Ch. 7 & 8: Appraisal value Ling and Archer

Ch. 7 & 8: Appraisal value
Real Estate Principles: A Value Approach
Ling and Archer
Outline




The appraisal process
Sales comparison approach
Cost approach
Income approach
Appraisal value = market value


Chapters 7 & 8 focus on estimating the
market value of RE, i.e., the most
probable selling price, assuming
normal sale conditions.
In contrast to market (appraisal) value,
investment value is the value a
particular investor places on a property
(Chapter 19).
The appraisal report


Chapters 7 & 8 try to arrive at an appraisal
that is an unbiased written estimate of the
fair market value of a property, usually
referred to as the subject property, at a
particular time.
This process leads to an appraisal report
that is the document the appraiser submits
to the client and contains (1) the appraiser’s
final estimate of value, (2) the data upon
which the estimate is based, and (3) the
calculations used to arrive at the estimate.
Uses of an appraisal report


Applying for a mortgage.
Establishing a benchmark for setting
the ask price and the bid price.
USPAP



The Uniform Standard of Professional
Appraisal Practice (USPAP), established in
1987 and maintained by the Appraisal
Foundation, are currently required and
followed by all states and federal regulatory
agencies.
USPAP imposes both ethical obligations
and minimum appraisal standards that must
be followed by all professional appraisers.
To comply with USPAP, appraisers follow a
general appraisal framework.
The appraisal process, I


1. Identify the appraisal problem.
The appraiser identifies (1) the property to
be valued, (2) the property rights to be
valued; e.g., fee simple absolute or
leasehold, (3) the type of value to be
estimated; value estimates for insurance,
taxation, or other purposes, (4) the date of
the estimate, and (5) limitations of the
analysis.
The appraisal process, II


2. Determine the required scope of
work.
The worked performed should be
consistent with the expectations of
typical uses of similar appraisals.
The appraisal process, III



3. Collect data and describe property.
Data are collected concerning the market
and property-specific context of the subject
property.
The information often includes such items
as recent transaction information, rental
rates, vacancy rates, physical
characteristics of the subject property and
comparable properties, flood zone data,
population and employment trends, and
land use data.
The appraisal process, IV





4. Perform data analysis.
This include market analysis: supply, demand,
marketability.
The highest and best use of a property is defined as
the use found to be (1) legally permissible, (2)
physically possible, (3) financial feasible, and (4)
maximally productive, i.e., yielding the greatest net
benefit to an owner.
In most appraisal assignments, property is valued
at its highest and best use.
The appraiser usually visualizes highest and best
use in two separate circumstances: (1) highest and
best use of the land as though vacant, and (2)
highest and best use of the property as improved.
The appraisal process, V

5. Determine value of land.
The appraisal process, VI






6. Apply 3 conventional approaches to valuation.
There are 3 conventional approaches: (1) the sales
comparison approach, (2) the income approach, and (3) the
cost approach.
Generally, all three approaches should be used in a formal
appraisal.
The sales comparison approach is usually the preferred
approach. It is applicable to almost all one- to four-family
residential properties and even to some types of incomeproducing properties where enough comparable sales are
available.
The income approach is the dominant approach for incomeproducing properties, e.g., offices.
The cost approach is usually the last resort when there are no
comparable sales and there is no income to measure, e.g.,
public auditoriums.
The appraisal process, VII




7. Reconciliation and a final estimate of
market value.
Each of the 3 approaches is applied to
establish alternative indicators of market
value.
Reconciliation: the process in which the
appraiser weighs the relative reliability of
value indicators for the property being
valued.
Usually, more weight is given to the most
applicable method and most reliable data.
The appraisal process, VIII



8. The appraisal report.
Report final value estimate.
The content of appraisal reports must
meet the requirements of one of the
reporting options defined in USPAP.
Sales comparison approach

Basic Idea:


Value of RE can be determined by
analyzing the sale prices of similar
properties.
Why?

Because in a competitive market close
substitutes will sell for similar prices.
The process

Exhibit 7-3
Identify
Elements of
Comparison &
Value
Adjustment
Select
Comparable
Sales
Adjust
Comparable
Sale Prices
w.r.t. Subject
Reconcile
Adjusted Sale
Prices; Obtain
Indicated Value
Step 1




1. Identify elements of comparison and
value adjustment.
These elements are the relevant
characteristics used to compare and adjust
the property prices.
Examples include location, site size, sale
date, construction quality, building age,
number of bath, etc.
That is, those elements that have
implications on the value of the property.
Step 2





2. Select comparable sales.
Identify recent sales that are similar to the
subject property and located in immediate
neighborhood.
Select commercial comparables that
compete with the subject property for buyers
and/or tenants.
Arm’s-length transactions. Comparable
sales are fairly negotiated transactions; no
foreclosures.
Usually need at least 3 comparable sales.
Data

The sources of market data on
comparable sales include: (1) public
records, e.g., the local (county)
property tax assessor’s office, (2)
multiple listing service (MLS) that is
usually maintained by the local board
of realtors, and (3) private data
services.
Step 3, I




3. Adjust comparable sale prices to approximate
subject.
2 categories: (1) transactional adjustments, such as
condition of sale, financing terms, and market
conditions, (2) property adjustments, such as
location, physical characteristics, legal
characteristics, use, and non-realty items (personal
property).
Condition of sale: arm’s-length transactions are
preferable.
Financing terms: a favorable financing term (e.g.,
low-income homebuyer programs) is often
associated with a higher purchase price. Try not to
use sales with special financing terms because their
adjustments are difficult.
Step 3, II





Market conditions: historical sale prices need to be
adjusted to reflect current market conditions.
Location: real estate value is about location; this
adjustment is rather difficult.
Physical characteristics: differences in lot size,
quality of structure, floor plan have implications on
RE value.
Legal characteristics: select sales with the same
bundle of rights; the adjustments are difficult.
Use: if you are asked to appraise a single-family
residence and a similar house next door is currently
used as a law office. Its current sale is not a
comparable sale.
Step 4



4. Reconcile adjusted sale prices; obtain
indicated value.
The final adjusted sale prices of
comparables are reconciled to the indicated
value.
Appraisers usually give more weights to the
final adjusted sale prices of comparables
that have more complete data, fewer and
smaller adjustments (more similar), and
more recent transactions.
Sequence of adjustments
Transaction price of comparable
+/- Property rights conveyed (most tricky adjustment)
+/- Financing terms (low-income loan?)
+/- Conditions of sale ( a forced sale?)
+/- Expenditures immediately after purchase
+/- Market conditions
= Market-adjusted normal sale price
+/- Location
+/- Physical characteristics (lot size, structure size, etc.)
+/- Economics characteristics (tenant mix, lease terms, etc.)
+/- Use (most tricky adjustment)
+/- Non-realty items
= Indication of subject value
An example









A comparable property (C1) sold six months ago for $150,000.
The adjustments for the various elements of comparison have
been calculated as follows:
Location: -5 percent
Market conditions: +8 percent
Physical characteristics: +$12,500
Financing terms: -$2,600
Conditions of sale: 0
Legal characteristics: 0
Use: 0
Nonrealty items: -$3,000
The indicated value











Transaction price $150,000
Adjustment for financing terms Minus $2,600
Adjusted price = $147,400
Adjustment for market conditions Plus 8% $11,792
Adjusted price = $159,192
Adjustment for location Minus 5% $7,959.60
Adjusted price = $151,232.40
Adjustment for physical characteristics Plus $12,500
Adjusted price = $163,732.40
Adjustment for nonrealty items minus $3,000
Indication of subject value = $160,732
Reconciliation



Comparable C1 yields an indication of
subject value = $160,732.
Suppose that comparable C2 yields an
indication of $170,050, and comparable C3
yields an indication of $158,405.
One possible reconciliation is: appraisal
value = $163,062 (simple average of
$160,732, $170,050, and $158,405).
Cost approach
Estimated reproduction cost of improvements
− Estimated depreciation
= Depreciated cost of building improvements
+ Estimated value of site
= Indicated value by the cost approach
Some elements


The reproduction cost is the cost to construct the
building today, replicating it in exact detail. This
includes any outdated functional aspects of the
building.
Accrued depreciation is the actual reduction in
market value of the building. It is the difference
between the market value of a building and the total
cost to reproduce it new. It can be attributed to (1)
physical deterioration, (2) functional obsolescence,
e.g., poor room arrangement, and (3) external
obsolescence, e.g., a deterioration in the
neighborhood.
Income approach



The use of the income approach is
popular for evaluating incomegenerating properties.
Commercial property owners usually
expect that they will receive cash flows
from their properties.
That is, the perceived value is derived
from incomes.
Step 1





1. First, estimate a property’s expected periodic
incomes.
The measure of income is the annual net operating
income (NOI).
NOI is equal to expected annual rental income, net
of vacancies, minus operating and capital
expenses.
Financing costs and income taxes are not
considered in the calculation of NOI because these
parameters are individual-specific.
Recall that appraisal is about estimating market
value, not investment value.
Step 2



2. Second, convert the income estimates
into a market value estimate.
This converting process is called income
capitalization.
Two categories of income capitalization
methods: (1) direct capitalization, and (2)
discounted cash flow method.
Principles for estimate NOI




Evaluate all income and expense items in terms of
current market conditions.
Take the experience of similar properties in the
market into consideration.
Take the historical experience of the subject
property into consideration.
Appraisers’ income and expense estimates need to
be in line with current market rents, average
vacancy and collection losses, and normal
operating and capital expenses for this type of
property in this location and market.
An example



Centre Point office building has 9
office suites.
The contract rents for 6 suites are at
$1,800 per month and for the other 3
suites are at $1,400 per month.
We want to estimate the NOI for the
next year.
NOI computation
PGI
– VC
+ MI
= EGI
– OE
– CAPX
= NOI
Potential gross income
Vacancy & collection loss
Miscellaneous income
Effective gross income
Operating expenses
Capital expenditures
Net operating income
Potential gross income (PGI)




Potential gross income (PGI) = 6 × $1,800
× 12 months + 3 × $1,400 × 12 months =
$180,000.
This estimate of PGI is based on contract
rents.
Contract rents may be different from market
rents. Appraisers may want to make an
adjustment to modify the PGI estimate
based on market rents.
Suppose that there is no need for the
adjustment for Centre Point .
Effective gross income (EGI)


Suppose that vacancy and collection losses
are 10% of potential gross income. The
property has no miscellaneous income, e.g.,
garage rentals, parking fees, vending
machines, etc.
Effective gross income (EGI) = PGI –
vacancy and collection losses +
miscellaneous income = $180,000 –
($180,000 × 10%) + 0 = $162,000.
Some definitions


Operating expenses: the ordinary and
necessary expenditures incurred during the
year (including incidental repairs) that do not
materially add value, but keep the property
operating and competitive in its market.
Capital expenditures: replacements and
alterations to a building or improvement that
materially prolong its life and increase its
value.
NOI



Suppose that operating expense, e.g., property
taxes, insurance, utilities, garbage removal,
maintenance, repairs, supplies, and property
management, is 40% of EGI each year.
Suppose that capital expenditure, e.g., roof
replacements, additions, floor coverings, kitchen
equipments, air-conditioning, electrical fixtures, and
parking surfaces, is 5% of EGI each year.
NOI1 = EGI – operating expenses – capital
expenditures = $162,000 – ($162,000 × 40%) –
($162,000 × 5%) = $89,100.
Direct capitalization on NOI1




NOI1 = $89,100.
Direct capitalization is the process of
estimating a property’s market value by
dividing the next calendar year’s NOI by a
current capitalization (cap) rate, R0.
V0 = NOI1 / R0.
(Current) cap rate R0 is also called the
overall cap rate or the going-in cap rate.
Cap rate



Cap rate is not an overall measure of return
because its use ignores the most of future (t
= 2, 3, 4, ….) cash flows from operations.
(Current) cap rate is analogous to the
dividend yield on a common stock.
Not a discount rate; it is a price ratio.
Estimating going-in cap rate



2 methods.
(1) Abstracting cap rates from comparables’
cap rates, i.e., using the average cap rate of
comparables.
(2) Required going-in cap rate survey
numbers. The Real Estate Research
Corporation (RERC) regularly surveys the
cap rate expectations of institutional
investors. The results are can be found (for
a fee) at www.rerc.com.
Direct capitalization result



Suppose that the appraiser chooses a
cap rate of 9.9% for Centre Point.
V0 = NOI1 / R0 = $89,100 / 0.099 =
$900,000.
That is, the appraisal value of this
income-property is estimated to be
$900,000.
IRR




Suppose that the Centre Point is bought at
$900,000, NOI1 (you can think of this as
dividends) = $89,100, and the property is
expected to increase in value to $916,650
by the end of year 1.
The expected total rate of return, y0, or,
equivalently, the IRR is:
y0 = [dividends + (V1 – V0)] / V0 = NOI1 / V0
+ (V1 – V0) / V0 ≡ R0 + g.
0.1175 = [$89,100 + ($916,650 - $900,000)]
/ $900,000 = 0.099 + 0.0185.
Expected return on RE



y0 = R0 + g.
Property return has two components:
(1) dividends, i.e., cash generating
power, and (2) appreciation
(depreciation).
Implication: with required return (yield)
constant, more appreciation implies
lower cap rate.
An extreme low cap rate



According to IPG/CRENews (2006), Taconic and
NY Common's sale of 450 Park should fetch $1,500
per square foot ($510 million), which would set a
new Gotham record…. The office is located at the
northern tip of "Wall Street North", at 57th and Park,
where rents continue to rise above the $100 psf
mark.
2006 NOI totaled $13.7 million, yielding a 2.7%
cap rate (!!!) at $510 million, excluding closing
costs.
Source: http://threecap.blogspot.com
Why is the cap rate so low? (4.68% for T-bills in
2006)
Causality


Note that risk drives return in
equilibrium, regardless of whether the
asset is a property or a stock.
That is, y0 is determined in the capital
market. The causality goes from y0 to
R0, not the other way around.
Discount cash flow analysis



We have studied the 1st method of
income capitalization: direct
capitalization on NOI1.
We now would like to look at the 2nd
method: DCF.
For this method, we need NOI
estimates for a longer period of time.
NOI estimates




Suppose that the holding period is 5 years.
A pro forma analysis gives us the NOI
estimates for the next 6 years: $89,100,
$91,773, $94,526, $97,362, $100,283, and
$103,291.
The going-out cap rate, R5, is 10.00%.
V5 = NOI6 / R5 = $103,291 / 0.10000 =
$1,033,000.
DCF result




The expected selling expenses are $58,300.
The discount rate for NOI’s is 11.75%.
CF5 = $1,033,000 + $100,283 - $58,300 =
$1,074,983.
V0 = $89,100 / (1+ 0.1175) + $91,773 / (1+
0.1175)2 + $94,526 / (1+ 0.1175)3 + $97,362
/ (1+ 0.1175)4 + $1,074,983 / (1+ 0.1175)5 =
$900,181.
Final reconciliation


A final reconciliation between
$900,000 (direct capitalization) and
$900,181 (DCF) is then reached.
Suppose that the appraiser has more
confidence on the DCF estimate, and
decides the indicated value to be
$900,150.
Risk of CF stability




Appraisers recently slashed the value of the
University Mall — from $116.3 million to $51.4
million.
University Mall appears to be in "fine shape" to
anyone walking through it (very low vacancy
rate).
"What's happening in the background is leases
that used to be five and 10 years are now oneyear renewals …There's no guarantee of an
income stream going forward.”
01/26/2016, Burlington Free Press.
The most expensive building
sold in the U.S.?


“The General Motors
Building (in Manhattan)
will likely be sold for
more than $3 billion...
with at least three
offers topping $3
billion…. work out to
about $1,500 per
square foot.”
Source: WSJ, Feb. 20,
2008
Individual assignment



Subject property for Spring 2016: Unit
#1503 in Lanikea at Waikiki
Note that the subject property changes
every time I teach this course; You
need to work on the subject property
that I hand out in the class.
Please compute its appraisal value
based on the sales comparison
approach.