Chapter 8 Flashcards
Income approach (appraisal method)
Value property by its anticipated future cash flows. Only use for income properties. Ex. Commercial buildings.
What are the two approaches to income valuation?
- Discounted Cash Flows (DCF)
2. Direct Capitalization (DC)
Discounted Cash Flows (DCF)
Take entire life of property from purchase to death and generate a required return (discount rate). Estimating cash flows YEAR over YEAR.
Direct Capitalization (DC)
Apply a rate (cap rate) to a SINGLE YEAR of cash flows.
What is the discount rate (aka required return)?
It is simply what you could make somewhere else. If another property offers 10% returns, that becomes my req. return for subject property.
If I buy a property at $1,000,000 and make $70,000 a year for 10 years, what will be my discount rate?
7% (70,000/1,000,000)
What three things does DCF require the appraiser to estimate?
- Expected holding period (generally 5-10 years).
- Net cash flows over est. holding period from OPERATIONS and SALE.
- Required return (disc. rate) to discount expected future CF to PV.
Use objective projections (typical buyer/investor)
Why not use gross cash flows (CF)?
We never get money without obligations. Use NET = CF - obligations.
What two calculations are used in estimating net cash flows?
Operations: Net Operating Income (NOI)
Sale: Net Sale Proceeds (NSP)
Potential Gross Income (PGI)
Rental income assuming 100% occupancy. These are the stabilized cash flows. Ex. Plane flying at cruising altitude.
Do we use market rents or contract rents for Potential Gross Income (PGI)?
Use MARKET rents. CONTRACT rents are in the past now, market rents are current. Only use contract rents if the contract(s) is longer than the holding period.
How do we generally quote rent for commercial real estate?
Square feet per year (sf/year)
How do we calculate vacancy and collection loss to determine EGI?
- Use historical experience of subject property.
- Look at competing/similar properties in the market.
- Use the “natural vacancy rate”
Natural vacancy rate
Vacancy rate expected in a stable market, can differ by property type. Ex. Shopping mall vs. Via Frascati house.
What are some examples of misc. income (calculating EGI)?
Garage rentals and parking fees, laundry and vending machines, clubhouse or conference room rentals.
Why is commercial RE quoted at sf/yr?
Tenant improvements are very common. Tenant can ask for expanded space and other improvements within constraints.
Easy way to remember operating expenses
Operate/maintain/repair. Regular expenses to keep a property functioning properly.
What is not included in Operating Expenses (OE)?
- Mortgage payments. If I bought the house on a loan I do not add the payments to lender.
- Income taxes. They are PERSONAL expenses, not property level.
- Depreciation. Tax concept, not part of RE. Has no effect on anything other than income taxes. Only consider when doing after-tax analysis.
Capital Expenditures (CAPX)
Expenses that materially increase value or extend the property’s useful life (think “replace/improve”)
If a tenant in my shopping mall asks for the floor to be replaced, where would this expense fall when calculating NOI?
CAPX! It’s a renovation.
If the roof begins leaking water and needs a patch, where would this expense fall when calculating NOI?
Operating Expenses (OE). It’s a repair.
If I need to hire security to watch the mall, where would this expense fall when calculating NOI?
Operating Expenses (OE). It’s maintenance.
If my mall requires payment for parking, where would this income fall when calculating NOI?
Miscellaneous income
If I decide to expand mall by 2000 sq feet, paid over the course of three years, where would this expense fall when calculating NOI?
CAPX! Major improvement that increases value of property.
What are the two ways of showing CAPX amount?
Itemized budget: NOT common. Would look year over year and calculate estimated spending. Ex. Year 1 = $1000, Year 2 = $3000.
Annual reserve: Project how much will be spent in TOTAL over 10 years. Divide by 10.
Ex. With #s above, Year 1 & 2 = $2000.
How would we find the discounted PV from future cash flows?
Future cash flows / (1 + disc. rate) = PV
If Property:Stock::NOI:???
Dividend
What is the fundamental determinant of value for income properties?
Projected future net cash flows
NOI must be sufficient to…
- Pay investor’s debt service (loan payments)
2. Provide return on equity for investor
What are the types of rents?
- Straight lease (constant level rent. Ex. 715 Marine)
- Step-up/graduated lease (periodic, predetermined leases)
- Indexed lease (rent tied to inflation index, such as CPI)
- Percentage lease (rent includes % of tenant’s gross sales)
What is the difference between gross and NNN (triple net) expenses?
Gross: Landlord pays OE, CAPX
NNN: Tenant pays OE, CAPX
Which form of expense allocation is more risky, gross or NNN?
NNN. OE and CAPX are less predictable.
I receive two similar leases: one with gross expense and one with NNN. Which one will I pay more for?
Gross. There’s a premium on decreased risk.
What are the Direct Capitalization (DC) methods?
- Capitalization (cap) rate
2. Income multiplier
What are the three components of triple net (NNN)? KNOW THIS FOR TEST.
Taxes, insurance, CAM (common area maintenance)
On a full net lease, what two calculations are equivalent?
EGI = NOI. Generally EGI - OE - CAPX = NOI.
Cap rate equation
V0 (property value) = NOI1 (year 1 op. CF) / R0 (cap rate)
How would I determine my cap rate if I’m buying a mall?
Look at sim. property values and find NOI and property value. Calculate their cap rate. Then I use my estimated NOI and their cap rate to est. value of my property.
I’m buying a basketball stadium. Similar stadium has NOI of $10M and sale price of $100M. My NOI is $5M. What’s my est. property value?
$10M/$100M = 0.1 cap rate. $5M/0.1 = $50M est. for my stadium.
What factors go into finding comps for cap rate calculation?
Same location, same type, same class. Not looking at similar sale prices but at similar DISCOUNT RATES.
Cap rates are a _______ of return, not a _______ of return.
Product (result); measure
In very simple terms, is a higher or lower cap rate better?
Higher. It means that the property’s NOI is closer to its property value.
When would we use DCF specifically as opposed to DC?
When the property won’t operate like the normal properties in subject area. Ex. Light rail station will open within holding period right next to subj. property.
Why do we describe R0 as the “going-in” cap rate?
This cap rate is used to estimate current property value. The “going out” cap rate (Rt) which is used to estimate sale price.
Income multiplier (EGIM)
Says how many times we would multiply CF to = sale price.
Under what terms of the lease would the cap rate be an exact reciprocal of the income multiplier (EGIM)? Assume you’re buying the property.
When the comps and subject property are both NNN. OE and CAPX aren’t used in EGIM and under a NNN lease the property buyer wouldn’t need to pay these.
Income multiplier (EGIM) equation
EGIM0 = (Selling Price) / EGI1 (first year effective gross income)
What is the critical assumption made when using EGIM?
Comps and subject have similar OE/CAPX. If they differ wildly, our EGIM won’t be accurate because it may output similar numbers.
Bonehead Property Management investment:
NOI = $7M
EGI = $10M
Sale price = $25M
What is the cap rate and EGIM?
Cap rate = $7M/$25M = 28%
EGIM = $25M/$10M = 2.5
I’m attempting to value a developed vacant lot for office buildings. Should I use income approach, cost approach, or sales comp. approach?
Sales comparison. There aren’t cash flows (no income) and no building (no cost).
Best approach to value suburban single family home?
Sales comparison because there are a lot of good comps! Maybe weigh in cost approach.
Best approach to value Palm Springs house?
Cost approach, maybe weigh in comps once there are enough.
Best approach to value MCE building?
Income approach. Best for commercial.
Best approach to value 1132?
Cost approach probably. There aren’t enough comps! Maybe small weight on comps.
