PROP 1020 / CHAPTER 5 Flashcards
Three methods to estimate the overall capitalization rate include:
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Three methods to estimate the overall capitalization rate include:
Market Derived Capitalization Rates;
Summation Method; and
Weighted Average Method.
Explain how the overall capitalization rate is found?
The preferred method is to analyze a number of recent sales of similar properties to determine the overall capitalization rate implicit in the transactions.
If the appraiser knows the sale price and the net operating income of each comparable sale, then an implicit overall capitalization rate can be determined by substituting the sale price for value.
The appraiser must be certain that the net operating income of each comparable sale is calculated and estimated in a similar manner to that estimated for the subject.
What are the assumptions / conditions when using the market cap rate to determine market value?
Accept that the net operating income fully represents the long-term potential leasing value of the property;
Agree to treat the stream of net operating income as constant and perpetual;
Conclude that neither non-market financing nor atypical sale conditions have affected the sale prices of the comparables; and
Trust the representativeness of our market sample and thus the resulting “market” overall capitalization rate.
When the appraiser cannot find sufficient comparable sales to estimate Ro from market evidence the _________ method and/or the ___________ method can be employed.
When the appraiser cannot find sufficient comparable sales to estimate Ro from market evidence the summation method and/or the weighted average method can be employed.
Explain the summation method of determining the overall capitalization rate?
Using the summation method, the overall capitalization rate is built up through a rough decomposition of the elements of a discount rate.
The analyst starts with the expected rate of return on a risk-free asset (generally assumed to be the rate on some short term government debt), then adds some risk premium to account for the additional risk borne by the subject property.
List 3 risk premiums to consider when building up the cap rate using the summation method?
Summation method risk premiums include:
illiquidity – the relative difficulties in disposing of real estate assets;
high transaction costs;
cyclicity – the business cycle, or ups and downs of real estate markets;
locational constraints; and
quality of management.
What are the problems with the summation method?
The obvious weakness of the summation method is that the ad hoc premiums are highly subjective and difficult or impossible to substantiate with empirical evidence.
Risk premiums cannot be accurately estimated and slight variations in such estimates lead to unacceptable variations in values.
This very crude method of risk adjustment is rarely applied in real property valuation practice.
It can be useful in a supporting role for another approach that has weak market support.
The ___________ implicitly recognizes that the expected total return on the investment must satisfy the return expectations of the debt holder and the return expectations of the shareholder.
The Weighted Average Approach
TRUE OR FALSE?
The weighted average method is the traditional way of determining the capitalization rate in corporate finance.
ANSWER:
TRUE
______________ is the procedure in which a discount rate is applied to a set of projected income streams and a reversion. The analyst specifies the quantity, variability, timing, and duration of the income streams as well as the quantity and timing of the reversion and discounts each to its present value at a specified yield rate.
Discounted cash flow (DCF) is the procedure in which a discount rate is applied to a set of projected income streams and a reversion. The analyst specifies the quantity, variability, timing, and duration of the income streams as well as the quantity and timing of the reversion and discounts each to its present value at a specified yield rate.
NOTE ONLY
Real property value is fundamentally a risk versus return relationship – a truly competitive market will provide a higher return only where there is associated higher risk.
Or, alternatively, that higher risk leads to higher demanded return, which inevitably leads to paying a lower amount for a riskier property, assuming anticipated income and all else is equal (i.e., a higher cap rate leads to lower market values).
Or, in the opposite case, to buy a less risky property, purchasers need to out-bid the market and thus have to pay more and the expected return is lower (i.e., a lower cap rate leads to higher market values).
NOTE ONLY
Real property value is fundamentally a risk versus return relationship – a truly competitive market will provide a higher return only where there is associated higher risk.
Or, alternatively, that higher risk leads to higher demanded return, which inevitably leads to paying a lower amount for a riskier property, assuming anticipated income and all else is equal (i.e., a higher cap rate leads to lower market values).
Or, in the opposite case, to buy a less risky property, purchasers need to out-bid the market and thus have to pay more and the expected return is lower (i.e., a lower cap rate leads to higher market values).
What is the Gordon Formula?
