Chapter 1 the nature of real estate and real estate markets



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Estimating vacancy and collection losses at 5 percent of potential gross income, reconstruct the operating statement to obtain an estimate of NOI. Remember, there may be items in the owner’s statement that should not be included in the reconstructed operating statement. Using the NOI and a Ro of 11.0 percent, calculate the property’s indicated market value. Round your answer to the nearest $500.


Solution:

Reconstructed Operating Statement


PGI: (10 units x $550 x 12)




$66,000

Less: Vacancy Loss (at 5 percent)




(3,300)

EGI:




62,700

Less: Operating Expenses







Power

$2,200




Heat

1,700




Janitor

4,600




Water

3,700




Maintenance

4,800




Reserves for replacement

2,800




Management

3,000

22,800

Net Operating Income




$39,900

Note: Mortgage payments and depreciation are not included in the calculation of the property’s NOI.


The indicated value of the property is $362,727 ($39,900 / 0.11), which rounds to $363,000.


  1. You have been asked to estimate the market value of an apartment complex that is producing annual net operating income of $44,500. Four highly similar and competitive apartment properties within two blocks of the subject property have sold in the past three months. All four offer essentially the same amenities and services as the subject. All were open-market transactions with similar terms of sale. All were financed with 30-year fixed-rate mortgages using 70 percent debt and 30 percent equity. The sale prices and estimated first-year net operating incomes were as follows:

Comparable 1: Sale price $500,000; NOI $55,000

Comparable 2: Sale price $420,000; NOI $50,400

Comparable 3: Sale price $475,000; NOI $53,400

Comparable 4: Sale price $600,000; NOI $69,000
What is the indicated value of the subject property using direct capitalization?


Solution:
The abstracted going-in capitalization rates from the four properties are listed below:
Comparable 1: 0.110

Comparable 2: 0.120

Comparable 3: 0.112

Comparable 4: 0.115

Simple Ave. 0.114
The simple average of the four comparable cap rates is 0.114. Thus, the indicated value of the subject property is $390, 351, ($44,500 / 0.114), which rounds to $390,000.


  1. You are estimating the value of a small office building. Suppose the estimated NOI for the first year of operations is $100,000.

a. If you expect that NOI will remain constant at $100,000 over the next 50 years and that the office building will have no value at the end of 50 years, what is the present value of the building assuming a 12.2% discount rate? If you pay this amount, what is the indicated initial cap rate?


Solution: The present value, using a financial calculator, is $817,078.


N = 50

I = 12.2

PV = ?

PMT = 100,000

FV = 0

The initial (going-in) cap rate is $100,000/$817,078 = 12.24%


b. If you expect that NOI will remain constant at $100,000 forever, what is the value of the building assuming a 12.2% discount rate? If you pay this amount, what is the indicated initial cap rate?
Solution: The value of the building with NOI remaining constant at $100,000 is calculated using the formula for a perpetuity, which is $100,000/0.122, or $819,672. If you pay $819,672 for the property, the initial (going-in) cap rate is 12.2% ($100,000 / $819,672).
c. If you expect the initial $100,000 NOI will grow forever at a 3% annual rate, what is the value of the building assuming a 12.2% discount rate? If you pay this amount, what is the indicated initial cap rate?
Solution: The capitalization rate consists of a required IRR on equity and a growth rate. Applying the general constant-growth formula and assuming that the growth rate is 3%, the indicated capitalization rate is equal to 9.2% (12.2% - 3.0%.). Therefore, using a cap rate of 9.2%, the indicated value of the building is $100,000/0.092, or $1,086,957.


  1. Describe the conditions under which the use of gross income multipliers to value the subject property is appropriate.


Solution: The use of gross income multipliers is predicated on two primary assumptions. First, it is assumed that the operating expense percentage of the subject property and the comparable properties are equal. Second, this approach assumes that the subject property and comparable properties are collecting market rents. In practice, gross income multipliers are most appropriate for valuing apartment buildings.


  1. In what situations or for which types of properties might discounted cash flow analysis be preferred to direct capitalization?


Solution: Direct capitalization is dependent on information obtained from sales of properties that are deemed to be comparable to the subject property. Identifying comparable properties is particularly difficult with commercial real estate investments. Discounted cash flow analysis is useful for valuing income-producing properties because the unique expected cash flows for a particular property are evaluated using the appropriate required internal rate of return. DCF is especially useful when valuing multi-tenant office buildings and shopping centers were lease terms can vary widely across even otherwise similar properties.


  1. Distinguish between levered and unlevered cash flows. In what sense does the equity investor have a residual claim on the property’s cash flow stream if mortgage financing is employed?


Solution: The use of mortgage debt to finance the acquisition of a real estate investment property is referred to as leverage. Levered cash flows measure a property’s income stream after deducting debt service payments. The amount of cash flow available for distribution to an equity investor is reduced by the amount paid to the lender. Therefore, the equity investor has a residual claim, known as the before-tax cash flow, which is simply NOI less debt service.


  1. What is the difference between a fee simple estate and a leased fee estate?


Solution: A fee simple estate is the highest form of property ownership. It is complete ownership of a property without regard to leases. A leased fee estate is ownership of a property subject to leases on the property. When acquiring existing commercial real estate, investors are most often acquiring a leased fee estate because they are acquiring the property subject to the existing leases.


  1. What is the difference between contract rent and market rent? Why is this distinction more important for investors purchasing existing office buildings than for investors purchasing existing apartment complexes?


Solution: Contract rent refers to the actual rent paid under existing lease contracts executed between owners and tenants. Market rent refers to the potential rental income a property could receive on the open market as of the effective date of an appraisal. The distinction is particularly important for investors in office buildings because commercial leases tend to be for multiple years, unlike apartment leases. Existing leases at below market rates will be included in the calculation of potential gross income, which will depress the appraised value of the property relative to the appraised value assuming market rental rates.


  1. Estimate the market value of the following small office building. The property has 10,500 square feet of leasable space that was leased to a single tenant on January 1, four years ago. Terms of the lease call for rent payments of $9,525 per month for the first five years, and rent payments of $11,325 per month for the next five years. The tenant must pay all operating expenses.

During the remaining term of the lease, there will be no vacancy and collection losses; however, upon termination of the lease it is expected that the property will be vacant for three months. When the property is released under short-term leases, with tenants paying all operating expenses, a vacancy and collection loss allowance of 8 percent per year is anticipated.


The current market rental for properties of this type under triple net leases is $11 per square foot, and this rate has been increasing at a rate of 3 percent per year. The market discount rate for similar properties is about 11 percent, the "going-in" cap rate is about 9 percent, and terminal cap rates are typically 1 percentage point above going-in cap rates.
Prepare a spreadsheet showing the rental income, expense reimbursements, NOIs, and the net proceeds from the sale of the property at the end of an 8-year holding period. Then use the information provided to estimate the market value of the property.
Solution: The fifth year of the 10-year lease is the first year of analysis. The problem calls for an 8-year analysis--one for the last year of the 1st 5-year period, five for the second 5-year period, one to allow the vacancy and collection loss to achieve a normal level, and one at the normal level for calculating the property's value (sale price) at that time. Assume vacancy and collections losses in year 7 are 25 percent, which reflects 100 percent vacancy for three months and no vacancy for 9 months. Assume the “normal” vacancy rate of 8 percent will apply in year 8 of the analysis and beyond.






Yr. 1

Yr. 2

Yr. 3

Yr. 4

Yr. 5

Yr. 6

Yr. 7

Yr. 8

Yr. 9

Contract Rent

114,300

135,900

135,900

135,900

135,900

135,900










Market Rent

115,500

118,965

122,534

126,210

129,996

133,896

137,913

142,050

146,311

Less: VC

0

0

0

0

0

0

34,478

11,364

11,705

Effective Gross Inc.

114,300

135,900

135,900

135,900

135,900

135,900

103,435

130,686

134,606

Less: Operating Exps

0

0

0

0

0

0

0

0

0

Net Operating Inc.

114,300

135,900

135,900

135,900

135,900

135,900

103,435

130,686

134,606

Sale price at the end of Yr. 8: = [NOI (yr9) / Terminal cap rate]

= $134,606 / 0.10

= $1,346,060

Cash Flows: CF1 = 114,300

CF2 = 135,900

CF3 = 135,900

CF4 = 135,900

CF5 = 135,900

CF6 = 135,900

CF7 = 103,435

CF8 = 1,476,746 (130,686+1,346,060)


PV of Cash Flows @ 11 percent = $1,246,090

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