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© Copyright: 2014 by the UBC Real Estate Division, Sauder School of Business, The University of British Columbia. Printed in Canada. ALL RIGHTS RESERVED. No part of this work covered by the copyright hereon may be reproduced, transcribed, modified, distributed, republished, or used in any form or by any means – graphic, electronic, or mechanical, including photocopying, recording, taping, web distribution, or used in any information storage and retrieval system – without the prior written permission of the publisher.
LESSON 5 Appraisal of Income Producing Properties Note: Selected readings can be found under "Online Readings" on your Course Resources webpage
Assigned Reading 1.
Real Estate Division. 2011. Real Estate Investment Analysis and Advanced Income Appraisal. Vancouver: UBC Real Estate Division. Chapter 5: Appraisal of Income Producing Properties Chapter 6: Valuation of Leasehold Interests
Recommended Reading 1.
Appraisal Institute of Canada and Appraisal Institute (US). 2010. The Appraisal of Real Estate, Third Canadian Edition. Vancouver: UBC Real Estate Division. Chapter 22: Direct Capitalization [pp. 22.1-22.6] Chapter 23: Yield Capitalization – Theory and Basic Calculations Chapter 24: Discounted Cash Flow Analysis and Special Applications in Income Capitalization [pp. 28.17-28.21] Chapter 28: Statistics in Appraisal [pp. 28.17-28.21] Chapter 29: Valuation of Partial Interests [pp. 29.1-29.3(top)]
2.
Lennhoff, D.C. 2011. "Direct Capitalization: It Might Be Simple But It Isn't That Easy". Appraisal Journal. 79(1). pp. 66-73. Direct capitalization is perceived to be simple, but the technique isn't easy. The capitalization rate must match the market's expectations for upside potential and risk with the subject's forecasted performance.
3.
Morassutti, P.J. 1999. "Forecasting Income and Property Value". Canadian Appraiser. Fall 1999. pp. 27-31.
4.
Martin, V. III. 1988. "Nine Abuses Common in Pro Forma Cash Flow Projections". Real Estate Review. 18(3). pp. 20-25.
5.
Ramsett, D. 1999. "Yield Capitalization for Market Analysis". Appraisal Journal. 67(4). pp. 398404. Yield capitalization is an alternative, more comprehensive valuation method. However, it demands considerable data. Yield capitalization can lend support to estimates produced by direct capitalization.
6.
Sevelka, T. 2004. "Where the Overall Cap Rate Meets the Discount Rate". Appraisal Journal. 72(2). pp. 135-146. This article explores the link between overall capitalization rate (Ro) and the discount rate (Yo) in discounted cash flow, in particular the relationship to growth of annual net operating income.
©Copyright: 2014 by the UBC Real Estate Division
5.2
Lesson 5
7.
Slade, B.A. and Sirmans, C.F. 2010. "Office Property DCF Assumptions: Lessons From Two Decades of Inventory Surveys". Appraisal Journal. 78(3). pp. 251-261. Input assumptions determine the reliability of a DCF analysis and the final estimate of value. This article examines ten DCF assumptions and their implications.
8.
Sonneman, D. 2009. "Bridging the Gap Between Discount Rate Theory and Investor Surveys". Appraisal Journal. 77(1). pp. 52-59. Reconciles differences between discount rates and overall capitalization rates, as well as disparities in the methodology used to estimate terminal value and define income streams.
9.
UBC Real Estate Division. 2011. Broker's Licensing Course Manual. Vancouver: UBC Real Estate Division. Chapter 18 – Fundamentals of Investment Analysis Part I: Single Period Analysis Chapter 19 – Fundamentals of Investment Analysis Part II: Multi-Period Analysis Chapter 20 – Property Appraisal: Valuing Income Producing Properties
Learning Objectives After completing this lesson, the student should be able to: 1.
Discuss the conceptual basis for the income approach.
2.
Explain the steps in the capitalization of single year net income.
3.
Apply the direct method of capitalization.
4.
Derive the overall capitalization rate by applying different approaches.
5.
Apply the discounted cash flow method of indicating property value.
6.
Compare and contrast direct capitalization and discounted cash flow techniques, outlining differences and when each is most appropriate.
7.
Analyze market and contract rents and explain the difference between the two.
8.
Calculate the present value of the various interests in a leased property, subject to simple leases and leases with rental escalations.
9.
Calculate the value of property that is subject to a lease containing a percent rent clause.
©Copyright: 2014 by the UBC Real Estate Division
Appraisal of Income Producing Properties
5.3
Instructor's Comments The basic premise of the income approach to value is that the investor is entitled to a return on and a return of the investment. The return on portion of the capital is called the discount rate, rate of return, yield rate or interest rate. The rate can be assumed to be made up of a safe rate plus a percentage to account for the risk involved, burden of management, and the lack of liquidity. Real estate can carry a high risk factor because of the burden of management that can be associated with it; and, it does lack liquidity in that it cannot be converted to cash as quickly as some other forms of investment. However, real estate does carry other advantages such as the opportunity for capital gain that helps make up for some of the other risk factors. Naturally, the safer the investment, the lower the discount rate and the higher the value of the property in the capitalization process. In theory, the return of the invested capital may be recaptured gradually through a portion of the income, or through resale of the property at the end of the investment horizon. Assuming depreciation applies on a straight-line basis, return of the capital can also be considered as the inverse of the rate of depreciation. For example, a building with a 40 year remaining economic life will depreciate, on a straight-line basis, at a rate of 1/40 or 2.5% per year. This 2.5% per year would be considered the rate of return of the investment in the depreciating asset. The yield methods of capitalization to be studied in upcoming lessons will give a clearer picture of the "return on" and "return of" concepts. It is important to have a clear understanding of the basics of capitalization. Therefore, we will review the basic formulas, terminology, and underlying premise of the capitalization methods. Capitalization is the process of converting income (as defined) from a property into an expression of capital value. Therefore, a capitalization rate is merely the mathematical relationship between the income and the capital value. There are two basic methods of capitalization: the direct method and the yield method. All of the methods of capitalization infer some form of the return on and return of capital invested. The direct capitalization methods do not differentiate between the two rates as they are inherent even in the simplistic methods. The Annuity or Inwood method, covered in a later lesson, provides for the return on and the return of capital. It is possible to use many techniques in the capitalization process: Direct Methods
1. 2. 3. 4.
Gross Income Multiplier (GIM) Equity Capitalization Rate (RE) (sometimes called "y") Mortgage Capitalization Rate (RM) (sometimes called "f") Overall Capitalization Rate (RO)
The direct methods do not differentiate between return on and return of capital invested. These methods are discussed in more detail in the remainder of this lesson. Annuity Methods
5. 6.
Inwood using a factor which provides for a return on and return of capital. Hoskold Method which provides for a return on capital at an appropriate discount rate, and the return of capital using a sinking fund factor.
The annuity methods are discussed further in Lesson 8. ©Copyright: 2014 by the UBC Real Estate Division
5.4
Lesson 5
Yield Methods
7. 8. 9.
Interest Rate (i) (may also be called "discount rate") Internal Rate of Return (IRR) Equity Yield Rate (YE)
The yield methods are studied later in this course. Direct capitalization is based on one year's income, while the yield method is based on a discounting process of future benefits over a finite investment period. A current rate is the ratio of one year's income to value (in the case of net income) and cash flow income, but when the effective gross income is used, it is a value to income ratio. Yield rates apply to a series of individual incomes over an investment holding period to obtain the present value of each. Annuity type income streams may be grouped into three main categories: variable, level, and increasing or decreasing annuities.
Current Income Rates (Direct Methods) 1. Gross Income Multiplier (GIM)
A gross income multiplier is the relationship between the gross income and the selling price of a comparable property. In Canada, it is the effective gross income multiplier (GIM) that is more commonly used, since it is applied to effective gross income (after deduction of vacancy and collection loss). Unless otherwise noted in this course, reference to gross income multiplier actually means the effective gross income multiplier, and the acronym GIM will be used. The GIM is derived from the analysis of comparable sales and is a pure or raw indicator in that no adjustments are normally made to the sale. It merely reflects the relationship between the effective gross income and the sale price at the time of the sale for a particular property. Care must be taken to ensure the properties have similar characteristics and that they are indeed comparable to the subject property before multipliers can be reliably used. They should be in the same price range, be of similar size and have similar locations, financing, rents, and expense ratios. Example:
GIM
=
Sale Price Effective Gross Income
GIM
=
$300,000 $50,000
Value
=
EGI × GIM
=
6.0
The strength of the GIM as an appraisal tool is that it is relatively easy to calculate and apply to a subject property. The method is easily understood by non-appraisers. Relevant data is usually available. The weakness of GIM, since it is derived from unadjusted data, is that it does not take into account the expenses that can vary from property to property; nor does it account for any variations in financing that affect the value of the equity interest being appraised.
©Copyright: 2014 by the UBC Real Estate Division
Appraisal of Income Producing Properties
5.5
Adjusted GIM
A GIM is a factor which relates the earnings of a property to the value of the property. The common practice is to use the current effective gross earnings of the property. This use of GIMs is most appropriate for very homogeneous properties, e.g., rental apartment buildings. Variations in the ability of a property to provide earnings to the investor are a function of both its income-producing capability and the cost of operating the project. The primary feature of the GIM is that most value characteristics, such as location and physical features, are accounted for in the ability of the property to generate income. The inherent problem with GIMs is that they do not account for differences in the net earnings of a property. Analysis may show that GIMs need to be modified to better reflect the motivation of investors who measure the worth of a property based on the NOI (net operating income) ratio. In this case, the following process should be undertaken: Adjusted GIM =
NOI ratio of the subject × Comparable unadjusted GIM NOI ratio of the comparable
The NOI ratio is simply the NOI divided by the EGI (NOI Ratio = NOI/EGI). It can be expressed as a percentage or as a decimal fraction. The sum of the NOI ratio plus the expense ratio is always equal to 100% or 1.0. Consider the following example: Sale #
Sale Price
SUBJECT PROPERTY
Effective Income
Net Operating Income
NOI Ratio
$978,220
$596,589
0.6099
GIM
Adjusted GIM
1
$ 5,375,000
$ 989,667
$ 510,970
0.5163
5.43
6.42
2
$11,125,000
$1,545,907
$1,065,789
0.6894
7.20
6.37
3
$ 7,750,000
$1,281,289
$ 729,352
0.5692
6.05
6.48
4
$ 6,750,000
$1,059,502
$ 642,502
0.6064
6.37
6.41
5
$ 6,700,000
$ 896,443
$ 634,709
0.7080
7.47
6.44
6
$ 8,354,000
$1,034,697
$ 813,498
0.7862
8.07
6.26
Range of Unadjusted GIMs: 5.43 to 8.07 Range of Adjusted GIMs: 6.26 to 6.48
In this example, the range of adjusted GIMs is much tighter than was the case with the unadjusted GIMs. An appropriate adjusted GIM for the subject property is indicated between 6.26 and 6.48. The analysis and application of adjusted GIMs may be necessary to account for differences in the magnitude of the current earnings ratio. This may be a function of either the income potential (e.g., location and/or rent controls) or operating expenses. In either its adjusted or unadjusted form, the GIM is only one method of valuation. It is the market's application of investment characteristics and operating ratios which will determine the most appropriate units of comparison to be used for the analysis.
©Copyright: 2014 by the UBC Real Estate Division
5.6
Lesson 5
2. Equity Capitalization Rate
The equity capitalization rate is the ratio between the forecasted before-tax cash flow and the equity capital of the purchase price. This is also a pure or raw indicator in that no adjustments are made to the sale. It is also assumed that there is no change in equity either through growth or decline in the value of the property or through mortgage pay down. The equity capitalization rate is also derived from sales of comparable properties; and the same requirements for similarity exist as in the selection of the GIM. Example:
RE
= =
NOI – Annual Debt Service Sale Price – Mortgage _$30,000 – $27,859_ $300,000 – $225,000
=
_$2,141_ $75,000
=
Cash Flow Equity
=
0.02854 rounded to 0.0285 or 2.85%
The equity capitalization rate can be used to capitalize the cash flow of the subject property directly, on the assumption that the existing mortgage is assumable by a potential purchaser. Value
=
Mortgage + Cash Flow RE
=
$225,000 + _$2,141_ .0285
=
$225,000 + $75,123
=
$300,123 (rounded to $300,000)
The equity capitalization rate can also be used in the "band of investment" method of calculating an overall capitalization rate. The strength of the equity capitalization rate is that only the equity portion of an investment has to be estimated by the appraiser if financing is a factor, since the mortgage is either existing or can be established from the current mortgage market. The weakness of the rate is that it can be misapplied if the equity portion of the property differs substantially from the properties analyzed to select the equity capitalization rate. Another weakness is where financing is only short term and the current cash flow might not be a significant factor if the purchaser is anticipating lower mortgage rates in the near future.
©Copyright: 2014 by the UBC Real Estate Division
Appraisal of Income Producing Properties
5.7
3. Mortgage Capitalization Rate (RM)
The mortgage capitalization rate (or mortgage constant) expresses the relationship between the annual debt service and the principal amount of the mortgage at the date of the sale. The annual mortgage constant is a percentage representing the portion of the loan amount which must be paid each year to repay the principal and interest owing on a loan. Another way of stating this is the annual payment which is required to repay the principal and interest on a loan of $1 within the amortization period. Below is an illustration of the calculator steps to find the mortgage constant for a mortgage with an interest rate of 10% per annum, compounded semi-annually, with a 25-year amortization period and monthly payments: Press
Display
Comments
10 O NOM%
10
Enter stated nominal rate
2 O P/YR
2
Enter stated compounding frequency
O EFF%
10.25
Compute equivalent effective annual rate
12 O P/YR
12
Enter desired compounding frequency
O NOM%
9.797815
Compute nominal rate with monthly compounding
300 N
300
Enter the number of months in the amortization period
1 PV
1
Enter loan of $1 as present value
0 FV
0
Zero future value (loan fully repaid)
PMT
–0.00894487
Compute required monthly payment ($0.0089)
× 12 =
–0.107338
Compute required annual payment
The mortgage constant is 0.107338. Therefore, to repay all principal and interest owing for a loan of $1, the required payment would be approximately $0.107 per year. Or, in other words, to repay this loan within the amortization period, the annual payments would have to be 10.7% of the loan amount. If the mortgage payments and principal amount are known, the mortgage constant can be quickly calculated by dividing the annual debt service by the principal amount of the mortgage. Example:
RM
=
_$27,859_ $225,000
= 0.123818 or 12.3818% The strength of the mortgage capitalization rate is that it is relatively easy to calculate and the market information is usually available. The weakness is that in volatile economic conditions, mortgage rates can change quickly and the equity capitalization rates can be affected dramatically.
©Copyright: 2014 by the UBC Real Estate Division
5.8
Lesson 5
4. Overall Capitalization Rate
The overall capitalization rate expresses the relationship between the current year's income and the value of the property. The formula is: Value =
Net Operating Income Overall Capitalization Rate
or V
=
NOI Ro
This is the basic capitalization formula and it applies to the rates and incomes (as defined) for all of the current ratio capitalization methods. The formula can be used to solve any of the components as follows: NOI
= V H RO
RO
=
NOI V
=
NOI Ro
=
$29, 250 0.10
Application: V
= $292,500 NOI
= V H RO
= $292,500 H 0.10 = $29,250 RO
=
NOI V
=
$29, 250 $292,500
= 0.10 or 10% As in the case with deriving GIMs, equity capitalization rates and mortgage capitalization rates, the overall rate using the above formula is pure or raw market data in that no adjustments are made to the sales of comparable properties being analyzed.
©Copyright: 2014 by the UBC Real Estate Division
Appraisal of Income Producing Properties
Sale #
Sale Price
SUBJECT PROPERTY
5.9
Effective Income
Net Operating Income
$978,220
$596,589
Capitalization Rate
1
$ 5,375,000
$ 989,667
$ 510,970
9.51%
2
$11,125,000
$1,545,907
$1,065,789
9.58%
3
$ 7,750,000
$1,281,289
$ 729,352
9.41%
4
$ 6,750,000
$1,059,502
$ 642,502
9.52%
5
$ 6,700,000
$ 896,443
$ 634,709
9.47%
6
$ 8,354,000
$1,034,697
$ 813,498
9.74%
Range of capitalization rates: 9.41% to 9.74%
The strength of the overall rate based on direct sales is that it is easy to calculate and does not require any adjustments or hypotheses about future incomes or existing or future financing. It is easy to understand by non-appraisers as it is directly supported by the activities and actions of the marketplace. The weakness of the overall capitalization rate based on direct sales is that the income and expenses from the sales and the subject property must be analyzed to make the proper comparisons. As well, this method does not take financing directly into account. The method does not readily explain the "return of" and "return on" analysis information. The method is only as reliable as the data that is available. In an active market, this is the usual analysis applied for the valuation of income properties. If properties are achieving net rental rates, the use of this method is stronger as fewer adjustments need to be made for expenses. Capitalization or DCF in Practice In a national survey of accredited members of the Appraisal Institute of Canada (AACIs), property managers, and consultants, these real estate practitioners indicated they generally appraise lower-valued properties, i.e., market value less than $1,000,000, using direct capitalization (NOI/RO) based on market rent, crosschecked by means of the direct comparison approach (DCA). If the property is under lease, the market-rent based value estimate is adjusted by the capitalized value of any rental surplus or rental shortfall experienced over the remaining term of the lease(s) in order to arrive at a fully adjusted estimate of market value. For higher value properties that are typically more complex and comprise several leases, practitioners apply both direct capitalization and discounted cash flow.
Application of the Income Approach The remainder of the lesson provides examples of the application of the usual method of the income approach to value. This involves estimating appropriate income and expense levels, and applying a market derived overall capitalization rate. Usually, the first step in analyzing an income property using the income approach is to stabilize the income and expenses of the subject property.
©Copyright: 2014 by the UBC Real Estate Division
5.10
Lesson 5
Example 1: Stabilization of Income and Expense Statement
The following information has been obtained from the owner of a property that is being appraised. The property is owned with other real estate under a corporate structure. Potential income $150,000 Actual collection $141,000 Taxes $12,000 Management $12,700 Payroll (including fringe benefits) $5,000 Car and related expenses for corporate president $12,300 Utilities $3,000 Maintenance and repairs - annual $6,000 Insurance (3 yr. premium) $4,500 Exterior paint (3 yr. life) $4,500 Interior decorating (3 yr. life) $15,000 Educational and convention expenses $6,300 Trash removal $500 Pest control $800 Corporate filing fees and income taxes $18,000 Supplies $300 Replacement projection (10 yr. life) $20,000 A.
Reconstruct this operating statement to reflect the net operating income of the real estate.
B.
Comment on the vacancy rate of the property, management and maintenance expenses, and any expenses that do not appear to be real estate related.
Example 1: Solution
A.
Potential gross income Vacancy and collection loss Effective Gross Income
$150,000 – 9,000 $141,000
Operating expenses Fixed Real estate taxes Insurance (annual) Total
$12,000 + 1,500 $13,500
Variable Management Payroll (including fringe benefits) Utilities Maintenance and repairs (annual) Trash removal Pest control Supplies Total
$12,700 5,000 3,000 6,000 500 800 300 $28,300
©Copyright: 2014 by the UBC Real Estate Division
Appraisal of Income Producing Properties
5.11
Replacement allowances Exterior paint ($4,500/3) Interior decorating ($15,000/3) Replacement projection ($20,000/10) Total operating expenses Net Operating Income Operating expense ratio NOI ratio B.
$1,500 5,000 2,000 $8,500 –50,300 $90,700
$50,300/$141,000 = 0.357 $90,700/$141,000 = 0.643
The vacancy rate is $9,000/$150,000 = 0.06, or 6% Management is $12,700/$141,000, or 9%, which seems high. Additional fringe benefits for the corporate president may be included, or the property may be a specialty operation that requires a great deal of management. Some types of maintenance extend over more than one year. Therefore, maintenance may be included as a variable expense or included in the replacement allowance. Expenses for the president's car ($12,300), educational and convention expenses ($6,300), and corporate filing fees and income taxes ($18,000) are not real estate related. Therefore, these expenses are omitted from the reconstructed operating statement. Once the subject income and expenses have been analyzed, the appraiser looks at the comparable sales which have occurred. These should be analyzed to determine the capitalization rate of each, stabilizing the income and expenses of each sale in a manner similar to that of the subject property. Once this has been completed, each sale is reviewed to determine its comparability to the subject, in order to determine the appropriate market capitalization rate for the property being appraised. More weight is typically placed on the rates yielded by the most comparable sales.
Example 2: Sales Analysis
The following information is provided for the subject property (see Example 1) and five comparable properties. Assume that each comparable sale was analyzed in the same manner as the subject property.
Price
Net Operating Income
Subject
$90,700
Sale 1
$936,000
$98,280
Sale 2
$900,000
$92,000
Sale 3
$430,000
$41,900
Sale 4
$825,000
$90,750
Sale 5
$1,140,000
$125,000
©Copyright: 2014 by the UBC Real Estate Division
5.12
Lesson 5
A.
Calculate overall capitalization rates for the comparable properties.
B.
What range of overall rates can be developed from these data? How can this range be narrowed?
C.
What overall rate is appropriate for the subject property? Explain your choice and calculate the indicated value of the subject property.
Example 2: Solution
A. Price
Net Operating Income
Overall Cap. Rate
Sale 1
$936,000
$98,280
10.5%
Sale 2
$900,000
$92,000
10.2%
Sale 3
$430,000
$41,900
9.7%
Sale 4
$825,000
$90,750
11.0%
Sale 5
$1,140,000
$125,000
11.0%
B.
The range of overall rates developed from this data is 9.7% to 11.0%. An appraiser might narrow the range by placing less emphasis on Sale 3 due to its considerably smaller size; usually, all other things being equal, smaller investments achieve lower capitalization rates as there is a greater potential pool of purchasers able to invest in such a property, and a smaller investment is at stake. This would then leave a range of 10.2% to 11.0%. With respect to the remaining sales, the appraiser should check if any are more comparable (in terms of sale date, location, age of building, etc.), and place more weight on the returns indicated by these comparables. The appraiser should also check to ensure that the remaining properties are truly comparable in regard to their operating expense ratios.1
C.
The overall rate for the subject property, if all four remaining comparables are equally similar, would be somewhere within the range of 10.2% and 11.0%; and a capitalization rate in the middle can be chosen, say, 10.6%. The indicated value of the subject property can then be calculated as $90,700/0.106 = $855,660. It should be noted that the sales indicate a range of values between $824,545 ($90,700/0.11) and $889,216 ($90,700/0.102). Thus the value lies between say $825,000 and $890,000, with the middle point being $855,000. This range is fairly wide, and every effort should be made to tighten it by carefully analyzing the comparables to see if adjustments for other factors are merited.
1
Please note that in reconciling capitalization rates, the final rate is determined to be the most reasonable (and most applicable to the subject property) given an analysis of market factors; it is not simply an averaging of values. ©Copyright: 2014 by the UBC Real Estate Division
Appraisal of Income Producing Properties
5.13
Point to Ponder If appraising the fee simple interest of a property, and assuming the property has below-market rents (i.e., MV of fee simple is not equal to MV of leased fee), does one: (a) Find the stabilized market-based NOI for subject. Find comparables, use their contract rents to find a capitalization rate; then, adjust the capitalization rate to account for the subject’s non-market rents. OR (b) Find the stabilized market-based NOI for subject. Find comparables, adjust their NOI to market levels and use their capitalization rate directly. This would be the so-called "manufactured" capitalization rate. Mathematically, both (a) and (b) produce the same result. Both are different ways of achieving the "apples to apples" comparison required for capitalization rates. The only difference is that (a) adjusts the capitalization rate directly, while (b) adjusts implicitly in rents. The advantage of (a) is that the appraiser deals with capitalization rate adjusting overtly rather than hidden in the analysis. The disadvantage of (a) is that a small change to the capitalization rate has a large impact on value; and, it is very difficult to substantiate capitalization rate changes, whereas rent difference can be easily substantiated.
Chapter 6: Valuation of Leasehold Interests Chapter 6 builds on the income valuation techniques from Chapter 5 to look at one specific case – how do you appraise various leasehold interests? This value is typically created when a longer-term lease has a rent that differs from what is typically expected in the market. This difference in rents creates an asset that has value. The techniques to appraise leasehold value are all forms of the income approach. However, they tend to be discounted cash flow rather than direct capitalization, since the valuation problem typically involves calculating the present value of a series of cash flows rather than an income flow in perpetuity. For the illustration of "market and contract rents" in this chapter, the following Excel calculation highlights the differences in present value for a 25-year term versus a 5-year term. This kind of analysis will be useful in the sensitivity analysis required in Project 2.
©Copyright: 2014 by the UBC Real Estate Division
5.14
Lesson 5
VALUATION OF INTERESTS
Harry
John
Maria
8%
9%
10%
Income/Rent Advantage
$30,000
$15,000
$5,000
Reversion
$600,000
$600,000
$600,000
Rate
Present Value 25-year Term
5-year Term
Lease Fee (Harry)
$433,473.49
$537,713.72
Leasehold (John)
$230,179.88
$453,554.63
Subleasehold (Maria)
$105,301.32
$393,402.12
Combined Interest
$768,954.69
$1,384,670.47
PV = (rate,nper,pmt,fv,type) * Rate is the interest rate per period * Nper is the total number of payment periods in an annuity * Pmt is the payment made each period and cannot change over the life of the annuity * FV is the future value * Type is the number 0 or 1 and indicates when payments are due
Below is an Excel solution for the "comprehensive lease problem" from Chapter 6: Solving with Excel
Rate
8%
Year
1 to12
13 to 37
38 to 62
Income
$8,000
$14,000
$20,000
PV at Beginning of Period
PV (Now)
Year 12
$8,000
$15,407.41
$15,407.41
Year 13 to 37
$14,000
$161,402.62
$138,376.73
Year 38 to 62
$20,000
$230,575.17
$28,864.97
Salvage Value
$200,000
$200,000.00
$3,655.90 $186,305.01
PV = (rate,nper,pmt,fv,type) * Rate is the interest rate per period * Nper is the total number of payment periods in an annuity * Pmt is the payment made each period and cannot change over the life of the annuity * FV is the future value * Type is the number 0 or 1 and indicates when payments are due Moving Cashflow back in time PV = future cashflow * (1 + interest rate) ^ (- number of years)
©Copyright: 2014 by the UBC Real Estate Division
Appraisal of Income Producing Properties
5.15
Review and Discussion Questions 1.
Why does the appraiser, when using the income method of appraisal, use the stabilized net operating income for the property instead of just the net operating income to determine the property's value?
2.
The chapter discusses three methods of determining a discount rate for use in the income method of appraisal. Briefly explain the principal strengths and weaknesses of each, indicating the preferred method.
3.
You are appraising a downtown office building called the Gravelle Centre. You have researched the income and expense amounts for the subject property. The building has 200,000 square feet of total leasable space, with 150,000 square feet currently leased. The market vacancy rate for similar space in the area is 8% and the market rent is $12 per square foot per annum. The landlord is responsible for all operating expenses, which account for approximately 30% of effective gross income. In addition, a replacement allowance of $75,000 per year has been determined as a reasonable amount for properties of this type. You have found five recent sales of commercial buildings which can be used as comparables. Comparable Sale
Price
Stabilized Net Operating Income
Arndt Place Bridal Towers Chappell Building Dolfo Square Ewing Plaza
$10,000,000 $11,360,000 $12,000,000 $14,000,000 $15,000,000
$1,150,000 $1,420,000 $1,260,000 $1,575,000 $1,650,000
(a)
Compute the stabilized net operating income for Gravelle Centre.
(b)
Calculate the market capitalization rate using the direct market observation method.
(c)
Calculate the market value of Gravelle Centre using direct capitalization (rounded to the nearest $1,000).
©Copyright: 2014 by the UBC Real Estate Division
5.16
4.
Lesson 5
An appraisal is required for a wood frame apartment block with an elevator. The building has 35 suites: 25 one-bedroom, 8 two-bedroom, and 2 three-bedroom. The building is in good condition. The following information has been obtained from the owner of the apartment. INCOME Gross income collected and deposited in the bank during the last 12 months. $166,500 EXPENSES Caretaker's salary Garbage collection Property taxes Mortgage payments Annual elevator maintenance contract Water Electricity and fuel Insurance: Fire-1 year policy Boiler/Machinery-1 year policy Liability-1 year policy Supplies and sundries Owner's personal income taxes Miscellaneous repairs TOTAL EXPENSES NET OPERATING DEFICIT
$13,600 5,200 16,500 1,936 2,000 500 15,000 2,000 500 250 4,800 15,700 8,225 176,211 –$9,711
You have also obtained the following information: (a)
The monthly rental rates for the suites are: one bedroom $385, two bedroom $495, and three bedrooms $605. Vacancy rate is estimated at 1% per annum.
(b)
There are 35 parking stalls that rent for $10 per month each. The vacancy rate for them is 25%.
(c)
The management fee is 5% per annum of the effective gross income. Assume that the variable expenses given in the owner's expense statement are for market occupancy levels. Also, for the purposes of this question, ignore replacement allowance.
(d)
There are two leased coin-operated washers and dryers, which together net approximately $100 per month. Assume that the laundry income is not affected by the building's vacancy rate.
(e)
The caretaker is given a free two-bedroom suite in the apartment building in addition to her salary.
©Copyright: 2014 by the UBC Real Estate Division
Appraisal of Income Producing Properties
5.17
Your investigation of recent sales has found the following data: Sale number 1 recently sold for $1,100,000 and is similar to the subject. The effective gross income was $175,000 and the operating expenses were $81,225. Sale number 2 is adjacent to the subject and is also similar to it. It sold for $1,060,000 and the effective gross income was $172,500 and the expenses were approximately 47.25% of the effective gross income. Sale number 3 sold last week for $1,150,000. Operating expenses were $85,940 which represented about 47% of the effective gross income. Problem
Based on the above information calculate the estimated net operating income for the building and the estimated value by the income approach. 5.
Some appraisers believe that the direct capitalization method of appraisal, which utilizes the formula V = NOI)R, is useful only in "a fantasy world where taxation...can be ignored and where assets generate, forever, a constant flow of incomes". Under what conditions can this simple appraisal method provide an accurate estimate of a property's value in a more complex world? What is the most common source of difficulty arising from the use of this method?
6.
Review the "CreekSide Apartments" sample property listing in the "Online Readings". This is a good example of a detailed commercial property information sheet, with income summaries. (a) (b) (c)
7.
At the time of listing, cap rates in Vancouver are typically below 4%, yet this property is at nearly 9%. Why? The building's valuation is based on an "aggressive market repositioning" based on $450,000 of capital investment in the past 12 months. How is this investment "recouped" when applying direct capitalization? If DCF allows you to more directly account for this, how might you analyze the underlying assumptions for this property? Assuming the current owners did a DCF analysis years ago when deciding to rehabilitate this property, does it appear their assumptions applied at that time were correct? Do you think this is a successful project?
Can the sum of the values of the various interests created by leases or subleases ever differ from the value of the fee simple? Can the sum ever exceed the value of the fee simple interest?
©Copyright: 2014 by the UBC Real Estate Division
5.18
Lesson 5
ASSIGNMENT 5 CHAPTER 5: Appraisal of Income Producing Properties CHAPTER 6: Valuation of Leasehold Interests Marks:
1 mark per question.
THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION:
Bob Newman has recently been reviewing his vast real estate investment portfolio and has decided to appraise one of his apartment buildings. He has researched recent sales and has found the following four comparables: Comparable Sales
Number of apartments Average monthly rent Operating costs (as % of PGI) Total yearly parking income Vacancy & collection losses (as % of PGI) Selling price
Le Maison d'Arndt
Bridal Manor
Chateau André
Dave's Place
40 $865 30% $35,000 3.5% $3,900,000
50 $800 30% $38,000 3.5% $4,600,000
38 $840 30% $32,360 3.5% $4,000,000
30 $825 30% $34,600 3.5% $3,300,000
Bob has hired you to help him with the appraisal. Assume that parking spaces are rented with apartments, and are thus affected by vacancy rates. 1.
Calculate the market capitalization rate using the comparable sales information and assume that all comparables are equally similar to the subject property. (Round the rate to two decimal places and round all dollar figures to the nearest dollar.) (1) (2) (3) (4)
2.
7.57% 7.19% 6.29% 6.26%
Based on the information above, and your knowledge that Bob's building has a net operating income (NOI) this year of $310,000, use the direct capitalization form of the income method to determine the market value of Bob's building. (1) (2) (3) (4)
$3,905,079 $4,640,719 $4,036,458 $4,311,544
***Assignment 5 continued on next page***
©Copyright: 2014 by the UBC Real Estate Division
Appraisal of Income Producing Properties
5.19
THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION:
Assume you are asked to appraise a property which has an expected net operating income of $45,000 at the end of the first year. You expect the net operating income to grow by 5% per year, compounded annually. 3.
What will the net operating income be at the end of year 5? Year 10? Year 20? (1) (2) (3) (4)
4.
$54,697.78; $69,809.77; $113,712.76 $57,432.67; $73,300.26; $119,398.40 $58,354.89; $74,297.28; $122,854.95 $60,304.30; $76,992.10; $131,145.93
Estimate the value of this property if the overall growth-oriented capitalization rate (R*) is 13%. (1) (2) (3) (4)
$346,154 $562,500 $734,690 $900,000
THE NEXT FIVE (5) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION:
A mixed-use building in Edmonton is currently offered for sale at a price of $2,000,000. The building consists of six residential units and one street level retail unit. Two of the residential suites are being rented on a long-term lease to a major oil and gas company as temporary accommodation for new managerial employees. They each have 2 years remaining on a 4-year lease, at a rent of $1,400 per month. Two other suites have 2-year leases, one with 6 months remaining, another with 8 months remaining, both at a rent of $1,300 per month. All leased units will revert to month–to-month tenancies at market rents when the lease term expires. The remaining two apartments are rented on a month-to-month basis, both at $1,375 per month. Both of these apartments have just had their rent raised and in accordance with Residential Tenancy legislation, rent can only be raised once per year. All the residential leases are fully gross, with the landlord responsible for all operating costs. Marie is considering purchasing the property. The current market level rents for similar apartments is $1,375 per month and as any prudent investor would, she intends to raise the rents to market level as soon as possible, thus increasing the net operating income and the value of the building. She considers this strategy reasonable and in line with the allowable annual residential legislation increase. The market rents are expected to rise 3% per year into the foreseeable future. Operating costs for the apartment units have consistently been 26% of effective gross income and this proportion should remain stable in the future. The retail unit is leased for 5 years, with 3 years remaining at a rent of $3,000 per month. This lease is fully net to the landlord, with the tenant paying an additional amount of $1,000 per month for operating expenses and their share of property taxes, increasing by 2% per annum. The tenant has a renewal option for an additional 5-year term at a rent of $3,200 per month, and it is assumed that this option will be exercised. A vacancy and collection loss of 5% would be appropriate for this type of property in Edmonton. She intends to hold the building for four years and sell it at the end of the fourth year. The resale value at that time will be determined by the capitalized value of Year 5 net operating income, using a market capitalization rate of 6.5%. Selling costs are expected to be 3%.
***Assignment 5 continued on next page***
©Copyright: 2014 by the UBC Real Estate Division
5.20
5.
Lesson 5
What is the NOI for Years 1, 2, 3, and 4. Round your answer to the nearest $1,000. (1) (2) (3) (4)
6.
What is the net sale price (after closing costs) at the end of Year 4 using the capitalization model? Round your answer to the nearest $100,000. (1) (2) (3) (4)
7.
$91,000; $93,000; $95,000; $99,000 $110,000; $112,000; $115,000; $120,000 $103,000; $105,000; $107,000; $112,000 $115,000; $117,000; $120,000; 125,000
Approximately $1.8 million. Approximately $1.7 million. Approximately $2.3 million. Approximately $2.4 million.
Assume NOI and the net sale price for Years 1-4 are as follows: Calculate the property's market value as of today using DCF at a effective annual discount rate of 10%. Round your answer to the nearest $1,000. Year 1 2 3 4
(1) (2) (3) (4) 8.
NOI $95,000 $99,000 $106,000 $111,000
Sale Price
$2.2 million
$2,063,000 $1,690,000 $2,018,000 $1,826,000
Which of the following statements would reduce the market value estimate? A. B. C. D. E. (1) (2) (3) (4)
The purchaser has a low personal tax rate. The market capitalization rate in 4 years will be higher than 9.0%. The estimates for market rent increases were based upon the employment created from the opening of a new plant, a project which has subsequently been cancelled. A larger amount of the purchase price can be apportioned to the building upon purchase and, therefore, a larger amount of CCA can be claimed. The purchaser can obtain a below-market interest rate for her mortgage because of a high credit rating.
Only Statements A, D, and E. Only Statement B. Only Statements B and C. Only Statements C and E.
***Assignment 5 continued on next page***
©Copyright: 2014 by the UBC Real Estate Division
Appraisal of Income Producing Properties
9.
A junior appraiser in your firm has appraised this property using the direct capitalization of Year 1 net operating income as well as the discounted cash flow (DCF) method, but she has come up with different figures for appraised market value. Which of the following is MOST likely to be a factor in this difference? (1) (2) (3) (4)
10.
The appraiser capitalized current rents in the direct capitalization approach, but accounted for anticipated future rent increases in the DCF method. The purchaser is in a lower tax bracket than the average real estate investor. Eight years ago, this property was sold with vendor financing written at a below-market interest rate. The direct capitalization approach recognizes the potential for significant property appreciation in future, but the DCF approach does not.
Which of the following statements is/are TRUE? A. B.
C. D.
(1) (2) (3) (4) 11.
5.21
Even though it may be difficult to find a large number of comparable properties, the market determined capitalization rate is widely accepted and recommended by the appraising profession. The weighted average method is the traditional way of determining the capitalization rate in corporate finance by implicitly recognizing that the expected total return on investment must satisfy the return expected of both debt holders and shareholders. The summation method of determining the capitalization rate can rarely be justified as the risk premiums cannot be accurately estimated and slight variations in such estimates can lead to large variations in values. In the direct capitalization model, we can rely on the existing or expected NOI for the first year of operation if we assume that this NOI is representative of future years.
Only Statement A is true. Only Statements A and B are true. Only Statements B and C are true. All of the above statements are true.
Apply the weighted average method to determine a discount rate and estimate the market value of the property, based upon the following information: Mortgage ratio Cost of debt Equity dividend rate Effective gross income Expense ratio (1) (2) (3) (4)
60% 7% 10% $250,000 33%
$3,048,780 $2,042,683 $3,571,429 $2,392,857
***Assignment 5 continued on next page***
©Copyright: 2014 by the UBC Real Estate Division
5.22
12.
Lesson 5
Calculate the average net effective rent (NER) per sq. ft.(psf) over the term given the following information for an office lease. Rentable Area Term: Base Rent: Inducements: (1) (2) (3) (4)
13.
2,000 sq.ft. 5 years $14.00 psf for years 1-3, escalating to $15.00 psf in years 4 to 5 2 months free rent; $5.00 psf tenant improvement (TI) allowance
$13.34 psf $12.12 psf $14.49 psf $12.93 psf
A new lease for a restaurant (retail) property indicates a net effective rent (NER) of $25.75 psf. The tenant wants the landlord to provide a $20.00 psf fixturing allowance. What is the new average NER psf assuming the landlord agrees to provide the incentive? The information for this lease is as follows: Rentable Area: Term: NER: Inducements: (1) (2) (3) (4)
14.
4,500 sq.ft. 10 years $25.75 $20.00 psf TI allowance
$22.00 psf $28.50 psf $23.75 psf $24.50 psf
What is the difference between net effective rent (NER) and contract rent? (1) (2) (3) (4)
NER is gross rent while contract rent is equivalent to base rent. NER reflects the net cash-flow after all tenant inducements and allowances. NER is the analogous to contract rent. Contract rent is based on the stated lease terms while NER is adjusted for the impact of percentage rent.
***Assignment 5 continued on next page***
©Copyright: 2014 by the UBC Real Estate Division
Appraisal of Income Producing Properties
5.23
THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION:
The property you are appraising is held on a net lease of $1,300 per month payable in advance for the first 15 years and $1,900 per month in advance for the next 5 years, which is the balance of the term. The property will have an anticipated value of $200,000 upon expiration of the lease. Current market rent estimated from several comparables is $1,600 per month, which is assumed to be stable and perpetual in the long-term, i.e., there is no need for escalation of rental levels in the future. 15.
Estimate the value of the leased fee based upon a return of j1 = 7%. Round your answer to the nearest $100. (1) (2) (3) (4)
16.
$182,600 $226,700 $234,300 $247,900
Estimate the value of the lessee's interest based upon a return of j1 = 9%. Round your answer to the nearest $100. (1) (2) (3) (4)
$26,100 $26,400 $27,100 $27,400
THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION:
A downtown retail property was leased 3 years ago on the following net terms: Years 1-10: Years 11-20: Years 21-35:
$6,000 per month, in advance $6,300 per month, in advance $6,500 per month, in advance
Current market rent is reliably estimated at $6,300 per month, which is assumed to be stable and perpetual in the long-term. Assume that the value at the end of the lease term (in 33 years) will be $865,000. Assume that a capitalization (yield) rate of j1=7.5% is applicable to both interests. 17.
What is the value of the leased fee? Round your answer to the nearest $100. (1) (2) (3) (4)
18.
$891,600 $931,500 $1,017,000 $1,124,100
What is the value of the leasehold estate? Round your answer to the nearest $100. (1) (2) (3) (4)
$13,400 $13,100 $12,400 $8,900
***Assignment 5 continued on next page***
©Copyright: 2014 by the UBC Real Estate Division
5.24
Lesson 5
THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION:
A lease signed ten years ago on an improved property calls for annual payments as follows, payable at the beginning of each year: Years 1-10: Years 11-16: Years 17-36: Years 37-46:
$22,000/year (already past) $27,000/year $36,000/year $50,000/year
The tenant has an option to purchase which must be exercised before the next annual payment is made. This would necessitate her liquidating another lucrative investment which is paying her 10% per annum, compounded annually (j1), with excellent prospects that this rate of return will continue as long as she wishes. She calls you to make an analysis of her problem and advise her of her proper course of action. The option price is $300,000. 19.
Calculate the present value of the lease payments. Round your answer to the nearest $100. (1) (2) (3) (4)
20.
Which of the following statements is TRUE? (1) (2) (3) (4)
20
$348,000 $170,900 $321,100 $165,900
If the option price was $350,000, it would be worthwhile to purchase the property. Since the present value of the lease payments is higher than the option price, it is worthwhile for the tenant to purchase the property. Even if the tenant purchases the property, she would not gain right to any proceeds upon sale. It is impossible to conclude if it is worthwhile for the tenant to purchase the property since there is no information provided on the value of the property at the end of the holding period. Total Marks
***End of Assignment 5***
©Copyright: 2014 by the UBC Real Estate Division
