10/6

Three approaches to Value

• USPAP Step 6: 3 approaches to estimating market value

  • sales comparison approach—> indicated value

  • costs approach—> indicated value

  • income approach—> indicated value

• cost approach- how much would it cost to replace the subject

• sales comparison approach- how much have properties similar to the subject sold for?

• income approach- how much income does the subject generate?

  • direct capitalization (direct cap)

  • discounted cash flow (DCF)

general references for 3 approaches to value

1. income approach

   1. property must be income producing

   2. reliable income & expense data must be available

2. comparable sales approach

   1. must be active market for property type

   2. sufficient amount of sales data must be available

   3. must be comparable

3. cost approach

   1. cost must indicate value

   2. sufficient amount of cost data must be available

Cost Approach

• how much would it cost to replace the subject?

• buyers perspective

  • why would i pay $150 psf when I can build the same thing for $125 psf?

• underlying assumption

  • the cost of creating a property is related to its market value

• strengths

  • keeps real estate values rooted in the “real world”, combats asset bubbles

  • adds “developer” to perspective to analysis

• weaknesses

  • depreciation can be hard to measure

  • estimating cost requires some construciction knowledge

  • investors may not care how much it cost to build if the income meets requirements

• procedure

  • estimated replacement cost of improvements- estimated accrued depreciation= depreciation cost of building improvements+ estimated value of land= cost approach value

sales comparison approach

• how much have propertities similar to the subject sold for?

• buyers perspective

  • why would I pay $150 psf when I can build the same thing for $125 psf

• underlying assumption

  • value can be determine dby analyzing the safe prices of similar properties, becasue propertties compete for buyers and users

• strengths

  • demonstraates whether there is an active market for the subject

  • gives a range of reasonable values

• weaknesses

  • sale data is usually limited. actual similarity to the subject can vary significantly

  • knowledge of sale conditions is usually limited

  • adjustments are diccicult to quantify

  • easy to manipulate

income approach

• how much income does the subject generate?

• buyers perspective

  • will the subject supply the magnitude of income I need, at the time I need it, with the appropriate risk

• underlying assumption

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

• strengths

  • the is the primary way the market values income generating real estate assets

• weaknesses

  • value can be tied more to the likehood tenants will continue paying rent than to the underlying costs

  • deriving capitalization rates and discount rates can be highly subjective

• procedure

  • direct capitalization

    • divide a single year of income by a capitalization rate (cap rate)

  • discounted cash flow

    • add multiple years of income, discounted annually, to the safe price of the property at the end of the holding period (reversion)

income approach- direct cap

• direct capitalization

  • value is expressed as a relationship between the

    • net operating income (NOI) and the

    • capitalization rate (cap rate)                       

  • this is an inverse relationship                    

    • rate goes down value goes up

    • rate goes up, value goes down

  • similar to valuing a stock using a price/earnings multiple

direct capitalization

• IRV

  • income (NOI)= rate*value

  • rate=income (NOI)/value

  • value=income (NOI)/rate

income approach-discounted cash flows

• procedure

  • project annual cash flows (NOI) for a holding period

  • discounted year 1-10 CF at the appropriate rate

  • use year 11 CF to calculate reversion

  • add discounted cash flows or years 1-10, plus the reversion

• estimates intrinsic value based on present value of future anticipated income

how do DCF and Direct cap differ?

• both models require a calculation of net operating income (NOI), which is the “cash flow” to the owner

• direct capitalization requires:

  • first year net operating income (NOI)

  • selection of an applicable cap rate

• DCF valuation requires:

  • estimate of holing period

  • estimates of annual CF (NOI) over the holding period, including rom the reversion (expected sale of the property)

  • selection of discounted rate (based on OCC or IRR)

Real estate income and property classes

• Income approach

  • often called “income capitalization”

    • capitalize- the process of converting future income into a present value

  • our discussion will focus on existing, improved properties

  • real estate development (ground up construction) has slightly different considerations

  • value depends on…

    • magnitude of expected cash flows

    • timing of expected cash flows

    • riskiness of expected cash flows

real estate income

• in most cases, real estate income is in the form of rents generated by a lease agreement. leases are the “economic engines” that drive the real estate industry

• rent can be expressed in different ways:

  • $ per month or per year

  • $ per square foot annually

  • $ per square foot monthly

• real estae operating expenses

  • operating expense (OpEx) of real estate

    • costs associated with the operating and maintenance of income producing property

    • should include all expenditures required to operate the property and command market rents

  • most common categories of real estate operating costs:

    • property taxes

    • insurance

    • maintenance

  • by default, these costs are the responsibility of the property owner (landlord)

  • however, the responsibility for these expense is often modified by a contract (lease) between the owner (landlord) and occupant (tenant)

• lease structure- who pays what?

• full service/gross lease structures

  • tenant pays a fixed rental fee and has no obligation to pay/ reinmburse any of the landlords operating costs

    • does not modify the landlords “default” responsibility for all operating costs

    • all operating costs risk is on the landlord

    • the ret paid is “pure” rent

    • tenant pays a specified amount of money for the use of the premises

    • most common residential lease structure

    • also common in other property types. also known as a full-service lease

• net lease structures

  • tenant pays “base” rent and also reimburses landlord for some share of operating costs

  • operating costs risk is now “pass throught” to the tenant and rent is “net” profit to the landlord

  • commonly used when an entrire building is being leases

  • triple net (NNN) is most common. tenant pays all (1) property taxes, (2) insurance and (3) maintenance

• rent analysis

  • the starting point for calculating NOI is potential gross income (PGI)

  • our perspective is that of the landlord (owner) receiving the cash flows

  • lease structures determine PGI, but property don’t impact NOI.

    • landlords arent “donating” the expenses they pay

    • if an expense is includedin the rental rate, the rental rate shoulf increase accordingly

• common lease provisions

  • inital lease term- how long the lease will last

    • 1-5 years for smaller tenants

    • up to 20 years for build to suit

    • month to month not desirable, a buyer will try to get these tenants to renew or move out

  • renewal option- additional term speculated in the lease

    • common: 1 to 4 options, 3 to 5 years each

    • there is usally a stated rent increase or provision for increase based on CPI or renegotiation

  • escalations- periodic increase in the rental rate

    • becasue of inflation, most landlord prefer to increase over time to account for increases in operating cost

    • this allows the landlord to pass along to the tenant increase in the costs, such as property taxes, utility chargers or insurance costs

    • “flat” rent remains constnt over the entire lease term

    • rents can be “stepped up” or graduated

      • could be percentage, like 2% annually or equivalent (10% every 5 years)

      • per square foot also common, ($1.50 psf every 2 years)

        rents can be “escalated” annually ( y CPI or some other index)

        

  • percentage rent

    • additional rent paid to landlord as a percentage of tenants business operations

      • effective way to share risk and aslign the incentives of the landlord and tenant

      • built-in inflation hedge to the extent that inflation causes the tenants receipts to increase

      • common in retail and resturant leases

• property classes: class A

  • command highest rents becasue they are most prestigious in their tenancy,location and overall desitability

  • usually newer structures

  • favored by insitutional investors

  • top amenitites, high-income earning tenants and low vacancy rates

  • well located in the market

  • little or no deferred maintenance issues

• class B:

  • rents usally less than class A buildings becasue of less desirable location,fewer amenitities, less impressive lobbies, elevators

  • generally older than class A, tent to have lower income tenants

  • generally well mainained, but some deferred maintenance issues are typical

  • many investors see this as a “value-add” investment opportunity

  • with renovation and common are improvements, the property can be upgrafed to class A

• class C:

  • usally once class A or B

  • are older and “ reasonably” maintained

  • are below current standards for one or more reasons

  • typically more than 20 years old

  • often located in less than desirable locations

  • generally in need of renovation, including updating the building infrastructure

  • tend to have the lowest rent rates

  • some need significant repositioning to get to stready cash flows