Advanced Income Approach

Question 1

Fee Simple Estate

Answer 1

Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.

Question 2

Leased Fee Interest

Answer 2

The ownership interest held by the lessor, which includes the rights to receive the contract rent specified in the lease plus the reversionary right when the lease expires.

Question 3

Leasehold Interest

Answer 3

The right held by the lessee to use and occupy real estate for a stated term and under the conditions stated in the lease.

Question 4

Sandwich Lease

Answer 4

A lease in which an intermediate, or sandwich, leaseholder is the lessee of one party and the lessor of another.

The sandwich holder is the lessee of the lessor.

The sandwich holder is the sub-lessor of the user, or sub-lessee.

Question 5

Percentage Rent

Answer 5

Rental income received in accordance with the terms of a percentage lease; typically derived from retail store and restaurant tenants and based on a certain percentage of their gross sales.

Question 6

Overage Rent

Answer 6

The percentage rent paid over and above the guaranteed minimum rent or base rent; calculated as a percentage of sales in excess of a specified breakpoint sales volume.

Question 7

Breakpoint

Answer 7

The level of sales beyond which a percentage clause in a lease is activated.

Question 8

Natural Breakpoint

Answer 8

The level of sales at which the percentage rent equals the base rent as specified in the lease.

=base rent / stated %

Question 9

Index Lease

Answer 9

A lease, usually for a long term, that provides for periodic rent adjustments based on the change in an economic index.

Question 10

This is usually the denominator for prorating expenses.

Answer 10

Total rentable building area

Question 11

If the tenant does not have to pay expenses above a certain level, reimbursements are considered _______________.

Answer 11

Capped

Question 12

Expense stop

Answer 12

A clause in a lease that limits the landlord’s expense obligation, which results in the lessee paying operating expenses above a stated level or amount.

Question 13

Expense cap

Answer 13

A clause in a lease that limits the tenant’s share of operating expenses.

Question 14

CAM has several definitions, including:

Answer 14

1. Line item expense for maintenance of parking lot, landscaped areas, and exterior of the building.
2. Refer to all opex.
3. Refer to the reimbursement by the tenant to the landlord for all expenses reimbursable under the lease.

Question 15

Replacement allowances can be treated differently according to…

Answer 15

1. Property Type
2. Market in which the property is located
3. Capitalization method used; either direct cap or DCF anaysis

Question 16

Eight methods for dealing with replacement allowances exist. The method selected should reflect how market participants view replacement allowances.

Answer 16

1. Method 1 (used with direct capitalization): Straight-line recapture using current cost over the useful life (not the remaining life) deducted as an operating expense
2. Method 2 (used with direct capitalization): Sinking fund premise, using the property yield rate over the useful life and usually the expected future cost

Note. Some replacement allowance items, especially equipment, are
addressed using a safe rate instead of a property yield rate.

3. Method 3 (used with direct capitalization and DCF analysis): As a dollar amount per square foot of building area, often combining all replacement allowance items
4. Method 4 (used with direct capitalization): As a percent of effective gross income (EGI)
5. Method 5 (used with direct capitalization): Implicitly in the capitalization rate

a. If neither the comparables’ nor the subject property’s operating
statements have deductions for replacement allowances, the replacement allowances are implicitly reflected in the capitalization rate, resulting in a higher capitalization rate.

b. When extracting a market capitalization rate, determine whether or not a replacement allowance is included in the comparable properties’
operating statements.

c. If the capitalization rate comparable sales do not show operating
statement deductions for replacement allowances and the subject
property does, either estimate and deduct replacement allowances from the comparables’ incomes and recalculate their capitalization rates, or remove the replacement allowance deduction from the subject property’s operating statement.

Question 17

Expenses are sometimes partly or entirely reimbursed by tenants.

Answer 17

This reimbursement can be calculated based on total building area (most common) or only on occupied space (aka grossed up).

Question 18

Below-the-line expense

Answer 18

An expense that is recorded “below” the NOI line in a reconstructed operating statement and is therefore not considered part of the total stabilized operating expenses for the property and valuations.

Question 19

Effective rent

Answer 19

Total base rent, or minimum rent stipulated in a lease, over the specified lease term minus rent concessions; the rent that is effectively paid by a tenant net of financial concessions provided by a landlord.

This concept is generally used to adjust lease rates on comparable buildings to make them easier to compare to the subject property.

Question 20

Effective rent can be calculated in three ways…

Answer 20

Straight line = total rent over lease / term of occupancy. TIs may or may not be added into total rent.
(Example pg. 52) This method is a simple average.

Modified straight line = total rent over lease / term of occupancy. TIs are amortized over the term of lease.
(Example pg. 53) This method is a hybrid of simple average and time-weighted average.

Level equivalent = cash flows over term of occupancy are discounted to PV, then converted to a level equivalent. This is what DCF does. (Example pg. 55) This is a time-weighted average. Somewhat difficult of a calculation using hp12c.

Question 21

Level equivalent annuity

Answer 21

A level annuity with the same PV and number of periods as a given irregular cash flow at a given discount rate.

1. Calculate PV of irregular cash flow with a given discount rate.
2. Calculate the level payment for that lump sum over the same number of periods at the same discount rate.

Question 22

Effective tax rate

Answer 22

Can be calculated as follows:

= property taxes / market value
or
=tax rate x assessment ratio

Question 23

Loading the capitalization rate

Answer 23

1. Calculate the effective tax rate as a % of market value.
2. Calculate NOI (w/o deducting RET).
3. Add the reconciled cap rate to the effective tax rate.
4. Apply the ‘loaded’ cap rate to the NOI.
5. Multiply tax rate times the market value to get RET.
6. Calculate the NOI including taxes to complete the operating statement.

Question 24

Property model

Answer 24

A short cut formula to DCF analysis that converts yield rate into a cap rate given certain specific patterns of income and a change value over a projection period.

Question 25

Perpetuity (flat market)

Answer 25

1. Traditionally, an infinite level income stream.
2. In contemporary usage, a finite level income stream with its reversion equal to the present value.

Question 26

How does cap rate compare to yield in a level, declining, and rising market?

Answer 26

R = cap rate, Y = yield

Level - R = Y

Declining - R > Y

Rising - R < Y

Question 27

Inwood premise

Answer 27

The concept that the PV of an income stream is based on a single discount rate applied to return on and return of capital; applies to income in the form of an ordinary level annuity.

Question 28

Hoskold premise

Answer 28

The concept that the PV of an income stream is based on combo of 2 separate rates - a speculative rate for risk (return on capital) and a safe rate for the sinking fund (return of capital).

Applies to income in the form of an ordinary level annuity of limited duration that is sufficient to pay a fair return on capital at the spec. rate and to contribute necessary installments to a sinking fund.

The sinking fund will grow with interest at a safe rate and repay the investor in full at termination of the investment.

Question 29

Safe rate

Answer 29

Minimum rate of return on invested capital.

Difference b/t the total rate of return and the safe rate is considered a premium to compensate the investor for risk, burden of management, and the illiquidity of the capital invested.

aka - riskless rate or relatively riskless rate

Question 30

Components of a yield rate

Answer 30

Safe rate + expected inflation + risk premium

Safe rate - reflects time value of money rate, which compensates the investor for waiting.

Expected inflation - adjustment to safe rate for the loss in purchasing power.

Risk premium - market, financial, liquidity, and management risks.

Question 31

Why is building up a discount rate (yield rate) for real estate by using theoretical components difficult in practice?

Answer 31

1. Inflation is measured by CPI, which is imperfect.
2. Difficult to quantify each type of risk premium.

Question 32

Reversion

Answer 32

A lump sum benefit an investor receives upon the termination or sale of an investment.

Two common ways to calculate.

1. Trending up current value.
2. Using terminal cap rate applied to annual income that flows to the property in the year following the final year of analysis. (Same model as direct cap, capitalizing the next year’s income)

Question 33

Why is terminal cap rate higher than going-in cap rate?

Answer 33

1. Age - property is moving into lower investment category
2. Improvements will be older, more expensive to maintain, and closer to the end of their useful lives.
3. The farther income is projected in future, the more uncertain.

Question 34

Gross building area (GBA)

Answer 34

Total floor area of building, excluding:
-unenclosed areas, measured from the exterior of the walls of the above grade area.
-includes mezzanines and basements if an when typically included in the market area of the property involved.

Question 35

Rentable area

Answer 35

Office/retail - tenant’s pro rata portion of the entire office floor, excluding elements of the building that penetrate through the floor to areas below.

-measure - inside of finished surface of the dominant portion of the permanent building walls, excluding vertical penetrations.

-alternatively, amount of space on which the rent is based (based on local practice)

Question 36

Usable area

Answer 36

Office - actual occupiable area of a floor or an office space

-measure - finished surface of the office side of corridor and other permanent walls, to center of partitions that separate the office from adjoining usable areas, and to the inside finished surface of the dominant portion of the permanent outer building walls

Question 37

The value of an annuity is…

Answer 37

The PV of the remaining payments

Question 38

Mortgages

Portion paid off =

Answer 38

1 - (Balance outstanding / Original loan amount)

Question 39

Loan to Value =

Answer 39

Mortgage loan / value of property

aka loan ratio

Question 40

Debt Coverage Ratio =

Answer 40

NOI / Annual debt service

A larger DCR typically indicates a greater ability for a property to withstand a reduction of income, providing an improved safety margin for the lender.

Question 41

The amount for which a mortgage is sold is affected by what?

Answer 41

1. Payment history
2. Borrower credit
3. Collateral securing the loan
4. Terms of the note
5. Anticipated payoff date

The amount for which a mortgage is sold is determined by the Yield on mortgage negotiated by the buyer and seller of the mortgage. Not a function of the yield rate when mortgage originated.

Question 42

Two meanings of “point” in appraising…

Discount point and basis point

Answer 42

Discount points - a percentage of the loan amount that a lender charges a borrower for making a loan - may represent a payment for services rendered in issuing the loan or additional interest to the lender payable in advance, also called “points”. Each discount point is 1% of the original loan amount.

Basis point - changes in interest rates and in the yields of stocks/bonds. One basis point is 1/100 of a percent.

Question 43

Origination fee

Answer 43

A fee paid to the lender for processing a loan application. Stated in the form of points, 1 point is 1% of the loan amount.

Question 44

When does interest rate = mortgage yield?

Answer 44

When the face amount of the loan is the same as the amount lent to the borrower or paid to the seller of a mortgage.

Question 45

Lock-in-period

Answer 45

1. The specified period during which a lender guarantees a borrower a specific interest rate and terms on a mortgage.
2. A period during which a lender prohibits the borrower from prepaying any/all part of the loan balance, sometimes called a lock-out period.

Once borrower accepts terms, terms are locked in for a specified period.

Intended to keep the borrower whole.

Can make it difficult for owner to sell the property.

Question 46

Yield maintenance

Answer 46

Prepayment premium allowing mortgage holders to attain the same yield as if the borrower made all scheduled payments until maturity.

Yield maintenance premiums are designed to make investors indifferent to prepayment and make refinancing unattractive and uneconomical to borrowers.

Question 47

Creative financing

Answer 47

Financing practice that differs from standard practices of the lending community.

Borrowers seek out creative financing when conventional sources are not available or when financing can be arranged at more favorable terms using nonstandard techniques.

Often involves seller financing.

A sale typically includes adjustment for cash equivalency if the transaction price would have been different with cash or standard financing.

Question 48

What markets are creative financing used?

Answer 48

1. Interest rates are rising.
2. Credit standards exclude potential buyers.
3. Affordable institutional financing is no readily available.
4. Property type does not meet normal institutional lending criteria.

Question 49

What are some examples of creative financing?

Answer 49

1. Interest rate buydown
2. Lease option
3. Installment sale
4. Loan assumption
5. Wraparound mortgage

Question 50

Interest rate buydown

Answer 50

A lump-sum payment (or series of payments) to a lender that reduces the interest payments of the borrower.

Cost of buydown usually reflected in the price paid.

A buydown does not necessarily cause an increase in price paid and can be expressed as a percentage of principal.

Ex. if a financially strapped builder’s construction lender is pressing for repayment, the builder may absorb most or all of the buydown just to move inventory, pay off a construction loan, and keep crews busy.

1. Common in residential tracts during weak markets or periods of high interest rates.
2. The home developer either pays a lump sum to the bank to reduce payments or subsidizes the buyer’s monthly payments.
3. Theoretically, when the payments step up, inflation will result in higher income for the borrower, or rates will drop to permit refinancing.

Question 51

Lease option

Answer 51

1. Common in single-tenant properties - residential, industrial, commercial.
2. Buyer leases the property with an option to purchase at a specified price at a specified rate.
3. Sometimes the rent is above market and/or a portion of the rent is applied to the purchase price.
4. Sometimes the seller finances the eventual sale.

Question 52

Installment sale

Answer 52

Aka - land contract or contract for deed

A contract in which a purchaser of real estate agrees to pay a small portion of the purchase price when the contract is signed and additional sums, at intervals and in amounts specified in the contract, until the total purchase price is paid and the seller delivers the deed.

Used primarily to protect the seller’s interest in the unpaid balance b/c default can be exercised more quickly than it could be under a mortgage.

Despite its name, a land contract can apply to improved property.

Question 53

Loan assumptions

Answer 53

Sometimes the responsibility for making payments on an existing loan is transferred from seller to buyer as part of sale.

There are various cases:

1. Assumption - when a lender approves the transfer and release of the seller from further obligations.
2. Lender may approve transfer but retain the seller liable for the loan.
3. Seller and buyer arrange for the buyer to make payments without the lender’s knowledge. The lender may disapprove the sale if they learn of the transfer and call the loan due.

Question 54

Wraparound mortgages

Answer 54

A type of loan used in refinancing through the creation of a new, subordinate mortgage.

The new lender assumes the payment of the existing mortgage and provides the borrower with a new, larger mortgage….usually at a lower interest rate than the current market rate.

1. Wraps provide the opportunity to retain a favorable existing loan.
2. They can be offered by a financial institution.
3. More commonly, they are offered by a seller as an alternative to, or as part of, a contract of sale.
4. In the case of a sale where a wraparound mortgage, “wraps around”, an existing loan, the face amount of a wraparound mortgage equals the sale price less the down payment.

Face amount = current balance of the underlying lien + amount of “new money” that the seller is effectively lending the buyer.

Question 55

Construction loan

Answer 55

Financing for construction of improvements.

Generally short term, floating rate debt, repaid with permanent financing.

Construction loans with a permanent financing component are called “with a takeout commitment” and those w/o one are “without a takeout commitment”.

May include carried interest or a very small permanent component to see the property from post-construction to full absorption.

Question 56

Takeouts aka takeout commitment

Answer 56

A lender’s commitment to provide long-term financing when a building is completed.

Question 57

Takeout loan

Answer 57

A long-term loan created to replace interim financing such as a construction loan.

Question 58

Bridge financing

Answer 58

Short-term b/t…

1. termination of one loan and start of another.
2. acquisition of a property and the rehab that will make it eligible for permanent financing.
3. maturity of a construction loan and the negotiation of permanent financing.

Question 59

Mini-perm loan

Answer 59

Short-term used during lease-up period that is used to pay off construction loan.

Question 60

Mezzanine financing

Answer 60

A form of secondary financing at a higher risk with a higher interest rate applicable to the secondary position.

Often supplementary financing where stock in the company is pledged for collateral.

Can be used when primary financing prohibits junior liens.

Question 61

Small Business Administration (SBA) loan

Answer 61

Institutional financing guaranteed by the SBA.

Typically….lower interest, low down payment, single-tenant/owner occupied

Question 62

Sale/leaseback

Answer 62

Real estate sold by owner then leased back from the new buyer.

Seller receives cash, buyer gets tenant.

Question 63

What are the 2 meanings of a participation loan?

Answer 63

1. Multiple lenders, one borrower - i.e. large projects, way for lender to keep risk down.
2. Lender shares in the borrower’s equity position…aka equity participation loan.

Question 64

Convertible mortgage

Answer 64

A debt secured by real property in which lender can choose to change all/part into an equity interest.

This allows lender to share in cash flow and appreciation.

Typically, lender advances more funds than would be indicated by conventional LTV ratios and charges the borrower a face rate lower than conventional rates.

Question 65

What are 4 applications of convertible mortgages?

Answer 65

1. Used by large institutional lenders with equity investors who need the tax benefits.
2. Lender often provides higher initial LTV ratio, sometimes 100%.
3. Provides inflation protection to lenders and an upside reward.
4. Non recourse mortgages give the borrower an option to give the property to the lender through default if property does poorly.

Question 66

How are convertible mortgages valued?

Answer 66

Discounting the expected cash flows.

Estimated value of the mortgage reflects probabilities assigned to various possible outcomes b/c lenders can choose to accept amortization or convert to equity.