Day 1: Valuation Process/Cap Rates Flashcards
COST APPROACH
Cost Approach is the cost of production not value in exchange (like the sales comparison approach). Works well for new property that doesn’t have much depreciation.
INCOME APPROACH
The income capitalization approach measures the present value of the future benefits derived from property ownership.
After income and expenses are estimated, the appropriate income stream may be: capitalized into a value opinion by applying an appropriate rate or factor (direct cap). This typically involves income over a one- year period.
Yield-Cap (DCF) involves income for more than one year.
WHO IS THE CLIENT?
Need to know how sophisticated your client is.
HYPOTHETICAL CONDITION: I know it’s not true but I’m going to assume it is for my appraisal (used in eminent domain)
“Assumptions in general are things taken to be true and are a normal part of every appraisal assignment. An extraordinary/special assumption is a unique assumption and must be treated more carefully by the appraiser.”
EXTRAORDINARY ASSUMPTIONS- “An assignment-specific assumption as of the effective date regarding uncertain information used in analysis which, if found to be false, could alter the appraiser’s opinion or conclusions.” P. 11
SPECIAL ASSUMPTION: an assumption, directly applicable to a specific service, which, if found to be false, could alter the opinions or conclusions in an appraisal or review.
EXERCISE IN JUDGMENT
EXERCISE IN PERFORMANCE OR EXECUTION
Answer
IDENTIFICATION OF THE PROBLEM - IDENTIFY THE CLIENT
BANK AND ITS REPRESENTATIVES: client and user
HUD/FHA: Intended user
APPRAISAL MANAGEMENT CO.: May or may not be an intended user
BORROWER: Not an intended user
THE VALUATION PROCESS - STEP 1: IDENTIFICATION OF THE PROBLEM
Intended use affects both appraisal development (scope of work, type and extent of research and analysis) and reporting (type of report, report content and level of information).
Identify the CLIENT and INTENDED USERS Identify the INTENDED USE Identify the PURPOSE Identify the EFFECTIVE DATE Identify the CHARACTERISTICS Identify ASSIGNMENT CONDITIONS
REVIEW QUIZ: The relevant characteristics of a property are part of identifying the problem.
HYPOTHETICAL CONDITION: This is a condition that is contrary to what exists by is supposed for the purpose of analysis.
A hypothetical condition is often a “what if” scenario intended to clarify a value issue such as the appraisal of proposed construction on a vacant site with the value opinion effective as of a current date.
OTHER ASSIGNMENT CONDITIONS: might include laws, regulations, guidelines, and other conditions that can affect the scope of work. For example, an FHA appraisal assignment would have assignment conditions based on regulations issued by HUD.
THE VALUATION PROCESS-
Step 3: DATA COLLECTION AND PROPERTY DESCRIPTION
MARKET AREA DATA: General characteristics of a region, city and neighborhood.
SUBJECT PROPERTY DATA: subject characteristics of land use and improvements, PP, business assets, etc.
COMPARABLE PROPERTY DATA: Sales, listings, offerings, vacancies, cost and depreciation, income and expenses, capitalization rates, etc.
APPRAISAL/VALUATION PROCESS
The process provides a checklist for both appraisers and users of appraisal services - and covers the requirements of an appraisal that complies with professional appraisal standards.
COMPARABLE SALES
A good way to look at potential comparables is: if these properties were on the market, would/how would they compete with the subject property.
HIGHEST AND BEST USE
The reasonably probable use of property that results in the highest value. The four criteria that the highest and best use must meet are legal permissibility, physical possibility, financial feasibility, and maximum productivity. Alternatively, the probably use of land or improved property- specific with respect to user and timing of the use- that is adequately supported and results in the highest present value.
HIGHEST & BEST USE - Review of Decision Process
Land as though vacant - Options
Improve
Leave vacant
Property as Improved - Options
Leave as is
Alter
Demolish
43,560 sq ft/ acre
5280 linear ft/ mile
640 acres/section
43,560 sq ft/ acre
5280 linear ft/ mile
640 acres/section
Highest and Best Use
The appraiser analyzes the ideal improvement to the property.
SIX PROCEDURES FOR ANALYZING LAND:
Sales Comparison (preferred method) Extraction Allocation (alternative method) Land Residual Technique (not tested) Ground rent capitalization (not tested) Subdivision development analysis (not tested)
Answer
LAND VALUE OPINION- Sales Comparison
Appraiser searches for sales of similar vacant parcels.
Each selected sale is analyzed and compared to the subject parcel and then adjusted for salient differences.
Sales comparison is the most common and preferred method of valuing land, assuming sufficient data is available.
You must organize your data for further analysis.
METHOD FOR VALUING LAND - EXTRACTION - When vacant sales are unavailable, the appraiser can analyze improved property sales similar to the subject property in land characteristics.
Sale Price - Contributory Value of the Improvements (Depreciated Cost) = Extracted Value of Land
When this procedure is applied, it can provide reliable data to assist the appraiser in forming a value opinion of the improved land. However, ample sales should be used, and the appraiser must be experienced in the use of cost and depreciation methodology.
This procedure is most applicable when improvements can be reliably valued, such as when the improvements are either new or very old (that is nearing the point when the improvements will be demolished).
COST APPROACH-
You don’t want to overbuild - that is called super adequacy.
SALES PRICE ADJUSTMENT PROBLEM (p.28)
Look at gross adjustments to determine whether it is truly comparable. If you have gross adjustments of $200 and net is zero, is it really a good comparable?
METHOD FOR VALUING LAND - ALLOCATION
As the name implies, the appraiser analyzes improves property sales and allocates prices paid between the improved land and total property, usually on a ratio basis.
The process can be based on vacant improved land sales that are compared to improved property sales, or the appraiser can use an executive process by isolating the depreciated cost of improvements from the improved land.
This procedure is rarely used as a primary improved land valuation technique, but it has secondary applications in the analysis of subdivision lots when there is a uniform ratio of land value to total value.
The procedure also might be useful in tax assessment studies.
COMMONLY USED ELEMENTS OF SALES COMPARISON
Real property rights conveyed
Financing terms (compared to cash equivalency)
Conditions of sale (consider motivation)
Expenditures made immediately after purchase
Market conditions (commonly known as “time adjustment)
Location
Physical characteristics (including energy efficiency, high-performance, and green feat.)
Economic characteristics
Use (based on comparable zoning, highest and best use, and utility)
Non-realty components of value (eg, business value, franchises)
THE VALUATION PROCESS - STEP 3: DATA COLLECTION AND PROPERTY DESCRIPTION
MARKET AREA DATA: General characteristics of region, city, and neighborhood.
SUBJECT PROPERTY DATA: Subject characteristics of land use and improvements, PP, business assets, etc.
COMPARABLE PROPERTY DATA: Sales, listings, offerings, vacancies, cost and depreciation, income and expenses, capitalization rates, etc.
THE VALUATION PROCESS- STEP 4: DATA ANALYSIS
MARKET ANALYSIS: Demand studies, supply studies, marketability studies.
HIGHEST AND BEST USE ANALYSIS: Land as though vacant, ideal improvement, property as improved.
THE VALUATION PROCESS - STEP 6: APPLICATION OF THE APPROACHES TO VALUE
Sales comparison approach
Income capitalization approach
Cost approachh
THE VALUATION PROCESS- STEP 7: RECONCILIATION OF VALUE INDICATIONS AND FINAL OPINION OF VALUE
Page 5
THE VALUATION PROCESS
Step 1: Identification of the problem
Step 2: Scope of work determination
Step 3: Data collection and property description
Step 4: Data Analysis **
Step 5: Land value opinion **
Step 6: Application of the approaches to value
Step 7: Reconciliation of Value Indications and Final Opinion of Value
Step 8: Report of Defined Value
THE VALUATION PROCESS - STEP 5: LAND VALUE OPINION
Six procedures for analyzing land:
Sales Comparison
Extraction
Allocation
PURPOSE of assignment
Defined value in the appraisal must address whether opinion is reported in terms of cash, cash equivalency, or other precisely defined terms.
If value opinion is based on non-market financing or financing with unusual conditions or incentives, the tens of such financing must be identified; and the appraisers opinion of their effect on value (positively or negatively) must be developed by the analysis of relevant market data.
To develop an opinion of a certain type of value which could include:
MV Use value Investment value Insurable value Assessed value Fair value
SCOPE OF WORK
The type and extent of research and analyses in an appraisal or appraisal review assignment.
Once the problem is identified, the valuation process logically leads to the scope of work decision. Appraiser must determine scope of work that is sufficient to produce credible assignment results.
STEP 3: DATA COLLECTION AND PROPERTY DESCRIPTION
MARKET AREA DATA - falls into the category of general data and focuses on trends that are affected by the four forces that influence value.
TREND: A series of related changes brought about by chain of causes and effects. Trends are forecast through economic base analysis, statistical analysis, market analysis, and analysis of economic indicators and surveys.
General data: Data that relates to the four forces that affect real property values- social, economic, governmental, and environmental forces.
Specific data: Details about the property being appraised, comparable sale and rental properties, and relevant local market characteristics.
Market trends analyzed as general data can include population shifts, declining office building occupancy rates, and increased housing starts.
Discussion and interpretation of the effects from the four forces influencing the use and value of the subject property are included in the appraisal report.
Supply and demand data on competing properties to the subject property is studied.
STEP 4: DATA ANALYSIS- MARKET ANALYSIS & HIGHEST AND BEST USE
MARKET ANALYSIS: The study of the supply and demand in a specific area for a specific type of property.
Competitive supply and demand data is necessary to determine the present and future competitive position if the property in its market. From what data source?
HIGHEST & BEST USE ANALYSIS: the reasonably probable use of property that results in highest use. The four criteria for the highest and best use must meet are: legal permissibility, physical possibility, financial feasibility, and maximum productivity.
HIGHEST AND BEST USE: an ideal improvement should meet the following criteria-
a. Take maximum advantage of the lands potential to satisfy market demand.
b. Confirm to current market standards and the character of the area.
c. Contain the most suitably priced components.
Highest and best use conclusions should specify the following criteria:
a. Use
b. Timing for the use(s)
c. Typical market participants for the use
VALUATION PROCESS
3 data types: market area data, subject property data, comparable property data.
2 types of data analysis: market analysis and highest and best use analysis.
3 data types: market area data, subject property data, comparable property data.
2 types of data analysis: market analysis and highest and best use analysis.
COST APPROACH STEPS
- Estimate the value of the site as though vacant and available to be put to its highest and best use.
- Estimate the direct and indirect cost of the improvements.
- Estimate the entrepreneurial incentive.
- Add steps 2 and 3 together to get the total current cost.
- Estimate the accrued depreciation from three sources ( physical deterioration, functional obsolescence, economic obsolescence).
- Deduct the depreciation from total current cost to derive an estimate of the depreciated cost of improvements.
- Add the contributory (as is) value of any site improvements.
- Add the site value to the total depreciated costs.
COST APPROACH- commonly used elements of comparison
RP rights conveyed
Financing terms (compared to cash equivalency)
Conditions of sale (consider motivation)
Expenditures immediately after sale (new roof)
Market conditions (commonly known as a time adjustment)
Location
Physical characteristics (including energy efficiency, high performance, and green features)
Economic characteristics (rents, expense ratios)
Use
Non-realty components of value (for example, personalty, franchises, business value)
THE VALUATION PROCESS- STEP 7: Reconciliation of value indicators and final opinion of value
Final analytical step is the reconciliation of the value indications (from the applicable approaches to value) into a single dollar figure or range into which the value will most likely fall.
Reconciliation takes place throughout the valuation process.
A reconciled value opinion is not derived through mathematical calculations or a simple mean of the various indicators. Reconciliation is a disciplined process using reason and judgment based on the quality and quantity of data.
THE VALUATION PROCESS - STEP 8: Report of Defined Value
He valuation process is not complete until the appraiser states the value opinion in a report and presents it to the client.
The report must properly disclose assignment conditions as well as any limiting conditions. The appraiser must clearly and conspicuously state in their report that their use might have affected the assignment results.
The appraisal report must include a signed certification that meets the requirements of professional appraisal standards.
Review ?: The first step in the cost approach is to value the land as improved and ready for development to its highest and best use.
True.
Review ?: Purpose defines the identified use of the appraisal. False.
The identification of the problem identifies both the intended use and purpose of the assignment (type and definition of value).
Introduction to Income Capitalization:
In each assignment, the appraiser considers the applicability of the three approaches to value. Sometimes all three approaches will be utilized, and sometimes only one approach might be applicable. If the appraiser’s scope of work determines that all three approaches to value should be employed, it’s the apprisers choice as to which approach will be tackled first.
More…
KEY DIFFERENCES BETWEEN INCOME AND YIELD CAP
Answer
INCOME CAPITALIZATION - SETTING THE STAGE
Income-producing property is generally purchased as an investment.
Earning capability is the critical element. Generally speaking, the higher the earnings, the higher the market will place on the property value, assuming the risk remains constant. This is why the appraiser must carefully analyze the quantity and quality of the income generated by the property.
The income capitalization approach is used to analyze a property’s ability to generate anticipated future benefits and to convert (that is, capitalize) these benefits into an indication of present value.
Capitalization: The conversion of income to value.
GROSS RENT MULTIPLIER:
You can use the sale price and monthly rent of comparable properties to get a gross rent multiplier. P. 40.
IRV
Net operating income / Rate x Value
VIF
Value/ Income x Factor/Multiplier
MARKET VALUE vs. INVESTMENT VALUE
Market value is objective, impersonal, and detached from any single investor and reflects what typical investors in the market might do.
In contrast to market value, investment value is associated with a particular investor. It is based on personal, subjective parameters, which may or may not coincide with those of typical investors in the subject properties market.
Unless specified otherwise, our discussion of income capitalization will focus on an opinion of market value rather than investment value.
THE CONCEPT OF FUTURE BENEFITS
Future benefits include the right to receive all revenues accruing to the real property over the holding period (the term of ownership) plus the net proceeds from resale or reversion of the property at the termination of the investment.
COMMONLY USED MEASURES OF FUTURE BENEFITS
Potential gross income (PGI): The total potential income attributable to property at full occupancy before vacancy and operating expenses are deducted.
Effective gross income (EGI): The anticipated income from all operations of the real estate after an allowance is made for vacancy and collection losses and an addition is made for any other income.
Net Operating Income (NOI): The actual or anticipated net income that remains after all operating expenses are deducted from EGI, but before mortgage debt service and book depreciation are deducted.
Pre-tax cash flow (PTCF): The portion of net operating income that remains after total mortgage debt service is paid but before income tax on operations is deducted; also called before-tax cash flow or equity dividend.
After-tax cash flow (ATCF): The portion of pre-tax cash flow that remains after all income tax liabilities have been deducted.
Reversion: A lump sum benefit that an investor receives or expects to receive upon the termination or sale of an investment.
INCOME RATE
An income rate expresses the relationship between one year’s income and the corresponding value of a property.
Overall Capitalization Rate (Ro): The relationship between a single year’s net operating income expectancy and the total property price or value.
MORTGAGE CAPITALIZATION RATE (Rm)
The capitalization rate for debt- the ratio of the annual debt service to the principal amount of the mortgage. The mortgage capitalization rate is equivalent to the periodic mortgage constant times the number of payments per year on a given loan on the day the loan is initiated.
Investors sometimes use the Rm to figure out how much they can afford to pay for an investment property by anticipating the annual debt service.
YIELD CAP
Interest rate: The rate of return, or yield, on debt capital.
Discount rate: A rate of return on capital used to convert future payments or receipts into present value.
X
Return ON and Return OF Capital
Return ON capital refers to the additional amount received as compensation (profit or reward) for use of an investor’s capital until it is recaptured.
Return OF capital refers to the recovery of invested capital
Direct cap: no separate mathematical distinction is made between return on and return of capital - ITS ALL IN THE RATE.
Yield cap: the distinction between the return of and return on capital is always definite and precise for each year’s cash flow and reversion.
NOMINAL INTEREST RATE
A stated or contract rate; an interest rate, usually annual, that does not necessarily correspond to the effective or compound interest rate.
X
Reciprocal
Is an element of a mathematical set that when multiplied by a given element yields the identity element. It is also referred to a a multiplicative inverse.
If a cap rate is 6.25% is corresponding factor is 16.
Symbol
How does an appraiser decide whether to use IRV or VIF?
The answer is largely determined by the type of property and the availability of market data. If the appraiser has good data on income and expenses for the subject property and competing properties, IRV is used. In some property types, the most accurate indicator of income is PGI or EGI. In that case, VIF would be chosen to capitalize income.
INCOME MULTIPLIERS
GIMs are ANNUAL multipliers used in commercial properties, and GRMs are MONTHLY multipliers used in residential properties of one to four units.
GIM- this is a ratio between the sales price (or value) of a property and its effective gross income (EGI) or its potential gross income (PGI).
Procedure for using gross income multipliers
Begin by examining sales of properties with similar highest and best use that were rented at the time of sale.
The selected sales must have operating expense ratios (OERs) similar to the subjects OER.
OPERATING EXPENSE RATIO
The ratio of total operating expenses to effective gross income (TOE/EGI)
Review quiz- if the capitalization rate is 9.5%, what is the equivalent factor (that is, multiplier)?
1/.095 (take the reciprocal of the rate)
