FINA 210 Topic 4 Valuation
FINA 210 Topic 4 Valuation
Real Estate
Real Estate Valuation
3. Develop a financial
analysis
4. Apply decision-making
criteria
5. Make an investment
decision
Capitalized NOI
• The most widely used method to estimate the value of a commercial property is the
Capitalized NOI approach.
• This valuation method presumes that a property will generate its stabilized NOI in
perpetuity
• The value and cap rate are an inverse relationship
• The higher the cap rate the lower the value
Stabilized NOI
Stabilized NOI
Potential Rental Income
- Vacancy and Credit Allowance
= Effective Rental Income
+ Other Miscellaneous Income
= Gross Operating Income
- Operating Expense
= Stabilized Net Operating Income (NOI)
Stabilized NOI
• Potential Rental Income – Potential Rental Income is the sum of all rents
(including expense participation) under the terms of each lease, assuming
the property is 100% occupied. If the property is not 100% occupied, then
a market-based rent is used based on lease rates and terms of
comparable properties.
• Vacancy and Credit Losses – Vacancy and credit losses consist of income
lost due to tenants vacating the property and/or tenants defaulting (not
paying) their lease payments. A historical average or a specific analysis
can be used to determine the vacancy and credit losses
Stabilized NOI
• Other Income – A property may collect income other than rent derived
from the space tenants occupy. This is classified as Other Income, and
could include billboard/signage, parking, vending, etc.
• Operating Expenses – Operating expenses include all expenditures
required to operate the property and command market rents.
Exclusions from NOI
• Debt Service – Financing costs are specific to the owner/investor and as
such are not included in calculating NOI.
• Depreciation – Depreciation is not an actual cash outflow, but rather an
accounting entry and is, therefore, not included in the NOI calculation.
• Income Taxes – Since income taxes are specific to the owner/investor
they are also excluded from the net operating income calculation.
• Tenant Improvements – Tenant improvements include construction
within a tenant’s usable space to make the space viable for the tenant’s
specific use.
• Leasing Commissions – Commissions are the fees paid to real estate
agents/brokers involved in leasing the space.
Exclusions from NOI
• Capital Expenditures – Capital expenditures are expenses that occur
irregularly for major repairs and replacements, which are usually funded
by a reserve for replacement. This does not include minor repairs and
maintenance which are considered an operating expense.
NOI Adjustments
• NOI usually includes management fees. If no fees are reported because
the landlord manages the property himself, a market management fee
will be estimated and included in operating expenses.
• In some circumstances NOI will be adjusted for recurring non-revenue
generating capital expenditures and leasing commission
• Institutional investors usually treat these items as “below the NOI” line
Cap Rates
Some of the determinants of the Capitalization Rate include the
following:
• Other investment yields (especially GOC rate)
• Real estate competes for investment dollars with other forms of investments
• Property characteristics
• Type (retail, office, hotel, etc)
• Quality
• Size
• Quality of the rent roll
Cap Rates
• In determining the cap rate for a particular property, cap rates on similar
properties sold will be examined and adjusted for the factors just listed.
• Cap rates for recent transactions can be obtained from third party service
firms
• See Cushman Wakefield Canadian Cap Rate Report
Capitalized NOI
Example
• A fully leased property has rent roll income of $2,500,000 and operating
expenses of $1,000,000.
• Historical vacancy and credit losses have averaged 1% of rental income
• The property generates additional income from signage and parking fess
of $50,000
• Cap rates for comparable properties are 8%
Capitalized NOI
NOI NOI
Potential Rental Income 2,500,000
- Vacancy and Credit Allowance (25,000)
= Effective Rental Income 2,475,000
+ Other Miscellaneous Income 50,000
= Gross Operating Income 2,525,000
- Operating Expense (1,000,000)
= Net Operating Income (NOI) 1,525,000
• This method requires an estimate of the cash flows (as seen in the previous lecture),
an estimate of the terminal value and one or more discount rates.
Discounted Cash Flows
• The discount rate used should reflect the rate of return required by an investor
for an investment with this level of risk
• This can be the same as the capitalization rate but if cash flows are uneven a
different rate of return may be required by an investor.
• The discount rate for the terminal value can be different than the rate used for the
cash flows if the condition of the property is expected to change
• Start-up of operations
• Age of property when sold
• Repositioning of the property (competitive position)
• Business plan to address vacancy issues
Discounted Cash Flows
Example
Year 1 Year 2 Year 3 Year 4 Year 5 Sale - Yr 5
Forecasted NOI 100,000 112,000 125,000 150,000 155,000 160,000*
Cap rate 10%
Terminal Value 1,600,000
Discount rate 10% 10% 10% 10% 10% 12%
PV 90,909 92,562 93,914 102,452 96,243 907,883
• Compare the value of the property using the capitalized NOI method
and the DCF method using a discount rate of 15%, (assume the same
discount rate for the terminal value).
Practice Problem