331- L5 Flashcards
What are the three methods of determining a discount rate for use in the income method of appraisal. Explain the principal strengths and weaknesses of each. Indicate the preferred method.
The three suggested methods for deriving capitalization rates, and their strengths and weaknesses, are as follows:
(a) DIRECT MARKET OBSERVATION: The overall capitalization rate is found by taking the ratio of stabilized net operating income to value in exchange for similar properties recently sold.
Strengths: Rates determined by this method are market-derived. The method is simple to use and understand.
Weaknesses: The method cannot be used in the absence of recent sales of similar properties. Comparable sales data must be reviewed for accuracy.
(b) WEIGHTED AVERAGE METHOD: The overall capitalization rate, determined by examining recent sales of similar properties, is broken down into a return to debt and a return to equity (equity dividend rate). The equity dividend rate is then used, together with financing details for the subject property, to determine an overall rate for the subject property.
Strengths: This method is market-based, like the direct market comparison method, and takes into account the effect of financing on equity returns.
Weaknesses: This method has even more restrictive data requirements than the direct market comparison method. It is less easily explained to the layman. A practical consideration is that equity dividend rates tend to vary widely even among similar properties due to differences in financing.
(c) SUMMATION METHOD: This method develops a discount rate by taking the risk-free rate prevailing in the market (e.g., the rate on term deposits) and adding to it premiums for the added risk and lack of liquidity associated with a real estate investment.
Strengths: Rates can be easily determined by this method, even in the absence of data from the local real estate market. In principle this method is very sound.
Weaknesses: Risk and liquidity premiums must be determined subjectively. Few investors use this method.
In general, the simplicity, directness and accuracy of the DIRECT MARKET COMPARISON method makes it preferable to the other two methods.
Why does the appraiser, when using the income methods of appraisal, use the stabilized net operating income for the property instead of just the net operating income for the property instead of just the net operating income to determine the property’s value?
Appraisers use stabilized NOI in the income method of appraisal as the basis for the market value estimate. Stabilized NOI may be described as the typical expected annual income. The use of stabilized versus non-stabilized NOI becomes an issue when considering repairs and maintenance and capital upgrading. When a single-year NOI is used in capitalization, the exact timing of future capital expenditures for replacement of fixtures is not forecasted. Although the decision to replace a fixture may be postponed or even repaired in the short run, this cost will eventually be incurred – ignoring this replacement cost will over-state value. One way to address this is by a replacement reserve, where an annual amount is set aside in the accounts to cover future expenses. This stabilizes the property expenditures, as opposed to dramatic fluctuations in years where capital expenses are required. However, market practice varies with respect to whether or not replacement reserves are deducted. What is most crucial is for the subject property to be analyzed in the same way as comparables used for capitalization rate calculations, so that you are comparing “apples to apples”. Note that this is not an issue in a dynamic discounted cash flow (DCF) analysis because expenses are forecasted and the actual cost recognized in the timeframe in which they occur.
Income and expense amounts subject property that is 200,000 sqft of total leasable space, with 150,000 sqft currently leased. Market vacancy rate for a similar space in the area is 8% and the market rent is $12 per sqft per annum. Landlord is responsible for all operating expenses, which account for approx. 30% of effective gross income. Has replacement allowance of $75,000 per year.
5 comparable sales
1) Price: $10,000,000Stabilized NOI: $1,150,000
2) Price: $10,000,000Stabilized NOI: $1,150,000
3) Price: $10,000,000Stabilized NOI: $1,150,000
4) Price: $10,000,000Stabilized NOI: $1,150,000
5) Price: $10,000,000Stabilized NOI: $1,150,000
(a) Compute the stabilized NOI for the subject property
(b) Calculate the market cap rate using the direct market observations method
(c) Calculate the market value of the subject property using the direct capitalization (nearest $1,000)
(a) Gross Potential Revenue (200,000 sq. ft. @ $12) $2,400,000
- Vacancy Rate @ 8% 192,000
Gross Effective Revenue $2,208,000
- Operating Expenses 662,400
- Replacement Reserves 75,000
Stabilized Net Operating Income $1,470,600
(b) Capitalization Rate for each property is calculated as the stabilized NOI divided by sale price.
1) = 1,150,000/10,000,000 = 11.5%
2) =1,420,000/11,360,000 = 12.5%
3) =1,260,000/12,000,000 = 10.5%
4) =1,575,000/14,000,000 = 11.25%
5) =1,650,000/15,000,000= 11%
Market Capitalization Rate = (11.5+12.5+10.5+11.25+11)/ 5 = 11.35%
(c) Market Value = stabilization NOI / Market Cap Rate
= 1,470,000/1135= $12,956,828 = $12,957,000
12 months of income: $166,500
Expenses: Caretaker- 13,600, Garbage- 5,200, Property Tax- 16,500, Mortgage- 1,936, Elevator- 2,000. Water- 500, Electrical- 15,000, Insurance- 2,000, Boiler- 500, Liability- 250, Supplies- 4,800, Income tax- 15,700, Miscellaneous repairs- 8,225
TOTAL EXPENSES- 176,211
NET OPERATING DEFICIT - $-9,711
a) Rent rates: 1bdrm- 385, 2bdrm- 495, 3bdrm 605. Vacancy rate – 1% per annum
b) 35 parking stalls - $10 each per monthVacancy rate – 25%
c) Management fee is 5% per annum of EGI. Ignore replacement allowance
d) 2 leased coin operated washers and dryers - $100 per month – not effected by bldgs. Vacancy rate
e) Caretaker is given a free 2bdrm in addition to her salary
Sales
1) Sale Price- $1,100,000EGI- $175,000Oper. Exp- $81,225
2) Sale Price- $1,060,000EGI- $172,500Oper. Exp- 47.25% of EGI
3) Sale Price- $1,150,000EGI- oper. Exp is 47% of EGIOper. Exp- $85,940
Calculate the estimated NOI for the building and the estimated value by income approach
Operating Statement of a 35-unit apartment building
POTENTIAL GROSS INCOME
Apartment Rentals Annual
25 One-Bedroom units @ $385 per month $ 115,500
8 Two-Bedroom units @ $495 per month $ 47,520
2 Three-Bedroom units @ $605 per month $ 14,520
TOTAL POTENTIAL GROSS INCOME $ 177,540
Less Allowance for Vacancy/Collection @ 1% 1,775 - $ 175,765
Ancillary Income
Parking 35 spaces @ $10 per month $ 4,200
less vacancy at 25% 1,050 $ 3,150
Laundry $100 × 12 months $ 1,200 $ 1,200
EFFECTIVE GROSS INCOME $ 180,115
LESS OPERATING EXPENSES
Realty Taxes $ 16,500 9.16%
Insurance $ 2,750 1.53%
Annual Elevator$ 2,000 1.11%
Water $ 500 0.28%
Electricity $ 15,000 8.33%
Garbage $ 5,200 2.89%
Janitor’s Salary $ 13,600 7.55%
Janitor’s free suite $ 5,940 3.30%
Supplies and Sundry $ 4,800 2.66%
Miscellaneous Repairs $ 8,225 4.57%
Management fee 5% of EGI $ 9,006 5,00%
TOTAL OPERATING EXPENSES $ 83,521 (46.37%)
NET ANNUAL OPERATING INCOME $ 96,594 (53.63%)
What are the 6 conditions under which the direct capitalization method (V=NOI/R) can provide a value estimate as accurate as the more complex income methods? What is the most common source of difficulty arising from the use of this method?
The subject and comparable properties must be identical (or very similar) in:
•forecasted future periodic changes in NOI;
•assumed holding period;
•the relationship between current value and forecasted resale price;
•the ratio of land to buildings and the capital cost allowance rate;
•the ratio of forecasted CCA recapture to total CCA claimed; and
•forecasted income tax rate, tax shelter benefits, and capital gains taxation.
In the absence of debt financing, it is reasonable to assume these conditions can be met if good comparables are chosen. The most likely source of difficulty would arise if the subject or comparable properties have contract rents which are not at market levels.
Can the sum of the values of the various interests created by the leases or subleases ever differ from the value of the fee simple? Can the sum ever exceed the value of the fee simple interest?
Fees simple interest is by definition the most complete interest. A lease creates various interests namely, leased fee and leasehold interest. The sum of the parts should generally equal the whole or fee simple. Fee simple interest is valued using market rent and discounted by a market discount rate yielding the estimated market value of the property while those interests of leased fee, leasehold interest are analysed using contract rents and the appropriate discount rate. The sum of various interest may differ from the value of the fee simple when contract rents are higher (ie. excess rent) or lower than the market rent. Some of those factors that may impact the differential in market and contract rents include:
•market conditions;
•estimate of reversion values of improved properties; or
•applied capitalization, discount, reversionary rates.
A situation where the sum of interests may exceed the fee simple interest is where a percentage rent above threshold sales has been negotiated. The base rent is based on market rents and the landlord then receives percentage rent for all sales that exceed a breakpoint. Note however that lenders may view this income as more risky applying a higher discount rate than that used for guaranteed rent.
You are asked to appraise a property which has an expected NOI of $45,000 at the end of the first year. You expect the NOI to grow by 5% per year, compounded annually.
1) What will the NOI be at the end of Year 5? Year 10? Year 20?
2) Estimate the value of this property if the overall growth-oriented capitalization rate (R) is 13%.
1) R5 = 45,000(1+0.05)^4 = 54,697.78
R10 = 45,000(1+0.05)^9 = 69,809.77
R5 = 45,000(1+0.05)^19 = 113,712.76
2) V=NOI/R*-gV= 45,000 / 0.13 – 0.5= 562,500
Which of the following statements are true?
) Even though it may be difficult to find a large number of comparable properties, the market determined cap rate is widely accepted and recommended by the appraising profession.
) The weighted average method is the traditional way of determining the cap 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 MOI is representative of future years
All 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 Ratio60%Cost of debt7.0%Expense Ratio33%
Equity Dividend Rate10%Effective Gross Income$250,000
OAR = Mortgage Ratio x Cost of Debt + Equity Ratio x EDR
=(60% x 7.0%) + (40% x 10%)= 4.2% + 4.0%= 8.2%
NOI= EGI – Expenses =250,000-(33% x 250,000) = 167,500
Indication of Value = NOI/OAR=167,500/0.82=2,042,683
Calculate the Net Effective Rent (NER) per sqft over the term given the following information for an office lease.
Rentable Area: 2,000 sqftTerm:5 years
Base Rent: $14 psf for years 1-3, $15 psf years 4-5Inducements:2 months free rent; $5 psf TI
Year 1: 2,000 x 14 = 28,000 minus Total value of Inducements (only year 1) = (5 x 2,000) + ((28,000/12) x 2) = 14,666.67 = 28,000 – 14,666.67 = 13,333.33
Years 2-3:2,000 x 14 = 28,000 x 2 = 56,000
Years 4-5: 2,000 x 15 = 30,000 x 2 = 60,000
Total Base Rent: 13,333.33 + 56,000 + 60,000 + 14,666.67 = 129,333.33
Average Net Effective Rent pft: $12.93
A new lease for a restaurant (retail) property indicates a NER of $25.75 psf. The tenant wants the landlord to provide a $20 pst fixturing allowance. What is the new average NER psf assuming the landlord agrees to provide the incentive?
Rentable Area: 4,500 sqftTerm:10 yearsNER: $25.75
Inducements: $20 psf TI
Total Inducement: 4,500 sqft x $20 = $90,000
Amortized over term: 90,000 / 10 = 9,000
Inducement pst/yr: 9,000 / 4,500 = $2 psf/yr
Adjusted NER: 25.75 – 2 = 23.75
What is the difference between Net Effective Rent (NER) and Contract Rent?
NER is the actual net cash-flow to the landlord after the impact of all inducements, such as free rent, caps on escalation of O & M expense, featuring allowances, etc. NER is always calculated over the term of the lease to account for the timing of inducements.
The property you are appraising is held on a net lease of $1,300 per moth payable in advance for the first 15years 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 (no need for escalation of rental levels in the future)
1) Estimate the value of the leased fee based upon a return of j1=7%. Round your answer to the nearest $100.
2) Estimate the value of the lessee’s interest based upon a return of j1=9%. Pound your answer to the nearest $100.
NOM% = 7j1 rate P/YR = 1 EFF% = 7 P/YR = 12 NOM% = 6.78497446489j12 rate CFj= 0 CFj= 1,300Rents for months 2-100 Nj= 99Months 2-100 CFj= 1,300Rents for months 101-180 Nj= 80Months 101-180 CFj= 1,900Rents for last 5 years Nj= 60Years 16-20 200000 CFj200,000Reversion NPV231,953.447228
\+ 1300=234,253.447228 = 234,300Total PV 2) NOM% =9j1 RATE P/YR= 1 EFF%= 9 P/YR= 12 NOM%= 8.64878j12 RATE CFj = 0 CFj = 300Excess RENT FOR MONTHS 2-100 Nj = 99months 2-100 CFj = 300Excess RENT FOR MONTHS 101-180 Nj =80months 101-180 CFj = -300Excess rent for last 5 years Nj = 60Last 5 years NPV26,085.2782619 \+ 300 = 26,85.2784 = 26,400Net cash flow for first month
A downtown retail property was leased 3 years ago on the following net terms:
Years 1-10: $6,000 / month, in advance
Years 11-20: $6,300 / month, in advance
Years 21-35: $6,500 / month, in advance
Currently 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 (33years) will be $865,000. Assume that a capitalization (yield) rate of j1=7.5% is applicable to both interests
1) What is the value of the leased fee? Nearest $100
2) What is the value of the leasehold estate? Nearest $100
NOM% =7.5j1 RATE P/YR= 1 EFF%= 7.5 P/YR= 12 NOM%= 7.25390282915j12 RATE CFj = 6,000 Nj = 84Years 4-10 (84 months) CFj = 6300 Nj =120Years 11-20 (120 months) CFj = 6500 Nj = 150Years 21-35 (180 months) CFj= 865000Reversion NPV= 1,016,971.55783 = 1,016,972= 1,017,000 2) NOM% =7.5j1 RATE P/YR= 1 EFF%= 7.5 P/YR= 12 NOM%= 7.25390282915 CFj = 300 Excess rent for Years 4-10 Nj = 84Years 4-10 (84 months) CFj = 0Excess rent for Years 11-20 Nj =120Years 11-20 (120 months) CFj = -200 Excess rent for Years 21-35 Nj = 180Years 21-35 (180 months) NPV= 13,389.274626 = 13,400
A lease signed ten years ago on an improved property calls for annual payments as follows, payable at the beginning of each year:
Year 1-10: $22,000/year (already past)
Year 11-16: $27,000/year
Year 17-36: $36,000/year
Year 37-46: $50,000/year
The tenant has an option to purchase which must be exercised before the nest 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.
1) Calculate the PV of the lease payments. Nearest $100
2) Which of the following is true?
a. If the option price was $350,000, it would be worthwhile to purchase the property.
b. Since the present value of the lease payments is higher than the option price, it is worthwhile for the tenant to purchase the property.
c. Even if the tenant purchases the property, she would not gain right to any proceeds upon sale.
d. 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.
1) I/YR =10Discount Rate P/YR= 1 CFj = 0 CFj =27000 Leasing Cost (Y 12-16) Nj = 5 CFj =36000Leasing Cost (Y 17-36) Nj =20 CFj = 50000Leasing Cost (Y 37-46) Nj = 10 NPV= 321,012.307451 \+ 27000 = 348,012.307451PV= 348,000
2)B. is true. Since the PV of the lease pmt is higher than the option price (300,000) it is worthwhile for the tenant to purchase the property. She would also gain the right to any proceeds upon sale. The PV of the reversion value will be insignificant given the length of the holding period.
