Reading 31: Types of Real Estate Investment

Question 1

What types of properties are classified as Commercial real estate?

Answer 1

1. Office
2. Industrial/Warehouse
3. Retail
4. Hospitality
5. Parking facilities/restaurants/Recreational Propoerties

Question 2

What are some reasons to invest in Real Estate?

**Critical Concept**

Answer 2

1. Current Income
2. Capital Appreciation
3. Inflation Hedge
4. Diversification
5. Tax benefits

Question 3

What are the principal risks of investing in Real Estate?

**Critical Concept**

Answer 3

1. Business Properties
2. New property lead time
3. Cost and availability of capital
4. Unexpected inflation
5. Demographic factors
6. Lack of liquidity
7. Environmental issues
8. Availability of information
9. Management expertise
10. Leverage

Question 4

For the 4 main types of Commercial Properties, what is the main factor that determines value?

**Critical Concept**

Answer 4

1. Office - demand is heavily dependent on job market
2. Industrial - demand is heavily dependent on the overall economy, especially import/export activity
3. Retail - demand is dependent on consumer spending
4. Multi Family - Demand depends on population growth, especially in the age that generally rents

Question 5

Appraisers use these three approaches to valuing real estate..

**Critical Concept**

Answer 5

1. Cost Approach
2. Sales Comparison Approach
3. Income Approach

Question 6

Describe the Cost Approach to Real Estate Valuation

**Critical Concept**

Answer 6

1. The premise is that a buyer would not pay more for a property than it would cost to purchase the land and construct a comparable building.
2. Value is derived by adding the value of the land to the current replacement cost of a new building less adjustments for estimated depreciation and obsolescence
3. Is most useful when the subject property is relatively new
4. Often used for unsual properties or properties where comparable tranactions are limited

Question 7

Describe the Sales Comparison Approach to Real Estate Valuation

**Critical Concept**

Answer 7

1. Premise is that a buyer would pay no more for a property than others are paying for similar properties
2. The sale prices of similar (comparible) properties are adjusted for differences with the subject property
3. Is most useful when there are a number of properties similar to the subject that have recently sold

Question 8

Describe the Income Approach to Real Estate Valuation

**Critical Concept**

Answer 8

1. Value is based on the expected rate of return required by a buyer to invest in the subject property
2. Value is equal to the present value of the subject’s future cash flows
3. Most useful in commercial real estate transactions

Question 9

What are the two different valuation methods used in the Income Approach and explain them….

**Critical Concept**

Answer 9

1. Direct Capitalization Method - value is based on capitalizing the first year NOI of the property using a capitalization rate
2. Discounted Cash Flow Method - value is based on the present value of the property’s future cash flows using an appropriate discount rate

Question 10

What is NOI (Net Operating Income) and how is it calculated?

**Critical Concept**

**PROBLEM**

Answer 10

• The amount of income remaining after subtracting vacancy and collection losses, and operating expenses from potential gross income

Question 11

A 50-unit apartment building rents for $1,000 per unit per month. It currently has 45 units rented. Operating expenses, including property taxes, insurance, maintenance, and advertising, are typically 40 percent of effective gross income. The property manager is paid 10 percent of effective gross income. Other income from parking and laundry is expected to average $500 per rented unit per year.

Calculate the NOI.

Answer 11

Question 12

NOI is expected to be $100,000 the first year, and after that, NOI is expected to increase at 2 percent per year for the foreseeable future. The property value is also expected to increase by 2 percent per year. Investors expect to get a 12 percent IRR given the level of risk, and therefore, the value is estimated using a 12 percent discount rate.

What is the value of the property today (beginning of first year)?

Answer 12

V = NOI / (r-g)

= 100,000 / (0.12-0.02)

= 1,000,000

Question 13

What is the capitalization rate (cap rate) and how is it calculated??

**Critical Concept**

***PROBLEM***

Answer 13

Question 14

The Net Operating Income for an office building is expected to be $175,000, and an appropriate cap rate is 8%. Estimate the market value of the property using the direct capitalization method…..

Answer 14

= 175,000 / 8%

= $2,187,500

Question 15

Beginning Jan1, renovation began on a shopping center. The NOI is forecast to be $6Million. Absent renovations, NOI would have been $10Million. After this yr, NOI Is expected to increase 4% annually. Assuming all renovations are completed by the seller at their expense, estimate the value of the shopping center assuming a 12% required rate of return.

Answer 15

Value after renovation: = Stabilized NOI / cap rate = 10,000,000 / (12%-4%)

= $125,000,000

Present Value of NOI during renovation:

N=1,I = 12, PMT = 0, FV = 4,000,000, -> PV = 3,571,429

Total Value of shopping center:

Value after renovation = 125,000,000

Loss in value during reno = -3,571,429

Total Value = 121,428,571

Question 16

How do you calculate the discount rate used in the Discounted Cash Flow Method?

**Critical Concept**

Answer 16

= cap rate + growth rate

Question 17

Because of an existing leasse, the NOI of a warehouse is epected to be $1Million per year over the next 4 years. Beginning in the 5th yr, NOI is ecpted to increase to $1.2Million and growth 3% annually. Assuming investors require a 13% return,calculate the value of the property today assuming the warehoue is sold after 4 years

Answer 17

Present Value of NOI:

N = 4, I = 13, PMT = 1,000,000 , FV = 0, -> PV = 2,974,471

Terminal Value after yr4: V₄ = NOI₅ / cap rate = 1,200,000 / (13%-3%)

= 12,000,000

Present Value of Terminal Value:

N = 4, I = 13, PMT = 0, FV = 0, -> PV = 7,359,825

Total Value of Wharehouse today:

PV of forecast NOI = 2,973,471

PV of terminal value = 7,359,825 = sum = 10,334,296

Question 18

How does the Term and Reversion Approach deal with the Reversionary Potential problem?

Answer 18

the contract(term) rent and the reversion are appraised seperately using different cap rates

Question 19

A single tenent office building was leased six years ago at 200,000 per yr. The next rent review occurs in 2 years. The estimated rental value (ERV) in two year based on current market conditions is 300,000 per yr. The all risks yield (cap rate) for the comparable fully let properties is 7%. Because of lower risk, the appropriate cap rate to discount the term rent is 6%. Estimate the value of the office building…

Answer 19

PV of Term Rent:

N = 2, I = 6, PMT = 200,000 , FV = 0, -> PV = 366,679

Value of Reversion to ERV:

V₂= ERV₃ / ERV cap rate = 300,000 / 7% = 4,285,714

PV of Reversion to ERV:

N = 2, I = 7, PMT = 0 , FV = 4,285,714, -> PV = 3,743,309

Sum the two Present Values = 366,679 + 3,743,309 = 4,109,988

Question 20

Using the discounted cash flow methods requires making these estimates and assumptions…..

**Critical Concept**

Answer 20

1. Project income from existing leases
2. Lease renewal assumptions
3. Operating expense assumptions
4. Capital expenditure assumptions
5. Vacancy assumptions
6. Estimated resale price
7. Appropriate discount rate

Question 21

What are some common errors made using the DCF method?

Answer 21

1. The discount rate does not adequately capture risk
2. Income growth exceeds expense growth
3. The terminal cap rate and the going-in cap rate are not consistent
4. The terminal cap rate is applied to NOI that is atypical
5. The cyclicality of real estate markets is ignored.

Question 22

Describe the Cost Approach

**Critical Concept**

Answer 22

The cost approach involves estimating the market value of the land, estimating the replacement cost of the building, and adjusting for depreciation and obsolescence.

Is often used for unusual properties or properties where comparable transactions are limited

Question 23

What are the 3 steps in using the cost approach?

**Critical Concept**

Answer 23

1. Estimate the market value of the land. Often done using the sales comparison approach
2. Estimate the building’s replacement cost
3. Deduct depreciatiom including physical deterioration, function obsolescence, locational obsolescence and economic obsolesence

= land value + (replacement building cost + developer’s profit) – deterioration – functional obsolescence – locational obsolescence – economic obsolescence

Question 24

Real Estate investors usually perform due diligence to confirm the facts and conditions that might affect the value of the transaction. Due diligence may include these things…….

Answer 24

1. Lease review and rental history
2. Confirm the operating expenses by examining bills
3. Review cash flow statements
4. Obtain environmental report
5. Perform a physcial/engineering inspection to identify structural issues
6. Have property surveyed
7. Verify payment of taxes, insuraance and other expenditures

Question 25

If the Income/Value is constant, what is the growth rate given the below data? * Going in cap rate = 5.25% * Terminal Cap Rate = 6.00% * Discount Rate = 7.25%

Answer 25

Growth Rate = Discount Rate - Going-in cap rate = 7.25% - 5.25% ►2.00%

Question 26

Why are appraisals often used to create real estate performance indices?

Answer 26

Because properties do not transact very frequently, it is more difficult to create transaction-based indices as is done for publicly traded securities. Appraisal-based indices can be constructed even when there are no transactions by relying on quarterly or annual appraisals of the property. Of course when there are no transactions, it is also difficult for appraisers to estimate value.

Question 27

How is an Appraisal-Based index like the NCREIF Property Index (NPI) calculated?

Answer 27

return = _NOI - cap ex + (end MV - beg MV)_ beg MV

Question 28

What are the two kinds of Transaction-based Indices? \*\*Critical Concept\*\*

Answer 28

1. _Repeat-Sales Index_ - relies in repeat sales of the same property. A regression is then developed to allocate the change in value to each qtr 2. _Hedonic Index_ - requires only one sale. A regression is developed to control for the difference in property characteristics such as size, age and location

Question 29

What are the two ratios lenders often use to determine the maximum loan amount on a specific property? \*\*Critical Concept\*\*

Answer 29

1. Debt Service Coverage Ratio (DSCR) 2. Loan-to-vale (LTV)

Question 30

How are the debt service coverage ratio (DSCR) and loan to value (LTV) calculated? \*\*Critical Concept\*\*

Answer 30

Question 31

A real estate lender agreed to make a 10% interest only loan on a property that was recently appraised at $1,200,000 as long as the debt service coverage ration is at least 1.5 and the loan-to-value does not exceed 80%. Calculate the maximum loan amount assuming the property's NOI is $135,000 \*\*Critical Concept\*\* \*\*Problem\*\*

Answer 31

**_Loan Amount support by LTV ratio_** = (1,200,000 \* 80%) = 960,000 **_Using DSCR, debt payment property will support_** : 135,000 / 1.5 = 90,000 The implied loan amount = 90,000 / 10% = 900,000 Since 900,000 At 900,000, the LTV = 900,000/1,200,000 = 75% At 900,000, the DSCR = 135,000/90,000 = 1.5

Question 32

A $1,200,000 property is financed with 900,000 debt and 300,000 equity. The debt is interest only 10%. Assume the Net Operating income is 135,000. Calculate the **Equity Dividend Rate**?

Answer 32

**_Calculate the first yr cash flow_** = NOI - Debt service = 135,000 - 90,000 **_Equity Dividend Rate_** = first yr cash flow / equity = 45,000 / 300,000 = 15%

Question 33

What is the net rent equivalent for an office building where the gross rent is $20 per square foot and operating expenses are $8 per square foot?

Answer 33

**_Remember_** : on a gross lease the owner of the building pays the operating expenses, on a net lease the renter does At the maximum the rent on a net lease basis would be (20-8) = 12 In reality, it will be even lower than this due to the risks of unexpected operating expenses

Question 34

What is the main difference between direct capitalization and discounted cash flow (DCF) analysis?

Answer 34

Direct capitalization applies a capitalization rate or an income multiplier to the forecasted first-year NOI. Thus, expected increases (growth) in NOI in the future must be implicit in the multiplier or cap rate. In contrast, when doing a DCF, the future cash flows are projected each year until sale of the property. Then each year’s cash flow and the expected resale proceeds are discounted using a discount rate. Thus, the future income pattern, including the effect of growth, is explicit in a DCF. Furthermore, DCF often considers other cash flows that might occur in the future that are not reflected in NOI, such as capital expenditures.