Chapter 15
Valuation Analysis:
Income Discounting, Cap Rates
and DCF Analysis
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Major Topics
 Simple multiplier models of value
 The income approach to value
 The derivation of a capitalization rate
 Overall market rate capitalization
 Discounted cash flow analysis
 The net present value decision rule
 The IRR decision rule
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Introduction
 “How much is the asset worth?”
 All methods of valuation reflect that
the present value of a property is
based on the future returns as
measured through cash flows
discussed in Chapter 15
 They are similar in that they are
based upon discounting the future
returns to the present using some
form of model
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Valuation using Multipliers
 GRM (Gross Rent Multiplier)
= Price / Gross Rent (PGI)
 Presumption: “Whatever investors are
willing to pay for similar property per dollar
of gross rent they should be willing to pay
for a subject property”
 GRM should be found from comps with:
 Similar ages
 Similar turnover
 Similar growth projections
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Traditional Income Approach to Value
 The most applicable appraisal technique
which directly considers the motivations
of the typical investor by quantifying the
benefits of owning real estate
NOI (net operating income)
Value = -----------------------------------R (capitalization rate)
NOI as used by appraisers is called the
stabilized NOI to reflect the longer-term
productivity of the property
The projected NOI would normally be
the NOI for the upcoming 12 months
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Cap Rates and Price/ Earnings Multipliers
 Think about cap rates as the inverse of a
price earnings multiple
 With cap rates, higher rental growth rates
and faster price appreciation means cap
rates will be lower
 Identical to the notion of risk premiums
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Cap Rates and Return of Capital
 Also think of cap rate as a return “on” and
return “of” capital
 Return on is the price for providing the
capital – example: mortgage interest
portion of the monthly payment
 The mortgage loan principal paid down
is the return “of” capital
Cap Rates and Cost of Capital
Several appraisal variations known as
mortgage-equity or band of investment
techniques for deriving a cap rate
Identical to weighted cost of capital method
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Market Conditions Matter
 Can affect both appreciation rates and risk
 A market becoming over supplied will
increase the uncertainty of income which
implies higher risk and also reduce rental
growth rates - cap rates will move higher
 If the market demand is getting stronger
with little possibility of new supply, we will
see faster rental growth and lower cap rates
Property Age and Cap Rates
Older properties tend to have more uncertain
repairs and capital improvement expenditures,
and tend to be located in lower appreciation
areas
Both these
factors cause a higher cap rate
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Summarized Influences on Cap Rate
Valuation Factor Impact on Cap Rate
Growth in Income
Faster growth means a low cap rate
and higher value
Risk
Higher risk means a higher cap rate
and lower value
Economic
obsolescence
Shorter economic life means a
higher cap rate and lower value
Interest Rates or
Cost of Capital
Higher interest rates imply higher
cap rates and lower value
Market Conditions
Stronger rental market imply lower
cap rates and higher values
Property Age
Older properties typically have more
risk as a result of greater repair
volatility. More risk means higher
cap rates and lower values
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Discounted Cash Flow Analysis (DCF)
 Total property value = mortgage value +
equity value
 Cash flows (after tax or before tax) are
projected for entire holding period
 Projected resale value at end of holding
period is calculated by dividing the NOI by
the going out cap rate
 The required rate of return (rrr) is the
discount rate based on long term yield
required by the investor
 The equity value is derived from the
following formula:
CF1
CF2
CFT
Projected Resale CFT
Equity Value = PVe = ------ + ------- + ..… + -------- + -----------------------------1 + rrr
(1 +rrr)2
(1 + rrr)T
(1 + rrr)T
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
DCF Analysis Example: With and
Without Debt
Assume no debt. In this case the value of the equity is the
value of the property. The subject property is an office
building with a single lease. The asking price is
$13,453,000. Suppose the present time is the end of the year
2002. The building has a 6-year "net lease" which provides
the owner with $1,000,000 at the end of each year for the
next three years (2003, 2004, 2005). After that, the rent
"steps up” to $1,500,000 for the following three years (2006
through 2008), according to the lease. At the end of the sixth
year (2008) the property can be expected to be sold for 10
times its then-current rent, or $15,000,000. Thus, the
investment is expected to yield $1,000,000 in each of its
first three years, $1,500,000 in each of the next two years,
and finally $16,500,000 in the sixth year (consisting of the
$1,500,000
rental payment plus the $15,000,000 "reversion"
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
DCF Analysis Example (Contd.)
 Value of the property is found
by applying the DCF formula as follows:
 If the price were less than this, say, $12
million, the buyer would see an expected
(going-in) return greater than 10%
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Discounted Valuation with
Mortgage Debt
 Identical to previous model
Value = Equity + Debt
 Keep in mind the lender’s requirements in
terms of the minimum debt coverage ratio
and the maximum loan to value
 Also important to use market rate
assumptions for terms of mortgage
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Typical Mistakes in DCF Application
 GIGO (garbage in, garbage out)
 If your case lacks merit, dazzle them
with numbers
 Excess laziness and Fairytale Worlds
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Is DCF really useful in the Real World?
 Just a formality?
 Used in evaluating alternatives
 Used in checking investment
decisions
 Loss of credibility due to too much
corruption with misinformation
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Capital Budgeting and NPV Rule
 NPV decision rule:
Maximize the NPV across all mutually
exclusive alternatives and never choose an
alternative that has an NPV<0
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Zero NPV deals are OKAY
 Zero NPV means that there is no supernormal profit
 If both buyer and seller are applying the
NPV rule, they both require NPV  0
 Hence the deal will be possible only when
they accept a NPV=0
 A zero NPV deal is “bad” only if it is
mutually-exclusive with another deal that
has a positive NPV
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
The “Hurdle Rate” version of the
Decision Rule
Maximize the difference between the
project’s expected IRR and required rate of
return and never do a deal with an expected
IRR less than required rate of return
 Required return is the total return including
risk premiums reflecting the risks of the
investment – referred to as the Hurdle Rate
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
END
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner