End of Chapter 15 Questions and Answers

1. What is the traditional income approach to value?

Answer: The traditional technique for commercial propert is the income approach to
value! which uses the simple formula:
"#$
%alue &
'
' is the (capitali)ation rate* used to discount the +ta,ili)ed net operatin- income.
"#$ is the free and clear return on propert prior to financin- .as if no financin- were
used/
0. 1ow can a perpetuit model result in a valid propert value?
Answer: "#$ is considered as perpetuit althou-h the properties do not have infinite
lives. 2roperties have little value ,eond 34 or 54 ears! however the present value of
those future returns is ne-li-i,le and hence i-nored. The model does not quantif a
residual or reversion value! which ,alances the assumption of perpetual returns.
5. What is the difference ,etween a discount rate and a hurdle rate?
Answer: The discount rate and hurdle rate ,oth are the (required rate of return* of the
investor. 6iscount rates use the hurdle rate when the analsis is not capital constrained
and all positive "2% deals can ,e accepted. When there are capital constraints and onl
the hi-hest return deal can ,e accepted an $'' approach ma ,e used. 7oth approaches
mi-ht ,e used if there are some capital constraints and some capital rationin-.
3. Wh is a cap rate often lower then the e8pected and required rate of return?
Answer: The cap rate reflects current returns on a non9levered ,asis. The do not
include the appreciation return. With -rowth in rents and appreciation the actual total
returns will ,e hi-her.
5. What is meant , the term (:$:#* in reference to the practical application of the
6C; valuation procedure for commercial propert?
Answer: :ar,a-e $n :ar,a-e #ut. $f the assumptions from mar<et research are not
realistic then the output of the proforma will also ,e unrealistic.
=. 6escri,e some was ou can ,ias a value up or down?
Answer: The followin- assumptions can over9value the propert:
1i-her -rowth rate of rents than possi,le.
>ower forecasts for capital improvements than reasona,le.
1i-h resale price of propert .i.e. ver low -oin-9out cap rate/
?nusuall hi-h occupanc rates with low vacanc assumptions.
The followin- assumptions can under9value the propert
>ow resale price of propert .i.e. hi-her -oin-9out cap rate/
?nusuall hi-h operatin- e8penses.
1i-her than normal vacanc rates
@. What is the appro8imate relationship ,etween the cap rate! the discount rate! and the
lon-9run avera-e -rowth rate in propert cash flow and value?
Answer: The faster .hi-her the lon- run avera-e -rowth rate/ the e8pected -rowth in
income! the lower the cap rate. The cap rate will ,e lower , appro8imatel the -rowth
rate in income. %er rou-hl spea<in-! the cap rate is equal to the current return less the
-rowth rate in the current return! '&9-! <nown as the :ordon -rowth rate model.
The -reater the ris< the hi-her is the cap rate as the required rate of return .discount rate/
is hi-her and the lower is value.
A. What is wron- with the followin- statement: ($nvestors tpicall overstate ,oth the
numerators and denominators in applin- the 6C; approach to commercial propert!
with the two tpes of errors lar-el cancelin- each other out! so that there is reall no
harm done , this tpe of mista<e.*
Answer: The harm is that investors will not see the returns that have ,een promised or
e8pected. $ncorrect num,ers also undercuts the credi,ilit of the 6C; valuation
framewor< and analsts lose faith in the a,ilit of 6C; modelers to tell them anthin-
useful! ,ecause the have witnessed too much corruption with misinformation.
B. Wh is a )ero "2% deal (#<a*? Where is the profit for the investor in a deal in
which "2%&4?
Answer: The discount rate reflects the opportunit cost of capitalC it includes the
necessar e8pected return on the investment. This return is the normal amount of DprofitD
that would ,e required for an investment of this nature. 1ence a )ero "2% proEect
indicates normal profit.
14. Wh is the "2% of the tpical deal )ero when evaluated from a mar<et value
perspective?
Answer: ;or the analst and over time the mar<et will ,id prices up or down to avera-e
"2%s of 4. $t is what should ,e e8pected over the lon- run or else the hurdle rates would
,e adEusted.
Quantitative 2ro,lems
11. Consider a propert with e8pected future net cash flows of F05!444 per ear for the
ne8t 5 ears .startin- one ear from now/. After that! the operatin- cash flow should step
up 04G! to F54!444! for the followin- 5 ears. $f ou e8pect to sell the propert 14 ears
from now for a price 14 times the net cash flow at that time! what is the value of the
propert if the required return is 10G?
5 14
%
4
& 05444H.1.10/
t
I 54444H.1.10/
t
I 544444H.1.10/
14
t&1 t&=
& F03A!4@5
4 99J C;
4
!
05444 99J C;
1
! 5 99J "
1
!
54444 99J C;
0
! 3 99J "
0
!
554444 99J C;
5
10 99J $HK'
"2% 99J 03A4@5
10. $n the previous question! suppose the seller of the ,uildin- wants F0=4!444. .a/
+hould ou do the deal? Wh or wh not? L1int: What would ,e the "et 2resent %alue
of the deal for the ,uer at F0=4!444?M .,/ What is the $'' if ou pa F0=4!444? 1ow
does this compare to the required return of 10G? .c/ What is the $'' if ou could -et the
seller to accept F03A!4@5 for the propert? What is the "2% at that price?
.a/ "o: "2% & F03A!4@5 9 F0=4!444 & 9 F11!B05 N 4
.,/ 11.03G N 10.44G
90=4444 99J C;
4
!
05444 99J C;
1
! 5 99J "
1
!
54444 99J C;0! 3 99J "
0
!
554444 99J C;
5
$'' 99J 11.03
.c/ 7 definition: $'' at F03A!4@5 is 10.44G "2% at F03A!4@5 is 4.
15. +uppose that the required return on the propert in the pro,lem 11 is 11G instead of
10G. What would the value of the propert ,e? 7 what percenta-e has this value
chan-ed as a result of this 144 ,asis point chan-e in the required return? L"ote the
sensitivit of propert value to small chan-es in the e8pected return discount rate used in
the denominators of the ri-ht9hand side of the 6C; valuation equation.M
Answer: F0=5!A55. This is a =.5=G increase in value .0=5A55H03A4@5&1.4=5=/ from a
1 point chan-e in discount rate.
13. :o ,ac< to the propert in the pro,lem 11 with the 10G required return. What is the
value of the propert if the cash flow steps up 05G in ear =! to F51!054! instead of the
ori-inal assumption of 04G? 7 what percenta-e has this rou-hl 1G per ear chan-e in
the rent -rowth assumption .05G over 5 ears instead of 04G over 5 ears/ chan-ed the
propert value? L"ote the sensitivit of propert value to small chan-es in the percenta-e
-rowth in e8pected cash flows in the numerators of the ri-ht9hand side of the 6C;
valuation equation.M
Answer: F053!=5=. This is a 0.=5G increase in value .053=5=H03A4@5&1.40=5/ from a
rou-hl 1 point chan-e in mar<et rent -rowth rate! even with 59ears fi8ed cash flows
from vinta-e lease.
4 99J C;
4
!
05444 99J C;
1
! 5 99J "
1
!
51054 99J C;
0
! 3 99J "
0
!
535@54 99J C;
5
10 99J $HK'
"2% 99J 053=5=
15. An apartment comple8 has 1444 units of which on avera-e 144 are vacant at an
-iven time. 2er unit! the rent is F344 per month! and the operatin- e8penses are F1A44 per
ear. $f ou e8pect ,oth rents and e8penses to -row at 5 percent per ear! and the
required return is 10.5 percent and the ,uildin- value is e8pected to remain a constant
multiple of its net income! then what is the "2% of a deal to ,u the propert for
F05!444!444? L1int: use the perpetuit formula: 2%&C;
1
H.r9-/.M
Answer: IF1!50=!544
1=. What is the $'' of the a,ove deal? L1int: Eust invert the perpetuit formula and solve
for r.M
Answer: 15.4AG
1@. The ta,le ,elow shows two 149ear cash flow proEections .in F millions! includin-
reversion/ for the same propert. The upper row is the proEection that will ,e presented
, the ,ro<er trin- to sell the ,uildin-. The ,ottom row is the realistic e8pectations.
+uppose that it would ,e relativel eas for an potential ,uers to ascertain that the most
li<el current mar<et value for the propert is a,out F14 million. .a/ What -oin-9in $''
.,lended rate/ will equate the presented cash flow proEection to the o,serva,le F14
million present value .as of Kear 4/? .,/ What rate will equate the realistic proEection to
that same present value? .c/ What is the most li<el amount of (disappointment* in the
e8 post rate of return earned , an investor who ,us this propert ,elievin- the ,ro<erOs
cash flow proEection .i.e.! difference in presented versus realistic return/?
Kear 1 0 5 3 5 = @ A B 14
2resented F1.4444 F1.4544 F1.4=4B F1.4B0@ F1.1055 F1.15B5 F1.1B31 F1.00BB F1.0==A F13.5505
'ealistic F1.4444 F1.4144 F1.4041 F1.4545 F1.434= F1.4514 F1.4=15 F1.4@01 F1.4A0B F10.4545
Answer: .a/ 15G! .,/ 11G! .c/ 0G .044 ,asis points/ li<el disappointment.
1A. +uppose a propert worth F14!444!444 in the mar<etplace provides an initial annual
-ross income of F0!444!444 and a net operatin- income of F1!444!444. What is the :'P!
and what is the cap rate prevailin- in the propert mar<et for this tpe of propert?
Answer: :'P & F14 million H F0 million & 5.
Cap rate & F1 million H F14 million & 14G.