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Valuation Approaches

Valuation Approaches
• The term valuation approach refers to generally
accepted analytical methodologies that are in
common use.
• Valuation types
1. Valuation to estimate market value
2. Valuation to estimate a defined non-market value
• Valuations of any type, whether undertaken to
estimate market value or a defined non-market
value, require that the Valuer apply one or
more valuation approaches.

Non-market Based Valuations


• Are generally common to virtually all types of valuation,
including on real property, personal property,
businesses, and financial interests.
• It involves different sources of data that appropriately
reflect the market in which the property (and/or service
or business) is to be valued.
• For example, individual buildings are commonly sold and
valued in the relevant real estate market whereas the
values of the shares of stock in a property company that
owns a number of buildings are reflected by pricing in
the relevant shares market.

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Valuation Approaches
• Sales Comparison Approach
• Income Approach
• Cost Approach

Valuation Approaches
• Valuation Technology in the 21 st Century
– Sales (market) comparison
• The 20th century was characterized by some movement at
the practitioner level from traditional adjustment grids to
regression analysis
– Income
• The income approach actually experienced a narrowed array
of choices during the 20th century
– Cost
• changed little during the 20th century; it remains rather
primitive even today, and not much of consequence seems to
be afoot that would bring about immediate changes.

Apply the
Sales Comparison
Approach

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Sales Comparison
Approach

Sales Comparison Approach


• Establishes the limits on the Market Value by
examining the prices commonly paid for
properties that compete with the subject
property for buyers.
• Sales are investigated to ensure that the parties
to the transactions were typically motivated.
• The property being valued is compared with
sale prices (and listings and offerings) of similar
properties that have recently been transacted in
the market.

Sales Comparison Approach


• Sale prices are analysed by applying
appropriate units of comparison and are
adjusted for differences with the subject on the
basis of elements of comparison.
• The property rights involved must be
considered to ensure similarity
• Is very persuasive whenever sufficient market
data are available.
• Reliability is limited when the market is marked
with volatility.

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Sales Comparison Approach
• Obtain sales of comparable properties from
the market.
• Note differences and adjust the comps
relative to the subject as to: location, age,
date of sale, size, etc.
• Then adjust the sales price of the comps
based on the qualitative and quantitative
adjustments made in the above. Reduce the
adjusted sales price to a per sqm price
• Apply the adjusted per sqm sales price to
the square meters of the subject

Sales Comparison Approach

• Principle of substitution:
– Potential buyer will pay no more for a property than what
has been paid for another equally desirable property
• Theory:
– Market value of (subject property) bears a close
relationship to the prices of similar properties (comparable
property) that have recently changed hands.
• Adjustments:
– Since no two properties are exactly alike we need to
adjust the sales price of comparable property to arrive at
the estimated market value for the subject property

Sales Comparison Approach


Factors to adjust
– Property characteristics:
• size of parcel
• location
• square footage
• number of bedrooms
• type of construction
• quality of construction
• number of bathrooms
• age of building
• living area, etc

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Sales Comparison Approach
Factors to adjust
– Non-property characteristics
• date of sale
• sales price
• financing terms
• condition of sale

Sales Comparison Approach

Sales Comparison Subject Comp1 Comp2 Comp3


Price P146,000 P138,000 P136,000
Pool No Yes No No
Garage Yes No Yes No
Adjustments
Pool -P5,000
Garage P2,000 P2,000
Adjusted Price P143,000 P138,000 P138,000
Weights 30% 40% 30%
Estimated Value P139,500 P42,900 P55,200 P41,400

Cost Approach

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Cost Approach
• This approach states that the value of a
property is roughly equal to:
(1) the cost of reproducing the property
(2) Minus a figure that approximate the amount of
value used up in the course of property’s life.
(3) Plus the value of the land.
• Two cost concepts:
1. Replacement cost
2. Reproduction cost

Cost Approach
• Procedure:
– Value of the land
– Current cost of constructing buildings
– Estimate depreciation from
• Physical deterioration
• Functional obsolescence
• External obsolescence
– Subtract depreciation from Cost
– Add land value to result from previous step

Cost Approach
• Estimating Costs
– Reproduction Cost (Exact Duplicate)
– Replacement Cost
• Most often used
– Methods
• Square metre
• Unit-in-place
• Quantity Survey
• Index Method

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Cost Approach
Depreciation
• Depreciation is loss in value due to any cause
• It can be curable or incurable
• Three classes of depreciation
– Physical Deterioration
– Functional Obsolescence
– External Obsolescence (always incurable)

Cost Approach
Accrued depreciation
– Physical depreciation
• incurable
• curable
– Functional depreciation
• curable
• incurable
– Economic or location depreciation

Income Approach

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Income Approach
• Also called capitalization approach
• Net Operating Income divided by
capitalization rate equals value
• Shortcut methods
– Gross Rent Multiplier times the Gross Rent
equals value (used to validate)
– Gross Income Multiplier times the Gross
Income equals value (used to validate)

Valuation shortcuts: “Ratio valuation” ...

1) DIRECT CAPITALIZATION:

A WIDELY-USED SHORTCUT VALUATION


PROCEDURE:

· SKIP THE MULTI-YEAR CF FORECAST

· DIVIDE CURRENT (UPCOMING YEAR) NET


OPERATING INCOME (NOI) BY CURRENT
MARKET CAP RATE (YIELD, NOT THE TOTAL
RETURN USED IN DCF)

Income capitalization approach

• V = NOI/R
• where V = market value
• NOI= net operating income
• R = capitalization rate
• What is capitalization rate?
• it is not a discount rate
• cap rate is net of values appreciation or
depreciation

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EXAMPLE:
250 UNIT APARTMENT COMPLEX
AVG RENT = P15,000/unit/yr
5% VACANCY
ANNUAL OPER. EXPENSES = P6000 / unit
8.82% CAP RATE

VALUATION BY DIRECT CAPITALIZATION:

POTENTIAL GROSS INCOME (PGI) = 250*15000 = P3,750,000


- VACANCY ALLOWANCE (5%) = 0.5*3750000 = 187,500
- OPERATING EXPENSES = 250*6000 = 1,500,000
------------------------------------- -------------------
NET OPER.INCOME (NOI) = P2,062,500

V = 2,062,500 / 0.0882 = P23,384,354, say approx. P23,400,000

2) GROSS INCOME MULTIPLIER (GIM):

GIM = V / GROSS REVENUE

COMMONLY USED FOR SMALL APARTMENTS.


(OWNER'S MAY NOT RELIABLY REVEAL GOOD
EXPENSE RECORDS, SO YOU CAN'T COMPUTE
NOI (= Rev - Expense), BUT RENTS CAN BE
OBSERVED INDEPENDENTLY IN THE RENTAL
MARKET.)

IN PREVIOUS APT EXAMPLE THE GIM IS:

23,400,000 / 3,750,000 = 6.2.

Income Approach
• Calculating Net Operating Income
– Potential Gross Income - Vacancy and Rent
loss = Effective Gross Income
– Subtract Expenses from EGI
– Expenses
• Fixed
• Operating
– Divide result by Capitalization Rate

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Income Approach Formula

Net Operating
Income NOI

Cap Value
Rate

Gross income multiplier (GIM)

• Gross Income Multiplier = sales price/ Gross annual income


• Sales price = Gross income X GIM
– A B C D
• Price P500,000 P800,000 P600,000 P400,000
• GI P100,000 P150,000 P100,000 P80,000
• GIM 5.00x 5.33x 6.00x 5.00x
• Subject gross income = P140,000
• Mean GIM = 5.3
• Estimated market value = 5.3x140,000 = P742,000

Income Approach
• Gross Rent Multiplier
– Uses comparables
– Selling price divided by Gross Monthly Rent
– Multiply subject property’s Gross Monthly
Rent by the Gross Rent Multiplier

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Selling Gross Gross
Price Monthly Rent
Rent Multiplier
$ 68,000.00 575 118.26
$ 71,000.00 600 118.33
$ 73,500.00 625 117.60
$ 74,750.00 650 115.00

Gross Rent Multiplier

Selling Price

GMR GRM

Gross Monthly Rent Gross Rent


Multiplier

DANGERS
IN MKT-BASED RATIO VALUATION. . .
1) DIRECT CAPITALIZATION CAN BE MISLEADING FOR
MARKET VALUE IF PROPERTY DOES NOT HAVE
CASH FLOW GROWTH AND RISK PATTERN TYPICAL
OF OTHER PROPERTIES FROM WHICH CAP RATE
WAS OBTAINED. (WITH GIM IT’S EVEN MORE
DANGEROUS: OPERATING EXPENSES MUST ALSO
BE TYPICAL.)

2) Market-based ratio valuation won’t protect you from


“bubbles”!

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Income Approach
THE DCF VALUATION PROCEDURE

Income Approach
THE DCF VALUATION PROCEDURE...
1. Forecast the expected future cash flows;
2. Ascertain the required total return;
3. Discount the cash flows to present value at
the required rate of return.

The value you get tells you what you must pay
so that your expected return will equal the
"required return" at which you discounted the
expected cash flows.

Why is the DCF procedure important


important?
?
1. Recognizes asset valuation fundamentally depends upon
future net cash flow generation potential of the asset.
2. Takes long
long-term perspective appropriate for investment
decision--making
decision making in
in illiquid
illiquid markets
markets (multi
(multi-period,
-period, typically
10 yrs in R.E. applications).
3. Takes the total return perspective necessary for successful
investment.
4. Due to the above, the exercise of going through the DCF
procedure, if taken seriously,
seriously , can help to protect the investor
from being swept up by an asset market “bubble ” (either a
positive or negative bubble – when asset prices are not related to
cash flow generation potential).
potential).

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DCF example...  Single-tenant office bldg
 6-year “net” lease with a “step-up”...
Lease:
 Expected sale price year 6 =
P15,000,000
Year: CF:  Required rate of return (“going -in
2001 P1,000,000 IRR”) = 10%...
2002 P1,000,000  DCF valuation of property is
P13,757,000:
2003 P1,000,000
2004 P1,500,000
2005 P1,500,000
2006 P1,500,000

1 ,000,000 1,00 0,000 1,000,000 1, 500 ,000 1,5 00,000 16,5 00,000
13 ,757,000 = + + + + +
(1.10 ) (1.1 0 )2 (1.10 ) 3 (1.10 )4 (1.10 )5 (1.10 )6

Remember:

Investment returns are inversely related to the price


paid going in for the asset.
e.g., in the previous example, if we could get the asset for
P13,000,000 (instead of P13,757,000), then our going-in return
would be 11.24% (instead of 10.00%):
1 ,000,000 1, 000,000 1,00 0,000 1,5 00,000 1 ,500 ,000 16 ,500 ,000
13,000,000 = + + + + +
( 1 .1124 ) ( 1. 1124 ) 2 ( 1. 1124 ) 3 ( 1 .1124 )4 ( 1 .1124 )5 ( 1.1124 ) 6

vs.
1,000,000 1 ,000,000 1, 000,000 1,5 00,000 1 ,500 ,000 16 ,500 ,000
1 3,757,000 = + 2 + 3 + 4 + 5 + 6
(1.1 0 ) (1.10 ) (1.10 ) (1.10 ) (1.10 ) (1.10 )

What is the fundamental economic reason for this inverse


relationship? [Hint: What determines fut. CFs?]

Match the discount rate to the risk. . .

r = rf + RP

Disc. Rate = Risk free Rate + Risk Premium

(Risk free Rate = T-Bill Yield)

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Deriving the capitalization rate
Market extraction approach
1 2 3 4
v 100,000 80,000 120,000 90,000
NOI = 9,500 7,680 11,352 8,505
NOI/R .095 .096 .0946 .0945

Mean R = 9.5025
Assume NOI for the property being valued is estimated to be 10,000
V = 10,000/.095025 = P105,235

Deriving capitalization rate


• Band of investment approach or the
weighted average cost of capital
• R = (L/V)(MC) + (1-L/V)(EDR)
• MC = mortgage constant,
• EDR = equity dividend rate
• L/V = loan-to-value ratio

Band of investment example

• L/V = 70%, interest rate = 10%


• amortization period = 25 years, monthly
payment
• BTCF = P1,968, Equity = P31,570
• EDR = 1,968/31570 = 6.2337
• R = (.7)(.009087)(12) + (.3)(.062337)
= .095031
• V = 10,000/.095031 = P105,228.

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Typical mistakes in DCF application to commercial
property...
CAVEAT!
BEWARE OF “G.I.G.O.”
===> Forecasted Cash Flows:
Must Be REALISTIC Expectations
(Neither Optimistic, Nor Pessimistic)
===> Discount Rate should be OCC:
Based on Ex Ante Total Returns in Capital Market
(Including REALISTIC Property Market Expectations)

· Read the “fine print”.


· Look for “hidden assumptions”.
· Check realism of assumptions.

Three most common mistakes in R.E. DCF practice:

1. Rent & income growth assumption is too high—


aka: “We all know rents grow with inflation, don’t we!”?...
Remember: Properties tend to depreciate over time in real terms (net of
inflation).  Usually, rents & income within a given building do not keep
pace with inflation, long run.

2. Capital improvement expenditure projection, &/or terminal cap ra te


projection, are too low –
Remember: Capital improvement expenditures typically average at least
10%-20% of the NOI (1%-2% of the property value) over the long run.
Going-out cap rate is typically at least as high as the going-in cap rate
(older properties are more risky and have less growth potential).

3. Discount rate (expected return) is too high –


This third mistake may offset the first two, resulting in a realistic estimate of
property current value, thereby hiding all three mistakes!

Market Value Valuation

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Market Value Valuation
• The International Valuation Standards are
intended to facilitate cross-border transactions
involving property and contribute to the viability
of global markets by promoting transparency in
financial reporting.
• Emphasis is placed on the use of factual market
information from which informed professional
judgements regarding property valuations can
be drawn.

Why do we need market value?


• Transfer of ownership
• Financing of property
• Taxation
• Compensation for eminent domain
• Insurance purposes

Factors affecting market value

• Physical forces: size, shape, location, topography


• Economic forces: income, mortgage terms, general
price levels, property tax rates, supply and demand
• Social forces: attitude towards house household
formation, population, household size, taste and
preferences.
• Governmental or institutional forces: zoning,
subdivision regulation, building codes, real estate
taxation, etc

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Market Value Valuation
Principle Of Substitution
– Market based valuations normally employ one or
more of the valuation approaches by applying the
principle of substitution, using market-derived data.
– This principle holds that a prudent person would not
pay more for a good or service than the cost of
acquiring an equally satisfactory substitute good or
service, in the absence of the complicating factors of
time, greater risk, or inconvenience.
– The lowest cost of the best alternative, whether a
substitute or the original, tends to establish Market
Value.

Non-Market Value Valuation

Non-market Based Valuations


• Non-market based valuations may apply similar
approaches, but typically involve purposes other
than establishing Market Value.
• For example:
– An entity may apply a cost approach to compare the
cost of other buildings with the cost of a proposed
building to the entity, thereby ascertaining the bargain
or premium accruing a particular property at variance
with the market at large.
• This application focuses on a particular property
and what may be a non-market cost.

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Non-market Based Valuations
Special Purchaser Value
• An owner of land may pay a premium price for
adjacent property.
• In applying a sales comparison approach to
determine a maximum price that owner is willing
to pay for adjacent land, a Valuer arrives at a
figure that may well exceed its Market Value.
• In some States, such an estimate is called
Special Purchaser Value.

Non-market Based Valuations


Investment Value or Worth
• An investor may apply a rate of return that is non-market
and particular only to that investor.
• In applying an income capitalisation approach to
determine the price that investor is willing to pay for a
particular investment based on the investor's anticipated
rate of return, a Valuer arrives at an estimate of
Investment Value or Worth rather than Market Value.
• Depreciated replacement cost is an application of the
cost approach used in assessing the value of specialised
assets for financial reporting purposes, where direct
market evidence is limited or unavailable.

Non-market Based Valuations


• Each valuation approach has alternative
methods of application.
• The Valuer's expertise and training, local
standards, market requirements, and available
data combine to determine which method or
methods are applied.
• The reason for having alternative approaches
and methods is to provide the Valuer with a
series of analytical procedures which will
ultimately be weighed and reconciled into a final
value estimate, depending upon the particular
type of value involved.

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Reconciliation or
Correlation of Value

Reconciliation or Correlation of
Value
• Weighing the results from each approach
• Note that certain properties are conducive
to certain approaches
• Which method?
– Residential
– Office Building
– Church

What about unique circumstances or abilities? . . .

Generally, real uniqueness does not affect MV.

Precisely because you are unique, you can’t expect


someone else to be willing to pay what you could, or
be willing to sell for what you would. (May affect
“investment value” – IV, not MV.)

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