Values real estate based on "what would it cost to replace the building in its current form with the value of the land added to it?" The cost approach sounds like a straightforward and easy-to-calculate method for determining value, but it is difficult to implement. Getting an apprised value for the cost of the existing structure can be difficult in some markets. Furthermore, the market value of the existing prosperity may be very different from its construction cost.
Sale Comparison Approach
This approach looks at the price at which other real estate property with similar characteristics (location, size, age, etc.) has recently been sold or valued. Most residential real estate is appraised or valued using this method. At times, this can also be a difficult method to implement: a comparable property may be hard to identify (especially if the property in question has unique features) or there may not be any sales of comparable properties in the recent past.
The Income Approach
This approach uses a perpetuity discount type of model. The net income derived from the property is discounted at a market required rate of return. The appraisal value = net operating income (NOI)/market cap rate. The Market cap rate is found by benchmark NOI/benchmark transaction price. The problem with this approach is that long-term tenants may not be paying current market rates, depressing the value of the investment. An inflationary environment may also take a bite out of the value of the property.
Discounted After-Tax Cash Flow Approach
Calculating the value of the discounted cash flows from a real estate investment can act as a validation or check on other valuation methods. This approach takes into account the investor's individual tax bracket, depreciation and any interest payments. See the example below.
Calculate Net Operating Income from a Real Estate Investment
The CFA Level 1 exam requires you to know how to create an income statement for a property. It goes as follows:
Potential Gross Income
Total potential gross income
Vacancy and Collection loss(10%)
Effective Gross Income
Comparable Property: NOI $135,000, which sold for $750,000
NOI = $135,000 - $5,000 - $5,000 = $125,000
NOI/(Transaction Price): $135,000/$750,000 = 0.18
NOI/Cap Rate = $125,000/0.18 = $694,000= Which is the amount this property is being valued at.
Do not include financing cost or depreciation when calculating NOI.
It would be very surprising if you have to compute all the types of rents and incomes because of the time constraints of the exam. However, candidates may be asked to calculate price increases of a certain time period to evaluate the impact on NOI.
Sales Comparison Approach:
Looks at the characteristics of similar properties and how they are valued:
|Number of rooms||Number||$25,000|
|Number of bathrooms||Number||$10,000|
|Distance to city||Miles||($2,000)|
The property you want to value has eight rooms, three bathrooms and is 10 miles from the city.
The value would equal (8 * $25,000) + (3 * $10,000) +(10 * -$2,000) = $200,000 + $30,000 - $20,000 = $210,000 based on similar property types.
In this approach, the investor would estimate total real estate value based on the rate of return from the property. Therefore, any potential rents expected from a lessee for use of the property would be compared against similar property types.
Calculating After-tax Cash Flows
Let's start with some basic information:
NOI = $125,000
Depreciation = $5,000
Mortgage payment = $60,000
Purchase price = $725,000
75% financing at 8% interest rate
NOI growth rate = 4%
Marginal Tax Rate = 31%.
After-tax cash flow = Amount borrowed ($725,000 * .75) = $543,750.
First year's interest = ($543,750* .08) = $43,500.
After-tax income = ($125,000 - $5,000-$43,500) * (1-.31)= $52,785
To arrive at after-tax cash flow from after tax income, depreciation must be added and the principal repayment of the mortgage payment must be subtracted.
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InvestingThe income approach is one of the three main methods that appraisers use to value property.
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