Lecture 10 Real Estate Valuationn.pptx

VALUATION & INVESTMENTS (FINC 412) Lecture 10: Introduction to Real Estate Valuation Muhammad M. Ma’aji, PhD, A C C A , F M VA  Lesson Plan Lesson Topic Introduction to Real Estate Valuation Learning Outcomes At the end of this lesson, students will be able to:...

VALUATION & INVESTMENTS (FINC 412) Lecture 10: Introduction to Real Estate Valuation Muhammad M. Ma’aji, PhD, A C C A , F M VA  Lesson Plan Lesson Topic Introduction to Real Estate Valuation Learning Outcomes At the end of this lesson, students will be able to: classify and describe basic forms of real estate investments; describe the characteristics, the classification, and basic segments of real estate; explain the role in a portfolio, economic value determinants, investment characteristics, and principal risks of private real estate; describe commercial property types, including their distinctive investment characteristics; compare the income, cost, and sales comparison approaches to valuing real estate properties; calculate the value of a property using the direct capitalization and discounted cash flow valuation methods; Activities/Methods Lecture, discussion, group exercise and excel practice Reading and References Textbook Reading: CFA Material, Alternative Investment: Part I; Practice: KAPLAN Schweser Notes 2018 Exam Preparation, Alternative Investment: Part I Additional reading: Reilly, F. & Brown, K. (2016) Analysis of Investments & Management of Portfolios, 10th Edition, South-Western, Cengage Learning. Agenda Real Estate Investment: Basic forms, Characteristics and classifications Benefits and Risk of Real Estate Investment Real Estate Valuation Real Estate Investment Real estate investments can take a variety of forms, from private equity investment in real estate properties to publicly traded debt investment, such as mortgage-backed securities. Private equity investment in real estate is sometimes referred to as direct ownership, in contrast to indirect ownership of real estate through publicly traded equity securities, such as real estate investment trusts (REITs). Private real estate investments are often included in the portfolios of investors with long-term investment horizons. Publicly traded pooled investment may be suitable for investors with short investment horizons and higher liquidity needs. Basic forms of Real estate investment Practice 1 An investor is interested in adding real estate to her portfolio for the first time. She has no previous real estate experience but thinks adding real estate will provide some diversification benefits. She is concerned about liquidity because she may need the money in a year or so. Which form of investment is most likely appropriate for her? A Shares of REITs B Mortgage-backed securities C Direct ownership of commercial real estate property Real estate: characteristics and classifications Real estate has characteristics that distinguish it from the other main investment asset classes and that complicate the measurement and assessment of performance. ◦ Heterogeneity and fixed location: Whereas all bonds of a particular issue and stocks of a particular type in a specific company are identical, no two properties are the same. ◦ High unit value: The unit value of a real estate property is much larger than that of a bond or stock because of its indivisibility. ◦ Management intensive: An investor in bonds or stocks is not expected to be actively involved in managing the company, but a private real estate equity investor does. Real estate: characteristics and classifications ◦High transaction costs: Buying and selling of real estate is also costly and time consuming because others, such as appraisers, lawyers, ◦Depreciation: Buildings depreciate as a result of use and the passage of time. ◦Illiquidity: As a result of several of the above factors, real estate properties are relatively illiquid. Real estate: characteristics and classifications There are many different types of real estate properties, a simple classification can be residential and non-residential properties. ◦ Residential: include single-family houses and multi-family properties, such as apartments. In general, residential properties are properties that provide housing for individuals or families. ◦ Non-residential: Non-residential properties include commercial properties other than multi-family properties, farmland, and timberland. ◦ Office properties range from major multi-tenant office buildings found in the central business districts of most large cities to single-tenant office buildings. ◦ Industrial and warehouse properties include property used for light or heavy manufacturing as well as associated warehouse space. Real estate: characteristics and classifications ◦ Retail properties vary from large shopping centers with several stores, including large department stores, as tenants to small stores occupied by individual tenants. ◦ Hospitality properties vary considerably in size and amenities available. Motels and smaller hotels are used primarily as a place for business travelers and families to spend a night. ◦ Farmland can be used to produce crops or as pastureland for livestock. ◦ Timberland can be used to produce timber (wood) for use in the forest products industry. ◦ Other types of commercial real estate that can be owned by investors include parking facilities, restaurants, and recreational uses, such as country clubs, marinas, sports complexes, and so on. Agenda Real Estate Investment: Basic forms, Characteristics and classifications Benefits and Risk of Real Estate Investment Real Estate Valuation Benefits of Real Estate Investment ◦ Current Income ◦ Investors may expect to earn current income on the property through letting, leasing, or renting the property. ◦ Price appreciation (capital appreciation): ◦ Investors often expect prices to rise over time. Any price increase also contributes to an investor’s total return. ◦ Inflation hedge: ◦ Investors may expect both rents and real estate prices to rise in an inflationary environment. ◦ Diversification: ◦ Investors may anticipate diversification benefits. Real estate performance has not typically been highly correlated with the performance of other asset classes, such as stocks, bonds, or money market funds. Risks of Real Estate Investment ◦ Business conditions: ◦ Fundamentally, the real estate business involves renting space to users. Changes in economic conditions will affect real estate investments because both current income and real estate values may be affected. ◦ Long lead time for new development: ◦ New development projects typically require a considerable amount of time from the point the project is first conceived until all the approvals are obtained, the development is complete, and it is leased up. ◦ Lack of liquidity: ◦ Liquidity is the ability to convert an asset to cash quickly without a significant price discount or loss of principal. ◦ Environmental: ◦ Real estate values can be affected by environmental conditions, including contaminants related to a prior owner or an adjacent property owner. Practice 2 An investor is concerned about interest rates rising and decides that she will pay all cash and not borrow any money to avoid incurring any risk due to interest rate changes. This strategy is most likely to: A reduce the risk due to leverage. B eliminate the risk due to inflation. C eliminate the risk due to interest rate changes. Practice 3 The primary economic driver of the demand for office space is most likely: Ajob growth. B population growth. C growth in savings rates. The demand for which of the following types of real estate is likely most affected by population demographics? A Office B Multi-family C Industrial and warehouse Agenda Real Estate Investment: Basic forms, Characteristics and classifications Benefits and Risk of Real Estate Investment Real Estate Valuation Real Estate Valuation Approach In general, there are three different approaches that appraisers use to estimate value: the income approach, the cost approach, and the sales comparison approach. ◦ Income approach: considers what price an investor would pay based on an expected rate of return that is commensurate with the risk of the investment. The value estimated with this approach is essentially the present value of the expected future income from the property, including proceeds from resale at the end of a typical investment holding period. ◦ Cost approach: considers what it would cost to buy the land and construct a new property on the site that has the same utility or functionality as the property being appraised (referred to as the subject property). ◦ Sales comparison approach: considers what similar or comparable properties (comparable) transacted for in the current market. Adjustments are made to reflect comparable’ differences from the subject property, such as size, age and location. The Income approach ◦ The direct capitalization method and discounted cash flow method (DCF) are two income approaches used to appraise a commercial (income- producing) property. ◦ To value a property using an income approach, we need to calculate the net operating income (NOI) for the property. ◦ NOI is a measure of the income from the property after deducting operating expenses for such items as property taxes, insurance, maintenance, utilities, repairs, and insurance but before deducting any costs associated with financing and before deducting federal income taxes. Net Operating Income (NOI) Rental income if fully occupied + Other income = Potential gross income - Vacancy and collection loss = Effective gross income - Operating expenses = Net operating income  Practice 4 A 50-unit apartment building rents for $1,000 per unit per month. It currently has 45 units rented. Operating expenses, including property taxes, insurance, maintenance, and advertising, are typically 40 percent of effective gross income. The property manager is paid 10 percent of effective gross income. Other income from parking and laundry is expected to average $500 per rented unit per year. Calculate the NOI. Answer Direct capitalization method ◦ Direct capitalization method Value = NOI/Cap rate Where: ◦ NOI = Net operating income ◦ Cap rate = NOI/Value or NOI/Sale price of comparable or Discount rate – Growth rate  Practice 5 Suppose the Effective gross income for an office building is expected to be $475,000 and the operating expenses Operating expenses, including property taxes and insurance amounting to $205,000 and Interest expenses cost $156,000. The appropriate cap rate is 8%. Estimate the market value of the property using the direct capitalization method Answer  Practice 6 A 200,000 square feet office building rents for $25 per square feet. It currently has 45 units rented. Operating expenses, including building utilities and maintenance total $875,000 and vacancy and collection loss is 5% of potential gross income. The building taxes and insurance cost $350,000. Interest expenses cost $400,000 and other income from parking is expected to average $75,000 per year. Calculate the value of the office building if discount rate is 12% and growth rate is 4%. Answer Practice 7 A property is being purchased that requires some renovation to be competitive with otherwise comparable properties. Renovations satisfactory to the purchaser will be completed by the seller at the seller’s expense. If it were already renovated, it would have NOI of $9 million next year, which would be expected to increase by 3 percent per year thereafter. Investors would normally require a 12 percent IRR (discount rate) to purchase the property after it is renovated. Because of the renovation, the NOI will only be $4 million next year. But after that, the NOI is expected to be the same as it would be if it had already been renovated at the time of purchase. What is the value of or the price a typical investor is willing to pay for the property? Answer Answer Discounted Cash Flow (DCF) Method ◦ Value under DCF is Value = NOI/(r – g) Where: ◦ NOI = Net operating income ◦ r = the discount rate (required return) ◦ g = the growth rate for income (given constant growth in income, value will grow at the same rate)  Practice 8 NOI is expected to be $100,000 in the first five years due to existing contract between the landlord and the tenants, and after that, NOI is expected to increase at 2 percent per year for the foreseeable future. The property value is also expected to increase by 2 percent per year. Investors expect to get a 12 percent IRR given the level of risk. What is the value of the property today? Answer Answer Exhibit 1 A B C Single Tenant Shopping Property description Office Center Warehouse Unit Size (square feet) 3,000 5,000 9,000 No of Units 9 10 15 Gross Rents ($/sq ft/month) $151.78 $125.50 $110.36 Other income $27,000 $183,000 $9,500 Vacancy and collection loss $0 $61,000 $59,000 Property management fee $21,500 $35,000 $22,000 Other operating expenses $34,000 $234,000 $84,000 Discount rate 11.50% 9.25% 11.25% See Assumption Growth rate See Assumption 2 2 3.00% Terminal year cap rate 15% 11.00% Market value of land $1,500,000 $1,750,000 $4,000,000 To prepare for the upcoming meeting, Green has asked her research analyst, Ian Cook, for a valuation of each of these properties under the income, cost and sales comparison approaches using the information provided in Exhibit 1, and the following two assumptions: Assumption 1: The holding period for each property is expected to be five years Assumption 2: Property A, B & C is expected to have the same net operating income for the holding period due to existing leases, and a one-time 20% increase in year 6 for Property A, & B due to lease rollovers. No further growth is assumed thereafter. Requirements: A. Based upon Exhibit 1, calculate the net operating income of the three properties B. Calculate the value of all the Properties using the direct capitalization C. Calculate the value of all the Properties using the DCF approach Answer Answer  Investment useful links – http://www.morganstanley.com – http://www.nabe.org – http://www.globalinsight.com – http://www.conference-board.org – http://www.yardeni.com – http://www.bea.doc.gov/bea/pubs.htm – http://www.whitehouse.gov/fsbr/esbr.html – http://www.stats.bls.gov – http://www.federalreserve.gov – http://www.cbo.gov – http://www.worldbankorg – http://www.whitehouse.gov/cea/ – http://www.phil.frb.org/econ/forecast/index.h – http://www.gpoaccess.gov/indicators/browse tml.html – http://www.spglobal.com/index.html – http://www.census.gov/csd/qfr – http://www.bis.org/cbanks.htm – http://www.federalreserve.gov/pubs/bulletin – http://www.bankamerica.com/ Thank you for listening Q&A