REQUIRED RATE OF RETURN

REQUIRED RATE OF RETURN

-The property owner is an investor; they could invest the same money in other investments

-an investor must look at the following attributes and compare these attributes among investments.

1. Risk: the likelihood that their return and/or their original investment of money will increase, decrease, or stay the same.

2. Management Requirements: the amount of time and effort they must invest in order to receive a return and protect the money they have put into the property.

3. Liquidity: the ease with which they can convert the asset to cash.

-After an investor has considered each of these attributes for a particular investment, they can estimate a return on that investment that they would be satisfied earning

-As all investors react in the same way to risk, management requirements, and liquidity, their collective decisions allow investments to be categorized into different return classes

-The appraiser’s classifications cannot remain stagnant because these attributes will change over time and among investments; as they change, so will the required return.

Relationship Between Income, Sale Price and Return/Yield

-The return an investor earns on an investment is also referred to as the investor’s yield.

- assuming interest payments remain the same, when the price paid for a bond falls, the return or yield earned on the bond rises.

-Conversely, when bond prices rise, yields fall.

-Bond prices and their associated yields are inversely related.

CAPITALIZATION PROCESS: MARKET VALUE

-In the income approach of appraisal, the market value for any particular real estate property is determined by the yields prospective purchasers reasonably expect to earn.

-Prospective purchasers base their return expectations on the yields earned on similar investments; similar in terms of risk, management requirements, and liquidity.

-To estimate the market value of an apartment building, the appraiser must establish:

1. the net operating income (NOI) the property will earn; and

2. the return (measured as a percentage of price) purchasers currently require in sales of similar properties with similar risk.

-After NOI is calculated, it is converted to market value, expressed as a capital sum.

-This conversion from net operating income to a capital amount is referred to as the capitalization process.

-To apply the income approach of appraisal, the appraiser must use the sale prices and net operating incomes of comparable properties to estimate the required yield for this type of property.

-The yield the appraiser derives from the comparables is then called a capitalization rate when it is applied to the net operating income of the subject property.

-The appropriate capitalization rate for any given case is best obtained by analyzing actual sales prices and reliable estimates of net operating income for recent sales of similar income-producing properties.

-the capitalization rate should reflect the difference in the comparables and the subject property.

Comparative Security of Real Estate Investments

-is possible to classify types of real estate in some order of security and to indicate the relative yields expected.

-Where a property is not expected to continue in its current use for as long as can be predicted or in more complex valuation assignments such as a hotel, it would be inappropriate and misleading to apply the income approach as described here.

-In this case, a rate derived by discounted cash flow (DCF) that considers changes in income and expenses over time including tax and debt, is more appropriate. → beyong this scope