PROP 1020 / CHAPTER 9 Flashcards
NOTE ONLY / INTRO TO CH9
In this chapter we move from the stable income, all-cash world depicted in the previous chapter, to the reality that property is typically purchased with financing, creating debt leverage.
Our focus is the mortgage-equity or M-E technique. This valuation technique is founded on the premise that the overall rate should reflect the importance of separate yields attributable to the equity position and to the debt position.
NOTE ONLY / INTRO TO CH9
In this chapter we move from the stable income, all-cash world depicted in the previous chapter, to the reality that property is typically purchased with financing, creating debt leverage.
Our focus is the mortgage-equity or M-E technique. This valuation technique is founded on the premise that the overall rate should reflect the importance of separate yields attributable to the equity position and to the debt position.
The M-E technique is not as commonly used as capitalization or discounted cash flow in everyday real estate practice. However, the M-E technique is helpful in certain situations to :
[LIST 4]
determine overall rates;
derive building and land capitalization rates for residual techniques;
analyze the capitalization rates derived through other techniques;
test separately determined value estimates; or
graphically analyze financial components of an overall rate.
In its simplest form, the BOI can be expressed as follows:
____________ (give the formula)
Ro is the capitalization rate
L/V is the initial loan-to-value ratio i is the interest rate
E is the entrepreneur’s investment or equity R is the expected return on investment
In its simplest form, the BOI can be expressed as follows:
Ro = (L/V) i + ER where
Ro is the capitalization rate
L/V is the initial loan-to-value ratio i is the interest rate
E is the entrepreneur’s investment or equity R is the expected return on investment
Rationale of Mortgage-Equity Concept
Mortgage-equity capitalization presumes that mortgage terms and equity yields influence the overall rate. As Akerson explains, “the overall rate is the fraction of the total investment that must be collected each year, on the average, to service the debt (principal as well as interest payments), yield the required benefits (cash flow and/or equity build-up), and compensate for depreciation or appreciation”.
Thus, mortgage-equity is a band of investment approach whereby the overall rate is calculated as the sum of capitalization rates for the mortgage component and the equity investment component – adjusted for changes in the equity position.
To calculate debt service, the analyst identifies the most probable mortgage loan terms available to the typical investor for the property type being analyzed, and then determines the mortgage constant. All that remains for the appraiser is to determine the equity yield rate. This requires an estimate of the proportionate allowance for cash throw-off to equity and provision for capital recovery. An increase in equity will occur through mortgage amortization and appreciation (or depreciation) in the residual captured at the conclusion of the holding period, when the property is sold.
Rationale of Mortgage-Equity Concept
Mortgage-equity capitalization presumes that mortgage terms and equity yields influence the overall rate. As Akerson explains, “the overall rate is the fraction of the total investment that must be collected each year, on the average, to service the debt (principal as well as interest payments), yield the required benefits (cash flow and/or equity build-up), and compensate for depreciation or appreciation”.
Thus, mortgage-equity is a band of investment approach whereby the overall rate is calculated as the sum of capitalization rates for the mortgage component and the equity investment component – adjusted for changes in the equity position.
To calculate debt service, the analyst identifies the most probable mortgage loan terms available to the typical investor for the property type being analyzed, and then determines the mortgage constant. All that remains for the appraiser is to determine the equity yield rate. This requires an estimate of the proportionate allowance for cash throw-off to equity and provision for capital recovery. An increase in equity will occur through mortgage amortization and appreciation (or depreciation) in the residual captured at the conclusion of the holding period, when the property is sold.
Why should the capitalization of land and building be treated differently?
Because buildings have a finite life, they depreciate in value and the investor may require a higher rate of return to compensate for this depreciation. This higher rate of return should include a recovery of the capital over and above the return on the capital.
On the other hand, the land component is not considered to be a wasting asset and, therefore, not depreciable and the rate of return should only reflect the opportunity cost of the capital invested: the return on the land value.
What are the two methods of handling the depreciation of the building?
Two primary methods of handling depreciation are described in the appraisal literature. These include:
1. The Hoskold method
2. The Inwood method
The recovery of capital can be obtained through the accumulation of a ____________
The recovery of capital can be obtained through the accumulation of a sinking fund.
In this method the recovery of capital takes the form of an annuity which accumulates at the same rate as the return on the capital (k).
ANSWER: The Inwood Premise
How does the Hoskold premise differ from the Inwood premise?
The Hoskold premise differs from the Inwood premise in that it employs two separate interest rates: a speculative rate, representing a fair rate of return on capital commensurate with the risks involved, and a safe rate for a sinking fund designed to return all the invested capital to the investor in a lump sum at the termination of the investment.
What is the procedure for the land residual method?
The procedure for the land residual method is as follows:
Estimate the value of the building VB (any approach will do: income, cost, or market).
Allocate the total NOI for the property to the building (NOIB) and to the land (NOIL).
Estimate the value of the land (VL) through the direct capitalization of NOIL. The value of the land is the capitalized value of the residual NOIL.
Finally, you obtain the full value through the identity V = VB + VL
The method which is often used by real estate developers to determine the value of land is an application of residual method called ________, or the ____________.
The method which is often used by real estate developers to determine the value of land is an application of residual method called developer’s residual analysis, or the development method of appraisal.
Provide a general overview of the development residual method.
The land residual can be calculated under several different frameworks, but all of these have a similar theme: calculate the income expectations for the developed land, subtract all expenses associated with this development, and the remainder is the land residual.
Give the specific procedure, outlining the income and expenses in determining the land residual DEVELOPMENT RESIDUAL METHOD?
Gross value upon completion (1)
- costs of sale (2)
Net value upon completion
- *- hard costs (3)
- soft costs (4)
- development financing costs (5)**
- *- developer’s profit (6)**
- *Residual to land and land financing cost (7)
- Land financing cost (8)**
Land residual (9)
This is the forecast for the maximum cash flow that the property will generate when completed.
ANSWER: Gross Value Upon Completion
Costs of Sales include such items as _ _ _ _ _
Costs of Sales are expenses required when selling real estate, and include items such as real estate commissions and legal fees. Marketing costs are also often included in costs of sale, as large development projects often require considerable promotional expense to facilitate their sale.
