2.2 Appraisal - Income Approach to Valuation PDF

Section 2  Section 2.1 Valuation Using the Cost Approach and Sales Comparison Approach  Section 2.2 Valuation Using the Income Capitalization Approach  Section 2.3 Investment Decisions: Ratios and Multipliers  Section 2.4 Time Value Concepts of Compounding and Discounting  Se...

Section 2  Section 2.1 Valuation Using the Cost Approach and Sales Comparison Approach  Section 2.2 Valuation Using the Income Capitalization Approach  Section 2.3 Investment Decisions: Ratios and Multipliers  Section 2.4 Time Value Concepts of Compounding and Discounting  Section 2.5 Investment Decisions Using Discounted Cash Flows 8-1  Introduction to Real Estate 2.2 Appraisal – Income Approach to Valuation Introduction to Real Estate Instructor: Joel Starbuck Fall 2024 Appraisal method #3: income approach…  3 appraisal methods…all solving for present value but applying different perspectives…  Sales comparison (Section 2.1: past comp sales)  Cost (Section 2.1: current depreciated cost)  Income (future capitalized cash flows)  Rationale of income approach…  Value of an income property is the present value of its anticipated future cash flows  Called “income capitalization”  Convert future income into a lump sum present value  Only “income properties”…  Properties generating cash flows from operations (rents)  Very important chapter…foundation for later → investing! 8-3 Two approaches to income valuation…  Discounted cash flow (DCF)  Discount multiple years’ cash flows at a required return (a/k/a discount rate) to estimate present value  Direct capitalization (DC)  Apply a capitalization rate (cap rate) or multiplier to a single year’s cash flow to estimate present value  Both use estimated future net cash flows from the property generated from the operation (rents net of expenses) or disposition/sale (sales proceeds net of sales costs) of the property 8-4 Discounted cash flow (DCF)…  Estimate all future cash flows over assumed holding period  Both operating cash flows from rents and terminal cash flow from disposition/sale at the end of the holding period  Discount those future cash flows back at a required return (a/k/a discount rate) to present value  Required return = necessary return on investments of similar risk…i.e., “opportunity cost” → why a/k/a “discount rate?”...  If you can earn 10% on other investments of similar risk (i.e., other “opportunities”), the value of this investment would be that value as would likewise return 10% given your assumed future cash flows  DCF solves for that value → the value that if we paid that amount and then received those cash flows it would return the required return!  DCF is the investment in reverse! → we make money buying (valuing), not selling → it’s all we ultimately control in the whole investment!  NO CALCULATORS!  → learning how/why we use DCF for now… will calculate DCF later when we’re learning investing 8-5 DCF elements…  DCF requires…  Estimate expected holding period  Estimate net cash flows over expected holding period from both operations and sale  Estimate required return (a/k/a discount rate) to discount those future cash flows back to present value (investment in reverse!)  Remember: objective → typical market participants (not appraiser’s subjective opinions)  Later we’ll use individualized/subjective assumptions when solving for investment value  Use net cash flows from the property…  Operations → net operating income (NOI)  Sale → net sales proceeds (NSP) 8-6 Estimating net operating income (NOI)… PGI Potential Gross Income - VC Vacancy & Collection Loss + MI Miscellaneous Income = EGI Effective Gross Income - OE Operating Expenses - CAPX* Capital Expenditures = NOI Net Operating Income *Above the line CAPX vs. below the line CAPX  Let’s estimate/calculate each level of cash flow → the property’s “cash flow statement/waterfall” 8-7 Potential gross income (PGI)…  “Potential” → property’s rental income assuming 100% occupancy  What rent?...  Contract rent per leases or current market rent?  We’re valuing future cash flows…current leases represent past rental values agreed upon at time of lease contract  We assume contract rents will increase to market rents over holding period → so, use current market rents  Unless long-term lease(s) prevent adjusting to market rents during holding period → then use contract rent  E.g., long-term single tenant property (fast-food or Walgreens) 8-8 Boulder Point: an office building operating cash flows…  Example from text → simple suburban office building…  Rent: 2 suites at $1,800/mo.; 1 at $3,600/mo.; 5 suites at $1,560/mo. (cf. rents quoted sf/year → Class A, B and C)  Rent increases: 3% (compounding annually)  Vacancy & collection: 10% of PGI  Operating expenses: 40% of EGI  Capital expenditures: 5% of EGI  Holding period: 5 years  Boulder Point’s PGI… 2 x $1,800/mo. x 12 mos.* = $ 43,200 1 x $3,600/mo. x 12 mos.* = $ 43,200 5 x $1,560/mo. x 12 mos.* = $ 93,600 Potential gross income = $180,000 *Always annualize cash flows for income capitalization/valuation! 8-9 Effective gross income (EGI)…  Deduct vacancy and collection (VC) loss from PGI  Historical experience of the subject property  Competing/similar properties in the market  “Natural vacancy rate”…vacancy expected in a stable market  Cf. multi-tenant vs. single tenant properties  Stabilized cash flows account for natural market vacancy…e.g., 5%-10%  Add miscellaneous income (MI) to PGI (if applicable)  Income other than contracted rents per leases  E.g., garage rentals/parking fees, laundry/vending machines, etc.  Boulder Point’s EGI… Potential gross income $180,000 − Vacancy & collection* 18,000 + Miscellaneous income** 0 = Effective gross income $162,000 *10% of PGI per assumptions ** N/A per assumptions 8-10 Net operating income (NOI)…  Deduct operating expenses (OE) from EGI  Ordinary/regular expenses necessary to keep a property functioning properly (think operate/maintain/repair)  Again, look to historical experience of the subject property and competing/similar properties in the market  Fixed OE do not vary with occupancy  E.g., property taxes and insurance  Variable OE do vary with occupancy (i.e., not stabilized!)  E.g., utilities, supplies, maintenance and repairs  Not included/deducted:  Loan payments (“debt service”…later) → “levered” cash flows  Income taxes (cf. property taxes) → after-tax analysis (uncommon)  Depreciation (“non-cash” expense) doesn’t affect property cash flows → only affects/reduces owner’s/investor’s income taxes → only included/deducted when doing after-tax analysis 8-11 NOI cont’d…  Deduct capital expenditures (CAPX)  Expenses that materially increase value or extend useful life of the property (think replace/improve)  Additions/renovations (e.g., tenant improvements…“TIs”)  Major replacements (e.g., roof, HVAC, parking lots)  Typically, estimated constant annual reserve (vs. actual yearly estimates…much simpler but not how it will be)  Boulder Point’s NOI… EGI $162,000 − OE* 64,800 − CAPX** 8,100 = NOI $ 89,100 *40% of EGI per assumptions ** 5% of EGI per assumptions 8-12 Boulder Point’s est’d value using DCF…  Years 2 thru 5 → increase PGI (rent) by 3% compounded annually per assumptions → then recalculate NOI  Have our estimated net cash flows from operations (NOI)  Is there another cash flow we need for DCF?...  We need the terminal cash flow from the sale of the property at the end of the holding period… 8-13 Boulder Point’s value using DCF cont’d…  We’ll learn to estimate Net Sale Proceeds (NSP) later  Discount rate reflects expected return from other investments of similar risk → required return/opportunity cost  Discount combined operating (NOI) and terminal cash flows (NSP) at discount rate to estimate present value (PV) 8-14 It’s all about the cash flows…  Estimated future net cash flows are the determinants of the income property’s value today  DCF/DC are just the valuation methods (tools)  Property level vs. investor level cash flows…  Property level: NOI is like an income property's “dividend” and the investment property like any business (annual income – expenses = net income → available for dividends)  Investor level: We’re not done with cash flows at NOI → we have the “investor level” of our cash flow “waterfall” still to go...  NOI must be sufficient to…  Pay the debt service (loan payments)  And then have enough left to still provide an investor return  Later we’ll include debt (“leverage”) in our cash flows and look at expected investor returns (IRR/NPV) 8-15 Direct capitalization (DC)…  Capitalization → convert future cash flow(s) to present value amount → the estimated value of the property  Just learned → DCF capitalizes all future cash flows over holding period including both operating + terminal cash flows  Direct capitalization → capitalize a single stabilized operating cash flow…  Stabilized operating cash flows = income (PGI/EGI) and expenses (OE/CAPX) operating (NOI) normally (think plane at cruising altitude vs. climbing/descending)  Two DC methods…  Capitalization rate (cap rate)  Income multiplier 8-16 Capitalization “cap” rate (R0)…  The “overall rate” → relies upon overall unlevered (no debt) income producing ability of a property to estimate value  “R0” is the “going-in” cap rate used to estimate value today (“V0”)  Later we’ll use the “going out” (a/k/a “terminal”) cap rate (“Rt”) to estimate “terminal” value (Vt) → sales price at end of holding period  Applied to first stabilized net operating income (NOI1)  The rate is extracted (calculated) from recent, nearby sales of comparable properties…wait a minute!…are we back at the sales comparison method?  No! → “comparable properties” is different here…  Valuing future cash flows using a rate (capitalization), not by comparing sales prices of close substitutes  Use same type/class of property → not necessarily close substitutes 8-17 Cap rate cont’d…  Cap rate = first stabilized NOI stated as % of value…  E.g., $10 NOI1 and $100 value = 10% cap rate → R0 = NOI1 V0  Value = first stabilized NOI ÷ cap rate… NOI1 V0 =  E.g., $10 NOI1 and 10% cap rate = value $100 → R0  Cap rate ≠ required return (discount rate) or expected return (IRR/internal rate of return)…  Required return applied to all future cash flows = value (DCF used by comp buyer to determine value of comp → i.e., DCF = comp sale $)  We extract cap rate by looking at the comp’s NOI relative to sale $  Then use extracted cap rate as short-cut to DCF to estimate present value of the subject property  So, cap rates are a product of return, not a measure of return 8-18 Steps in cap rate valuation method… Step 1: Extract cap rates from recent sales of comparable properties by dividing the comp’s estimated NOI1 by the comp’s selling price… NOI 1 R0  ← comps Selling Price Step 2: Estimate subject property’s value by dividing the subject property’s estimated NOI1 by the extracted cap rate to estimate the value of the subject property… NOI1 V0  ← subject R0 8-19 Boulder Point’s value using cap rate… Step 1: Extract cap rate (R ) from comps… 0  Note big differences in NOI and prices → valuing cash flows using rate (capitalization), not the physical property → don’t have to be close substitutes (sale comparison method) → just same type/class!  That said, this example assumes each comp is equally comparable to the subject (uses mean average/no weighting…weighting okay)  Where do we get comps’ NOIs and sales prices?...  NOIs from marketing info, deal players or estimate on own  Sales price is public info…more later 8-20 Boulder Point’s value using cap rate cont’d… Step 2: Estimate the subject’s value using extracted cap rate and subject’s NOI1… $ 89,100 Value= =$ 1,060,714.084(8.4%)  Cf. est’d value per DCF at 10% discount rate = $1,060,291  Note: a 10% discount rate and 8.4% cap rate result in essentially the same value! → can’t be same thing (can’t both be measuring return) → different methods of estimating present value of future cash flow(s)  Embedded in R0 are all future operating/terminal cash flows and the required return (discount rate)  R0 is a short-cut tool to estimate present value of multiple cash flows using only a single cash flow…NOT a measure of required return (discount rate) or expected return (IRR) 8-21 Other sources of cap rates…  Cap rates are tracked and known by participants in the industry/markets every day as properties sell  Cap rates are tracked and published by various free and subscription sources…  Brokerage firms (CBRE)  CoStar  Real Capital Analytics  RealtyRates.com  REIS/Moody's  Real Estate Research Corporation 8-22 Income multiplier (EGIM)…  Like cap rate, multipliers use first stabilized operating cash flow to estimate present value  Except multiplier states cash flow as multiple of value rather than percentage (rate) of value…  I.e., we multiply the cash flow #x to estimate value? (e.g., 10x)  Cf. cap rate = cash flow as % of value (e.g., 10%) Selling Price  Step 1: Extract multiplier from comps → EGIM 0  EGI 1  Same comps and method as cap rate, except…  Reciprocal of cap rate fraction using EGI instead of NOI  Step 2: Estimate the subject’s value using extracted multiple and subject’s estimated EGI1 → EGI1 x EGIM0 = V0  EGI requires no OE or CAPX → simpler than cap rate  Critical: comps and subject assumed to have similar OE/CAPX  Popular with simple income properties (e.g., small apartments) 8-23 Boulder Point’s value using multiplier…  Step 1: Extract multiple from comps…  Step 2: Estimate the subject property’s value by multiplying the subject property’s estimated EGI1 by the extracted multiple to estimate the value of the subject property… $162,000 (EGI1) x 6.49 (EGIM0) = $1,051,000 (V0)  So, both DC methods = short-cut valuation methods using the smaller cash flow in (NOI/EGI) relative to (rate [%] or multiple [x]) the larger cash flow out (value)  It’s the extraction of the rate/multiple from recent, nearby comparable sales (type/class) that ensure the efficacy of the valuation → all future cash flows and require returns are embedded in the extracted rate/multiple 8-24 Boulder Point’s appraisal concluded…  Appraiser reconciles indicated values across all methods to determine the final appraised value  Weighting w/in the income approach and across all three methods all okay…here we see appraiser’s subjective expertise is used in determining the objective value  Questions? 8-25 Which appraisal method?... 8-26 End: 2.2 Appraisal – Income Approach to Valuation Next up: 2.3 Investment Decisions and Ratios Introduction to Real Estate Instructor: Joel Starbuck Fall 2024