Overhead Set

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Overhead Set2 VALUATION APPROACHES

• 3 Approaches to Valuation
• Cost Approach
• Income Approach
• Sales Comparison or Market Approach

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1. Cost Approach

• a. cost of duplicating property minus
  depreciation
• b. most fruitful in engineering or cost-to-cure
  cases
• c. potential problems in ranking projects
• 1. new vs. established structures--different
  risks from being leased up
• 2. non-viable structures e.g., the World Trade
  Center in Kansas City

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2. Income or Cap Rate Approach

• a. capitalizes cash flow as perpetuity via a cap
  rate
• 1. VI/r
• where Vproperty value, Istabilized income
  flow, rcap rate
• b. cap rates vs. discount rates
• 1. cap rate reflects purely real estate/property
  factors
• a. e.g., site-specific factors, property-type
  issues, property-specific factors
• 2. discount rates reflect opportunity cost of
  capital as learned in introductory finance

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2. Income or Cap Rate Approach

• 1. Direct Capitalization
• V NOI / R
• 2. Present Value Method
• V NOI / (r-g)
• r competitive discount rate
• g growth rate
• R r-g
• 3. Mortgage/Equity Method
• V D E
• D mortgage debt
• E equity

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Cap Rate Example

• Building Cash Flow 100,000/yr for 25 yrs.
• Loan Amount 700,000 at 10 for 25 yrs.
• Pmt 77,177.65
• Required Rate of Return 15
• Investors Cash Flow 100,000 - 77,177
  22,882.35
• Present Value 147,915
• Value 700,000 147,915 847,915
• IRR 10.91
• Cap Rate NOI/V 100,000/847,915 11.79
• Assumption NOI remains level

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gtold exam question on meaning of cap rates

• Assume that AA noncallable corporate bonds with
  ten years to maturity currently are yielding 10.
  Further assume that the real estate cap rate is
  7 for an entirely owner-occupied office building
  with a standard lease whose occupant also has a
  AA credit rating. If the building owner were to
  come to you and propose a sale/leaseback with a
  ten year term, you would consider the AA
  corporate bond rate as more appropriate than the
  real estate cap rate for determining the present
  value of the cash flows on the sale/leaseback.

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2. Income or Cap Rate Approach

• c. potential problems if cash flows are not
  stable--
• large differences in PVs of equal dollar flows if
  one is cyclical and the other is not
• d. potential problems from no attempt to
  differentiate among the components of cash flow
  by risk level
• e. in practice, often very ad hoc assumptions
  made in determining I

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3. Market Approach

• a. identify comparable properties and value
  accordingly
• b. how should this be implemented empirically?
• e.g., how to value a warehouse in terms of its
  value for conversion to condominiums?

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4. Mass Appraisal (Hedonic)

• (means implicit in the Greek)
• a. used first by consultants to the auto industry
• b. simple regression analysis
• 1. HPi a bjXij ei ,
• where HP is the price of the ith home,
• X is the vector of house traits
• a is the regression intercept term
• b is the coefficient vector of trait prices
• e is the error term
• 2. b ?HP/?X
• the marginal effect of a small change in trait j
  on home price HP

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4. Mass Appriasal (Hedonic)

• 3. Potential problems with the statistical
  approach
• a. specification error--never know all the
  relevant traits
• b. some traits very hard to quantify--e.g., style
  features
• c. changes in trends in neighborhood from which
  sample of comparables is drawn
• ?in absence of transactions-based prices, any
  approach gives you at best an educated guess
  about asset value market approach is the best
  from a conceptual perspective (simple market
  approach valuation now required in house
  appraisals by secondary market agencies)

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Linear Regression

• Simple Real Estate Example
• We wish to explain/predict the price of single
  family homes (find their value).
• Dependent Variable (Y) Sales Price

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Linear Regression

• Independent Variable (X)
• What causes sales prices to vary?
• Size of property?
• Test to see if sales prices change as property
  size changes.
• X size in square feet.

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Linear Regression

• SCATTER PLOT
• diagram that plots the relationship between two
  variables
• In our case, we wish to plot the relationship
  between sales price and property size.

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Linear Regression
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Linear Regression

• Linear model is estimated by least squares
• Ordinary Least Squares (OLS)

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Regression Equation
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Multiple Regression

• Add independent variables to model to explain
  more of the price.
• of bedrooms
• of bath rooms
• year built
• location
• amenities
• fireplace, garage, deck, etc..

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Multiple Regression

• Problem Collinearity
• As you add variables, some of the independent
  variables may be collinear with each other.
• Example As the number of bed rooms increases,
  you expect the number of bathrooms to increase as
  well.
• This will bias your regression equation. (Makes
  it difficult to support the results in court.)

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Example

• Factors that influence warehouse valuation.
• building size
• office space
• ceiling height
• doors (dock and drive-in)
• rail service
• sprinklers
• age

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