DISCLAIMER: Copyright: 2011

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1 DISLAIMER: This publication is intended for EDUATIONAL purposes only. The information contained herein is subject to change with no notice, and while a great deal of care has been taken to provide accurate and current information, UB, their affiliates, authors, editors and staff (collectively, the "UB Group") makes no claims, representations, or warranties as to accuracy, completeness, usefulness or adequacy of any of the information contained herein. Under no circumstances shall the UB Group be liable for any losses or damages whatsoever, whether in contract, tort or otherwise, from the use of, or reliance on, the information contained herein. Further, the general principles and conclusions presented in this text are subject to local, provincial, and federal laws and regulations, court cases, and any revisions of the same. This publication is sold for educational purposes only and is not intended to provide, and does not constitute, legal, accounting, or other professional advice. Professional advice should be consulted regarding every specific circumstance before acting on the information presented in these materials. opyright: 2011 by the UB Real Estate Division, Sauder School of Business, The University of British olumbia. Printed in anada. ALL RIGHTS RESERVED. No part of this work covered by the copyright hereon may be reproduced, transcribed, modified, distributed, republished, or used in any form or by any means graphic, electronic, or mechanical, including photocopying, recording, taping, web distribution, or used in any information storage and retrieval system without the prior written permission of the publisher.

2 PROPERTY APPRAISAL: VALUING INOME PRODUING PROPERTIES After studying this chapter, a student should be able to: Learning Objectives # explain the difference between appraisal and investment analysis; # describe the gross and net rent multipliers; # discuss the capitalization of net operating income to find the value of a property; # describe how the capitalization rate is found by direct market observation; and # describe the mortgage-equity method. Introduction While there are four common appraisal techniques, the comparative method, the income method, the cost method and the residual method, the focus of this chapter will be on the income method of appraisal. The income (or investment) method was developed to cover what is probably the biggest limitation of the comparative method, namely, its poor applicability to the appraisal of income producing real estate. Although the income or investment method is a separate method of appraisal, it may be considered an adaptation of the comparative method. It is based on a principle similar to that of the comparative method: the market value of a property producing a given net operating income will be the price at which a property producing a similar net operating income can be bought. The net operating incomes must be similar in amount, risk, and timing in order for the properties to be comparable. The basic principle of the income method is that all investors should pay the same price for a property, given the income the property should earn and the timing and expected risk of this income. This amount can be characterized as the present value (or present worth) of the expected future income stream. The method therefore bases itself upon observed market behaviour. It makes assumptions (usually concerning income), and supposes that buyers and sellers will act as if they have certain expectations (usually concerning returns or yields). However, the income method must provide rational and consistent values, otherwise it is of no use. For this reason the method's stated assumptions must be related to actual market behaviour, but the method is not impaired since individual buyers and sellers have different expectations than those the method attributes to them. In sum, the primary element of the income or investment method is a careful analysis of market transactions. The subsequent calculations made to estimate the value of a subject property are secondary, merely a way to complete the process of analysis. This chapter will introduce the general framework for financial analysis using the income method of property appraisal. Two techniques for using the income method to value a property will be illustrated ) one using information from direct overall capitalization and the other using discounted cash flow data. Essentially, the purpose of the analysis of market transactions is to establish the ratio of net operating income to sale price (the overall capitalization rate). If this ratio can be established, and if either the net operating income or the capital values of the subject property are known, then it is straightforward to determine the unknown value. opyright: 2011 by the UB Real Estate Division 20.1

3 hapter 20 Appraisal Versus Investment Analysis Appraisers are generally concerned with stabilized net operating income on a before-tax and before-financing basis in estimating the market value of a property. The appraiser will go to the market to estimate "typical" revenues, vacancies, and operating expenses (borne by the landlord), including management costs for this type of property. The calculation of net operating income is made independent of a specific owner (and property manager) and is intended to represent the income a typical owner could expect to receive. Appraisers often include replacement reserves (also known as replacement allowances) in their estimate of stabilized net operating income to account for the cost of replacing equipment which has a shorter usable life than the life of the building. These reserves are treated separately from ongoing operating expenses and, in practice, cash is seldom set aside for them. On the other hand, the investment analyst is typically more interested in estimating cash flows from the property, either on a before-tax or after-tax basis, for a particular investor. Debt financing and income tax are specific to each investor. The analyst uses a personal (or individual) forecast of future benefits and costs and a discount rate which reflects individual circumstances. While he or she will also estimate the net operating income from the property in preparing the cash flow statements, replacement reserves are not usually included (unless cash is actually set aside to cover this eventual replacement of fixtures). The appraiser will attempt to re-create or simulate market conditions and forms of analysis, to estimate the market value of an interest in real property. In response to the question "What will this interest in real property sell for, given adequate market exposure, a willing buyer, and a willing seller?", the appraiser will answer that the expected sales price or market value is equal to the present value of all future net benefits (future benefits less future costs), discounted at the appropriate discount rate. This fairly describes the income method of appraisal. Therefore, the appraiser is interpreting the market, simulating the action of potential buyers and sellers in a hypothetical sales situation. When the appraiser applies the income method, the appraiser will use market based data ) the average forecast of benefits and costs and an average discount rate over some range of potential buyers and sellers ) since the appraiser cannot forecast which particular investor would likely buy the property. Moreover, the individual investors have a greater degree of knowledge regarding the appropriateness of a particular investment for their own use than would the appraiser. As a consequence, the appraiser must work with a more general set of information. Justified Investment Price As an illustration of investment analysis, consider the following example. A small industrial building is offered for sale at $202,000. This 8,000 square foot light industrial building is presently leased to a single tenant at a gross rent of $3.25 per square foot per annum, with rents increasing in the fourth year. urrent market rents are $3.40 per square foot per annum. The existing lease has three years remaining. The particular investor considering this property has a marginal income tax rate of 40% and proposes to use a mortgage of $140,000 amortized over fifteen years. It is assumed that this investor plans to hold the property for five years and expects to sell it for $240,000, realizing an after-tax cash residual of $91,500 after all income taxes and repayment of the mortgage. Under these circumstances, the investor forecasts the following after-tax cash flows (and we need not be concerned with how the investor makes these forecasts): After-Tax ash Flows Year 1 $ 4, , , , ,151 + $91,500 If this particular investor is seeking an after-tax return of 15% on equity and discounts these net cash flows at the appropriate rate, the present value (or his or her equity investment) would be calculated as follows opyright: 2011 by the UB Real Estate Division

4 Property Appraisal: Valuing Income Producing Properties O ALL 0 lears memory 1 O P/YR 1 15 I/YR 15 0 F j 0 alculation Press Display omments 4738 F j 4, F j 4, F j 3, F j 6, = F j 97,651 O NPV 62, NPV Hence, this particular investor should be prepared to pay $202,300 for the property ($140,000 mortgage plus $62,300 initial equity). This maximum bidding price is also referred to as the justified investment price (JIP). It is the maximum price this investor can offer to obtain an after-tax yield of 15% on the equity invested. The final negotiated price may be lower than the JIP calculated and thus the expected return will be greater than the indicated 15%. Since the property is offered at $202,000, this investor is obviously a potential purchaser. While unlikely to immediately offer $202,300 (or even $202,000), the investor could offer this amount and still expect to earn the required 15%. In fact, in the market process, the investor is apt to offer 10% to 15% less than the asking price as a first step in the bargaining process. Note that the value of $202,300 reflects the value to a particular investor. In the appraisal literature, this is commonly referred to as value to the owner, whether it be a current owner or potential owner (purchaser) of the property. Individual Price Forecasts One is apt to discover many potential investors, assuming adequate market exposure, and each investor may arrive at a different ultimate bid price (or value to owner). Many circumstances may result in individual potential buyers arriving at different bid prices, including the following: Different marginal tax rates: Assuming all other circumstances are similar, investors with marginal tax rates in excess of 40% would bid less than investors with marginal tax rates less than 40%. Different discount rates: Investors with lower required discount rates (less than 15%) would bid more and investors with higher required rates would bid less, all else remaining equal. Different forecasted sales prices: Investors who are more optimistic in their forecast of the future resale price would bid more, while the less optimistic investor would bid less, all else remaining constant. Different forecasted benefits (rents) and costs (operating expenses and interest charges) would result in different bid prices. More optimistic forecasts of rents (higher) or costs (lower) would result in higher bids (and vice versa), all else remaining constant. opyright: 2011 by the UB Real Estate Division 20.3

5 hapter 20 Different assumptions concerning the tax status of the investment will alter bid prices. If the investors assume all the gain in capital value will be treated as ordinary (taxable) income, they will bid less than the investors who assume the increased value will be treated as capital gains. Similarly the (optimistic) investor who assumes a larger portion of the purchase price can be used for capital cost allowance will bid more for the property than the investor who pessimistically assumes a low capital cost allowance base. Different assumptions about the mortgage will alter investors' bid prices, although the direction and amount is less obvious. In this particular case, assumptions for longer amortization periods, higher loan-to-value ratios, or both, would increase the bid prices of investors. One or more of these six general factors may contribute to differences in the maximum bid prices of the potential buyers in the market. However, the collective behaviour of all investors in the market will eventually reduce the spread in bid prices. For example, the overly pessimistic investor (or the investor with unrealistically high yield expectations) will find his or her bid prices are consistently too low to attract investment properties. As a consequence, the investor will either look to other investment markets, reduce the required yield, or re-evaluate the pessimistic forecasts. Appraisal Information Now consider the plight of the appraiser who is asked to appraise a single-occupant industrial building. According to the office records, the industrial building has sold for $200,000. This sale price is confirmed through discussions with the real estate representative who handled the sale and a check of the records at the Land Title Office. What other useful information can the appraiser obtain concerning this sale and other sales of comparable properties? The appraiser may find: sale price for each transaction; current lease conditions at the time of the sale and the remaining term on the existing leases; any registered mortgages, either assumed from the vendor or newly borrowed or agreements for sale; name of the purchaser (which may be a blind trust); time required to sell the property (or the duration of the listing); physical characteristics of the building and site; the current market rents based upon comparison rents paid for similar space available in the market; and current market yields for this type of property. Of equal importance is the information which the appraiser cannot readily obtain, at least for the majority of market transactions. This list of information not generally available includes: tax status of the purchaser (and vendor); discount rate used by the purchaser; expected holding period for the purchaser; expected future resale price used by the purchaser; the forecasted rents and expenses used by the purchaser; the method of analysis used by the purchaser; and closing costs, legal fees, and other expenses forecasted by the purchaser. Appraisers are, at this point, forced to make some critical decisions. They may either use the information which is readily available for most transactions (sale price, current contractual rents, current market rents, and mortgage data) and make some assumptions about the missing data, or simply rely upon available data and make the fewest possible assumptions. For example, continuing with this illustration, the appraiser knows the sale price of the comparable property is $200,000, the current contractual rent is $26,000, and the current market rent is $27,200 ($3.40 per square foot per annum). The appraiser also knows the mortgage details (providing it is registered). The appraiser is therefore left to forecast the income tax rate, the investment holding period, the expected change in rents and expenses (both the timing and amount), the income tax status of the property (e.g., allocation of land and improvements), and the future resale price for every comparable sale used opyright: 2011 by the UB Real Estate Division

6 Property Appraisal: Valuing Income Producing Properties If the appraiser was able to forecast this information, he or she could then determine that the after-tax rate of return on equity used by this investor was around 15%. In order to be consistent, the appraiser would have to make exactly the same assumptions in analyzing all other comparative transactions and for appraising the subject property. Most appraisers would be uncomfortable having to make such assumptions. As a consequence, the appraisal vocation has chosen to work with data which is available for each market transaction and to develop the appraisal methods which minimize the amount of forecasting required. omparative Method and Income Method In principle, there is no difference between analysis of the market in relation to the comparative method and the income method of appraisal. There is, however, a difference in technique. In the former case, where capital value is the purpose of the analysis, value as evidenced in the market from recent sales is expressed as a lump sum (sometimes on a unit basis). With the income method, evidence of value or price is sought and expressed as a rate of discount or overall capitalization rate. In both cases, it is necessary to use recent sales (those occurring since the last major change) relating to similar properties. It should be pointed out that general changes in interest rates occur because of changes in the demand and supply of investment capital. If some reliable indicator of general changes in interest rates can be found, it may serve as an index for the adjustment of value expressed as a discount rate. For example, suppose that at the date of a real estate sale the general investment or investments selected as an index showed a return of 14% and analysis of the particular sale transaction gave a return of 15%. Later, at the valuation date, the general index of investments showed a return of 16%, indicating a general increase in interest rates. Then, for the purpose of valuation, the yield obtained from the analysis of the particular property might be increased by a similar proportion to, say, 17%. However, considerable danger exists in making adjustments of this kind because it does not follow that changes in the general index will reflect proportional changes in all investments. There is the further difficulty of identifying an investment which can be used as an index. are should be exercised in applying any index. In any case, it is necessary for the appraiser to continually observe the general changes in investment rates. In establishing similarity for the purpose of analysis, investment quality or the degree of risk must be taken into account. This will require that consideration be given to the credit standing of the tenant, which has an impact on the security of current rental income. Differences in management responsibilities attributable to the terms of the lease will also have an effect. However, when the current lease is renewed, these factors might change considerably, and they should not, therefore, be given too much weight. Gross and Net Rent Multipliers It is worth outlining the relationship between the income method of valuation and the two common multipliers introduced in an earlier chapter. One simple method used by appraisers to analyze real property transactions is to assume that the ratio of gross (effective) rental income to sale price remains constant. This ratio can then be used to appraise the subject property. Since both figures are generally available, this ratio can be used consistently. If the gross effective rental income from a property is $26,000, the net operating income is $24,000, and the appraiser knows the sale price was $200,000, this implies a gross rent multiplier of 7.69 and a net rent multiplier of This gross rent multiplier is found by dividing the observed purchase price by the gross effective rental income: opyright: 2011 by the UB Real Estate Division 20.5

7 hapter 20 Gross Rent Multiplier = = Sale Price Gross Effective Rental Income $200,000 $26,000 = 7.69 onsequently, the purchaser paid $7.69 for each dollar of effective gross income. The ratio may also be presented as a measure of the payback period, or the number of years required to cover the total purchase price of the property. The GRM of 7.69 indicates that it takes 7.69 years of effective gross income to recover the investment of $200,000. Note that this payback measure ignores the time value of money. Based upon this sample of one transaction (hopefully an appraiser would use a number of sales of comparable properties in order to find a market gross rent multiplier), the appraiser could then use this gross rent multiplier to appraise another property where the gross effective rental income is known. Although not commonly used in practice, the net rent multiplier is useful for comparison purposes. As well, you will see in a later section of this chapter that the net rent multiplier is directly related to the capitalization rate; in fact, it is the inverse of the capitalization rate, which is used frequently in practice. The net rent multiplier is found by dividing the observed purchase price by the net operating income: Net Rent Multiplier = Sale Price Net Operating Income = $200,000 $24,000 = 8.33 Again, the net rent multiplier indicates that the purchaser paid $8.33 for each dollar of net operating income, and that it will take 8.33 years of NOI to recover the investment. There are three considerable weaknesses to the gross rent multiplier approach to appraisal: (1) It will only be reasonable to apply a GRM when the ratio of operating expenses (borne by the landlord) to gross effective rental income for the subject property is exactly the same as that ratio for the comparable properties from which the multiplier is obtained. (2) It is much more difficult to adjust for slight variations in risk between properties since gross rent multipliers do not reflect investment risks. For example, consider two buildings with the following characteristics: Property A Property B Gross Effective Rent $ 26,000 $ 26,000 Operating Expenses (Borne by the Landlord) $ 2,000 $ 10,000 Net Operating Income $ 24,000 $ 16,000 Sale Price $200,000 $156,000 Gross Rent Multiplier Net Rent Multiplier The difference between the gross rent multipliers may be partly due to the different proportion of operating expenses (borne by the landlord) and partly due to differing degrees of risk. If these sales were analyzed using the net operating income (rather than gross effective rental income), then the first two concerns would be eliminated. In these cases, the net rent multipliers are 8.33 and 9.75 for Properties A and B, respectively, 20.6 opyright: 2011 by the UB Real Estate Division

8 Property Appraisal: Valuing Income Producing Properties and the difference is due solely to factors other than differences in the operating expenses borne by the landlord. Since data required to calculate net operating income is generally available, and since it appears to give more consistent results, it should be used. It would, of course, lead to errors if the gross rent multiplier of 7.69 for Property A were applied to any property which did not have a ratio of operating expenses to gross income of 1:13 ($2,000 : $26,000). (3) In this example, the gross rent multiplier (and the net rent multiplier) were calculated based upon current contractual rents and not current market rents. Obviously the contractual rents will be received until the lease renewal or expiry; however, some recognition must be granted to this expected change in rents. The gross rent multiplier assumes that the gross effective rental income and operating expenses are stable and perpetual, while the net rent multiplier only assumes net operating income is stable and perpetual. The gross and net rent multiplier can be rewritten such that: Sale Price = Gross Effective Rental Income Gross Rent Multiplier and Sale Price = Net Operating Income Net Rent Multiplier Income Method of Appraisal: A General Framework The general model of the income method of appraisal is based upon our understanding of how investors make or appear to make investment decisions. Basically, the income method assumes that the market value of an interest in real property is based on the expected future net benefits to be enjoyed from the ownership of such interests in land. Market Value = f (future net benefits) Market value is said to depend upon, or be a function of, the future net benefits. The generally accepted model is to assume the market value of an interest in real property will be equal to the present value of all future net benefits. Market Value = Present Value of all future net benefits T j t'1 or Market Value = (Future Net Benefits)(1 + R) -t where j = summation sign t = future periods (t=1, 2, 3,..., T) R = market determined discount rate Note that a market determined discount rate (R) is used, not the rate of return required by one particular investor. In valuing a property using the income method, the appraiser may use two techniques, namely: the direct overall capitalization technique; and the discounted cash flow technique. opyright: 2011 by the UB Real Estate Division 20.7

9 hapter 20 Direct apitalization of Net Operating Income Both the estimate of future income and the market determined rate of return are based on market analysis, and, as in the case of the comparative method, the accuracy of the appraisal depends on the soundness of the analysis. Appraisers attempt to forecast a stabilized net operating income to represent expected future net benefits from ownership of an interest in real property and, where the property represents highest and best use, the stabilized net operating income is assumed to continue forever: Market Value = j NOI (1 + R) -t t'1 where T = 4 T Since net operating income is assumed to be stabilized or constant, this equation can be rewritten as: Market Value = NOI aú4, R%á where NOI = stabilized or constant net operating income 4 = symbol for infinity R% = market determined discount rate This can be rewritten as: NOI MV = R since the value of a perpetual annuity is equal to 1/R where R is the discount rate used. Selecting an Overall apitalization Rate It now remains to determine where the capitalization rate (R%) is to be found. This discount rate (R%) is often referred to as the broker's yield, return on investment (or capital), and is commonly known as the overall capitalization rate in the appraisal industry. Several alternative approaches are used to determine this overall capitalization rate, as shown in Figure 1. Figure 1 Source of apitalization Rates The direct observation method will be discussed primarily in this chapter as it is most commonly used; the mortgage equity method will be discussed briefly in a later section. The other sources include, for instance, the summation method where the capitalization rate is built up ("summed up") by adding risk premiums for illiquidity, locational constraints, management, and so on to a risk-free return (e.g., Treasury Bills) opyright: 2011 by the UB Real Estate Division

10 Property Appraisal: Valuing Income Producing Properties Table 1 Summation Method: Expected Rate of Return and Risk Premiums Risk-free return (e.g., Treasury Bills) 10% + Premium for illiquidity 3% + Premium for high transaction costs 3% + Premium for cyclicity 2% Total Discount Rate (R) 18% The major weakness of this method is the subjective and arbitrary way in which the risk premiums are estimated and the fact that they cannot be substantiated. Direct Market Observation: Overall Rates In order to undertake an appraisal problem, the appraiser must know the purpose of the assignment, the nature of the property, and the terms of the lease. Moreover, in order to know whether the income or investment method should be used, the appraiser must be satisfied that no exact comparable units are available (hence the comparative method cannot be used) and that recent sales of comparable properties (from an investment risk point of view) are available to determine an overall capitalization rate. Illustration 1 Assume the purpose of the appraisal is to determine the market value of an apartment building expressed as a capital sum (e.g., How much is it worth?). The appraiser has concluded that the apartment building represents highest and best use of the land. Finally, the appraiser observes that the landlord has maintained the rents such that they represent current rental levels (and there are no long term leases at less than market rents). The appraiser is able to obtain some unaudited financial statements for the last two years and calculates the stabilized net operating income as shown in Figure 2 in summary form. Figure 2 Income Statement Gross Potential Rental Income: Suites $45,600 Parking 2,460 Miscellaneous 700 Total Gross Potential Rental Income $48,760! Vacancy Allowance: Suites 3% $1,368 Parking 10% 246 1,614 Effective Gross Income $47,146! Operating Expenses (Paid by the Landlord) $20,957! Management (5% of Total Gross Potential Rental Income) 2,438 Total Operating Expenses 23,395 Net Operating Income $23,751 opyright: 2011 by the UB Real Estate Division 20.9

11 hapter 20 The appraiser might also show reserve accounts if they were able to accurately cost each item and estimate its expected life. The annual reserve allowance is calculated by dividing the cost by the estimated life span. The statement would be revised as follows: Effective Gross Income $ 47,146! Operating Expenses (including management) 23,395 Net Operating Income $ 23,751! Replacement Reserves: Air onditioners $ 1,500 arpet 700 Drapes 300 2,500 Stabilized Net Operating Income $ 21,251 If the ratio of operating expenses to effective gross income for this type of property generally ranges between 40% and 50%, the percentage of this example at 49.6% falls within the general market range. The appraiser has identified five recent sales of investment properties which are considered similar from a risk point of view (see Figure 3). These transactions are used to derive a market determined capitalization rate for each sale assuming the net operating incomes are stable and perpetual. Figure 3 omparative Sales Analysis Sale Price Net Operating Income Indicated apitalization Rate A B D E $209, , , , ,000 $19,000 24,500 21,000 20,000 26, % 9.53% 8.75% 9.09% 8.97% Based on these transactions, the appraiser has arrived at an overall capitalization rate of 9% for the subject property. While the simple average of the five rates is 9.084%, rounded to 9%, it is common, to estimate a rate using only the comparables considered most like the subject. If an average of all of the rates is used, this presumes that we have placed equal weight on each comparable (which could, in fact, be appropriate). The appraiser can then calculate the market value assuming the net operating income is perpetual and stable: Market Value = = Stabilized Net Operating Income R $21, = $236,122 In practice, this figure would likely be rounded to $236,000. It should be noted that this illustration tends to conceal the true difficulties inherent in using the income method of appraisal. The final step (i.e., the capitalization process or discounting process) is a very minor part of the appraisal assignment. The difficult and time consuming parts of the appraisal process are the detailing of gross incomes and opyright: 2011 by the UB Real Estate Division

12 Property Appraisal: Valuing Income Producing Properties operating expenses and the difficult task of identifying similar properties which have recently sold. These are the main areas requiring the expertise of the appraiser. Sensitivity Analysis An appraiser should seldom rely upon one set of calculations when using the income method. As a minimum, the appraiser should compare certain ratios for the subject property to those ratios available elsewhere. For example, the appraiser might compare the ratio of operating expenses to gross revenue or the market value per suite (or square foot) of the subject property to some market averages. In addition, the appraiser may wish to check the sensitivity of the market value to some of the assumptions made. Sensitivity analysis in this context simply refers to the question: "What would happen to the market value if...?" The appraiser may wish to recalculate the market value on the premise that one assumption was unreasonable. For example, the appraiser may want to examine the effect of changing the selected discount rate. Say, for example, comparable Sale B was the most comparable property and the appraiser should be using an overall capitalization rate of 9.53%. Then the market value of the subject property should be: Market Value = $21, = $222,990, say $223,000 Hence a change of in the overall capitalization rate results in a difference of $13,132 or 5.6% ($13, ,122). In contrast, assume that the total operating expenses should have been $22,162 instead of $23,395, which the appraiser used. Therefore, the stabilized net operating income should be $22,484 and the market value, at 9%, would be $249,822. This change in operating expenses results in a $13,700 increase (or 5.8%) in the market value. The estimated market value is more sensitive to certain types of change than others, so the appraiser should concentrate attention in the most sensitive areas. apitalization Rate by Mortgage-Equity Method Stabilized net operating income represents the measure of net benefits expected to be derived from the property, before financing and income tax payments are incurred. Net operating income was used because the appraiser could almost always obtain the necessary data (gross rents and operating expenses) from which to calculate it. In the income method, the issue of financing is handled indirectly. Only exceptional financing is considered. Providing that financing for the subject property and all comparables are at current market rates and terms, financing is ignored in the traditional income method. In the event that the subject property or any of the comparable properties, or both, have financing that is not at market rates, the effect of such financing is calculated separately and then the adjustment is added to (or subtracted from) our estimate of market value. Specifically, it was assumed that the impact of financing at other than current market terms would be fully capitalized into the price of the property. hanges in the use of mortgage financing and increasing complexity in the nature of mortgage contracts have given rise to extensions of the application of the income or investment method. These extensions, generally referred to as mortgage-equity concepts of appraisal, are designed to give explicit recognition to the extensive use of mortgage financing, the impact of mortgage lending on yields in real estate investments, and the potential for changes in the capital value. These mortgage-equity concepts, including the Ellwood method, represent variations of the traditional income approach. opyright: 2011 by the UB Real Estate Division 20.11

13 hapter 20 The mortgage-equity concept considers the financial composition of the capital invested and the sources of return for a real estate investment. Because of the profound effect mortgage financing may have on cash flows and yields, it is essential to understand how financing influences market values and prices. The application of this valuation concept applies mainly to income producing properties, but the same principles would apply to owner-occupied properties as an income could be estimated for these properties. The mortgage-equity concept is a special form of discounting process or present value model. Most discounting models involve two parts, the income or cash benefits during the investment period and the reversion or cash residual at the end of the investment period. However, the usual application of the mortgage-equity concept discounts the income stream and residual value in one step. The terms mortgage and equity refer to the component sources of capital invested: (Price) Value = Mortgage Amount + Equity Invested 8 8 cost of debt equity return (return to lender) (return to investor) The capitalization rate incorporates these two returns; our sophisticated mortgage-equity models (such as Ellwood) allow us to "dissect" the capitalization rate and also reveal the impact of principal repayment and property appreciation on investor equity. Recall that over the holding period, the investor's equity will change due to principal repayment ("captured" equity) and from appreciation or depreciation in the property value. Equity is either the original equity, which equals the purchase price less all original debt, or the current equity, which equals the current market value less the outstanding balance on all existing debt. The principal aim of the mortgage-equity concept in appraisal is to determine a capitalization rate which explicitly considers the effect of financing and possible changes in capital value. This capitalization rate is then applied to the net operating income of a subject property to estimate market value. How does the mortgage equity method compare to the direct overall capitalization technique? The direct method assumes that all future net benefits are equal and continue forever (i.e., in perpetuity). It is the most direct method of evaluating the net income generated by the property and is most easily understood by the market; however, direct capitalization is only truly reliable when abundant market evidence for the appropriate overall capitalization rate is available. Furthermore, the direct method makes no explicit recognition of the property's potential "upside", growth in income over the longer term resulting from renegotiating existing leases to market rents or from leasing up a property in the short term. Anticipated changes in income will be reflected only in the market discount rate, where a lower capitalization rate would be used if there was good short term growth in income expected. A further refinement of the direct capitalization technique is the discounted cash flow (DF) analysis. Discounted ash Flows in Appraisal The DF technique involves projecting the net operating income of the property over a selected time period and estimating the reversionary value of the property at the end of this time period. The incomes in each year are discounted to reflect their present value and the discount rate is predicated on current alternative investments available in the marketplace. The DF technique uses the following equation: NOI 2 NOI n Reversion MV = NOI (1 % k) 1 (1 % k) 2 (1 % k) n (1 % k) n where, NOI =Stabilized net operating income; k =Market derived discount rate; and Reversion =Estimated net selling price of the property at the end of the investment horizon opyright: 2011 by the UB Real Estate Division

14 Property Appraisal: Valuing Income Producing Properties This technique is considered to be appropriate when significant increases are anticipated in the net income of the property over the short term. For example, a large office building or shopping centre will have numerous lease rollovers during a ten year period with substantial growth in income. This form of analysis could also be applied to consider only the investor's equity position rather than the total market value of the property. In this situation, the appraiser would be acting as an investment analyst, whereby the before-tax or after-tax cash flows would be estimated over the selected period and discounted at the investor's before-tax or after-tax equity return. This concept was presented earlier in our discussion of justified investment price, and the analyst would estimate the amount of equity the investor should invest based on these forecasted cash flows and selected discount rates. Scope of the Income or Investment Method of Appraisal As a matter of convenience, one can identify eight general appraisal problems: (1) market value, expressed as a capital sum for highest and best use; (2) market value, expressed as an income flow for highest and best use; (3) value to the owner, expressed as a capital sum for highest and best use; (4) value to the owner, expressed as an income flow for highest and best use; and (5) to (8) the same as Problems 1 to 4 except that the property has redevelopment potential rather than representing highest and best use. This chapter has not covered the full range of the income method's application. The principal omission involves a case of declining net operating income, which can be represented by a freehold interest in a building which has a limited economic life and can, therefore, be expected to be demolished in the foreseeable future. (A case of a property which possesses redevelopment potential such as Problems 5 to 8 above). Similarly, the income method as applied to cases involving value to the owner, has not been discussed in detail. For these reasons, it is not possible to make a comprehensive statement regarding the scope of the method. Like the comparative method, with which it has much in common, the income method is a reliable means of estimating market value, provided the necessary evidence can be obtained. Essentially, the purpose of the analysis of market transactions is to establish the ratio of net operating income to sale price (the overall capitalization rate). If this ratio can be established, and if either the net operating income or the capital values of the subject property are known, then it is simple to determine the unknown value. It follows from this principle that if the subject property is not ordinarily leased, the income method cannot be applied since no rental information will be available. And for this reason, it is generally inappropriate in the appraisal of single-detached houses and other properties in which owner-occupation is the customary form of tenure. Even where single-detached houses are leased, the rents frequently do not reflect the full measure of capital value. Instead, they are designed to cover the costs of ownership such as property taxes and maintenance and the occupier is looked upon more as a caretaker than as a tenant. Such non-monetary considerations are incompatible with this appraisal method. On the other hand, it has been shown that the comparative method is extremely weak when the subject property is commonly held for investment purposes since it cannot satisfactorily accommodate variations in net operating income, expense ratios, and risk. For similar reasons, the comparative method can seldom be used satisfactorily in the appraisal of leasehold interests because the difficulties referred to prevent the development of a practical form of analysis of leasehold transactions. In these cases, the income method is undoubtedly superior and must be regarded as the standard method of estimating capital value. opyright: 2011 by the UB Real Estate Division 20.13

15 hapter 20 Although the income method can be used to determine market value expressed as an income flow (market rental value), the comparative method is used since this exercise involves estimating the income stream only. This is the initial step required in the income approach to estimate the capital value of the property. Here it is not necessary to go to the next step and determine market yields and then capitalize this income stream. No strong grounds exist for employing the income method in these cases. In cases where an appraiser is concerned predominantly with investment returns from real estate, the income method provides the only satisfactory means of enabling value to the owner to be determined, although in practice the investor would likely use net cash flows rather than net operating incomes as the measure of benefits to be discussed. Taking an overall view, the comparative and income methods are applicable to most appraisal problems regarding highest and best use properties. In the absence of market evidence, it will be necessary to resort to other methods of appraisal opyright: 2011 by the UB Real Estate Division