Real Estate Valuation and Income Analysis: Key Concepts and Approaches

Market Value

the most probable selling price, assuming "normal" sales conditions.

"How much would most buyers pay right now?"

Market Rent

the most probable rental rate, assuming "normal" leasing conditions.

"How much would most tenants rent for right now?"

Investment Value

value to a particular individual (investor); considers their specific financial situation.

Transaction Price

Price actually paid for a specific property

Contract Rent

How much a specific tenant is actually paying.

Three approaches to Real Estate Valuation:

Cost Approach

Sales Comparison Approach

Income Capitalization Approach.

Cost Approach

What would it cost to replace the asset?

Sales Comparison Approach

What are similar assets selling for?

Income Capitalization Approach

What is the present value of the anticipated income?

What is real estate income primarily generated from?

Rents generated by a lease agreement.

What are leases considered in the real estate industry?

The 'economic engines' that drive the real estate industry.

Underlying Assumption

The value of a real estate asset can be estimated from the present value of its future anticipated income.

Value depends on:

Timing

Size

Risk

(Timing) Single-Year Proforma

Direct Capitalization

(Timing) Multi-Year Proforma

Yield Capitalization

(Size) Net Operating Income

Direct cap and Yield cap

(Size) Reversion

Yield Cap

(Risk) Overall Cap Rate

Direct Cap

(Risk) Discount Rate/Terminal Cap Rate

Yield Cap

Internal Risk Factors

Building component failure (Property-specific)

External Risk Factor

Economic downturn (impact the entire market)

Tenant Quality

Ability to meet future lease obligations (National credit tenants pose a lower payment risk than small, local tenants)

Actual NOI

(Observation)

- Proven, current or backward looking

- based on contract rent, current vacancy and expenses

- If the property is stabilized, actuals and stabilized income will be the same.

Proforma NOI

(Assumption)

- unproven, forward looking

- Assumes that rent, vacancy, and expenses are at market.

- Riskier than actual income because it has not been proven.

Income Approach Two Methods:

Direct Cap and Yield Cap

Direct Cap

Divide a single year of income by a Cap rate

Yiel Cap

(Discounted Cash Flow)

- Add multiple years of discounted income and the sale price of the property at the end of the holding period (reversion)

Inverse Relationship

- Rate goes down, value goes up

- Rate goes up, value goes down

Operating Statement

standardized report that shows exactly how much cash moves from the tenants' pockets to the landlord's bank account. (Financial funnel)

Pro forma

a projected (forward looking) income and expense statement

Operating Funnel

Potential Gross Income (PGI): The "Dream." Total rent if every unit is 100% full at market rates.

(-) Vacancy & Collection Loss (VCL): The "Reality Check." Subtract money lost to empty units or "deadbeat" tenants.

(+) Miscellaneous Income: Extra cash from parking, laundry, or vending machines.

Result: Effective Gross Income (EGI) (The actual check the landlord deposits).

(-) Operating Expenses (OpEx): The "Bills." Taxes, insurance, utilities, and management fees.

(-) Capital Expenditures (CapEx): The "Big Fixes." Money set aside for the roof, parking lot, or HVAC.

Result: Net Operating Income (NOI) (The "I" in your $V = I/R$ formula!).

Potential Gross Income (PGI)

The total income attribution to property at full occupancy before vacancy and operating expenses are deducted.

- rental income assuming 100% occupancy

- if there are no existing leases, we can base PGI on Market Rent

Vacancy and Collection Loss (VCL)

A deduction from potential gross income (PGI) made to reflect income reductions, due to vacancies, tenant turnover, and nonpayment of rent.

Market Vacancy

The actual amount of vacant rentable area in a market or submarket, expressed as a percentage of all rentable space. (changes over time based on the balance of supply and demand)

Vacancy Sources

- Management and leasing agents

- Rent comparables

- Sales comparables

- Published surveys

- History of the subject property

Effective Gross Income (EGI)

The anticipated income from all operations of the real estate after an allowance is made for VCL and an addition is made for any Other Income.

Operating Expenses

The periodic expenditures necessary to maintain the real estate and continue production of the EGI assuming prudent and competent management.

NOT Considered OpEx:

- Interes

- Tax (income)

- Depreciation

- Amortization

EBITDA

Earnings before interest, taxes, depreciation, and amortization

Fixed Expenses

Do not vary with occupancy

- ex: real estate tax and property insurance

Variable Expenses

Do vary with occupancy

Pro Rata

is the percentage of the building that a specific tenant occupies.

Property Insurance

A personal contract to indemnify the insured party for a potential loss; specific coverages relate to the asset insured or the potential hazard

Common Area Maintenance

The expense of operating and maintaining Common Areas; may or may not include management charges and usually does not include capital expenditures on tenant improvements or other improvements on the property.

3rd Party Management

Calculated as a percentage of EGI

Capital Expenses (CapEx)

Non-recurring expenditures that increase value of structure and prolong its Useful Life:

- Roof replacement

- HVAC Replacement

- Resurfacing of parking areas

Net Operating Income (NOI)

This is the most important number in real estate

Market Extraction (Sale Comparables)

Its imperative that each comp is as similar to the subject as possible

Investor Surveys

Typically Updated quarterly, biannually, or annually

Finacial Capital

Any economic resource used in the conduct of businesses operations

Two sources of financing for any asset:

Debt and Equity

Equity

the investor portion

- a down payment is a form of equity

Investors expect to receive returns in two forms:

rental income (NOI)

growth (appreciation)

Debt

the lender portion

- a mortgage is a form of debt contribution

- lenders expect to receive returns in the form of interest payments and fees

Overall Cap Rate

- a way to describe the relationship between the income and the value with a single number

- a current income yield rate applied to a single year's NOI

DCF Analysis Steps:

1. Determine holding period

2. Calculate future cash flows

3. Calculate Reversion

4. Discount and add all cash flows

Reversion

a lump-sum benefit that an investor receives or expects to receive upon the termination or sale of an investment.

Terminal Cap Rate

Rate used to convert annual net cash at the end of an expected holding period into an estimate of future sale price.

Discount Rate

A rate of return on capital; used to convert future payments or receipts into present value

Risk-free rate

- Minimum risk on any investment

- Return on a "riskless" investment

Risk premium

- Additional risk associated with a particular asset

- the most complex and sensitive variable to determine in any valuation exercise

Who pays what?

Lease structures vary depending on which OpEx are included in the rent paid by the tenant

Escalation

Periodic increases in the contract rental rate