Return, Income, Value and Capitalization

• Learning objectives:– Understand the meaning of investment

decision making.

– Understand the role of the appraisal function in real estate investing.

– Examine the appraisal process using capitalization methods.

9 Points of (Ascending) Main Importance

1. Any property is a potential investment by virtue of the income producing capability of real estate.

2. Income potential of real estate is measured using the net operating income (NOI).

3. NOI is a function of market rents (+), vacancies (-) and operating expenses (-).

9 Points of (Ascending) Main Importance

4. Expenses are classified as fixed (property taxes, insurance, hard repairs/maintenance, marketing) or variable (utilities, management/operation, soft repairs/maintenance).

5. Leases are the (legal) mechanisms that specify the division of tenancy and ownership rights of a real property.

6. Leases also stipulate the direction and magnitude of cash flows (revenues and costs) to and from landlords and tenants.

9 Points of (Ascending) Main Importance

6. Cash flows are adjusted for risks originating from the uncertainty in the above revenues and costs.

7. Such risks are associated with variations in rent due to lease provisions (step-up/% revenue), concessions (grace, tenant improvements) and options (equity participation, renewal, first refusal, relocation, term flexibility) that arise from the economic forces affecting real estate.

9 Points of (Ascending) Main Importance

8. The risk-adjusted expected revenues and costs associated with a real property’s cash flows result in estimates of the economic value for a property.

9. Likewise, the estimate of the economic present discounted value of a property can be used to infer cash flows and/or return characteristics of a real estate investment.

The Nature of Real Estate Returns

• Real estate returns originate from the income generated by sharing tenancy rights of a property.

• For this reason, it is of preliminary importance to calculate a property’s “yield” potential, to compare real estate with competing investment alternatives.

The Capitalization (CAP) Rate

• The CAP rate is a measure of the estimated first year yield for an income generating property.

CAP = NOI ÷ value

• Because the CAP rate is a function of NOI and value, it incorporates features of both, return and risks associated with a property.

The Appraisal Function and the Cap Rate

• The appraisal process:

Identify property and ownership distribution

Specify purpose of appraisal

Specify effective date(s) of estimated value

Obtain and analyze market data

Estimate value

The Appraisal Function and the Cap Rate

• Income capitalization approach:

CAP = NOI ÷ value

Value = NOI ÷ CAP

NOI = ?

• Estimate from market demand and supply analysis (in feasibility study).

• Estimate from rental history of the property (when one exists or is available), with proper adjustments in marketing strategy and costs.

CAP Rate = ?

• Should be derived from what investors are receiving from and paying for comparable properties in the market for the specific property under evaluation.

• If you can estimate rents, prices, operating expenses and vacancy rates for relevant (comparable) properties, then you can arrive at CAP rate estimate.

The CAP Rate and Efficient Markets

• If investment markets are efficient, there should be no arbitrage across different investments = the risk-adjusted time value of money is the same across all investments.

CAP = r – gi

The CAP Rate and Efficient Markets

• If investment opportunities occur in efficient markets the CAP rate should be equal to the risk adjusted required rate of return on investments, r, minus a factor accounting for value appreciation, gi.

• Alternatively, r = CAP + gi. The discount rate = current yield + capital gain = required rate of return.

Mortgage + Equity Value Capitalization

• V = M + E

• M = LTV*V

• E = PDV(BTCF)

+ PDV(price)

– PDV(balance on mortgage)

• PDV(BTCF) = PDV(NOI) – PDV(DS)

Mortgage + Equity Value Capitalization

• V = LTV*V + PDV(NOI) – PDV(DS)+ PDV(price)– PDV(balance on mortgage)

• V = k*V + PDV(NOI)• V = PDV(NOI)/(1-k)• CAP = 1-k• ‘k’ is the depreciated cumulative fraction of the

property’s value used during the holding period by the current investor.