FINA 210: Introduction to

Real Estate
Real Estate Valuation

Michel Deslauriers, CPA, CA

 Topics
• Real Estate Valuation
• Income Approach
• Capitalized NOI

• Discounted Cash Flow

• Comparable Sales Approach

• Cost Approach
 Real Estate
Investment (“REI”)Process
1. Determine your objectives
and constraints

2. Analyze the investment Repeat process

& market environment

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

• Perceived risk of asset class

• Usually seen as a lower risk asset class it is still susceptible to overvaluation
• Less liquid investment
 Cap Rates
• The market
• High growth metropolitan market vs stagnant market

• 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

𝑆𝑡𝑎𝑏𝑖𝑙𝑖𝑧𝑒𝑑 𝑁𝑂𝐼 1,525,000

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦= = =$ 19,062,500
𝑐𝑎𝑝 𝑟𝑎𝑡𝑒 .08
 Practice Problem
• Calculate the asset value for the following property:
Unit 1 Unit 2 Unit 3
Square footage 10,000 15,000 7,000
Base rent $15 $10 $5
Lease type Gross Gross Triple Net

• The operating expenses for the building are:

• Property taxes $70,000
• Insurance $15,000
• Maintenance $10,000
• Security $3,000
• Management fees $7,000
• Other $10,000
• The vacancy and credit losses on average are 1% of the total base rent and miscellaneous
income is $18,000 per year.
• The cap rate for comparable properties is 15%
 Practice Problem
Calculate the Potential Rental Income:
Unit 1 Unit 2 Unit 3 Total
Square feet 10,000 15,000 7,000 32,000
Base rent per sq. ft. 15 10 5
Lease type Gross Gross NNN
Base rent 150,000 150,000 35,000 335,000
Expense participation 0 0 25,156 25,156
Total rent 150,000 150,000 60,156 360,156
 Practice Problem
NOI NOI
Potential Rental Income 360,156
- Vacancy and Credit Allowance (3,350)
Calculate the NOI: = Effective Rental Income 356,806
+ Other Miscellaneous Income 18,000
= Gross Operating Income 374,806
- Operating Expense (115,000)
= Net Operating Income (NOI) 259,806

Calculate the value:

𝑆𝑡𝑎𝑏𝑖𝑙𝑖𝑧𝑒𝑑 𝑁𝑂𝐼 259,806
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦= = =$ 1,732,040
𝑐𝑎𝑝 𝑟𝑎𝑡𝑒 .15
 Discounted Cash Flow
• The Discounted Cash Flow (DCF) method values a property by adding together the
present value of its future cash flows including its Terminal Value.
• The Terminal Value (TV) is the value of the property at the end of the investment
period and is calculated based on the NOI at that time.

• 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

* Projected year 6 NOI.

𝑉𝑎𝑙𝑢𝑒𝑜𝑓 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦=( ∑ 𝑃𝑉 ( 𝐶𝑎𝑠h 𝑓𝑙𝑜𝑤𝑠 ) ) + 𝑃𝑉 ( 𝑇𝑉 )= $476,080+$907,883=$1,383,963

 Practice Problem
• Last year a property generated an NOI $100,000

• The NOI is expected to increase by 2% per year.

• The investment horizon is three years

• Cap rate for similar properties are 15%

• 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

Year 1 Year 2 Year 3 Sale - Yr 3

Forecasted NOI 102,000 104,040 106,121 108,243*
Cap rate 15%
Terminal Value 721,623
Discount rate 15% 15% 15% 15%
PV 88,696 78,669 69,776 474,479

* Projected year 4 NOI.

𝑉𝑎𝑙𝑢𝑒𝑜𝑓 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦=( ∑ 𝑃𝑉 ( 𝐶𝑎𝑠h 𝑓𝑙𝑜𝑤𝑠 ) ) + 𝑃𝑉 ( 𝑇𝑉 )= $237,141+$474,479=$711,620

 Comparable Sales
Approach
• The Comparable Sales Approach estimates the value of a property by
comparing it with the recent selling price of properties that have similar
characteristics.
• Often used for single family houses
• Sales data for commercial properties are available through third party service
companies such as CBRE and Altus.
• Comparable sales should be for properties of the same or similar
• Type
• Location
• Age
• Condition
 Comparable Sales
Approach
• The data from the comparable sales is converted to some common factor such as
doors, square feet or units in order to take into account properties of different sizes.
The appraiser must then use judgement to determine the value after considering the
different characteristics (condition, age, location, etc.) of the properties.

Characteristics Comparable 1 Comparable 2 Comparable 3 Evaluated property

Square feet 1,000,000 850,000 1,250,000 900,000
Price - $ 10,000,000 9,000,000 10,350,000 9,225,000
Price/sq foot - $ 10.00 10.59 8.28 10.25
Year built 2005 2010 1999 2008
Location Excellent Excellent Average Excellent
Finish Good Excellent Good Good
Amenities Good Excellent Good Excellent
 Cost Approach
• The Cost or Replacement Cost Approach estimates the current cost of
replacing the subject property using industry sourced construction cost
data.
• Comparing the replacement cost to the market value informs the investor of the
likelihood of new properties being developed.
• The replacement cost is artificially depreciated to take into account the age of the
property.