Lesson 7
Valuation Example
Sections:
Introduction
We will now do a complete detailed
valuation of the same 4-plex property that we used for examples in Lesson 5
and Lesson 6.
How complicated one needs to make a valuation
analysis depends upon a number of factors.
- Size and complexity of property - Obviously, a large mixed-use
commercial property requires much more analysis than a single-family
house.
- Loan-to-value ratio of planned financing - The higher the
loan-to-value ratio, the closer the lender will look at the property.
- Condition of property - The more deferred maintenance, the more
carefully you need to analyze.
- What information is available to you - The less information provided,
the more difficult it will be to perform the analyses and the more
effort will be required to obtain accurate results.
Regarding actually doing the analysis,
there is a wide range of ways to do the math. For a single-family
home, a pencil and sheet of paper may be all you need. For a shopping
mall, you will probably want to use a sophisticated computer program.
For the average property, a computer spreadsheet program such as Corel
QuattroPro or Microsoft Excel will be helpful because, once you set up a
template, it is easy to do analyses for numerous properties using a variety
of different parameters. We hope to develop some Excel spreadsheet
templates in the future for valuation analysis. You
will be able download them from our Forms
Web, use them on your computer, and even modify them if you are
proficient in Excel spreadsheet construction. When they are available,
we will edit this paragraph to indicate that fact, so check back here in the
future. A link to the first of these templates is found at the end of
the Income Approach section of this lesson.
We will be doing a more complex analysis of
our subject property than is usually required for a 4-plex in order that you
can see how it is done. You will be able to apply the same procedures
to much more complex properties once you understand them.
Throughout the entire lesson, keep in mind
that valuation is both an art and a science. While the analyses
involve mathematical calculations, the answers are only as good as the data
available and as accurate as the various estimates and assumptions that must
be made. Accordingly, one must not surprised when the results of the
three methods do not closely agree, You should also not be very
surprised when you cannot make a deal at the value you came up with.
This may occur because the sell overvalues his property or because the
market is rising rapidly and data based on previous sales is more out of
date than any adjustments you have made.
Assumptions
For our example, we will assume that
you have available cash of about $35,000 and have found a particular 4-plex
for which you are seriously considering writing a purchase contract.
We also assume that the following information has been received from the
seller and/or his agent. We have been told that the expenses are for
the most recent full calendar year (not past 12 months).
|
Amount |
Lease |
Listing Price |
177,900 |
|
Size (SF) |
3500 |
|
Monthly Rent - Unit A
(2-bdrm/1-bath) |
605 |
3 months |
Monthly Rent - Unit B
(2-bdrm/1-bath) |
625 |
9 months |
Monthly Rent - Unit C
(1-bdrm/1-bath) |
525 |
2 months |
Monthly Rent - Unit C
(1-bdrm/1-bath) |
505 |
4 months |
Annual Property Tax |
1,560 |
|
Annual Insurance |
365 |
|
Annual Water/Sewer |
1,588 |
|
Trash |
660 |
|
Annual House Electricity |
489 |
|
Annual Landscape Maintenance |
600 |
|
Annual Repairs & Maintenance |
896 |
|
The time remaining on current leases is of
importance because it tells us when we can get rents up to market,
increasing the value of the property. This information is not always
offered prior to making an offer, but should be obtained if at all possible
- there is no logical reason for it to be withheld.
We also assume the following:
- A vacancy rate of 5 percent - the lender will almost certainly not
assume less and may assume more if the particular market requires it.
- Any rent tax applying to the location is collected from the tenants,
so need not be considered. To the degree that leases do not
provide for payment of the taxes by the tenants (as leases should), the
expense must be considered.
- This is the same 4-plex used as an example in Lesson 5, where we
determined reserve account set aside of approximately $219 per month in
order to pay for the major future expenditures as they come due.
- This is the same 4-plex used as an example in Lesson 6, where we
determined the current appropriate capitalization rate for this property
is 9.3.
Furthermore, we assume that there are no
market conditions, economic trends, or neighborhood factors that
significantly affect the value either positively or negatively.
Finally, our survey of area rents shows that
the rents are under market and that the current market rent is around $650
for a 2-bedroom/1-bath unit and $560 for a 1-bedroom/1-bath unit.
Income
Approach Valuation
Although you have been provided the above
expense information, in real life one should not take numbers provided by
the seller as being correct. They may be either high or low - more
likely the latter. The current tax bill could be significantly higher
than what was used in the old listing, which itself might have listed an
older tax bill. Call the county and get the correct
current number. Insurance expense could be high or low because of
failure to shop rates or failure to have adequate coverage, respectively.
Get a couple of quotes yourself. Landscape maintenance could be high
because the seller has used his son and paid more than market cost for
personal reasons. It could instead be low because he used his
son. If your experience doesn't allow you to estimate relatively
accurately, get a quote or two for the specific services you will want.
Also, there may be missing expenses, either because they were simply
forgotten due to incomplete bookkeeping by the seller or because the seller
had deferred certain items in the period prior to listing the property for
sale. Finally, expenses may have been purposely understated because it
was thought (probably rightfully) that better cash flow would produce more
interest and that corrected data could be provided after a potential buyer
was hooked without losing the deal. So, you need to think about what
expenses should be expected for the subject property and include them even
if the seller didn't.
The bottom line is that the potential buyer
should carefully analyze all data used for the Income approach. In
other words, utilize data provided by the seller, but improve on it by using
experience, common sense, and as much as independently verified data as
possible. The data available prior to making an offer will usually be
less accurate and less complete than will be available after acceptance.
Net Operating Income
Starting with the information provided by the
seller, we have determined the appropriate expenses as follows:
-
We called the County and found that current annual
property tax is $1,875 rather than the $1,560 provided by the seller.
-
We got quotes for our desired coverage from two
insurance agents and will use the lower one of $475 rather than the $365
provided by the seller.
-
Although the agent says that he has viewed the utility
bills for the previous calendar year and confirms the water/sewer to
have been $1,588 and electricity to have been $489 as provided by
the seller, we know that rates have increase during the current calendar
year and will likely increase further. Accordingly, we will use
$1,750 for water/sewer and $485 for electricity.
-
Although the seller reported trash expense as $641 for
the past calendar year, we have called two other service providers and
found that we can obtain adequate service for $594 per year.
-
Although the seller reports spending $600 ($50 per
month) for landscape maintenance, we feel that the landscaping has not
been maintained as well as it should and have gotten a quote of $900
from the service that maintains the yard of our personal residence.
-
Although the seller reports spending $896 on routine
repair & maintenance during the last calendar year, following a
discussion with a friend who owns a similar 4-plex, we will use a more
conservative $1,200.
-
Although the seller did not show such an expense, we
have checked with the City and determined that there is a $50 annual fee
for a required business license.
-
We will throw in an additional miscellaneous expense of
$500 because we know there are always unexpected small expenditures.
-
Finally, we will include the reserve account expense as
determined in Lesson 5.
Utilizing the
information provided and results of our efforts to determine the correct
expense amounts, we can generate the following annual income-expense
statement:
ANNUAL INCOME |
|
|
Base Rents |
|
$27,120 |
Laundry |
|
0 |
Total Scheduled Income |
|
$27,120 |
Allowance for Vacancy - 5 % |
|
-1,356 |
|
|
|
Total Net Income |
|
$25,764 |
|
|
|
ANNUAL EXPENSES |
|
|
Property Tax |
|
$1,875 |
Insurance |
|
475 |
House Water/Sewer |
|
1,750 |
House Electricity |
|
485 |
Trash |
|
594 |
Landscape Maintenance |
|
900 |
Repairs & Maintenance |
|
1,200 |
License/Permit |
|
50 |
Miscellaneous |
|
500 |
Reserves |
|
2,517 |
Total Expense |
|
$10,346 |
|
|
|
Net Operating Income |
|
$15,418 |
Note the following:
-
We have included a Laundry income item even though the
property under consideration has not common laundry facility to remind
you that other income items are often involved.
-
We have determined realistic expenses to be $10,346,
significantly higher than the $6,158 provided by the seller, about half
of the difference due to the lack of a reserve account expense in the
sellers data.
Income Approach Value
We see that with the current
rents, the value of the property is:
Current Income Approach Value = NOI/Cap Rate =
$15,418/0.093 = $165,785.
Now, since you are only now
preparing an offer, it will likely be at least a couple of months before
escrow closes. Accordingly, we will also calculate value using the the
market rents for the three units for which leases expire in less than 6
months. Using those market rents adds $1,620 to our scheduled income,
giving us an additional $1,539 of income after deducting for vacancy, and
resulting in a NOI of $16,957. This gives a value with future rents of:
Future Income Approach Value = NOI/Cap Rate = $16,957
/0.093 = $182,333.
From this significant
increase in value from a relatively small increase in rents you can see how
future rent increases will increase your net worth.
For our final estimation of value we will
give some weight to the future value because the existing leases expire in
the not-too-distant future and renewal dates will be even closer by the time
escrow actually closes. Thus, for later use in our reconciliation of
values determined by the three methods we will tentatively adjust the result
of the Income Approach to approximately half-way between the two values.
We will likely give even more weight to the future value result after we
have reviewed the leases and completed physical inspections if there have
been no unpleasant surprises.
Reconciled Income Approach Value = $174,000
We see that the listing price
of $177,900 is a little higher than the value determined by the above
Income approach analysis. This is not unexpected because we know that
most listings are at a higher price than market and more than the seller
really expects to get.
However, the listing price is significantly
under the $182,333 that the property will be worth per the Income Approach
when we get the rents up to market. Accordingly, based only on the
Income Approach analysis, we might consider offering $170,000. This
would be close enough to the asking price for a good chance of acceptance.
We might even offer several thousand less if the market is not very active
and we are willing to risk another buyer beating us to a deal.
Finally, we would probably be willing to go as high as the full listing
price because of the near-term potential.
Income Approach Comments
We want to return again to the
reserve account. While $219 per month sounds like a lot, keep in
mind that increasing the rents to market as leases expire, will give you an
additional $128 per month even at current market rents and we market rents
might be even a little higher by the time leases are renewed.
Furthermore, we could likely easily stretch a few replacements out a little
if really necessary. Finally, we can reduce expenses by that amount by
simple doing the landscape maintenance ourselves.
One additional note regarding the above
assumptions and discussion. Because the heating/cooling systems are
old low-efficiency units, you might want to consider replacing them as soon
as possible with new higher efficiency units. This is particularly
important if the owner is paying the electric bill, because the payback
period is only a few years and gets shorter every year due to rapidly
increasing electric rates. Even if the tenants are paying the electric
bills, lowering their utility costs significantly will allow larger future
rent increases. For additional discussions regarding reduction of
utility costs, including both electricity and water, visit our Reducing
Utility Costs page.
Finally, we have provided an Excel
spreadsheet that can be used to calculate the NOI and value of properties
similar to the subject of this example. A discussion of the
spreadsheet and links to various versions of it are reached by clicking here.
Market
Data Approach Valuation
The Data
With the subject property being a 4-plex, it
is possible that we will be able, even on our own, to dig out information
for comparable properties. This is usually not as easy for larger
properties, where there are greater differences between similar type
properties and fewer sales. If we are working with an agent, he
should certainly be able to come up with some comparables. For
purposes of our example we will assume that the following information is
available for similar properties. You will note that some some data
for each of the properties has an asterisk in front of the number .
This indicates data that we had to determine ourselves because (1) it was
not available or (2) though available, was questionable. This is often
the case in the real world.
Sometimes the only reliable data is the sales
price and income at the time of the listing. Even this information may
require correction if the listing is old. Even when expense data is
provided in the listing, it must be viewed with suspicion. First,
there may be innocently missing expenses, either because they were simply
forgotten due to incomplete bookkeeping by the seller or because the seller
had deferred certain items in the period prior to listing the property for
sale. Second, expenses may have been purposely minimized because it
was thought (probably rightfully) that better cash flow would produce more
interest and that corrected data could be provided without losing the deal
after a potential buyer was hooked.
The bottom line is that the potential buyer
must usually provide some of his own data for doing the Market approach,
just as usually required for the subject property when doing the Income
approach. Again, property tax information is available from the County
and, if you obtained a quote from your insurance agent for the subject
property, this same amount should be applicable to the comparables.
Other expenses determined for the subject property should also be usable for
the comparables, with corrections for known property differences.
While we could utilize income, vacancy, and expense numbers to calculate NOI
for each comparable just as we did for the subject property when performing
the Income Approach analysis, but there is no educational value in doing and
we will simply list the NOI for each.
Property |
Subject |
Comp 1 |
Comp 2 |
Comp 3 |
Comp 4 |
Property Type |
4-plex |
4-plex |
4-plex |
4-plex |
3-plex |
Gross
Sq. Ft |
3480 |
3400 |
3885 |
2650 |
2800 |
Unit Mix
(# X bdrm/bth) |
2 X 2/1
2 X 1/1 |
2 X 2/1
2 X 1/1 |
4 X 2/2 |
4 X 1/1 |
3 X 2/2 |
Age (years) |
15 |
22 |
10 |
27 |
13 |
Total Bedrooms |
6 |
6 |
8 |
4 |
6 |
Total Baths |
4 |
4 |
8 |
4 |
4 |
Distance Subject |
|
2 miles |
1/2 mile |
1 mile |
1 block |
Sale Date |
|
3 mo |
2 mo |
4 mo |
1 mo |
Sale Price |
|
$177,000 |
$192,000 |
$153,000 |
$151,000 |
NOI |
$15,418 |
$15,879 |
$19,466 |
$14,120 |
$13,225 |
We include the 3-plex because it has about
the same size units as the subject property, is a very recent sale, and is
more comparably located than any of the other properties. Although we
do not here actually determine the NOIs of the comparable, they would be
analyzed in the same manner that the subject property was in the above
Income Approach analysis.
The following information is also known
about the properties:
Comp 1: Has laundry room, but no data. Has dishwashers.
Comp 2: Each unit has own laundry hookups, no common facilities.
Has dishwashers & microwaves. One covered parking space per unit.
Comp 3: Has laundry room.
Comp 4: Each unit has own laundry hookups, no common facilities.
Has dishwashers & microwaves. One covered parking space per unit.
Adjustments
We now need to adjust for
differences among the comps. The adjustment table of that lesson is
repeated below. We take into account all information mentioned about,
making judgment, estimating the plus or minus value of each factor compared
to the subject property.
Adjustments |
Comp 1 |
Comp 2 |
Comp 3 |
Comp 4 |
Age |
-5,000 |
+5,000 |
-6,000 |
2,000 |
Time Since Sale |
1,000 |
0 |
2,000 |
0 |
Location & Neighborhood |
5,000 |
+4,000 |
-3,000 |
0 |
Construction
Quality |
1,000 |
-2,000 |
0 |
3,000 |
Size, Floor Plan, Amenities* |
0 |
12,000 |
-10,000 |
-30,000 |
Interior Condition** |
0 |
0 |
0 |
0 |
Exterior Condition |
2,000 |
-4,000 |
-1,000 |
0 |
|
|
|
|
|
Net Adjustment |
4,000 |
15,000 |
-18,000 |
-25,000 |
* includes number of
bedrooms & baths, appliance features, etc. |
** based on agent reports |
Analysis
Summarizing the above tables, we have
Property |
Comp 1 |
Comp 2 |
Comp 3 |
Comp 4 |
Sale Price |
$177,000 |
$192,000 |
$153,000 |
$151,000 |
Subtract Adjustment |
4,000
|
15,000
|
-18,000
|
-25,000
|
Adjusted Price |
$173,000 |
$177,000 |
$171,000 |
$179,000 |
Market Data Approach Value
Based on the above information and
discussion, we estimate that the value of the subject property is $175,000
Market Data Approach
Comments
We note that the value determined
by the Market Data Approach is very close to that found from the Income
Approach, which we determined as the average of the Current and Future
values from that analysis. The results from two different valuation
approaches are not usually so close. In this case it occurs partly
because we chose a reconciled Income Approach value half-way between the
Current and Future value results. Often the Income and Market Data
approaches provide values differing by 5 or 10 percent. For example, a
sellers' market, resulting from a shortage of inventory, usually pushes
sales prices (Market Data Approach) significantly above values justified by
incomes of the properties.
Cost
Approach Valuation
You will not usually perform a cost
approach valuation of a 4-plex for two reasons. First, it's a lot of
work. Second, the result is not usually particularly useful for
smaller properties. Duplexes, triplexes, and even 4-plexes are
typically developed in groups, often one or two dozen at a time, just as for
single-family homes, to make them economically viable. Accordingly,
determining the cost of reproducing a single small property leads to high
values that cannot be easily or reliably reconciled to the other two methods
of valuation.
Although you may seldom, if ever, need to do
a Cost Approach analysis, we will take the effort to do one for this example
because we want you to understand how one is done so that you can utilize
the method when necessary to do so.
Procedure
The basic steps of the Cost approach are as
follows:
-
Estimate land value as if vacant
-
Estimate reproduction or replacement cost new of all
improvements.
-
Estimate the amounts of accrued depreciation from
physical deterioration, functional obsolescence, and adverse economic
influences.
-
Deduct the accrued depreciation of step 3 from
improvement costs of step 2.
-
Add the land value of step 1 to the depreciated cost
estimate of step 4.
Site Valuation
There are at least four different procedures
for use in the valuation of land. The one most applicable for our
purposes and generally preferred is the Market Data Approach. This
approach requires the gathering and analysis of sales data for comparable
sites, with the most weight placed on actual sales of similar land made
relatively concurrent with the date of valuation and under comparable
conditions.
For our example, we have come
up with the following comparable land sales, all of which were properly
zoned and had utilities to the lot lines:
Property |
Subject |
Comp 1 |
Comp 2 |
Comp 3 |
Comp 4 |
Sale Date |
x |
1 year |
6 mon |
2 mon |
3 mon |
Gross SqFt |
8800 |
7800 |
8600 |
9200 |
6600 |
Distance Subject |
x |
1/2 mile |
2 miles |
1 mile |
1 block |
Sale Price |
x |
30,000 |
32,000 |
35,000 |
27,000 |
Adjustments
Adjustments |
Comp 1 |
Comp 2 |
Comp 3 |
Comp 4 |
Time Since Sale |
+3,000 |
1,000 |
0 |
0 |
Lot Size |
-4,000 |
-1,000 |
5,000 |
-9,000 |
Location/Neighborhood |
-6,000 |
-3,000 |
-2,000 |
0 |
|
|
|
|
|
Net Adjustment |
-7,000 |
-3,000 |
3,000 |
-9,000 |
|
|
|
|
|
Net Adjusted Value |
37,000 |
35,000 |
32,000 |
36,000 |
Note that, while one could
base the lot size adjustment directly upon the exact square footage of the
lots, we have not done this, but have simply given an estimated value of the
difference. The reason for not using an exact proportional calculation
is that the value of a lot greater in size than needed for the desired
project is not directly proportional, but is often significantly less or
nothing at all.
Based on the above information and
discussion, we determine that the current value of the site of the subject
property is $35,000.
Construction Cost Estimate
A distinction must be made between
reproduction cost and replacement cost. Reproduction cost is the cost
of constructing a new replica of the improvement. Replacement cost is
the cost of constructing a substitute improvement which has the equivalent
utility. The difference between the two becomes more important for
older properties because (1) new construction materials and methods are now
available and (2) the market requires different functional considerations.
Because our subject property is only 15-years old, has basic residential
use, and is not of unusual or complex construction, we will not need to
consider the distinction.
Both materials (e.g., lumber, concrete, and
shingles) and equipment (e.g., air conditioners) are factors in the cost of
construction.
Construction costs must include not only the
cost of constructing the building itself, but all other items including
utilities, parking lots, sidewalks, landscaping, etc.
Building costs must include both direct
construction costs and indirect costs. Direct costs are those for
material and labor, including contractor's overhead and profit.
Indirect costs include professional services (e.g., design, engineering),
permits, and carrying costs during construction and until occupancy (e.g.,
construction loan costs, property tax, insurance).
There are a number of ways to determine
construction costs for a given property. One extreme would be to treat
the analysis as a construction project and determine costs of the materials,
equipment, labor, and other costs needed to reproduce or replace the
improvements of the subject property even to the point of obtaining bids
from contractors. This approach would be quite accurate because it
would be based on current costs for the specific improvements.
However, it would also be very time-consuming and costly and, unless willing
to compensate contractors for preparation of bids, might be considered
unethical. It would certainly give you a bad name among builders in
the community.
The much easier approach and that most often
utilized by professional appraisers is to utilize available data regarding
construction costs. This information is collected, analyzed, and
published by various construction-related industry associations. The
available information is categorized by location and type of construction in
considerable detail.
Probably the simplest method of determining
cost is to use the published per-square-foot construction cost for the
particular type of property in the subject area and simply multiply that
number by the gross square feet of the improvements to calculate the cost.
However, one must be certain that the number used includes all construction
costs (e.g., parking lot & landscaping) and not just the cost of the
building itself or, worse yet, only the building shell. Adjustments
must be made for items not included n the available cost per square foot.
Direct costs must also still be considered if not included in the number
used.
Even though one may often use the
per-square-foot method because it can be done quickly once one has the
proper numbers, we will use a modified version of a full construction
project analysis. This version will use known costs for principal
components and tasks to arrive at the construction cost. While this
method requires one to obtain fairly detailed information and this might be
considered daunting, it is possible for the layman to accomplish.
There are a number of ways to come up with
the data. You or your agent might know
-
A general contractor who builds 4-plexes (even duplexes
would be close)
-
An appraiser who has the information at his fingertips
or at least access to the data
-
Direct access to the published data discussed above.
For purposes of our example,
we will assume that we have used the appropriate sources to determine that
the costs related to constructing the improvements of the subject property
are as follows:
Component |
Cost |
Note |
Design &
Engineering |
$
7,000 |
|
Permits |
4,500 |
|
Excavation |
4,000 |
|
Exterior
Utilities |
4,800 |
1 |
Concrete |
5,000 |
|
Carpentry,
shell |
15,000 |
|
Pre-fab
trusses |
4,000 |
|
Roof sheathing |
3,900 |
|
Roofing |
3,600 |
2 |
Electrical,
incl. lighting |
7,700 |
|
Interior
plumbing |
7,600 |
|
Heating/cooling |
7,900 |
2 |
Plumbing
fixtures |
1,600 |
2 |
Cabinetry |
14,000 |
2 |
Appliances |
3,600 |
2 |
Mini-blinds |
1,700 |
2,
3 |
Insulation |
6,000 |
|
Drywall |
11,000 |
|
Carpentry,
interior |
10,000 |
|
Windows &
doors |
5,000 |
|
Flooring -
carpet |
4,000 |
2,
3 |
Flooring -
vinyl |
1,600 |
2,
3 |
Interior
painting |
4,800 |
2,
4 |
Stucco |
8,000 |
2 |
Exterior
painting |
2,000 |
2,
4 |
Parking area
paving |
4,000 |
2 |
Carports |
9,000 |
2 |
Fencing |
1,500 |
|
Landscaping |
3,000 |
2 |
Irrigation |
2,000 |
|
Equipment
rental |
500 |
|
Miscellaneous |
5,000 |
|
Overhead &
profit |
17,000 |
|
Loan costs |
4,800 |
|
Other carrying
costs |
3,500 |
5 |
|
|
|
Total Cost |
$198,600 |
|
NOTES
-
Water, sewer, electric, phone, cable TV.
-
Considering both chronological age and condition.
-
Takes into account fact that some were changed out over
the past few years and are not original.
-
Takes into account fact that some units were re-painted
since construction.
-
Includes property tax and insurance prior to rent-up.
We note that the total cost
divided by the total square feet is $57.07 per square foot, a typical
cost for a project of this type in a typical region of the country.
Accrued Depreciation
Accrued depreciation is the loss in value
that has taken place up to the date of valuation. Estimating accrued
depreciation is an important step in the Cost approach to valuation.
Depreciation includes loss in value from all causes, including physical
deterioration (both curable and incurable), functional obsolescence (both
curable and incurable), and economic obsolescence. Each of these
categories can be taken into account when determining the accrued
depreciation. Which categories are considered depends upon the age and
type of property as well as the time available to complete the valuation.
Physical deterioration is not just deferred
maintenance such as the need for paint. It is also the decrease in
life of all components, including roofing, heating/cooling systems, and
parking lot surface.
There are a number of methods that can be
used to determine the accrued depreciation, of varying degrees of complexity
and accuracy. The simplest method would be straight-line basis of
physical life. For example, we will assume that the building has a
life of say 100 years, for ease of computation. Depreciation would
therefore be one percent per year and the accrued depreciation for our
example would be percent (15/100) of the $198,600 cost, or $29,790.
However, as you might have already guessed,
this method usually underestimates the degree of physical deterioration
because many components have a useful life considerably under 100 years.
As examples, a range may have a life 25 to 35 years, carpeting a life of 5
to 8 years, and exterior painting a life of less than 5 years in
particularly hostile climates. In spite of this deficiency, the basic
straight line method is adequate for some uses and is often used because it
is so easy, adding a few percent to the calculated number to take into
account the error from short-life components.
A more complex analysis that takes component
lives into account is sometimes called component physical life method.
For this method the useful lives of the major components are separately
considered, with the deterioration of some items (e.g., heating/cooling
systems and plumbing) based strictly on age and normal useful life while
deterioration on other items (e.g., painting, roof, and parking lot surface)
based on inspection.
Discussions of functional and/or economic
obsolescence (see Glossary
) are beyond the scope of this lesson. For our example it is likely
that any functional or economic obsolescence would be negligible compared to
physical deterioration because the subject improvements are of general use
and are only 15 years old. Also, we will not distinguish between
curable and non-curable physical deterioration. If the property under
consideration has obvious functional and economic obsolescence issues, one
should take those factors into consideration, even if only by making rough
estimates. Although an appraisal will likely be required by the
lender, it will usually not be a full-blown one that would consider
obsolescence in any detail as would an appraisal for a more complex
property.
Although we will assume a physical life of
100 years for our example 4-plex, you should be aware that the life of a
particular building can be significantly more or less, depending upon
versatility of use, type of construction, type and quality of materials
used, and the severity of the climate where located. We now expand the
above Cost table to include depreciation information.
Component |
Cost |
Normal
Life (yrs) |
Percent
Deteriorated
|
Depre-
ciation |
Note |
Design &
Engineering |
$
7,000 |
100 |
15 |
$ 1,050
|
|
Permits |
4,500 |
100 |
15 |
675 |
|
Excavation |
4,000 |
100 |
15 |
600 |
|
Exterior
Utilities |
4,800 |
100 |
15 |
720 |
1 |
Concrete |
5,000 |
100 |
15 |
750 |
|
Carpentry,
shell |
15,000 |
100 |
15 |
2,250 |
|
Pre-fab
trusses |
4,000 |
100 |
15 |
600 |
|
Roof sheathing |
3,900 |
100 |
15 |
585 |
|
Roofing |
3,600 |
25 |
60 |
2,160 |
2 |
Electrical,
incl. lighting |
7,700 |
100 |
15 |
1,155 |
|
Interior
plumbing |
7,600 |
100 |
15 |
1,140 |
|
Heating/cooling |
7,900 |
25 |
60 |
4,740 |
2 |
Plumbing
fixtures |
1,600 |
50 |
30 |
480 |
2 |
Cabinetry |
14,000 |
50 |
30 |
4,200 |
2 |
Appliances |
3,600 |
35 |
43 |
1,543 |
2 |
Mini-blinds |
1,700 |
5 |
NA, see note 3 |
300 |
2,
3 |
Insulation |
6,000 |
100 |
15 |
900 |
|
Drywall |
11,000 |
100 |
15 |
1,650 |
|
Carpentry,
interior |
10,000 |
100 |
15 |
1,500 |
|
Windows &
doors |
5,000 |
100 |
15 |
750 |
|
Flooring -
carpet |
4,000 |
8 |
NA,
see note 3 |
1,500 |
2,
3 |
Flooring -
vinyl |
1,600 |
20 |
NA,
see note 3 |
600 |
2,
3 |
Interior
painting |
4,800 |
5 |
NA,
see note 4 |
1,500 |
2,
4 |
Stucco |
8,000 |
100 |
15 |
1,200 |
2 |
Exterior
painting |
2,000 |
7 |
NA,
see note 4 |
1,200 |
2,
4 |
Parking area
paving |
4,000 |
50 |
30 |
1,200 |
2 |
Carports |
9,000 |
50 |
30 |
2,700 |
2 |
Fencing |
1,500 |
25 |
60 |
900 |
|
Landscaping |
3,000 |
50 |
30 |
900 |
2 |
Irrigation |
2,000 |
50 |
30 |
600 |
|
Equipment
rental |
500 |
100 |
15 |
75 |
|
Miscellaneous |
5,000 |
100 |
15 |
750 |
|
Overhead &
profit |
17,000 |
100 |
15 |
2,550 |
|
Loan costs |
4,800 |
100 |
15 |
720 |
|
Other carrying
costs |
3,500 |
100 |
15 |
525 |
5 |
|
|
|
|
|
|
Total Cost |
$198,600 |
|
|
$44,668 |
|
NOTES
-
Water, sewer, electric, phone, cable TV.
-
Considering both chronological age and condition.
-
Takes into account fact that some were changed out over
the past few years and are not original.
-
Takes into account fact that some units were re-painted
since construction.
-
Includes property tax and insurance prior to rent-up.
Thus, we have determined the
accrued depreciation to be $44,668, half again more than the $29,790
determined with the basic straight line method and a much more accurate
amount. This is another example of why it is important to do as
accurate a valuation as possible.
Cost Approach Valuation
The rest is easy.
Value = Site Value + Construction Cost - Accrued
Depreciation
Value = $35,000 + $198,600 - $44,668
Value = $188,932
Cost Approach Valuation
Comments
For our example, the cost approach value is
significantly higher than either the Income Approach value and the Market
Data Approach value, as expected from our earlier discussion. If we
had been considering a dozen such buildings, costs of most components would
have been less due to economy of scale. Some costs would be
significantly less. For example, design and engineering would have
been divided by 12 for each building if all buildings were fairly identical.
Most of the hard construction costs will also be less per building.
For larger projects, for example a 50-unit complex, the cost approach can
produce quite accurate results if good cost data and depreciation data are
utilized.
Reconciliation
We have three different answers from three
different approaches to determining value, We repeat the current and
near-future values for the Income Approach, as they will be of interest in
making our final reconciliation value.
Income Approach Value (current rents) = $165,785
Income Approach Value (near-future rents) = $182,333
Income Approach Value (adjusted) = $173,000
Market Data Approach Value = $175,000
Cost Approach Value = $188,932
We need to reconcile
the above valuations to one "true" value.
For this particular example, we will
give the Market Data Approach result more weight than the Income Approach
result and, for reasons previously discussed, we will give negligible
consideration to the Cost Approach result.
Taking the above factors into consideration,
we will estimate that
Reconciled Value = $175,000
Price
To Offer
As discussed at the end of the
Income Approach section, if this is a pre-offer analysis, then based on this
value we would probably offer $170,000, but, in view of the below-market
rents that can be raised soon after closing escrow to give a value of over
$182,000, we would probably not hesitate to go to the listing price of
$177,900 if necessary. Just be sure that you include adequate
contingencies so that you can cancel the deal if unable to renegotiate the
price if, after doing further analysis and inspections, you find things
different than expected.
If, instead, this a post-offer valuation that
comes in significantly under the contract price, we can also exercise the
contingency (that we were supposed to have written into our offer) and walk
away if the seller is unwilling to re-negotiate a lower price. If
willing to spend the extra time and costs of continuing with the inspections
and loan application, including paying for the appraisal and inspections, we
can continue with the escrow and see how the lender's appraisal comes in.
Since we should have also included a contingency that the lender's formal
appraisal would come in at least as high as the contract price, if it
doesn't, we can at that time decide whether to continue if the seller
refuses to re-negotiate.
Debt
Coverage Ratio
As discussed in an earlier lesson, many
lenders utilize the Debt Coverage Ratio (DCR) in making loan decisions and,
although the DCR may be more a financing issue than a valuation issue, we
will cover it here because it is intertwined with the Income approach to
valuation.
We can check whether our proposed deal will
pass muster in a couple of ways. First, we can calculate the ratio
using the expected purchase price, the amount of cash we have available, and
the loan terms expected. Second, we can instead work the problem
backwards and, using the same information, determine the maximum price that
we can pay for the property for a given ratio. The first approach is
probably more intuitive for most people, but the second approach is often
more useful in the real world. Accordingly, we will use the second
approach for our example. We also want to verify that the property
will support the amount of loan we need considering the amount of cash that
we have available, $35,000.
Since the debt coverage ratio is not normally
used with a NOI that includes a reserve account expense item, we first need
to calculate the NOI without the reserve. We will use the actual
current numbers rather than near future improved income because there is no
guarantee that we can get the lender to consider potential. Adding the
reserve expense amount back in, we have
NOI w/o Reserve expense = NOI* = $15,418 + $2,517 =
$17,935
By definition, Debt Coverage Ratio = DCR = NOI*/ALP
Where ALP = Annual loan payments
Thus,
ALP = NOI/DCR
Assuming that our lender uses a DCR of 1.2, a typical
criterion, we have
ALP = $17,935 /1.2 = $14,946
and
Monthly loan payments = ALP/12 = MLP = $1,245
For our analysis we will
assume that, in the current market, we can get a 25-year fixed rate loan at
8 percent with one discount point. We also assume that the appraisal
will cost $500, a lenders title policy will cost $500, and other costs will
total $500.
With our loan assumptions and using a
calculator or amortization tables, we find that the loan supported by this
payment is approximately $161,000. Thus, with our assumed loan and a
Debt Coverage Ratio of 1.2, we will have no trouble buying the property with
the amount of cash that we have available. Note, however, that with a
higher interest rate and/or higher DCR, the result will be different.
However, lenders will not finance rental
property without the borrower having a relatively significant cash equity.
We will assume the worst case scenario that
-
We must pay the full listing price of $177,900
-
The lender will loan 80 percent of value
-
The lender's appraisal will equal the purchase price
Accordingly, we can obtain a
loan of $142,320, requiring a down payment of $35,580. Now, since we
have cash available of $35,000, we're only short $580, which we know we can
borrow from our kids, and we've got it made, right?
Not quite. We now know that the one
point discount point will equal $1,423 , so
Closing costs = $1,432 + $500 + $500 + $500 = $2,932
Thus, we will need $38,512
($35,580 + $2,932) cash in order to close escrow and we're short $3,512.
We see that, with our available case, we
cannot give quite as much for the property as we were willing to pay even
though we know that the property will be worth significantly more soon after
closing. At this point, we can either come up with additional cash of
in order to reduce the loan needed or we can offer a lower price.
For our example, we could pay the listing
price by borrowing the difference of $3,512 on a credit card if the kids
won't loan that much to us.
Intuitively (without any math), we guess
correctly that we wouldn't have a cash shortfall if we could buy the
property for only $170,00. We can also calculate the exact price we
can pay with the amount of cash we have. Rather than go through the
exact calculations, a simpler approach is to realize that the cash shortage
divided by the loan-to-value ratio gives us the approximate amount that the
sale price must be reduced from the listing price in order to avoid a cash
shortfall. We say approximately because the loan fee will also be
reduced, but since the fee is only one percent, the error will be negligible
if ignored.
Reduction = Shortfall / 0.8 = $3,512/0.8 = $4,390
If we want to correct for the reduced loan fee, we can round
the reduction to $4,300, giving us the price of $173, 600 ($177,900 -
$4,300).
Cash
Flow Analysis
As for the house of Lesson 2, we can now do a
cash flow analysis based on having to pay the full listing price. We
have already calculated everything that we need, so we just have to do a
little basic arithmetic.
The monthly payment for the
80 percent loan on the full listing price the monthly payment will be $1098,
or $13,176 per annum,
Current Cash Flow = Net Operating Income - Loan Payments =
$15,418 - $13,176 = $2,242/annum = $187/month.
For one final calculation,
we'll determine the cash flow after renewing the shortest leases to market
rents as discussed in the Income Approach analysis.
Near-future Cash Flow =
$16,957 - $13,176 = $3,781/annum = $315/month
We can now determine the
return on investment, similar to what we did in Lesson 2. We can
easily see that the cash-on-cash return will simply be $3,781 divided by the
$38,512 cash invested, or 9.8 percent. We could also look at the other
returns considered in Lesson 2, including after-tax cash-on-cash and
considerations of appreciation, but we'll leave those calculations as an
exercise for you. Just follow the Lesson 2 example.
More
Complex Properties
Analysis of larger residential
properties is really little different from a 4-plex. Most differences
are simply those of degree. That is, more units, more rent prices, and
a greater variety of expenses. The latter may include resident
manager, maintenance personnel, and
community amenities such as pool and/or fitness room. Mainly, it's
just that all the numbers are larger.
Commercial properties usually offer more of a
challenge to analyze than even very large residential properties. This
is because commercial properties usually have units of a variety of sizes
and types, sometimes have more complex physical components, and, most
important, they almost always have more complex leases. The last
factor is important because the terms of existing leases can greatly affect
the value of a property. The lease issues that can be of most
importance, and can vary among units of same property, are:
-
Who pays expenses -- landlord (gross) or tenant (NNN),
with many possible variations in between
-
Long duration -- typically 2 to10 years, can be longer
-
Variety of scheduled increases -- tied to various rate
indicators, fixed percentage
-
Extension options -- typically similar to original term,
with fixed or negotiable rent increases
However, no matter how
complex the property, the procedure is basically the same as that we used
for the 4-plex example of this lesson.
A full analysis will often only be possible
after the offer has been accepted because that is when you will have all the
necessary information. For making your offer, you or you agent will
have to ask as many questions as possible and push for as much preliminary
inspection as you can get. For some items you will have to make
educated guesses. As for the 4-plex example of this lesson, you can
get a lot of information by casual inspection. In addition to the
methods previously mentioned, you can usually visit commercial units as a
customer, an advantage over the normal residential deal. Finally, as
before, the valuation done prior to writing the offer may be rough because
it had to be done without complete and accurate information, but it will be
better than none at all. You will have to update your analysis after
obtaining more information subsequent to acceptance of your offer and if you
now find that the property is worth less than your preliminary analyses had
indicated, you will have to re-negotiate the price if possible or, if not
possible, either walk away or, if you decide there is an adequate upside
potential, continue with the deal at the original price.
|
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