Urban Real Estate

Economics
Class 10: February 18, 2015
Susan Wachter
Market Value and Appraisal
1

Administration and Introduction

Todays Class
Readings:
Appraisal Institute, Understanding the
Appraisal (canvas)
Linneman, Real Estate Finance and
Investment: Risk and Opportunities, (pp.
30-31), Ch. 7 (BP#17), and Ch. 9
(BP#18)

No readings for Mondays class

project work due
3

Project: Specifics and

Deliverables
Initial PowerPoint
Project Name, Team Members 2/23
Location, concept, draft, Idea/Investment ThesisWhy?
2/25
Feasibility analysis, not necessary to do, do start thinking
about it.

Please upload PowerPoint presentations to canvas.

If you have fewer than 6 people in your group and
would like others or if you have no group please
come see me at the end of todays lecture.
4

Todays Class
1.
2.
3.
4.
5.
6.

Administration and Introduction

Feasibility Analysis
Valuation Methods
Appraisal and Market Analysis
Market Puzzles
Takeaways

Feasibility Analysis

Should you develop a specific

site?
This is your group decision
Depends on market pricing, including
price of inputsspecifically land
You do not want to build or redevelop
if the market will not support your
project at a price that rewards your
efforts and covers your costs
How do you know?
Point of feasibility analysis
7

Return Target: cap rate versus a

build to cap rate
A cap rate is what you pay for an asset
based on its earnings and its market based.
A build to cap rate is essentially the return
target you earn based on the developers
cost to deliver an asset.
A good developer always gets build to
rates well in excess of market cap rates or
they lose money.

Market Cap Rates

Market Cap Rates are estimates of market-clearing yields

that real estate investors are achieving for similar assets in
that market

With a Market Cap Rate and known (or pro forma) NOI, one
can calculate current asset Value
Value = NOI / Cap Rate, or
Cap Rate = NOI / (Cost or Value)
Cap Rate is essentially inverse of EBITDAx multiple
Build To Cap Rate is the return earned on a development
Build To Cap Rate = annual NOI / total Project Cost
Acquisition Cap Rate is what you buy a specific asset for
Acquisition Cap Rate = annual NOI / total Purchase
Cost

Feasibility Analysis and Rentable Space:

Not All Space is Revenue Generating
You must pay to build the entire building, not just the
leasable space
You incur operating costs for the entire
building, not just the leased space
You recover rents from leased space, which
excludes vacant space and non-leasable
common space
To determine whether to build or not, you need to
know whether rent from leasable space covers cost
of building.
Use concept of replacement rent to determine
feasibility of development/redevelopment project.
10

Feasibility Analysis Example

Land
Hard Costs
Soft Costs
Total Cost Gross

Rent
foot (per year)
Operating Cost
Occupancy
footage
Loss Factor

$30 per gross foot

$90 per gross foot
$30 per gross foot
$150 per gross foot
$30 per leasable
$10 per gross foot
95% of leasable
30% of gross footage11

Replacement Rent
Replacement rent is the rent level needed
to justify building.
Replacement rent per gross foot
Gross foot includes vacant space and nonleasable common space (loss factor)
Build to Calculation
Replacement Rent per Gross Foot = Build To Cap Rate
(Return) * Expected Total Cost + Expected Operating
Costs
Replacement Rent per Gross Foot = (10%) * ($150) +
$10 = $15 + $10 = $25
12

Replacement Rent Per Leasable

Foot
Replacement Rent Per Leasable Foot
Rent per Leasable Foot =
Replacement Rent per Gross*(1/(1-Loss Factor))*(1/(1Vacancy))
Rent per Leasable Foot = $25 * (1/0.7) * (1/0.95) =
$37.59

If rent per gross foot is $25, rent per leasable

foot is $37.59.
13

NOI vs. SNOI

Net Operating Income - NOI = Rent per leasable
foot operating costs
In this case, NOI = $25 - $10 = $15
Stabilized NOI SNOI term for when the new
building is fully rented
In this case, NOI = SNOI = $15

14

For your projects: show feasibility

through calculating psf construction
cost, build to cap rate and compare to
market comp leasable

Build to Calculation

Replacement Rent per Gross Foot =Build To Cap Rate (Return) * Expected
Total Cost + Expected Operating Costs

Replacement
perPer
Gross
Foot = (10%)
ReplacementRent
Rent
Leasable
Foot * ($150) +
$10
= $15
+ $10
=Replacement
$25
Rent per
Leasable
Foot =
Rent per Gross* (1/(1-Loss
Factor))*(1/(1-Vacancy))

Rent per Leasable Foot = $25 * (1/0.7) * (1/0.95) =

$37.59

Compare to market comp rent per

leasable foot for your development or
redevelopment project
15

Does the price, P, exceed the

cost to construct, redevelop?
Tobins Q

If leasable rent is $37.59, then rent

per gross foot is $25 and after
operating costs, NOI=$15
Value of NOI at a 10% cap rate is $150
With construction cost=$150, this is
feasible.
Should you build in that market?
P/Construction Cost = Tobins Q
If P = or > Construction Cost, Tobins Q =

16

Should you build/redevelop in this market?

Ex.: P = $12.5M, rent = $1M, market cap
rate = 8, construction cost = $10M
Price at $12.5 > Construction Cost=$10
If P = or > Construction Cost, Tobins Q =
or > 1 Yes
Should you build in that market?
Ex.: P = $12.5M, rent = $1M, market cap
rate = 8, construction cost = $10M
Build to cap rate is 10>market cap rate=8 ,
so yes!
17

Would you do this deal?

Total Development Cost is
$2.15M
Building is 40,000SF
Gross Building Rent is $5.5PSF
Building Expenses are $0.5PSF
Return target is 10%

18

Would you do this deal?

Total Development Cost is $2.15M

Building is 40,000SF
Gross Building Rent is $5.5PSF
Building Expenses are $0.5PSF
Return target is 10%
No. Minimum return to meet target
is $215K per year ($2.15M x 10%).
Projected cash flow is only $200K
per year [40,000sf x ($5.5psf$0.5psf)]. Its not enough.

19

Valuation Methods

20

Valuation Methods Used in Appraisal

What are the three accepted valuation methods
used in an appraisal?
Name a fourth method to value real estate.
Why is it important?

21

Valuation Methods Used in Appraisal

What are the three accepted valuation methods
used in an appraisal?
Name a fourth method to value real estate.
Why is it important?
1. Cap Rate
2. Comparable Sales (Sales Comparison)
3. Discounted Cash Flow (DCF)
4. Replacement Cost: replacement is important
because it impacts:
a. When developers build
b. What insurers consider
c. What analysts use to evaluate market

22

Sales Comparison
Sales Comparison Valuation Method utilizes
recent sales of comparable properties to estimate
value
Sales are shown in price per applicable unit of
measurement
Prices per unit are adjusted to account for
significant differences between the Subject
Property and each Comparable sale
Adjusted prices per unit are then grossed up by
subject size to find overall value

23

Sales Comparison Apartment

Complex
Subject Property

Property
Sale Price / Proposed Value
Sale Date
Units
(Proposed) Price per Unit

Adjustments

Total Adjusted Price / Unit

Pleasant Run
$10,640,000

Apartments at
Similar Pines
$10,000,000

Mediocre
Estates
$10,000,000

Proposed
160
$66,500

June 2011
175
$80,000

August 2013
150
$66,667

March 2006
200
$50,000

B
B
$0
B
$0
A$0

B+
B-

A-

($1,000)
$750

$7,500
C
$2,000

$0
($250)

A
($3,000)
$16,500

$66,500

C
$10,000
C

$0

($5,000)
A
($2,000)

$66,500

$5,000
($13,500)

A
($11,500)
A-

$0

Adjustment per Unit

Amenities
Adjustment per Unit
Market Timing
Adjustment per Unit
Total Adjustments per Unit

Comparable Sales

The Moneyed
Villas
$14,000,000

Asset Quality
Adjustment per Unit
Location Quality

$66,417

$66,500
24

Replacement Cost Approach

The Cost Approach equates asset value to the
construction cost, less depreciation, plus land value
Often used for:

Insurance purposes
Non-income producing assets (such as a church)
Recently constructed buildings
Buy vs. build scenarios
Comparison purposes (at time of construction, costs are
theoretically highly correlated to value)
Analysis of market trends

Cost Approach ignores market cycle

Difficult to understand derived values when there is
scarcity of developable land, assets are old and
hence may contain functional or locational
obsolescence, or the asset type is not highest and
25
best use

Replacement Cost Approach

Apartment Complex - 206,160 SF, 1960s vintage, located in Orlando, FL:

Units/%

Basic Structure
Base Cost
Exterior Walls
Heating & Cooling
Total Basic Structure Cost
Superstructure
Balconies
Total Superstructure Cost
Miscellaneous
Land1
Misc1
Total Miscellaneous
Estimated Replacement Cost
Less Depreciation

Cost / Unit

Total (000s)

206,160
206,160
206,160
206,160

SF
SF
SF
SF

$44.18
$14.45
$3.41
$62.04

$9,108
$2,979
$703
$12,790

4,000 SF
206,160 SF

$29.33
$62.61

$117
$12,907

206,160 SF
206,160 SF
206,160 SF
206,160
SF

$8.85
$3.34
$12.19

$1,824
$687
$2,514

$74.80

$15,421

Physical and Functional2

41.3%
$5,331
206,160
1)
Land
and
Misc
costs
shown
as
per
square
footSF
of buildable
area
Estimated Current Value
$48.94
$10,090
2) Depreciation is only applied to Total Superstructure Cost (land does not depreciate)

26

Discount Cash Flow (DCF)

DCF Valuation Method analyzes the net present
value (NPV) of the pro forma cash flows of the
asset
Purchase Price derived from NPV of cash flows at required
Discount Rate
Inversely, a given Purchase Price is used to calculate an
IRR
IRR = the Discount Rate at which the NPV of the cash
flows equals 0

Key factors to consider for pro forma include:

growth rates, rents, expenses, terminal value,
leverage, capital needs, investment timing, etc.
Required Discount Rate is key factor in analysis,
but difficult to determine
Discount Rate should reflect overall risk of
investment

27

Terminal Cap Rate

Need terminal cap rate to capitalize
last periods cash flow

28

DCF Unleveraged Example

Annual Pro Forma
Period

Acquisition

Income

Year 1

Year 2

Year 3

Year 4

$1,000

$1,035

$1,071

$1,109

($600)
$400

($618)
$417

($637)
$435

($656)
$453

($6,500)

$7,549

($6,500)

$400

$417

$435

$8,002

5.5%

6.0%

6.5%

$8,235

$7,549

$6,968

12.1%

10.0%

8.1%

NPV at 8% Discount Rate

$7,459

$6,954

$6,527

NPV at 10% Discount Rate

$6,969

$6,500

$6,103

NPV at 12% Discount Rate

$6,520

$6,084

$5,715

Expenses
NOI
Purchase Price
Terminal Value
Cash Flow to
Equity

Sensitivity Analysis
Exit Cap Rate
Terminal Value
IRR at Purchase Price of $6.5 MM

29

Appraisal Methods: In Sum

There are 3 methods, each has its uses
1. Replacement cost- use concept to calculate long
term equilibrium price and replacement rent
Level needed to spur construction activity

2. Comps- for market price-what is current pricing?

how does your building compare?
3. DCF- based on projected cash flows
Appraisers are not allowed to forecast rents by law (in
many states)!

4. Appraisers often base value on SNOI/market cap

rate
Market Cap Rates are estimates of market-clearing
yields that real estate investors are achieving for
similar assets in that market

30

Appraisal and Market Analysis

31

Appraisal and Market

Analysis

In equilibrium, all appraisal methods

give the same value: construction
costs=comp=cap rate = DCF
Markets are not always in equilibrium.
Comps reflect market prices which
may not equal value based on market
fundamentals

32

Market prices may be wrong,

unstable, leading to opportunity

Why? Expectations based, looking backwards

Marginal buyer is the optimist buyer
The optimistic buyer is financed by banks
Banks, appraisers use market prices for lending
Banks use comps
Lack of short-selling

Prices may be too low

Why? Expectations based, looking backwards
Lack of capital from banks, financial markets,
after the crash
33

Cycles/Appraisal

In equilibrium, all appraisal methods: give

the same value: construction costs= cap
rate = comp = dcf
Price does not always equal construction
cost!
Comps reflect market prices which may be
wrong
4 phases of cycle: if disequilibrium are they
all equal? No!

34

Market Cycle Quadrants

Phase 3 - Hypersupply

Phase 2 - Expansion

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Long Term Vacancy Average

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Occupancy

Demand/Supply Equilibrium Point

n
io
s

Phase 4 - Recession

Phase 1 - Recovery
Time

35

Cycles/Appraisal

In equilibrium, all appraisal methods

give the same value: construction
costs=cap rate =comp = dcf
4 phases of cycle:
1.
2.
3.
4.

Recession
Recovery
Expansion
Hypersupply

If disequilibrium are they all equal?

No!
36

Cycles/Appraisal

Recession => unanticipated demand

decreases

Demand does not increase as anticipated

Supply is excessive => vacancies and rent
declines

Building stops, recovery occurs with

demand increase

Rents and effective rents increase faster than

inflation until replacement rent levels are
reached
With backward looking expectations, rents are
expected to continue to increase at high rates
Reflected in too low cap rates
37

42
38
34

RECESSIO
N
RECOVER
Y

30
46

EFFECTIVE RENT ($)

Incorrect Expectations and Cycles

2001

2002

2003

2004

2005

2006

2007

YEAR
38

The common mistake=> and

opportunity
Market extrapolates rent growth and price
growth to continue at recent past rate
Market cap rates reflect these expectations

What do you do-- grow rents at what rate,

to what levels ???
How do you form your price estimates?
At what rate do you grow your rents?
That will determine your DCF
Also your view of current market cap rates
39

How Do Cash flows

Change Over the Cycle?
Bad form to grow NOI at extrapolated rate
for any extended period unless the market
is in equilibrium and growing at the
inflation rate and supply is elastic then
grow NOI at inflation.
Markets are sometimes in equilibrium.
For example, many property markets were
in equilibrium from 1998 to 2001, and were
supply elastic.
If not at equilibrium, need to estimate of
equilibrium rents levels and derive growth
rate
40

Market Puzzles

41

Historic Property Cap

Rates

Historic Property Cap Rates 1989-2002

11.0

10.5

9.5

9.0

8.5

8.0

7.5
Source: Real Estate Research Corp.

Office - CBD

Apartment

Office - Suburban

Industrial - Warehouse
42

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

7.0
1989

Going-in Cap Rate (%)

10.0

Industrial R&D

Cap Rate By Asset Class

Office

Industrial

Multihousing

Retail

43

Forward Cash Flow Cap Rate Spreads

over the 10-year US Treasury

44

Market Puzzles: US
Depopulated cities not just decentralized
Cities still the center of large, growing MSAs
But some US cities are growing, where, why
reversal?
Urban population growth in US and world

Sharp discontinuities in gradients

In current use, rents cover depreciated costs, do
not cover maintenance, upgrade or new building

Poor live in center of cities in US not

elsewhere
Market forces do not predict. If due to market
forces, would be more universal

45

Rent

Emergence of new centers as well as growth

at Center. Will the center repopulate?

Distance

46

Rent

Distance

47

Where and How - Urban Growth in US:

Decentralizing from urban centers to

suburbs
Where has growth occurred in the
USnew metro areas
Historically growth in south and west
in US
Why?
Result? National markets for firms
Global urban growth, new outcomes
48

US Lights at Night

49

Urban Growth
Where will the build out be in the US
existing cites/metros/in new metro
areas?
Growth in industrialized countries, in
emerging economies, China, India?
How do you know which cities will
grow?
Projections based on industrial growth
and cost based forecasts

How do you know where new cities

will grow?

50

Takeaways

51

Global Urbanization: Why?

Role of low labor costs

Declining transportation costs
Market integration globally
Superstar cities: Role of agglomeration
economies on a global scale?

52

Takeaways: -Undervalued Real

Estate

Takeaway:
Takeaway:
Takeaway:
Takeaway:

1-Undervalued
2-Undervalued
3-Undervalued
4-Undervalued

Real
Real
Real
Real

Estate
Estate
Estate
Estate

53

1-Real Estate Not at Highest Use

Highest and best use & price
discovery
See gaps in the skyline at specific
sites
Economic height / redevelopment
option
Value creation
Price of building minus cost to construct
Rent * # floors capitalized minus
construction costs

Residual = land value:

54

2-Re-pricing markets
The rebranding of University City
Expected rent growth up, risk down,
cap rate down in neighborhood that
re-prices
Citys can re-price as well, see
detour

55

The Quick-Change Artist: The South

of Fifth area in Miami Beach has highrises along the water and low-rises in
the center.

High-end neighborhoods
come and go, though few
swing from blighted status
to the height of luxury living
in just one decade. Thats
what happened in the South
of Fifth Street neighborhood

http://
www.nytimes.com/2013/02/17/reales
ate/a-miami-beach-fla-neighborhood
-rises-to-the-height-of-luxury-liv
ing-in-just-one-decade.html?hpw
56

57

58

59

60

61

3-Urban Growth at New Edges: Land

Value where not priced
$334,286

Cap Rates: i =
0.07 and with
growth of 2% i=.05

$ P(d)
$228,571
Current Location

$105,715 =
value at edge

Value

Future Growth in

$91,429

Location Value

$14,286

ra

Agricultural Value

20
mi

d (distance)
62

MSA Growth and Market

Rents
Income growth at
center => rent growth
throughout

Trans. cost decline =>

rent growth (except at
center), with no
population growth

II

63

MSA Growth with Land Value Growth

and Rent Growth at New Urban CentersElastic S
New centers

III

64

Diverging Cap Rates

Avg Cap Rate by City Type

Turnaround
Growing
Declining

65

San Francisco Population

Boston Population

New York Population

San Francisco Cap Rate

San Francisco
Rent

Home Price

$
1,140

$ 783,000

Boston

Boston Cap Rate

New York Cap Rate

Rent

Home Price

$
1,050

$ 420,000

New York
Rent

$ 920

Home Price

$ 482,0000
66

3
.
7

Denver Population

Seattle Population

Atlanta Population

Denver Cap Rate

Denver

Rent

Home Price

$ 700

$ 229,000

Seattle Cap Rate

Seattle
Rent

Home Price

$ 810

$ 434,000

Atlanta Cap Rate

Atlanta
Rent

Home Price

$ 640

67
$ 154,000

Los Angeles

San Antonio Population

Jacksonville Population

Los Angleles Cap Rate

San Antonio Cap Rate

Jacksonville Cap Rate

Los Angeles

Rent

Home Price

$ 910

$ 596,000

San Antonio
Rent

Home Price

$ 660

$ 93,000

Jacksonville
Rent

Home Price

$ 730

68
$ 164,000

Philadelphia Population

Philadelphia Cap Rate

Philadelphia
Future
population?

69

4 - Distressed real estate

After the bubble due to irrational
price expectation formation and/or
hypersupply
Market expected rent growth down
due to backward looking
expectations
Even as markets stabilize and
recover
In recovery phase, after recession,
rents and prices can be expected to

70

4 - Mispricing over the cycle

In expansion, unrealistically high forecasts
for future rents, common mistake is to
extrapolate demand growth
Overshooting of supply is likely
Real estate recession results, estimate
starts v. existing vacancy
In recovery from recession, common
mistake to extrapolate passed no growth
Most serious error: Prices extrapolated to
continue to increase based on past,
leverage up to those prices, cap rates
converge and collapse
71

Historic Property Cap

Rates

Historic Property Cap Rates 1989-2002

11.0

10.5

9.5

9.0

8.5

8.0

7.5
Source: Real Estate Research Corp.

Office - CBD

Apartment

Office - Suburban

Industrial - Warehouse
72

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

7.0
1989

Going-in Cap Rate (%)

10.0

Industrial R&D

Last Mispricing Episode

Overpricing Phase
Mid-1980s-1989 -- Lack of liquid capital market
instruments to short sell. Misaligned incentives and
deal-driven pricing caused typical DCF pricing to be
systematically too high, rents extrapolated to grow

Underpricing Phase
Early 1990s -- Lack of liquid capital market
instruments to buy. Market surprise caused
traditional sources of capital to withdraw and cap rates
to increase. Lack of access to capital for informed
buyers. Once again, typical DCFs resulted in
mispricing

73

Next Class
Monday, February 23
No readings for class work on projects

74