Powerpoint class 5 Flashcards
three approaches to Real Estate appraisals
Cost approach
Sales comparison approach
Income approach
Cost approach
Buyer would not pay more for a property than it would cost to purchase land and construct a comparable building
Sales comparison approach
Buyer would not pay more for a property than others are paying for similar properties
Income approach
Value is based on the expected rate of return required by a buyer to invest in the subject property
Value = present value of anticipated income
Often called “income capitalization”
–> Capitalize: to convert future income into a present value
the two income approach methods
Direct Capitalization Method
Discounted Cash Flow Method
Direct Capitalization Method
Value is based on capitalizing the first year NOI of the property using a capitalization rate
Similar in spirit to valuing a stock using a price/earnings multiple
Discounted Cash Flow Method
Value is based on the present value of the property’s future cash flows using an appropriate discount rate
Project net CFs for a standard holding period (say, 10 yrs)
Discount all expected future CFs at required return (IRR)
DCF valuation models require:
- estimate of typical buyer’s expected holding period
- estimates of net (annual) CFs over expected holding period, including net income from expected sale of property
- appraiser to select discount rate (required IRR)
NOI formula (for Real Estate)
Potential Gross Income
- Vacancy and Collection Loss
+ Miscellaneous Income
= Effective Gross Income
- Operating Expenses
- Capital Expenditures
= NOI
Potential gross income:
Rental income assuming 100% occupancy
Sometimes referred to as potential gross revenue (PGR)
Contract rent from in-place leases
+
Rent that could be collected on vacant space if it were leased at current market rental rates
VC-vacancy & collection loss is based on:
Historical experience of subject property
Competing properties in the market
“Natural vacancy” rate
“Natural vacancy” rate
Vacancy rate that is expected in a stable or equilibrium market
Miscellaneous income
Garage rentals & parking fees (office)
Laundry & vending machines (apts., office)
Clubhouse rentals (apts.)
Operating Expenses
Ordinary & regular expenditures necessary to keep a property functioning competitively
fixed operating expenses
Expenses that do not vary with occupancy (at least in the short-run)
ex: hazard insurance and local property taxes
Variable operating expenses
Expenses that tend to vary with occupancy
ex: Utilities and Maintenance & supplies
Operating Expenses do not include:
Mortgage payments
Tax depreciation
Capital expenditures
Leasing commissions
How do most appraisers treat Capital Expenditures (CAPX) when calculating cash flow and NOI?
Treat it as the “above line”
Above Line
EGI
- OE
- CAPX
= NOI
How do institutional investors treat Capital Expenditures (CAPX) when calculating cash flow and NOI?
as the “below line expense”
EGI - OE = NOI - CAPX = Net Cash Flow
Income Approach: Direct Capitalization
Value = NOI (first year) / cap rate
Direct capitalization only uses first year NOI, but Ro reflects all future cash flows:
–> Transaction prices of the comparable reflect the value of future cash flows.
–> Cap rates extracted from these sale transactions reflect the value of future cash flows as well.
Effective Gross Income Multiplier (EGIM)
EGIM = sale price ÷ effective gross income
Quick indicator of value for smaller rental properties
Requires no operating expense information
Effective Gross Income
Potential gross income
– Vacancy and collection loss
+ Miscellaneous income
Effective Gross Income Multiplier (EGIM) (critical assumptions)
Roughly equal operating expense percentages across subject & comparable properties
Assumes market rents are paid
when is the Effective Gross Income Multiplier (EGIM) best used?
Best used for properties with short-term leases (apartments & rental houses)
how do you find the value of a property using the EGIM
Average EGIM * Effective Gross Income
Issues with the Direct Capitalization Method
Inadequate data on comparable sales due to:
–> Above- or below-market leases
–> Differing length of leases & rent escalations
–> Differing distributions of operating expenses between landlord and tenant
