Real Estate Valuation

Question 1

Describe a profit and loss statement for a real estate property.

Answer 1

It has 3 main sections:
gross income
- operating expense
= net operating income (NOI).

Question 2

What is included in gross income in a P&L statement of a real estate property?

Answer 2

The gross income includes rental income along with any other types of income received from the property. Other forms of income may include pet fees, laundry, late fees, covered parking, etc.

Question 3

What is included in operating expenses in a P&L statement of a real estate property?

Answer 3

Operating expenses include all of the costs and expenses of owning and operating rental real estate. Different property types have different operating expenses.
Some common examples include property taxes, property insurance, management fees, cleaning and maintenance, repairs, supplies, leasing commissions, licenses and permits, professional fees, garbage removal, utilities…

Question 4

Describe the 3 types of development costs.

Answer 4

1)Acquisition costs - the amount paid for the fixed assets and all expenses related to the acquisition.
2) Hard costs - ‘brick-and-mortar’ expenses - any costs involved in the physical construction of a project.
3) Soft cost - all other costs that are not hard. Market research, consulting insurance, marketing/sales…

Question 5

What is land impact? How is it calculated?

Answer 5

Price of the land / sqm to be built above ground.

Question 6

What is the gross construction index?

Answer 6

It is the amount of sqm allowed to be developed per sqm of surface area in a plot.

Question 7

What is the universal formula for yields in real estate?

Answer 7

YIELD = annual NOI / sales price (aka market value).

Question 8

What is the gross yield?

Answer 8

The ratio of the property’s gross rental income to its market value.
GROSS YIELD= TOTAL INCOME / PURCHASE PRICE

Question 9

What is the net initial yield?

Answer 9

It is the initial net income at the date of transaction or valuation expressed as a percentage of the sale price or valuation.
TRIPLE NET INITIAL YIELD = (NOI/ (Purchase Price + Acq Cost + Capex))
SEMI NET INITIAL YIELD = (NOI / (Purchase Price+Capex))

Question 10

What is the running yield?

Answer 10

It is the current income return that an investor can expect to earn in the current year, taking into account both rental income and expenses
RUNNING YIELD = (Gross Income - Expenses) / Market Value

Question 11

What is the exit/prime/market yield?

Answer 11

It is the yield an investor expects to achieve at the time of sale or disposition of a property, assuming that the property’s net operating income (NOI) remains constant after the sale
Exit Yield = NOI at sale / Expected sale price

Question 12

What are real estate valuations used for?

Answer 12

Financing, appraisal for litigation, due diligence, accounting, acquisition/exchange, and IPO.

Question 13

What are the 4 main valuation methods in real estate?

Answer 13

1) Comparison
2) Residual
3) Capitalization
4) DCF

Question 14

When do we use a
a) the comparison method
b) the residual method
c) the DCF method
d) the capitalization method

Answer 14

a) Comparison method can be used in all scenarios.
b) The residual method is used for land and Work-in-Progress property.
c) DCF or capitalization methods are used for rental properties and operating real estate assets.

Question 15

Describe the comparison/comparable/benchmark method.

Answer 15

The Sales Comparison Approach (SCA) is a common method used to determine the value of a property by comparing it to recently sold properties in the same area that are similar in terms of features, location, and physical characteristics. The SCA assumes that a property’s value is directly related to the value of similar properties that have recently sold.
In every valuation method, the comparable method is always used as a complement to check for values.

Question 16

What are the shortcomings of the comparison method?

Answer 16

1) There are differences in quoting prices (valuators) vs closing prices.
2) Data can be interpreted differently: headline versus net effective rent, definition of areas…
3) There is a lack of knowledge of each specific deal - every transaction is unique.
4) Requires subjective objectives since no properties are the same.

Question 17

Describe the residual method.

Answer 17

The residual land value is calculated by estimating the value of the completed project and subtracting the cost of construction and any other expenses.
Market Value is obtained by deducting from the estimated sales value of the development to be developed, all the development costs as well as the developer’s profit.
The developer’s profit can be measured in terms of profit over cost (static residual) or in terms of IRR profitability (dynamic residual).

Question 18

What are the shortcomings of the residual method?

Answer 18

1) It is hard to be accurate when estimating costs.
2) We don’t consider time value of money (IRR).
3) We have to make make revenue assumptions.

Question 19

What is the general formula for the residual method?

Answer 19

Market value = A - B - C
A = gross development value (sales amount)
B = development costs
C = developer’s profit.

Question 20

How is (A) gross development value (sales amount) in the residual method obtained?

Answer 20

It is generally obtained through the Comparison Method = by carrying out a market study of comparable developments by use and location. Or by the Capitalization Method.

Question 21

What are (B) development costs in the residual method?

Answer 21

Hard costs (construction costs) and additional costs (architect, engineering, quantity surveyor, project manager, geotechnical studies, health/safety control, marketing).

Question 22

What is (C) the developer’s profit in the residual method?

Answer 22

It is measured in terms of profit over the total cost of the investment (expressed as a ratio/percentage/margin).

Question 23

Describe the capitalization method and explain when do we use it?

Answer 23

It consists of applying a given rate of return to the rents that a property is estimated to generate during the 12 months following the valuation date:
The method is also used for more simple valuations: residential, car parking spaces, high street retail, industrial and retail warehouse units, or a single tenant office.

Question 24

What are the shortcomings of the capitalization method?

Answer 24

1) It is subject to lease contracts - of long duration and mandatory period.
2) Does not consider CPI, rent reviews, rents… too simplistic.
3) Requires stable income and expenses in the long term.

Question 25

What is the formula for the capitalization method?

Answer 25

MV = E (I-G) / i
I = annual income
G = annual expenses
i = yield

Question 26

Describe the DCF method.

Answer 26

This method is the most widely used in the valuation of properties in profitability.
The typical holding period analysis is 5 or 10 years. This method is used to estimate the value of an investment property by calculating the present value of the property’s future cash flows. The DCF analysis considers the time value of money and the risk associated with the investment.

Question 27

What are the shortcomings of the DCF method?

Answer 27

1) Requires a lot of assumptions.
2) It is subjective, complex, and requires a lot of data.
3) Hard to model ‘imperfections’ for multi-tenant properties, vacant spaces, void periods, unstable income…

Question 28

What is the Expected Rental Value (ERV)?

Answer 28

It is the expected rental value of the property (€/sqm) that we expect to lease at during and at the end of the forecast period.

Question 29

What does the void period refer to?

Answer 29

The VOID period refers to the expected percentage of time a property will remain vacant and unoccupied.

Question 30

What does a fit-out contribution refer to?

Answer 30

The fit-out contribution is the amount per square meter that the landlord contributes towards the cost of preparing and customizing the property for tenant use, including repainting walls, replacing furniture, and cleaning.

Question 31

What do tenant incentives (T.I.) refer to?

Answer 31

Tenant incentives (T.I.) are benefits offered by the landlord, such as rent-free periods or discounts on initial rents, to attract or retain tenants.

Question 32

What is the difference between the facial/headline and effective rent?

Answer 32

Facial or headline rent is the rent agreed upon in the contract, while effective rent is the actual rent received by the landlord after accounting for tenant incentives, fit-out contributions, and other concessions, typically resulting in a 20-25% difference.

Question 33

How is exit value calculated in the DCF method?

Answer 33

Using the capitalization method.
It is calculated by capitalizing in perpetuity the rent estimated to be generated by the property during the year following the end of the period analyzed at a rate of return (exit capitalization rate - exit yield) set at the appraiser’s discretion.
The exit capitalization rate (exit yield) is equivalent to the initial return at which the valued property would be sold at the end of the DCF period analyzed.