
 Real Estate Valuation:
Income Approach

Relationship Between the Cap Rate and the Discount Rate

In general, the capitalization rate, R, is not equal to the required yield, or

discount rate, for income property investments. Under some assumptions, it
is possible to develop the relationship between the cap rate and the required
yield. The formula was developed in the 1950s by the appraiser Pete
Ellwood and assumes:

1. NOI is an annuity (a series of equal payments)

2. the acquisition is finance with fixed rate debt

 Real Estate Valuation:
Income Approach

Relationship Between the Cap Rate and the Discount Rate

Under these assumptions, the Ellwood overall capitalization rate is:

R = dbte - m  C - b  SFF(dbte , N),

where dbte = the required yield on before tax equity

m = the loan to value ratio
C = the mortgage coefficient = dbte + P  SFF(dbte,N) - f
b = the rate of appreciation/depreciation in the market value
of the property over the holding period.
SFF= sinking fund factor computed at the equity yield rate over
the holding period
P = the proportion of the loan repaid over the holding period;
f = annual mortgage constant
 Real Estate Valuation:
Income Approach

Relationship Between the Cap Rate and the Discount Rate

For an all cash acquisition (e.g. m = 0):

R = dbte - b  SFF(dbte , N),

1. the cap rate will equal the discount rate only when there is no
expected change in the value of the property (e.g. b = 0).

2. if b > 0, then the cap rate will be less than the before tax required
yield on equity by the amount b  SFF(dbte, N). This term
annualizes the total increase in property value that occurs over the
expected holding period.
 Real Estate Valuation:
Income Approach

Relationship Between the Cap Rate and the Discount Rate

The Ellwood formula also helps us understand the relationship between

interest rates and capitalization rates. Suppose income property investors
compute their required before tax equity yields by adding 400 basis points
to the before tax cost of debt. That is, if interest rates are 9% then investors
discount expected before tax equity cash flows at 13%. The Ellwood
capitalization rate for a property that is held for five years, financed with an
80% loan with monthly payment for 30 years, and expected to appreciate
1.5% per year is:

R = dbte - m  C -b  SFF(dbte , N)

= .13 - .8  0.03981 - 0.07728  0.1543 = 8.623%

 Real Estate Valuation:
Income Approach

Relationship Between the Cap Rate and the Discount Rate

If interest rates fall by 100 basis points to 8%, then investors discount before
tax equity cash flows at 12% and the capitalization rate is:

R = 0.12 - 0.8  0.03971 - 0.07728  0.1574 = 7.607%

So if interest rates fall by 100 basis points, the cap rate fall by 101.6 basis
points.

What happens to property values? For a property with NOI = $100,000:

@ 9% debt, V = $ 100,000/0.08623 = $1,159,689

@ 8% debt, V = $100,000/0.07607 = $1,314,579

A $154,890 increase (13.36%) in property value.

 Real Estate Valuation:
Income Approach

Discounted Cash Flow (DCF) Valuation

 Estimate market value by adding the present value of all expected

future cash flows.

 Assumes the holding period cash flows can be estimated

1. Operating period cash flows

a. NOI
b. Before Tax Equity Cash Flows
c. After Tax Equity Cash Flows
2. Future expected selling price

 Assumes the required yield is known (or can be estimated).

 Real Estate Valuation:
Income Approach

B e fo re D e b t, B e fo re T a x D C F

N
N C F N e t S a le s P ro c e e d s
V a lu e =  t
+ N

1  1 
t N
t=1 + d p + d p

w h e re N C F t = e x p e c te d N e t C a s h F lo w in y e a r t;

d p = re q u ire d y ie ld o n e x p e c te d p ro p e rty c a s h flo w s ;

N = le n g th o f th e h o ld in g p e rio d
 Real Estate Valuation:
Income Approach

Example of Before Debt, Before Tax Valuation

Estimate the market value of the following property:

 First year’s NCF is $100,000

 NCF is expected to increase 4% per year

 The property value is expected to appreciate 3% per year

 The property will be held for three years

 The required yield for property cash flows is 13%

 Real Estate Valuation:
Income Approach

E xam p le o f B efo re D ebt, B efo re T ax V aluatio n

$ 1 0 0 ,00 0 $1 0 4 ,0 0 0 $ 1 0 8 ,1 6 0 (1 .0 3 ) 3  V alu e
V alu e = + + +
(1 .1 3 ) 1 (1 .1 3) 2 (1 .13 ) 3 (1 .1 3) 3

1 .0 9 2 7 3  V alu e
= $ 2 44 ,9 0 3 +
(1 .1 3 ) 3

= $ 2 44 ,9 0 3 + 0.7 5 7 3 1  V alu e

0 .24 2 6 9  V alu e = $ 2 4 4 ,9 0 3 ; and V alu e = $1 ,00 9 ,1 1 9 ; R = 9 .9 1 %

 Real Estate Valuation:
Income Approach

A fte r D e b t, B e fo re T a x D C F

N
B T C F O B T C F R
V a lu e = P V of D ebt +  t
+ N

t= 1 1 + d b te  t
1 + d b te  N

w h e re B T C F O t = e x p e c te d b e fo re ta x c a s h flo w s fro m o p e ra tio n s ;

B T C F R N = e x p e c te d b e fo re ta x c a s h flo w fro m re v e rs io n ;

d b te = re q u ire d y ie ld o n b e fo re ta x e q u ity c a s h flo w s ;

N = le n g th o f th e h o ld in g p e rio d
 Real Estate Valuation:
Income Approach

A fte r D e b t, A fte r T a x D C F

N
A T C F O A T C F R
V a lu e = P V of D ebt +  t
+ N

t= 1 1 + d a te  t
1 + d a te  N

w h e re A T C F O t = e x p e c te d a fte r ta x c a s h flo w s fro m o p e ra tio n s ;

A T C F R N = e x p e c te d a fte r ta x c a s h flo w fro m re v e rs io n ;

d a te = re q u ire d y ie ld o n a fte r ta x e q u ity c a s h flo w s ;

N = le n g th o f th e h o ld in g p e rio d
 Real Estate Valuation: Income Approach
Office Property Example

Estimate the market value of the following office property. The

property has 100,000 net rentable square feet (nrsf). The current
market rent for office space is $12.00 per square foot (psf). The
property will also provide $100,000 in non rental income during the
first year of operation. Vacancy losses are 4% of gross potential
income and collection losses are 2% of gross potential income.
The first year’s variable expenses total $260,000 and the first
year’s fixed expenses total $170,000. The property also requires
$200,000 in capital improvements during the first year of operations.
Income and expenses are expected to increase 2% per year for the
entire 4 year holding period. In addition, expenses in excess of the
expense stop will be reimbursed. The expense stop is the first year’s
pro-forma per square foot expense.
 Real Estate Valuation: Income Approach
Office Property Example

The equity investor will finance 75% of the purchase price

with a 9.0% fixed annual interest rate, 25 year, monthly
payment loan. Financing costs amount to 2% of the loan
amount and the borrower must pay a 3% prepayment penalty if
the loan is repaid within seven years.
The investor expects to hold the property for four years.
The future selling price is estimated by capitalizing the fifth
year’s NOI at 10%. The investor will have to pay a 2% sales
commission at the time of sale in four years.
Discount future expected property cash flows at 11%
annually and expected (before tax) equity cash flows at 13%.
 Real Estate Valuation: Income Approach
Office Property Example
Revenues

Ye a r : 1 2 3 4
REVENUES a nd EXPENSES:
Gr os s Re nt a l Re ve nue 1, 200, 000 1, 224, 000 1, 248, 48 0 1, 273, 450
l e s s Va c a nc y Los s - 48, 000 - 48, 960 - 49, 939 - 50, 938
l e s s Los s t o Le a s e 0 0 0 0
l e s s Col l e c t i on Los s - 24, 000 - 24, 480 - 24, 970 - 25, 469
Tot a l Ne t Re nt a l I nc ome 1, 128, 000 1, 150, 560 1, 173, 57 1 1, 197, 043
pl u s Re i mbur s a bl e s 0 8, 817 17, 81 0 26, 983
pl u s Ot he r I nc ome 100, 000 102, 000 104, 040 106, 121
Re i mbur s a bl e s + Ot he r 100, 000 110, 817 121, 850 133, 103
Gr os s Ef f e c t i ve I nc ome 1, 228, 000 1, 261, 377 1, 295, 42 1 1, 330, 146
 Real Estate Valuation: Income Approach
Office Property Example
Expenses and Net Operating Income

Ye a r : 1 2 3 4
REVENUES a nd EXPENSES:
Gr os s Ef f e c t i ve I nc ome 1, 228, 000 1, 261, 377 1, 295, 421 1, 330, 146
l e s s OPERATI NG EXPENSES:
Va r i a bl e Expe ns e s - 260, 000 - 265, 200 - 270, 504 - 275, 914
Fi xe d Expe ns e s - 170, 000 - 173, 400 - 176, 868 - 180, 405
Tot a l Ope r a t i ng Expe ns e s - 430, 000 - 438, 600 - 447, 372 - 456, 319
NET OPERATI NG I NCOME 798, 000 822, 777 848, 049 873, 827
 Real Estate Valuation: Income Approach
Office Property Example
Net Cash Flow before Disposition

NET OPERATI NG I NCOME 798, 000 822, 777 848, 049 873, 827
l e s s Ca p i t a l Ex p e n s e s - 200, 000 0 0 0
NCF Be f o r e Di s p o s i t i o n s 598, 000 822, 777 848, 049 873, 827
 Real Estate Valuation: Income Approach
Office Property Example
Disposition Cash Flow

Es t i ma t e d Se l l i n g Pr i c e 9, 001, 197
l e s s Se l l i n g Co s t s - 180, 024
Ne t Sa l e s Pr o c e e d s 8, 821, 173
Real Estate Valuation: Income Approach
Office Property Example

Property (Unlevered) Value

598,000 822,777 848,049

Value   2

1.11 1.11 1.113

873,827  8,821,173

1.114

 $ 8,213,006
 Real Estate Valuation: Income Approach
Office Property Example

Before Tax (Levered) Value

How would you estimate the levered value of the property?

The loan is for 75% of the price, but you don’t know the price.

This is what computers are for.