R305 Exam #1

What are the classifications of income property?

residential and non-residential property

What is residential real estate?

single family or multifamily

What are the types of non-residential real estate?

commercial, industrial, special purpose, etc.

What skills are needed to work in the real estate field?

analytical, people skills + creativity

What are the career paths in the real estate field?

brokerage and leasing, residential agent, appraiser, underwriter, investment and development, property management, corporate real estate, mortgage and construction lending, institutional real estate investment and asset management

Cash Flow Model

Gross Rental Income

__- Vacancy__

Effective Gross Income

__- Operating Expenses__

Net Operating Income

__- Debt Service__

Cash Flow (before tax)

Risk Premiums

Risk-free short-term rate (prior to inflation)

\+ Expected annual inflation

\+ Liquidity risk premium

__+ Economic, business, & political or other risk premiums__

Investor’s desired return or discount rate

What is the risk level for real estate?

moderate to low

What is the current yield level for real estate?

moderate

What is the appreciation potential level for real estate?

slow

What is the total return level for real estate?

moderate

What is the inflation protection level for real estate?

excellent

How do you calculate leverage?

What is port?

What is risk?

Risk is the possibility that actual outcomes will vary from what was expected when the asset was purchased

How is risk understood or quantified?

Using time-value-of-money techniques

How is risk avoided or managed?

What is the price of risk?

What is a common way to measure risk?

One common way to measure risk is through volatility such as the variance of past returns from a particular type of investment over a given historical period

What are the causes of risk?

economic, liquidity, political, business or management risks, or financing reasons

What are the sources of returns and risk?

* Cash flow
* Tax shelter
* Equity build up from amortization of the debt
* Value increase or decrease
* Partitioning the IRR
* Changing the RRR or Discount Rate

What are other risk considerations?

* Sensitivity analysis
* Due diligence - is the risk acceptable or avoidable?
* Real estate cycles and risk

What are the phases of the real estate cycle?

Phase 1: Recovery

Phase 2: Expansion

Phase 3: Hypersupply

Phase 4: Recession

What is the recovery phase?

Declining vacancy, little construction, and increasing rents

What is the expansion phase?

Increasing rents and increasing construction

What is the hypersupply phase?

Rental growth, slows or stops while construction continues further softening the market until vacancy inc. to the point where rent starts to decline

What is the recession phase?

Rents decline and construction stops. Beginning of phase 1

What is leverage?

It is the use of debt to finance an equity investment. It magnifies the risk and return performance of the equity

What is capital structure?

It is the proportion of equity to debt in the transaction

What is the formula for leverage ratio?

Value/Equity

What is the effect of leverage on risk and return to equity?

What is positive leverage?

What is negative leverage?

What is the expectation of equity investors in real estate?

Equity investors in real estate expect to receive a return on their investment through the collection of rent and through price appreciation

What are debt participants?

The debt participants are the lenders. They hold claims to interest on borrowed funds that are secured by individuals, businesses, and property

What is the purpose of property markets?

Property markets determine the required property-specific investment returns, property values, capitalization rates, and construction feasibility

What is capitalization rate?

It is a fundamental pricing metric in commercial real estate markets. It is the ratio of a property’s annual net income from rental operations to its value

What is the goal of market analysis?

It is to develop market-specific knowledge about the factors that affect the demand and supply of properties similar to the subject and to use that knowledge to forecast how real estate values are likely to change over time

How is interest calculated for each month?

(Loan Amount x Interest Rate)/12

How do you calculate available loan amount?

(NOI/Debt Service Coverage Ratio)/12 = Monthly Debt Service

For the monthly loan constant, solve for monthly payment

Monthly DS/Monthly Loan Payment = Available Loan

How is Debt Service calculated?

NOI - BTCF = DS or NOI/DSC = DS

How is Potential Gross Income calculated?

EGI/(1 - vacancy %) = PGI

How is Breakeven Point calculated?

(OE + DS)/PGI = B/E

How is the “going-in” cap rate based on the asking price calculated?

NOI/Purchase Price

How is the operating expense to EGI ratio calculated?

Annual Operating Expenses/(PGI(1 - vacancy %))

What is the GRM approach?

Why does the PV = -1 when solving for the monthly payment to find the annual loan constant?

Because you are looking at this from the lender’s perspective

How is the annual loan constant calculated?

Solve for the monthly payment using PV = -1 as the present value

Multiply the monthly payment by 12 to find the annual percentage

How is Net Operating Income calculated?

(PGI x (1 - vacancy %)) - Operating Expenses

What is incurable depreciation?

How is incurable depreciation calculated?

How is Total Depreciation calculated?

Curable Depreciation + Incurable Depreciation = Total Depreciation

How do you calculate Debt Coverage Ratio?

NOI/DS = DCR

What is financial risk?

The risk that NOI will be less than debt service

What is default risk?

The risk that borrowers will cease to make timely payments of principal and interest, as required by the mortgage contract

What is the most significant risk faced by commercial mortgage lenders?

The signature risk of commercial mortgage lending is default risk. Putting aside transaction costs and other considerations, commercial borrowers with nonrecourse mortgages are more likely to default on their loans if the value of the property falls below the value of the remaining mortgage balance

What is market value?

Real estate appraisers generally define the market value of a property as its most probable selling price, assuming “normal” sale conditions

* It can be estimated from observed transaction prices of similar properties

What are the methods that provide a means for estimating a property’s market value without directly considering the property’s income-producing potential?

the sales comparison approach and the cost approach

What is investment value?

It is the value a particular investor places of a property

What is a buyer's investment value?

The maximum that he or she would be willing to pay for a particular property

What is a seller’s investment value?

The minimum he or she would be willing to accept

How are market value and investment value different?

Although the methods used to estimate investment value and market value are similar, analysts who determine investment value apply the expectations, requirements, and assumptions of a particular investor, not the expectations of the typical market participant

What are the steps to the valuation process? ???

Step 1: Identify the Appraisal Problem

Step 2: Determine the Required Scope of Work

Step 3: Collect Data and Describe Property

Step 4: Perform Data Analysis

Step 5: Determine Value of Land

Step 6: Apply Three Approaches to Valuation

Step 7: Reconcile Indicated Values from Three Approaches

Step 8: Report Final Value Estimate

How is highest and best use of a property defined?

that use found to be (1) legally permissible, (2) physically possible, (3) financially feasible, and (4) maximally productive

What is the purpose of highest and best use analysis?

It is central to the estimation of market value, primarily because it serves as the foundation for identifying comparable properties

What is the principal idea of highest and best use?

The principal idea is that the market value of a property is a function of its most productive use

How is land valued?

Land, vacant or not, is always valued as though vacant and available for development to its highest and best use. The value attributed to the land is the total estimated value of the property, assuming its highest and best use, less the estimated value of the anticipated improvements

What is highest and best use of the property as improved?

This is when the appraiser looks at the value of land as it is currently developed to help the appraiser identify the appropriate comparable data to select in valuing the property

What is the purpose of highest and best use of the property as improved?

It may help to determine whether the existing improvement should be retained, modified, or demolished

What is the sales comparison approach applicable to?

It is applicable to almost all one-to-four family residential properties and even to some types of income-producing properties where enough comparable sales are available

What is the income approach?

It is the dominant approach when estimating the value of income-producing property. It assumes a property’s value is determined by its expected future cash flows

What is the cost approach?

It involves estimating the cost of replacing the property new, and then subtracting the loss in value due to physical, functional, and external obsolescence the property has suffered

When is the cost approach typically used?

It is relied on more when reliable comparable sales or income data are absent. It is the approach most relied upon for valuing specialty properties such as education facilities, places of worship, or special-purpose government properties (parks, monuments, etc)

What is the preference for methods of appraisal?

1. Sale of Comparable Properties
2. Income Approach
3. Cost Approach

What is reconciliation?

This is a procedure that uses each of the three approaches to value to assign a final (single) estimate of market value. The appraiser weighs the relative reliability of value indicator for the property being valued

What are the steps in the sales comparison approach?

Step 1: Identify elements of comparison and value adjustment

Step 2: Select comparable sales

Step 3: Adjust comparable sales prices to approximate subject

Step 4: Reconcile adjusted sale prices; obtain indicated value of subject

\`What are the categories of adjustment for the sales comparison approach?

transactional adjustments and property adjustments

What is the purpose of adjustments in the sales comparison approach? How is this done?

The goal of these adjustments is to convert each comparable sale transaction into a closer approximation of the subject property. If the comparable property is inferior to the subject property with respect to important characteristics, the comparable property’s sale price would be adjusted upward

What are transactional adjustments?

These concern the nature and terms of the deal. These potential influences on the bargaining position or motivation of the buyer, seller, or both can affect the negotiated price, regardless of the physical, economic, and locational characteristics of the property

What are the five reasons for transactional adjustments?

1. Property rights conveyed
2. Financing terms
3. Conditions of sale
4. Expenditures made immediately after purchase
5. Market conditions

What are property adjustments?

These recognize that the location, physical, and economic differences between properties, plus the ways in which the properties are used and the presence or absence of personal property, all can add or subtract incrementally to a base value

What are the five reasons for property adjustments?

1. Location
2. Physical characteristics
3. Economic characteristics
4. Use
5. Nonrealty items

How are adjustments applied?

Transactional adjustment are generally applied first and in the order of the types. Then, property adjustments are applied but in no particular order. This sequence matters if percentage adjustments are involved. Each adjustment is made to the adjusted price of the comparable property, not the sale price of the comparable

What is the final step in obtaining an indicated opinion of value of the subject property from the sales comparison approach?

To reconcile the final adjusted sale prices of the comparable properties

What does it mean to reconcile value at the end of the sales comparison approach?

The appraiser considers which, if any, of the comparable properties are better indicators of the subject property’s value. More complete data, fewer and smaller adjustments, and more recent transactions probably would cause the appraiser to consider the adjusted sale prices of some comparable properties to be better indicators of the value of the subject than others

What happens when the total cost to construct a property is less than its expected market value upon completion?

Developers have an incentive to build additional competing properties which tends to reduce market values

What happens when the total cost to construct a property exceeds its expected market value?

Developers have the incentive to stop or slow construction, which tends to increase the market value of competing properties

Cost Approach Formula

Estimated cost to construct structure today

__- Estimated accrued depreciation__

Depreciated cost of building improvements

__+ Estimated value of land__

Indicated market value by the cost approach

What is the cost approach?

The cost approach to valuation is based on the economic principle of substitution and assumes the market value of a new building is similar to the cost of constructing it today. The appraiser subtracts all elements of accrued depreciation from today’s current value

What are the types of construction cost estimates?

reproduction cost and replacement cost

What is reproduction cost?

It is the expenditure required to construct the building today, replicating it in exact detail

What is replacement cost?

It is the expenditure needed to construct a building of equal utility to the existing building

What is the theoretical basis for the cost approach to valuation?

reproduction cost

* However, replacement cost is most often used because it is easier to obtain

What is accrued depreciation?

The difference between the current market value of a building (or improvement) and the total cost to construct it new

What is physical deterioration?

This represents the loss in value of a building over time associated with the aging and decay of its physical condition

What is functional obsolescence?

It is a loss in the value of a structure due to changes in tastes, preferences, technical building innovations, or market standards

What is external obsolescence?

It reflects the loss in market value due to influences external to the site. It results from a deterioration in the subject property’s neighborhood

To what extent are markets efficient?

Markets are efficient to the extent that all of the available information is reflected in the current market prices

Do efficient markets have trading?

* Efficient markets have no trading (buying or selling) based on inside information
* They do not require universal agreement, but among those interested in buying, selling, or holding there are no informational advantages

What do efficient markets consider?

* Efficient markets consider all of the expectations influencing demand or supply
* Over the last few decades the quality and quantity of current market information has substantially improved