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Cost Table of Contents Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Cost Concepts Depreciation Land Value Cost Approach Highest & Best Use Market Analysis Feasibility Analysis 1 7 15 23 31 39 49 Ted Whitmer, MAI 2508 Merrimac Ct. College g Station,, TX 77845 Phone: (979) 690-9465 Email: [email protected] Website: www.tedwhitmer.com NOTES Thispageleftintentionallyblank. Chapter 1 Cost Concepts The cost approach is probably the least favored approach to value. However, the fundamental relationship between the cost of a project and market value absolutely must be understood. The direction of a local real estate market can be determined by the understanding of how the cost of putting improvements on the ground affects the value of real estate. One old investor remarked that it is not purchasing on low rates of return or yields that gets investors in trouble, but buying properties over cost. In a market characterized by relatively low rental rates relative to market rental rates, the rates must out-pace inflation if new product is to be built. This could be seen in the over-built markets of the 1980’s when rates declined by 50% or greater. The rates had to increase 100% to just get back to their previous levels. The markets all experienced higher than inflation increases to get back to a healthy real estate market. Market direction can be determined by comparing cost to value. If the cost to complete a property (with sufficient profit) is less than value, then there is a “true” profit and money will be attracted to that type of property in that location. Often land values for the particular use will spike until the true profit goes away or so much product will be built that there is a downward pressure on profits and it goes away. If the cost to complete a property is greater than value, then construction will cease. Since there is a lag between conception of a project and permitting, the building may briefly continue once the market realizes it is over-built. Furthermore, some builders will build at no profit to even a loss to prevent carrying land, with its associated costs, in a soft market. The understanding of the underlying land value as compared to the contribution of the improvements also helps assess risk of a project. One investor bought a retail center because the underlying land value created a safety net in case the building didn’t perform. A Putt-Putt facility was purchased for essentially land value. This is the application of the cost approach. A developer once remarked that he likes to develop steel buildings because appraisers always overvalue them based upon cost. In other words, the appraisers do not understand cost. Finally, after attending a seminar an appraiser from the northeast wrote a letter expressing his disfavor with the cost approach and stated he was on a REIT board that bought real estate. He stated that they did not consider cost, but in the closing of his letter stated “of course we do not purchase for over the replacement cost of the improvements.” How does he know? The cost approach is probably in disfavor because the theory in textbooks is evolving and in many cases flawed. Furthermore, many appraisers believe they have to break down the depreciation method. This is not a requirement for employing proper methodology, as there are alternative methods to estimate depreciation. Summation approach ¾ ¾ Land value (from 1 or more of 6 acceptable methods), plus Value of improvements o Cost new as of the appraisal date (never when built) o Minus: Depreciation (depreciation is an adjustment to cost to indicate value of improvements) Copyright Ted Whitmer. All rights reserved. Cost 1 Cost Misconceptions ¾ The cost approach is most applicable to new buildings. In fact, it is applicable when sufficient data concerning cost, depreciation and site value is available regardless of use. Additionally, it is often very accurate at the end of the economic life of improvements because most of the total value is land value. If land value can be supported, then the cost approach is a very good indicator of value. Example: Land value is $500,000. Improvements are 35 years old with a remaining economic life of 5 years and would cost $1,000,000 to replace. Given economic age-life the improvements have value of 5 years/ 40 (total economic life) or 12.5% of total cost ($125,000). Therefore, the land value comprises 80% of total value. Even if the value of the improvements is over or understated by 50% ($62,500), this is only 10% of the total value. Therefore, the cost approach is a reliable indication for an older building. ¾ The market does not consider the cost approach. In fact, many buyers purchase because it “would cost x% more to build than to buy.” ¾ The cost approach is applicable to special purpose properties. No matter what the property, an experienced appraiser would like sales of similar properties and would rather rely on a sales comparison approach than a cost approach. Special purpose or use properties are often characterized by their uniqueness and/or lack of sales of properties that are similar. Therefore, the cost approach is not so much applicable as it is necessary without income and sales information. The result is generally less reliable than with more data. Additionally, the appraisal is usually for “use value” which means we do not feel comfortable to call the result “market value.” Relation to appraisal principles Substitution – people will not pay more for a property than the cost of another property built for the specific design and demand of the person(s), without undue delay. Supply & demand – If the market is characterized by shortage, cost with true or economic profit may explain value. If the market is characterized by over-supply, cost with significant obsolescence may explain value. Balance – The agents of production are land, labor and capital and coordination or profit(profit is sometimes included in labor). Value is maximized when the agents of production are in their proper mix. Furthermore, the components of a cost approach are land (same as the first agent of production) and direct, indirect costs and profit (same as labor and capital). Externalities – Forces outside the property good and bad affect value and the cost approach. Good locational attributes are expressed in high land value and bad may affect obsolescence. Highest & best use – Cost can be used to help establish highest and best use. The highest and best use of the land is the use that produces the highest value (not rate of return) to the land. This analysis can be made after studying value versus cost and deriving residual land values by comparing the two. The highest and best use as improved can also be studied with a cost approach related to deferred maintenance or other curable or incurable items. The cost versus value added analysis aids in determining if an item is curable (spend the money now to correct) or incurable (spend money later or not at all). The cost approach is essential for the highest and best use as vacant or as improved to be understood. Copyright Ted Whitmer. All rights reserved. Cost 2 Cost Cost Approach Reliability À The cost approach is applicable when the improvements are new & when the improvements are older! High Reliability Low New Old Age of Property Copyright Ted Whitmer. All rights reserved. Cost 3 Cost Cost Approach CostApproach • ReproductionCost Reproduction Cost • ReplacementCost Replacement Cost – Exactcopy – Cana5yearoldhouse Can a 5 year old house byreproduced?What aboutHVAC?TheSER haschangeddrastically inthelast5to10 years You cannot years.Youcannot purchaseHVACunits withlowSERs. – Doesthisrelateto marketvalue definition? – Sameutility – Onlycostoffunctional Only cost of functional superadequateitemsare differentthanfor reproductioncost. Therefore,itisamodified Reproduction cost Reproductioncost. – Itdoesnotbuildthe buildingthatisappraised Profit in the Cost Approach ProfitintheCostApproach y Salepriceminuscost,excludingprofit? y Isitwhatitwouldtaketobuildimprovementsasone oftheagentsofproduction? Ń Land Ń Labor Ń Capital C it l Ń Profitorcoordination y Isitonlyintheimprovements? y Whataboutchurches&ownerͲoccupiedbuildings? p g Copyright Ted Whitmer. All rights reserved. Cost 4 Cost C tA CostApproachConsiderations h C id ti yThefouragentsofproduction areland,labor,capitaland coordination.Thisappliestoany goodsorservices.Thecost d i Th t approachexpressesthefour agents.Thevalueoftheland+ direct & indirect costs (labor & direct&indirectcosts(labor& capital)andprofit(coordination) areelementsofcost.Profit,in thecostapproach,isnotthe diff differencebetweencostand b t t d value,butisacost,&should alwaysbeincluded. yNewertextssetforthonlythree agentsofproduction. Coordination or profit is a labor Coordinationorprofitisalabor cost. yThecostapproachbuildstothe dateofappraisal.Theincome approachdiscountstothedate ofappraisal.Theprofitinthe f i l Th fit i th incomeapproachisnotthesame asprofitinthecostapproach. yProfitcanbederivedandeven appliedasapercentageofdirect costs, direct & indirect costs, or costs,direct&indirectcosts,or direct,indirectcostsandland value.However,theprofitor coordinationisonlyattributable t th i totheimprovements.Ifthe t If th improvementsaredestroyed,the profitisalllost. WhyDoAppraisersHatetheCost Approach? • M Manythinkofthebreakdownmethodofdepreciation thi k f th b kd th d f d i ti andequatethatwithacostapproach. • Themarketdoesconsidercost. The market does consider cost • Youmustunderstandthefundamentalrelationship betweenfeasibility(cost)inamarketandmarket y( ) value … – IfpropertiesaresellingwithTRUEeconomicprofit(over what is needed to build) construction will be brisk whatisneededtobuild),constructionwillbebrisk – Ifpropertiesaresellingforundercost(withsufficient profit),constructionwillstop – Asabadmarketrecovers,rentsHAVEtooutpaceinflation ortherewillnotbemoreproductbuilt.Inotherwords, pp marketrenthastoapproachnewfeasiblerents. • Somehateitbecauseitishard&manyclientswillnot Copyright Ted Whitmer. All rights reserved. Cost 5 payforit. Cost NOTES Thispageleftintentionallyblank. Copyright Ted Whitmer. All rights reserved. Cost 6 Cost Chapter 2 Depreciation Depreciation is defined as loss in value from all sources. Accrued depreciation is considered to be the difference between value of improvements and the cost of improvements, with all profits included. The terms are often used interchangeably. Depreciation overview ¾ Types of depreciation a. Physical b. Functional c. External 1. in the building, wear & tear 2. outside of the buildings 3. in the building Answer: A, C, B ¾ Curable vs. incurable A roof will definitely be replaced in 9 months, is the roof curable or incurable? INCURABLE, IT IS A TEST OF ECONOMIC FEASIBILITY Focus: Not can or will it be replaced or cured, but as of the date of the appraisal is it economically feasible. ¾ Items that look like depreciation, but are not An overhead crane in a building of 10,000 sf would increase rents 75¢ psf per year (Ro = 12%), would cost $70,000 to add ($65,000 if in new construction & $50,000 when the building was built). What type and how much depreciation is it? NONE, THE VALUE ADDED OF $62,500 ($10,000 X .75 / 12%) DOES NOT JUSTIFY PUTTING THE CRANE IN A NEW BUILDING AT A COST OF $65,000. THEREFORE, IT IS NO OBSOLESCENCE. ¾ Methods to estimate depreciation o Sales Formula: Cost new minus (sale price minus land value) = depreciation Depreciation divided by Cost new = % depreciation A sale sold 1 year ago for $450,000 and the land value was $150,000. The structure was 4,000 sf and would cost $90 to build now, $70 when built, and $80 as of the sale Copyright Ted Whitmer. All rights reserved. Cost 7 Cost date. What is the indicated depreciation assuming land values increased 10% and the market is stable? BUILDING VALUE = $450,000 - 150,000 = $300,000 $ DEPRECIATION = (4,000 X $80 psf) - 300,000 = $20,000 % DEPRECIATION = $20,000 / 320,000 = 6.25% o Economic age-life Formula: Cost x effective age/total economic life A 5 year old building would cost $50 psf to build new, has an effective age of 4 years and a remaining life of 40 years. What is the indicated depreciation? $50 X 4 / (40 + 4) = $4.55 psf USE THE TOTAL ECONOMIC LIFE, NOT THE REMAINING LIFE. (REMAINING LIFE + EFFECTIVE AGE) o Modified economic age-life Cost Formula: [(Cost - curables) x effective age/total economic life] + curables A 10 year old building is in need of paint and new wallpaper (because of design). The paint is 50¢ psf and the wallpaper 75¢ psf of building area. What is the indicated depreciation if cost new is $40 psf, and the building has a remaining economic life of 35 years? [($40 - 1.25) X 10/45] + $1.25 = $9.86 psf Copyright Ted Whitmer. All rights reserved. Cost 8 Cost o Breakdown 1). Physical curable 2). Physical incurable short-lived Cost of short-lived items x age/life 3). Physical incurable long-lived Total reproduction cost - physical curable - cost of physical incurable short-lived items Remaining cost after physical curable & cost of short-lived items X actual age/total physical life Physical incurable long-lived 4). Functional - All forms 3A is considering the item if curable & 3B is considering the item as though it is incurable. You scratch out the highest value & use the lowest between 3A and 3B. Line 4 is a subtraction & usually is the value of the “correct” item, or the one that is functionally correct. 5). External Cost to cure (1) Cost of existing item (if in the improvements) (2) - physical depreciation previously charged (this is the physical depreciation taken off physical incurable short-lived or the physical incurable long-lived; the depreciation is deducted to avoid double counting) (3A) + cost to cure (removal costs + cost to add, renovate, etc. - salvage value of item removed), OR (3B) + PV of loss from item (if it remains; this is the present value of the loss due to extra expenses or lost occupancy. Offset any loss by value a superadequate item may contribute to the improvements.) [Go with the smaller of the two, above.] (4) - value of the correct item (This is the value of an item that is not in a building but should have been included in the construction of a building as of the appraisal date or the correct item’s value (less depreciation). For example, assume a building needed a service door and the door would have cost $400 when building a new building, but will cost $1,000 to add to the existing building. The functional obsolescence is the cost to cure minus the cost if is a new building.) a). PV of total loss - loss to land b). Io loss to building / RB c). (Io loss to property / Ro) - Loss to land d). Discount loss over specified period & allocate appropriate loss to the land e). Paired sales analysis Relationship between depreciation and other approaches ¾ Older properties with more depreciation tend to have higher Ro, higher OER and lower GIM's, until the buildings contribute little value then because of low income but high (possibly) land value, the Ro becomes small, OER high, and GIM high. ¾ Higher depreciation can show up in sales comparison by larger age/condition adjustments. Adjustments in the cost approach Do not forget bottom-line adjustments for present worth of excess rent (add) or present value of below market rent (subtract). The value of intangibles or personal property may also be added. A cost approach generally results in a fee simple value without adjustments. If the appraisal is to estimate another interest such as a leased fee or leasehold estate, then an adjustment is necessary. Copyright Ted Whitmer. All rights reserved. Cost 9 Cost Depreciation Breakdown Physical curable Economic Agelife incurable short-lived long-lived Functional Universal format 1. 2. Cost new of existing - depreciation charged 3A. + cost to cure, or 3B. + value of loss 4. - cost if installed new, or + value added by item, etc. External Cost x Effective age/Total economic life Modified Economic Agelife Curables & Incurables [(Cost - curables) x Effective age/Total economic life] + curables Extraction From Sales 1 curable??? 2 incurable 3 S.P. - land value Cost - building value Depreciation/Cost Copyright Ted Whitmer. All rights reserved. Cost 10 Cost Depreciation z Some buildings depreciate significantly at first and others at the end of the economic life Vo as a % of cost C Vo = 100% of cost B A Vo = 0% of cost Age of property Depreciation for a Corporate Headquarters, Many Special Use Properties & Many Houses z Vo is less than 100% of cost at construction Vo as a % of Cost Vo = 100% of cost Obsolescence due to “overimprovement” or due to use of market value definition Vo = 0% of cost Age of Property Copyright Ted Whitmer. All rights reserved. Cost 11 Cost 1 Likely Depreciation of Improvements Over Time z You must determine where an improvement is in relation to the deferred maintenance maintenance. Vo = 100% of cost Vo as a % of Cost Average over long period of time Money spent on curables over time If no $ is spent Vo = 0% of cost Age of Property Depreciation With Renovation z This assumes the renovation costs were reasonable. bl Note N t the th life lif iis extended. t d d Vo = 100% of cost Vo as a % of Cost Renovation New depreciation line Average over a long period of time Vo = 0% of cost Age of Property Copyright Ted Whitmer. All rights reserved. Cost 12 Cost 2 Depreciation Of Components z Not all components of a building depreciate over the same life Vo as a % of Cost Vo = 100% of cost “Skeletal Structure” or total physical life Economic Life of all improvements Items that last 50% of total life Items that last <50% of total life Vo = 0% of cost Age of Property Copyright Ted Whitmer. All rights reserved. Cost 13 Cost 3 TREATING DEPRECIATION IN THE OTHER APPROACHES Physical curable The easiest way to account for physical curable depreciation in the sales comparison approach is to add all curable physical depreciation to the sale comparables. This requires researching the anticipated deferred maintenance of the buyer and seller of each comparable property as of the date of sale. The subject should be first analyzed as though it has no deferred maintenance (physical curable). After the value of the subject is reached ignoring physical depreciation, an appraiser deducts the physical curable from the indicated value derived earlier that ignored curable items. (This works for all curable depreciation. Also, it is advisable to do this because there are so many different conditions of property in the universe of sales. This makes it easy to reuse sales and reach consistency.) One more note. If curable is significant there may be a profit added to the physical curable to entice a buyer to purchase. Sometimes the dollar amount is not the critical decider if profit is added, but the time and effort needed to correct deferred maintenance by the buyer. For example, an apartment complex may need a complete roof, it may have significant cost, but there is little effort in calling a roofer so little profit may be attached to the problem. If the effort is significant, profit should be added, if the market recognizes it. In the income approach, develop the rents, vacancy, expenses and capitalization rate as though there is no curable physical, derive a value then subtract the curable. In the sales comparison approach add all curables present in the sales to the sales, analyze the subject as though there is no physical curable and deduct all of the physical curable estimated. Alternatively, if all sales have similar physical curable obviously you could just derive a value for the subject and it would include the physical curable, no deduction would be necessary. If there are varying amounts of curable then an appraiser could adjust the difference in curable between the comparables and the subject. This exercise is unnecessary if all curable items are added to the comparables and then all the subject curable physical is deducted at the end of the process. Physical incurable In the sales comparison approach, sales are adjusted for age and condition. This should account for any physical incurable taken in the cost approach. In the income approach, the rents, vacancy, expenses and rate use to capitalize the net income should reflect the age and condition and thus the physical incurable. Functional Line 3A (Curable Functional) The following applies if line 3A (curable) is the lowest between 3A and line 3B (incurable). You deduct line 3A in the income approach and usually in the sales comparison approach. The reason was set out in the discussion of physical curable. The income approach should always be developed as though there is no functional obsolescence represented in 3A. All rents, vacancy, expenses and rate of return would be developed as though there is no functional curable and then the amount would all be deducted at the end of the process. Functional Line 3B (Incurable Functional) Incurable functional obsolescence would be built into the income approach by either lower rents, higher vacancy, higher expenses or higher cap rates. All of the previous would cause a lower value. Remember the appraiser used line 3B only if it is lower than line 3A (if curable). Therefore, this is built into the income approach. Incurable functional obsolescence would typically be deducted in the sales comparison approach unless the comparables have the same characteristic (functional obsolescence is in the sales and thus is represented in the sale price.). External Obsolescence The external obsolescence would be built into an income approach by way of decreased rents or occupancy, higher expenses and higher capitalization rates. An exception to this is if the external obsolescence is curable or temporary. An appraiser may develop an income approach as if the problem doesn’t exist, then deduct the loss as a bottom-line item. The sales comparison approach should reflect external obsolescence if the loss is from market conditions and no bottom-line deduction would result. An exception would be if the problem in the subject is locational and not a market loss. The analysis could be as though there is no problem, then the present value of the problem deducted. However, this may also show up in a location adjustment, etc. Copyright Ted Whitmer. All rights reserved. Cost 14 Cost Chapter 3 Land Value Land Value Estimate 1. Sales comparison 2. Allocation 3. Extraction 4. Land residual 5. Ground rent capitalization 6. Subdivision analysis Note: Some authors treat the methods 4 – 6 above as an “Income Approach” and have four methods to value land. The land residual, ground rent capitalization and subdivision analysis are subsets of the income approach. Methods to estimate land value ¾ Sales comparison ¾ Allocation - Results in a percentage to apply to a total value. ¾ Extraction - Sale price minus improvement value, as of the date of sale. Results in a dollar value. Should the extraction of sale price minus improvement value be as of the appraisal date or sale date? Answer: Sale date. (Try not to use cost, but value; and extract as of the date of sale). You may have to combine extraction with sales comparison. For example, the test may have partially improved land where the improvements are extracted from the sales price. Then the indicated land value is put into an adjustment process with other unimproved sites. ¾ Land residual You need which of the following to solve? a. Io, RL, RB, and land value b. Io, RL, RB, and building value c. Io, RL, RB, and total value d. Io, RL, RB, and mortgage value Answer: b Copyright Ted Whitmer. All rights reserved. Cost 15 Cost What is the value of land if the RL= 10%, RB= 11%, Io is $25,000 and the building is worth $100,000? Value of building = $100,000 Io = $25,000 IB (building) = 11,000 IL (land) = $14,000 Value of land = 14,000/.10 = $140,000 ¾ Ground rent capitalization - Is an income approach to valuing land. Formula: Income to land ÷ Capitalization rate to land Assume market rent for similar tracts is 50¢ psf per year absolute net and an appropriate rate for land is 11%, what is the value of a 4.5 acre tract? (.50 X 4.5 X 43,560) / .11 = $891,000 ¾ Subdivision Which of the following is a general model that expresses the subdivision approach to valuing land? a. PV of (Retail values of lots/tracts - expenses - costs - profit) over time b. PV of (Retail values of lots/tracts - expenses - profit) over time c. PV of Retail values of lots/tracts over time d. PV of 50% x sum total retail value of the lots The answer is (a). To derive the value of land with a subdivision approach, deduct the costs of infrastructure. To derive the value of a finished subdivision, you would not deduct the costs of infrastructure, but would assume the money has already been spent. To appraise a subdivision partially improved or with another one or more phases to be completed, deduct the unspent monies for costs of infrastructure, but do not deduct costs that are already assumed to be spent. Developer's profit - What does it account for? Management or the money necessary to make the “investment hands off”. What is the difference between subdivision analysis for vacant land, improved, and partially improved land? The inclusion of costs as a line item for land value. Should construction or carry interest be included as a line item in the DCF? NO, it is in the overall discount rate! The overall discount rate includes the cost of all capital including interest on a loan. The deduction of interest in a DCF would double count the deduction. An appraiser may value a subdivision using an equity residual approach. However, the total debt service, not just interest would be deducted to result in equity cash flows. The equity cash flows would then be discounted to present value, resulting in the value of the equity position. This value would be added to the value of the loan to result in total value. Most areas of the country use a property model to value subdivisions. Many in California and other areas of the country use an equity residual model because the data lends itself to this analysis. Copyright Ted Whitmer. All rights reserved. Cost 16 Cost COMPONENTS OF AN AVERAGE LOT PRICE IN A SUBDIVISION Return to: "On" Capital Return on equity capital Ongoing Management Return on debt capital Management expense or Profit Line (To make the investment a hands off investment) All Expenses Marketing expenses Commissions Closing expenses of sale Overhead Other expenses All Costs Costs of infrastructure Costs of offsite improvements Prorated cost of amenities Raw Land Cost Underlying raw land value THE SUM OF THE ABOVE IS THE AVERAGE LOT PRICE THAT RETURNS ALL EXPENSES, COSTS, RETURN ON CAPITAL, UNDERLYING LAND VALUE, COSTS OF AMENITIES AS WELL AS THE PRORATED LAND COSTS TO THE AMENITIES TO THE AVERAGE LOT. NOTE: THE RETURN "OF" IS IN THE RETURN OF EXPENSES, COSTS AND UNDERLYING LAND VALUE. Copyright Ted Whitmer. All rights reserved. Cost 17 Cost Other considerations ¾ No income approach for land? - Look at the last three methods. ¾ Is the capitalization rate to land always lower than the capitalization rate to the improvements? o Subordination to debt: Land leases are often subordinated to debt. o Long-term level leases: The longer the lease is with level payment the closer the capitalization rate must be to the yield rate. Therefore, the land capitalization rate is higher for long-term level leases than building capitalization rates that apply to leases that are not as long-term and level. o Tax advantage is all to building: Although the building is a wasting asset, the life of a building is long and is accounted for by a sinking fund factor. However, depreciation benefit, which is all to the building, is received annually and is either 1/27.5 = 3.6%/year or 1/31.5 = 3.2%/year. This more than offsets the wasting away of the building (e.g. a sinking fund factor at 12%, 40 years is only .0013, or .13%). o Risk in land higher than buildings: If R = Y - CR, and Y is higher to land than buildings, then the capitalization rate could be higher. Problem: What is the value of a subdivision that has expected sales of $1,500,000 over three years if expenses are 20% of sales (marketing, closing costs, commissions, etc.) and costs of construction are $750,000, all in the first year? Assume also a management (profit) line of 15% of retail sales, interest of $25,000 per year, an equity yield requirement of 25%, and a property yield requirement of 17%. Assume that entitlements cost (last year) $40,000. The problem is to “value the subdivision.” Therefore, costs will not be deducted, nor will past costs of entitlements. The interest and Ye are not needed to solve the problem. 1 2 3 Sales $500,000 $500,000 $500,000 Expenses (20%) - 100,000 - 100,000 - 100,000 Profit (15%) -75,000 -75,000 -75,000 Net Proceeds $325,000 $325,000 $325,000 3 N; 17 I; 325,000 PMT; solve PV [$718,115] Problem: What is the value of land that can be subdivided into 100 lots with an average sale price of $30,000 per lot, if the infrastructure costs are $10,000 per lot, expenses are 15% of sales, and the desired profit is 10% of sales? Assume the market wants a 16% return and the absorption is 20 lots per quarter. Copyright Ted Whitmer. All rights reserved. Cost 18 Cost 100 lots / 20 lots per quarter = 5 quarters The problem states to “value the land.” Therefore, costs are deducted. $30,000 x 100 lots / 5 quarters = $600,000 gross sales per quarter. Expenses & Profit: 25% X $600,000 = $150,000 Net: $600,000 - 150,000 = $450,000 PV of $450,000, 5 quarters: $450,000 PMT; 5 N; 16/4 I; solve PV [$2,003,320] However, the above value is for the subdivision as though there are no costs of construction. Two alternatives are to (1) discount the costs over 5 quarters at a safe rate, or (2) simply deduct the costs of $10,000 X 100 lots = $1,000,000. It is reasonable to assume almost all costs would be up front, especially with such a short sell-out and construction period. Therefore, the value is $2,003,320 - 1,000,000 = $1,003,320 for the vacant land. A developer would not earn much if any interest on the money needed for the costs. If the costs were discounted over the 5 quarters at 16%, there would not be enough money to complete the subdivision. If the costs are discounted, it must be at a safe rate. Copyright Ted Whitmer. All rights reserved. Cost 19 Cost Land Valuation Six (or Four) Acceptable Methods ` Sales Comparison ` Allocation ` Extraction Income Approach – The following are all considered an ` income approach … ` Ground Rent Capitalization ` Land Residual ` Subdivision Sales Comparison ` Elements of Comparison ` At date of sale ` ` ` ` ` ` Property rights Financing Conditions of sale Expenditures p after Market conditions At date of appraisal ` ` ` ` ` Location Use Economic Physical Non-realty ` Units of Comparison ` ` Whole property Per square foot ` ` ` Of land area Of buildable area Per front foot ` ` ` Residential Lake front Other Allocation ` The percentage (%) of total value to land value ` Is common in residential lots ` Is useful as a rule of thumb ` Example: ` A house sold for $200,000 in a new neighborhood & the lot was sold for $40,000. Therefore, the land value is 20% of a total house sale price. Copyright Ted Whitmer. All rights reserved. Cost 20 Cost 1 Extraction Is also called Abstraction. It is the sale price less contributory building value to result in a dollar ($) value for the land. ` It is used in areas with older buildings or b ildi buildings representing i iinterim i uses. ` Example: ` An older property sold for $500,000 & the buyer gave the building $50,000 in value. Therefore, the land is worth $450,000. ` Ground Rent Capitalization ` Is an income approach to valuing land. ` Is useful with leased land along highways, downtown areas, or other commercial areas ` You should not state in a report: “Because the subject in vacant land, an income approach is not applicable.” ` Example ` A site was leased for a restaurant for $5 psf absolute net for 25 years to a fast food chain. Rates of return for similar leases are 11% - 13%. The value of the site is approximately $45 psf. Land Residual ` The following must be known for a land residual ` Building value ` Building capitalization rate ` Land capitalization rate ` Estimated E d Io I ` Example: ` ` A drug store is to be constructed for $2,000,000, inclusive of profit. The market requires a 9% return on investment for buildings and 8% for land. What can be paid for a site if the net operating income is expected to be $270,000/year? Answer: ($270,000 - $180,000)/.08 = $1,250,000 Copyright Ted Whitmer. All rights reserved. Cost 21 Cost 2 Subdivision ` To develop land value: Estimate retail sales Estimate absorption period ` Deduct expenses ` Have a line item for profit or put it in the discount rate ` Deduct all development costs ` Discount at rate of return The above procedure results in how much one could pay for land. To value a subdivision, only costs to complete would be deducted. By deducting all costs above, vacant land value results. ` ` ` ` Copyright Ted Whitmer. All rights reserved. Cost 22 Cost 3 Chapter 4 Cost Approach ¾ Reproduction vs. replacement cost o Reproduction - duplicate o Replacement - substitution, replicate ¾ What is the difference between the two costs? Answer: Only superadequacies. Build deficiencies into reproduction or replacement cost. If a house has a 5 ton A/C unit and the market requires a 10 ton unit, do you cost out a 5 or 10 ton unit for reproduction cost? Replacement cost? Answer: You cost the 5 ton unit regardless of using reproduction or replacement cost. When is original cost relevant to estimate cost? Never, use cost as of the appraisal date. When is original cost relevant to test depreciation? Never, use cost as of the appraisal date. When is original cost relevant to measure depreciation? Never, use cost as of the appraisal date. ¾ Types of cost - direct, indirect & profit. ¾ Methods to estimate cost -The methods to estimate cost from most to least accurate. o Quantity survey – A detailed breakdown of cost o Unit-in-place (segregated cost) – Costing systems, such as framing, plumbing, etc. o Comparative unit (calculator method) – Done by square foot, lineal foot, etc. Copyright Ted Whitmer. All rights reserved. Cost 23 Cost ¾ Indexes & multipliers Assume a building cost $40 psf when built 5 years ago. Inflation was 4% and the cost index was 110, and is currently 145. What is the indicated cost new? $40 x 145/110 = $52.73 A base cost indicates a cost for a building of $50, unadjusted. The time multiplier is 1.05, the area multiplier is .98, and the height multiplier is .97. What is the indicated cost? $50 x 1.05 x .98 x .97 = $49.91 Note: Do not net out the 5% to the –2% & -3%. ¾ Marshall Valuation o Calculator - includes almost all cost. Does not include financing fees, lease-up costs, developer’s profit, or other extraordinary fees, but does include architect’s fee, contractor’s fees, etc. o Segregated cost - does not include architectural fees. o Both calculator and segregated include contractor’s profit. ¾ Profit o Should always be included in cost, even in a poor market. Is as much a cost as direct or indirect cost. o Even though it may be expressed as a percentage of either direct costs, or direct and indirect costs, or direct costs, indirect costs, and land value, it is only attributable to the improvements. Relationship between depreciation and other approaches Older properties with more depreciation tend to have higher Ro, higher OER and lower GIM's, until the buildings contribute little value then because of low income but high (possibly) land value, the Ro becomes small, OER high, and GIM high. Higher depreciation can show up in sales comparison by larger age/condition adjustments. Bottom-line adjustments for property rights appraised, etc. Do not forget bottom-line adjustments for present worth of excess rent (add) or present value of below market rent (subtract). The value of intangibles or personal property may also be added. Copyright Ted Whitmer. All rights reserved. Cost 24 Cost Misconceptions About the Cost Approach It sets the upper limit of value Investors do not consider the cost approach You cannot reflect leased fee or leasehold valuations It should be independent of the income & sales comparison approaches It is most useful for special purpose properties It is not useful for older properties Copyright Ted Whitmer. All rights reserved. Cost 25 Cost Cost Approach Inconsistencies ( (Not Support S Problems) bl ) The cost does not match with the quality of the improvements The e multipliers u p esa and d other adjustments are not properly applied Lease-up costs are not accounted for The cost is not as of the appraisal i ld date t The cost manuals do not reflect current costs from the local market (even after all adjustments) Soft costs are omitted because the owner built with a small loan or all cash Profit is not included Copyright Ted Whitmer. All rights reserved. Cost 26 Cost Cost Approach Inconsistencies Curables do not have profit or sufficient profit fit built b ilt into i t th the estimate (when appropriate) Depreciation is inconsistent with highest & best use as vacant ((and land value)) Cost is not consistent with time line The age of the improvements is not consistent with p previous renovations the age of improvements in the area the condition of the improvements after considering all curables Copyright Ted Whitmer. All rights reserved. Cost 27 Cost Cost Approach Inconsistencies If leasehold estate or leased fee, is there a bottom-line or other adjustment? Are site improvements in the land and the cost? Overall, does the age of the improvements, the functionality and market justify the adjustment from cost expressed by the depreciation? Copyright Ted Whitmer. All rights reserved. Cost 28 Cost Cost Approach Inconsistencies Appraising on the time line - soft & hard costs g of completion. p Get the date reflect stage correct. As Is Could Be Land Value. There may be $ spent for entitlements, marketing, site impro ements or eeven improvements en some of the costs. If materials are on site, contact yyour client & find out how to handle them. Cost As Complete, But Not Stable Occupancy As Complete p & Stable Occupancy Occupied & Finished Building The Shell Of a Building Land a d value va ue Land value Hard cost to shell & finish Hard cost to shell Soft cost to shell & finish & leaseup (marketing, commissions, tenant improvements) Soft cost to shell Copyright Ted Whitmer. All rights reserved. Profit to completion 29 Profit to completion & stabilization! Cost NOTES Thispageleftintentionallyblank. Copyright Ted Whitmer. All rights reserved. Cost 30 Cost Chapter 5 Highest & Best Use Land as though vacant Property as improved Four tests of highest and best use 1. Physically possible 2. Legally permissible 3. Financially feasible 4. Maximally productive Highest & Best Use - that use that produces the highest dollar value to either the site as vacant (highest and best use as vacant) or to the property as improved (highest and best use as improved). The highest and best use is not the use that would potentially give the highest yield. Instead, it is the use that would bring the most value in the open market. Relationship of market analysis, feasibility & highest and best use 1. Market analysis a. to identify demand for alternative uses b. supply and demand analysis to forecast absorption rate and probable rents for: use no.1, use no. 2, etc. 2. Feasibility Analysis a. to determine respective values on the basis of criterion variables b. calculation of Io/cash flows and selection of appropriate cap rate/discount rate to determine property value based on criterion variables for: use no. 1, use no. 2, etc. [Note: Market analysis & feasibility analysis focus on predefined uses] 3. Selection of Highest & Best Use a. the use resulting in the maximum value b. specification in terms of use, timing, and market participants (i.e. user of the property, equity investor, debt investor) Copyright Ted Whitmer. All rights reserved. Cost 31 Cost ¾ Highest & best use of land as though vacant o Purpose of highest & best use analysis as though vacant to determine potential, rather than actual use any building can be demolished to estimate a separate land value identify comparable sales of vacant land o The appraiser should determine the highest & best use of a site as though vacant, even if there are improvements on the site. They are ignored in the analysis. ¾ Highest & best use of property as improved o Purpose of highest & best use analysis as though vacant identify the use that maximizes the dollar return help identify comparable properties o The appraiser should determine the highest & best use of the property as improved regardless of the highest & best use as though vacant. The objective is to determine the use that the seller would get the most money with the improvements in place and regardless of the highest and best use as though vacant. o The value as though improved may be lower than as vacant. For example, the improvements may have a negative value due to environmental problems or they may be at the end of their economic life. ¾ Criteria in highest & best use analysis o The four tests of highest & best use Legally permissible Physically possible Financially feasible x Highest capitalization rate wins? Problem: When would a use have a higher capitalization rate indication than another use, yet the highest and best use be for the use resulting from the lower capitalization rate? For example, as an office the property would result in an Ro = 10%, but as retail the property would have an Ro = 11%. When would the highest and best use be for office even though the capitalization rate is higher for retail? Solution: 1. Risk 2. Yield Maximally productive o The four tests apply to both "as vacant" and "as improved." Copyright Ted Whitmer. All rights reserved. Cost 32 Cost ¾ Testing highest & best use 1. Highest and Best Use of Land as Though Vacant a. Single-Family Residence Market Value Cost to construct new Developer's fee Land value The 4,600 sf house should be built. 5,000 sf $500,000 -375,000 -50,000 $75,000 4,600 sf $450,000 -320,000 -45,000 $85,000 b. Income-Producing Use Restaurant Use Potential Io $100,000 Overall capitalization rate 13% Capitalized Io $769,000 (R) Development costs -500,000 Residual land value $269,000 The development should be for restaurant use. Other Retail Use $120,000 12.5% $960,000 -700,000 $260,000 c. Alternative Approach Heavy Industrial Service Center Cost to build $500,000 $890,000 Io 70,000 110,000 IB (12%) -60,000 -106,800 IL $10,000 $4,000 VL (10%) $100,000 $40,000 The property should be developed with heavy industrial. Office WH $600,000 75,000 -72,000 $3,000 $30,000 2. Highest and Best Use of Property as Improved a. No Capital Expenditure Storage Gross income $20,000 Vac & coll loss (5%) -1,000 Expenses -5,000 Io $14,000 ÷ Ro 10% Value $140,000 The property should be marketed for storage. Industrial $40,000 -2,000 -23,000 $15,000 11% $136,000 b. Capital Expenditure Required Apartments Apartments after Renovation Io $125,000 $150,000 Ro 12.5% 11.5% Capitalized Io 1,000,000 1,300,000 (R) Conversion costs $000,000 -300,000 Value $1,000,000 $1,000,000 Further analysis would be necessary to determine the long-term impact by not renovating. This analysis shows either to renovate or not, the values are equal. Copyright Ted Whitmer. All rights reserved. Cost 33 Cost ¾ Special situations in highest & best use o Single uses - e.g. when market demand is sufficient for one large office building o Interim uses - use may change in the foreseeable future o Legally nonconforming uses - are legal, but do not currently conform to zoning o Uses that are not HBU - many existing improvements o Multiple uses - parcel with more than one use o Special-purpose uses - appropriate for one or a limited use, e.g. church o Speculative HBU vs. HBU for speculation – in the first one doesn’t know the ultimate use a property will be put to. In the second, the use is defined but the timing (when) is not. o Excess land & surplus land - excess land is an economic unit & may be sold off; surplus land cannot be sold off because of the layout of the improvements ¾ Other considerations o To demolish or not to demolish test If the value of the land as vacant is greater than the value as improved minus demolition costs, then demolish. If not, do not demolish. ¾ o To renovate or not to renovate test If the value of the property is greater after renovation than the value “as is” plus renovation costs, then renovate. The costs to renovate must include a sufficient profit. If not, then do not renovate. o Negative values Land Improvements Property Leaseholds Problem: The value of land as vacant is $150,000. The toxic waste clean up is estimated at $350,000. What is the value of the property assuming the owner is liable for the clean-up? Solution: No more than a negative $200,000. Note: If a value is negative, don't report a zero value. It is both incorrect and misleading. o The underlying land value in a value in use of a property; highest and best use as vacant? Problem: A church located on a downtown block wants to sell its property to a smaller church and build on a larger campus (site). You determine the highest and best use of the site is for a 60-story office building and would be worth $5,000,000. The whole property as a church is worth $2,500,000. How should you value the land for a value in use appraisal? Copyright Ted Whitmer. All rights reserved. Cost 34 Cost Answer: The land should be valued consistent with the use defined for the property (as a church site). However, it would be prudent to report the value of the site as vacant and in its highest and best use. o Assuming similar highest and best use as improved and identical structures (e.g. houses in different subdivisions, gas stations, fast food stores), which buildings are worth more, those on a higher or lower valued sites? Problem: Assume you are appraising 30 gas stations with exact construction details. Are the improvements likely to be worth more, less, or equal value on inferior versus superior sites? Answer: The improvements on the inferior sites are likely worth more than on the superior sites (assume no superadequacies exist). Gas stations on superior sites often have a shorter economic life and considerable money is spent to update the improvements for competitive reasons. If the station is closed, a purchaser is more likely to destroy the improvements on a superior site but renovate and use the improvements on an inferior site. Problem: Assume a site can be purchased for $500,000 and may be developed with either retail or office. Io if retail will be $250,000, and construction costs will be $2,000,000. Io if office will be $225,000, and construction costs will be $1,900,000. Retail rents are expected to increase 4.5% and office rents 4.75%. Terminal capitalization rates for retail are 11% and are 10.75% for office. Which development, if any is appropriate for the subject? What are your considerations and criteria? Land value Cost Total Io Overall cap rate Terminal cap rate Retail $500,000 2,000,000 $2,500,000 Office $500,000 1,900,000 $2,400,000 $250,000 10% 11% $225,000 9.38% 10.75% Although rents increase 4.5% (retail) & 4.75% (office) the yield for retail would be somewhat less than 10% + 4.5% = 14.5% and less than 9.375% + 4.75% = 14.1% for office because the terminal capitalization rates exceed the going-in capitalization rates. [Y = R + CR if both income & value increase at the same rate (CR). However, the terminal cap rates are higher than the going-in cap rates. Therefore, the yields will be less than the sum of the cap rate + rental increase per year.] It would be difficult to decide between the two given the information because it is not clear if profit is in the costs given, what the terminal capitalization rates apply to, and the appropriate market yield for office or retail. Copyright Ted Whitmer. All rights reserved. Cost 35 Cost Special Purpose Property Definition: | Economically Economically, suitable for only one use | Therefore, many use “use value.” (Because there is a l k off sales lack l and d income data, the cost approach becomes the default.) | In property tax the result is to shift the burden of proof of functional obsolescence to the owner. Copyright Ted Whitmer. All rights reserved. Cost 36 Cost Highest & Best Use Problem A corner tract with an acre, zoned R-1. What is the highest & best use and market value of the property? Fact: The market would accept the property as a commercial location and would pay more than if it is a residential property. Fact: There is a good chance the zoning can be changed, the area is in transition. Fact: The access is average to good for a commercial property. The property is on a road with a high traffic count and is not suitable for new residential development. Fact: There is an old house occupied on the property that has an elderly couple living in it. The couple has lived there for 30 years and has no interest in moving. Fact: The house would cost $3,000 to remove, and the land would be worth at least $250,000 with three entities expressing interest at that price and if vacant and zoned C-1. Similar sites have sold over the past three years for $190,000 to $225,000. The zoning change should cost $10,000 and should take 2 months. It would sell for $100,000 as a residential property. Go through the tests: Legal Physically possible Financially feasible Maximally productive What is the highest and best use and the value? Solution: The problem does not center on the couple not wanting to move. The market value definition assumes a willing buyer and seller. The property is currently in conformity with zoning as a residential property. The 2 months to get the zoning change would be no problem since it could be included in the construction period. Assuming the zoning change could be accomplished, the highest and best use would be to sell as a commercial tract to be developed at least two months out. The value would be $250,000 - $3,000 (to remove the house) - $10,000 (to get the zoning change) – the risk premium that zoning change would not go through + the premium that the tract could finally sell for given the activity expressed in the problem with various entities wanting the property. The sales prices in the past merely show a rising market. An appraiser should reflect the higher price in the analysis and not merely appraise at past sale prices. Copyright Ted Whitmer. All rights reserved. Cost 37 Cost NOTES Thispageleftintentionallyblank. Copyright Ted Whitmer. All rights reserved. Cost 38 Cost Chapter 6 Market Analysis Market Research in Appraisal ¾ Market Research Scenario 1 - A Site in Search of a Use or Market Productivity analysis - Subject attributes Market activities - Supply & Demand Appraisal Analysis - 3 approaches Use or value ¾ Market Research Scenario 2 - A Use or Market in Search of a Site Market activities - Supply & Demand Productivity analysis - Subject attributes Appraisal Analysis - 3 approaches Site & value ¾ Market Research Scenario 3 - Real Estate as an Investment Alternative Investment/appraisal analysis - 3 approaches Market activities - Supply & Demand Productivity analysis - Subject attributes Levels of Market Analysis ¾ Inferred vs. fundamental analysis - Inferred analysis is trend analysis & is an attempt to estimate future changes in value by looking at past market behavior. Fundamental analysis goes past trend analysis, forecasting demand based upon segmentation of broad demographic & economic data to reflect the subject’s specific market. A & B, below, are inferred and C & D, below, are fundamental. ¾ Levels of study A Least. Is general & descriptive, not subject-specific. Is based on historical data, not future projections. B Employs area wide data on general property class. The projected conclusions are more subject-specific, & the timing projections are based on interpretation of market wide data on the property type. C A&B uses historical absorption rates, C uses future-oriented forecasting techniques. Future demand & absorption are forecast by projecting the growth of population, income & employment. It provides detailed submarket data to base projections as well as a competitive ranking for the subject. D Is the most detailed. May also include surveys and advanced techniques. Copyright Ted Whitmer. All rights reserved. Cost 39 Cost Situs process 1. ID of activities in the area 2. Study of nature of associations between activities a. Dominant use/subordinate use b. Dominant use/ancillary use c. Codominant use(s)/satellite uses 3. Analysis of accessibility of site a. Macro-level accessibility 1). Major economic activities 2). Associations between these & related activities 3). Relationship of activity center to major traveled roadways b. Micro-level accessibility 1). Linkages 2). Movements a). Assembling b). Dispersive c). Trapping point d). Random 4. Evaluation of impact of total area on the site use a. Physical environment b. Social & cultural environment c. Psychological environment d. Economic environment e. Institutional & political Urban Structure – Ways to view or study. Concentric zone – A series of concentric circles from a downtown area or other focal point. Sector or wedge model – Think of a pizza with the pieces cut in an irregular pattern. This is the concept that property uses often are developed in a certain pattern from a downtown area or other focal point. Copyright Ted Whitmer. All rights reserved. Cost 40 Cost Multiple nuclei model – Many urban areas, such as Houston, have many large office and other business areas other than just the downtown development. The multiple nuclei is used to categorize and study uses from more than one focal point. Axial (Radial Corridor) model – Uses are studied and explained based upon their proximity to transportation corridors such as a river, rail, highway and other byways. Economic Base ¾ Economic base is the sector of the economy that exports goods or services and imports money into an area. ¾ Demand analysis 9 ID base components of economy 9 Determines change in base employment 9 Estimates an employment multiplier 9 Develop a population or employment forecast 9 Develop a real estate demand forecast Ratios, multipliers, quotients & other relationships in market analysis 1. Local employment % in industry e = Local employ in industry / Total local employment 2. National employment % in industry E = National employment in industry / Total national employment 3. Location quotient (If >1, then the industry is basic and imports money & exports goods or services) LQ = e / E 4. Percentage of basic employees (LQ - 1.0) / LQ = % of basic employees in industry 5. Number of basic employees Total employed in industry x % of basic 6. EB multiplier (Employment to basic employment) Total employment / Basic employment Basic employment x EB multiplier = Total employment 7. Population/employment ratio (PE) Total population / Total employment Copyright Ted Whitmer. All rights reserved. Cost 41 Cost 8. To forecast total population Forecast total employment x PE ratio 9. To forecast total employment Forecast basic employment x EB multiplier = Forecast total employment 10. Total employment Basic + nonbasic employment = total employment 11. m = Number of jobs created by a basic job Nonbasic employment / Basic employment 12. Population multiplier = reciprocal of % population in workforce Estimating demand - future in an area ¾ Retail 1. ¨ in households in market area 2. x average household income 3. x % of income for retail 4. divided by sales psf per year ¾ Office 1. ¨ in office employees over given period 2. x sf of office per employee 3. x capture rate of submarket ¾ Housing 1. ¨ in households in area (population divided by persons per household) 2. + demolitions 3. - (actual - normal vacancies) 4. - (actual - normal units under construction) Existing buildings and demand ¾ Existing Shopping Center Market Analysis Process Step 1 ¨ in households in market area Step 2 Delineate the market area Step 3 Forecast demand A. 4cast households B. Est. mean/median income & total income C. % household income spent on retail D. % of retail in subject type property E. Repeat above for secondary market F. Determine total demand in market G. Est SF by dividing F by sales PSF H. Adjust for vacancy (add) Step 4 Measure competitive supply Step 5 Analyze market equilibrium/disequilibrium Step 6 Forecast subject capture Copyright Ted Whitmer. All rights reserved. Cost 42 Cost ¾ Existing Office Step 1 Step 2 Step 3 A. B. C. D. Step 4 Step 5 Step 6 Market Analysis Process ¨ in households in market area Delineate the market area Forecast demand Trend analysis using inferred demand Fundamental analysis using segmentation 1. 4cast: workplace in office, employment by occupational category & multiply the % in category by employees 2. Estimate size of workforce in subject class of space 3. Estimate the space per employee 4. Multiply 2 x 3 5. Adjust for normal vacancy Conduct fundamental analysis by ratio method e.g. 1. total sf in class A/total employment = sf per worker 2. forecast total employment change 3. 1 x 2 is total demand over time Reconcile the results Measure competitive supply Analyze market equilibrium/disequilibrium Forecast subject capture ¾ Existing Apartment Complex Market Analysis Process Step 1 ¨ in households in market area Step 2 Delineate the market area Step 3 Forecast demand A. Trend analysis using inferred demand - Data on general growth, market occupancy, rent trends, & subject history B. Fundamental analysis using segmentation 1. Estimate current & forecast population 2. Estimate current & forecast average household size 3. Segment # owner & renter occupied 4. Segment # households by inc levels to get % to afford 5. Adjust for normal vacancy Step 4 Measure competitive supply Step 5 Analyze market equilibrium/disequilibrium Step 6 Forecast subject capture Copyright Ted Whitmer. All rights reserved. Cost 43 Cost COMMON RATIOS & MULTIPLIERS - EXAMPLE Population in area Employment in area Basic employment in area Employment in mining Mining in country Forecast basic employment change 50,000 30,000 10,000 3,600 5% 5,000 e (Local employment % in industry) = 3,600 / 30,000 = 12% E (National employment % in industry) = 5% (given) Location quotient (mining) = 12% / 5% = 2.40 EB multiplier (Total employment / basic employment) = 30,000 / 10,000 = 3 % of basic employees in industry = (2.40 - 1) / 2.40 = 58.3% PE ratio (Population to employment) = 50,000 / 30,000 = 1.67 Forecasting: Total employment: Total population: 5,000 x 3 = 15,000 15,000 x 1.67 = 25,050 Note: 1. Basic employment x EB multiplier x PE ratio = Population (This can be used for change in basic employment as well as point in time analysis). 2. Forecast population = Forecast employment growth x PE ratio SUBDIVISION LOTS (Also homes, apartments, duplexes, mobile homes, timeshare, condos, etc.) Keys: 1. 2. 3. 4. 5. 6. 7. Population change per year or quarter, etc. % to live in property type (e.g. mobile homes, single-family, etc.) Monthly payments (inclusive of taxes & insurance) % of households that can afford Factor in current supply Factor in competitive position of subject Capture rate Problem: Population increase: 1997 to 2002 = 35,000 persons Median household income: $35,000 25% ± $5,000 of median ; 50% ± $15,000 of median ; 75% ± $25,000 of median Average household size: 2.75 persons % single-family units: 60% Existing supply homes: 500 units Existing supply of home under construction: 100 units Existing single-family lots: 750 lots Typical lot value as % of total value: 22% Capture of subject subdivision: 20% of the market Proposed subdivision: 400 lots from $20,000 to $35,000/lot Mortgage terms: i = 8%, n = 360 months, LTV = 90%, Qualify at 28% total PITI Taxes are based on $20 per 1,000 of value and insurance on .75% of total home value Copyright Ted Whitmer. All rights reserved. Cost 44 Cost Solution Housing units demanded: Housing units per year: 35,000 ÷ 2.75 x 60% = 7,636 single family units 7,636 ÷ 5 years = 1,527 per year City wide supply: Duration of supply: 500 + 100 + 750 = 1,350 lots & houses 1,350 / 1,527 = .88 years, or 10.6 months Home prices in subject: 20,000 / .22 to 35,000 / .22 = $90,900 to $159,000 Incomes to qualify: [90,900 x 90% x .0881* + (90,900 x .0275**)] /.28 = $34,700 (R) [159,000 x 90% x .0881* + (159,000 x .0275**)] /.28 = $60,600(R) * Rm = 360 N, 8 ÷ 12 I, -1 PV, solve PMT x 12 (.0881) ** Taxes are 2% & insurance .75% of value = 2.75% % who qualify: The median income is $35,000 and 75% of the population is within $25,000 of the median income, or $10,000 to $60,000. Therefore, 1/2 of 75% is from $10,000 to $35,000 & 1/2 is from $35,000 to $60,000. This translates to 75% divided by 2, or 37.5% of the population is in the range of the subject home value. Lots/homes demanded: 1,527 per year x .375 = 572 units per year Capture rate: 20% Absorption: 572 x 20% = 114 lots per year Sellout: 400 lots ÷ 114 = 3.5 years Variations: 1. If the market study is for apartments, etc. (rental units), then instead of mortgage payments, look at affordability and rental payments that will be made. 2. Also look for % owner vs. renter, & possibly further segmentation based upon type of subject property (e.g. high amenity apartments, extended care facilities, etc. 3. The problem above gives the capture rate (20%) for the subject. You may be asked to make a judgment call on the test based upon competitive supply. Copyright Ted Whitmer. All rights reserved. Cost 45 Cost RETAIL Keys: 1. 2. 3. 4. 5. 6. 7. 8. 9. Households Average household income % income spent on retail % spent in subject type % retention Sales required psf Less existing supply Less forecast supply Residual demand Problem Households: Average household income: % spent taxes % spent on nonretail services, recreation, savings) % of retail sales by subject type % retention of sales in primary mkt % supportable in secondary mkt Sales required psf subject type Frictional vacancy Existing retail space Under construction Permitted Change of 1000 over the next 5 years (Currently 10,000) $35,000 25% 45% (housing, medical, insurance & professional, 20% 80% (Note: on the test this may be expressed as 20% leakage) 15% (of primary) $250 5% 250,000 sf (20% in subject type) 50,000 sf (25% in subject type) 40,000 sf (15% in subject type) Solution 1. 2. 3. 4. 5. 6. 7. 8. 9. Total income = 11,000 x $35,000 = $385,000,000 Retail sales potential = $385,000,000 x (1 - 25% - 45%) = $115,500,000 Retail sales by subject type = $115,500,000 x 20% = $23,100,000 Sales retention = $23,100,000 x 80% = $18,480,000 Primary sales sf required = $18,480,000 / $250 psf = 73,920 sf Plus: Secondary sales = 73,920 x 1.15 = 85,008 sf Plus: Frictional vacancy = 85,008 / (1 - 5%) = 89,482 sf Less: Existing, U.C., proposed = 250,000x20% + 50,000x25% + 40,000x15% = 68,500 sf Shortage of space (next 5 years) = 89,482 sf - 68,500 = 20,982 sf OFFICE & INDUSTRIAL Keys: 1. 2. 3. 4. 5. 6. 7. Employment % of employment in office Average sf per employee Capture by subject area Capture by subject property class (A, B, etc.) Add existing, under construction (U.C.), proposed Calculate residual demand Copyright Ted Whitmer. All rights reserved. Cost 46 Cost Problem: Employment Population PE ratio 1.75 to 1 Percent of employees in office Total office in city Total Class B in city Total office in submarket Occupancy Total Class B in submarket Occupancy in Class B Frictional vacancy Average space per employee Est. capture by subject area Est. % class demand Office U.C., proposed Class B Currently 50,000 Expected growth in population over next 4 years is 20,000 persons 20% 1,000,000 sf 550,000 sf 100,000 75% in submarket 50,000 sf 80% 5% 225 sf 25% 50% 25,000 sf Solution: 1. 2. 3. 4. 5. 6. 7. Total employment growth = 20,000 / 1.75 = 11,429 Total occupying office = 11,429 x 20% = 2,286 persons Office demand = 2,286 persons x 225 sf per person = 514,350 sf Capture in subject market = 514,350 x 25% = 128,588 sf Total demand for Class B in market = 128,588 sf x 50% / (1-5%) = 67,678 sf Less: Existing, UC, proposed = (50,000 sf x 20% vacant) + 25,000 sf = 35,000 sf Residual demand = 67,678 - 35,000 = 32,678 sf needed Variations: 1. There may not be a frictional vacancy given. Compute demand without making up a vacancy. Copyright Ted Whitmer. All rights reserved. Cost 47 Cost NOTES Thispageleftintentionallyblank. Copyright Ted Whitmer. All rights reserved. Cost 48 Cost Chapter 7 Feasibility Analysis Feasibility involves decisions as to “build or do not build.” Additionally, the quantity and quality of a project is assessed against the market or a particular client who wants a property built. Maximum building size on a site Building size for surface parking Land area = X + X (Efficiency ratio)(SF needed per parking space) + Setbacks + Open areas Stories SF of rentable per parking space Solve for X. (Note: X is the gross building area. X times efficiency ratio is NRA) The above can also be expressed as follows: Total land area - Setbacks - Open areas = X + X (Efficiency ratio)(SF needed per parking space) Stories SF of rentable per parking space Example: Land area = 75,000 sf Setbacks = 5,000 sf Open areas = 4,000 sf Parking by zoning: 1 space per 350 sf of building (rentable area) Land requirement: It takes 300 sf of land to construct 1 space Building efficiency = 88% net-to-gross (2-story) 75,000 = X/2 + X (.88) (300) + 5,000 + 4,000 350 75,000 - 9,000 = .5X + .75429X 1.25429X = 66,000 X = 52,619 sf (gross building area) Proof: 52,619 sf bldg / 2 = 26,310 gross bldg footprint 52,619 sf x .88 = 46,305 sf Rentable Parking spaces required: 46,305 / 350 = 132 spaces 132 spaces x 300 sf per space = 39,600 sf 26,310 sf (footprint) + 39,600 (parking) + 9,000 (setbacks & open area) = 74,910 sf [Note: There is a slight difference because the amount of parking was rounded] Note: There are no easy formulas. Algebra is required. Set up the problem and solve for “X” (the unknown). The solution is based upon one side of the equation representing the available land area that improvements can be built upon (Total land area - setbacks - other open areas - easements, etc. where no improvements can be placed.) The other side of the equation represents the improvements as a function of the building or improvement area. The building area is represented by “X”. Parking is generally a function of building size, or “X”. Copyright Ted Whitmer. All rights reserved. Cost 49 Cost HOW MUCH BUILDING CAN I GET ON THE SITE PROBLEM... Site has 300 feet of frontage on Commercial Blvd. and is 425 feet deep Parking will be surface and 325 sf per space is required Parking requirements are 500 sf per GLA by zoning & the market requires 400 sf per GLA (The above are minimums) Open area requirements are 10%, not including setback areas Setbacks are 10 feet on both sides, 30 feet in the front, and 20 feet in the rear & no improvements may be put on the setbacks including parking (No parking or buildings are allowed in the setbacks) Sidewalk areas will be 15% of the footprint of the building The building will be 2-story Solution 1. 2. 3. The total site area is 300 x 425 = 127,500 sf The amount in open areas = 127,500 x 10% = 12,750 sf The amount in setbacks 10 ft 300 ft 10 ft 20 ft Notice the corners. Do not count the corners twice. The setback area is (2x10ftx425ft)+ (280ftx20ft) + (280ftx30ft) = 22,500sf 425 ft deep 30 ft 4. 5. 6. 7. 8. Therefore, the land that can be built on is 127,500 - 12,750 - 22,500 = 92,250 sf The equation is as follows. 92,250 sf = 1/2X + (X/400 x 325 sf) + .15/2X X represents the total size of the building. The 1/2X is the footprint of the building, or 1/2 of the total rentable area (it is 2-story). X/400 is the number of parking spaces needed. Use the more stringent, zoning or market. The lower the number at the bottom of the fraction, the more the parking spaces that will be indicated. The number of spaces, X/400, is multiplied by 325 sf per space. The sidewalks will be 15% of the footprint, or 1/2 of the total. Therefore, .15/2 is the percentage of the total size needed for sidewalks. Make all the fractions decimal equivalents. 92,250 sf = .5X + .8125X + .075X 1 divided by 2 = .5 325 divided by 400 = .8125 .15 divided by 2 = .075 Combine terms 92,250 sf = 1.3875X Solve for X by dividing both sides by 1.3875. X = 66,486 sf Copyright Ted Whitmer. All rights reserved. Cost 50 Cost 9. Check: 66,486 / 2 33,243 x .15 66,486 / 400 x 325 127,500 x 10% Setbacks Total = = = = = = 33,243 sf for the footprint of the building 4,986 sf for the sidewalks 54,020 sf for parking 12,750 sf for open areas 22,500 sf 127,499 sf total land area Measures of investment performance Use the following investment and returns to calculate the following measures of investment performance. Investment = $100,000 (investor wants a 10% return, reinvestment rate = 5%) Year 1: $12,000 12,000 g CFj Year 2: $15,000 15,000 g CFj Year 3: $25,000 25,000 g CFj Year 4: $110,000 110,000 g CFj 10 i; f NPV [$117,220] Payback period - Period the sum of the inflows = the investment. Strength: Capital recapture focus Weakness: Ignores time value of $ Year 4: Only $52,000 total dollars are received through year 3. Profitability index - PV of inflows ÷ investment (PV outflows) [(Investment + NPV) ÷ Investment] 117,220 / 100,000 = 1.1722 Net present value (NPV) - PV of inflows minus PV of investment 117,220 - 100,000 = $17,220 Note: NPV is the PV of inflows minus the PV of outflows. Internal rate of return (IRR) - Rate of return where PV of inflows = investment NPV($) Profitability Index(±1) IRR(%) Positive >1 > discount rate Negative <1 <discount rate $0 1 = discount rate 100,000 CHS g Cfo 12,000 g CFj 15,000 g CFj 25,000 g CFj 110,000 g CFj f IRR [15.38%] Copyright Ted Whitmer. All rights reserved. Cost 51 Cost Modified internal rate of return (MIRR) - The rate or return where PV of inflows compounded at a reinvestment rate = PV of the investment. FV of Invested Compounded @ reinvestment rate ---------> ---------> ---------> cash flow 1 Investment cash flow 2 cash flow 3 ... cash flows @ reinvestment rate MIRR is the rate that makes the FV of invested cash flows = PV of the investment 12,000 g CFj 15,000 g CFj 25,000 g CFj 110,000 g CFj 5 i f NPV 4 N FV [-166,679] 100,000 PV i [13.62%] Note: The MIRR is always between the IRR & the reinvestment rate, unless all three are equal. If the MIRR is < the reinvestment rate, then the IRR is less than the two rates. If the MIRR is greater than the reinvestment rate, then the IRR is greater than the two rates. Expected values The reversion of land is dependent upon three events in the market. (1) Construction of a mall, (2) home sales increasing at a higher than current rate, and (3) a highway will be announced near the property. There is a 20% chance all three will happen (the value will be $8.00 psf), a 15% chance (1) and (2) will happen (value $6.00 psf), a 10% chance (2) & (3) will happen ($5.00 psf), a 20% chance (1) & (3) will happen ($7.00 psf) and if none occur the value will be $3.00 psf. What is the expected value? .20 X 8.00 .15 X 6.00 .10 X 5.00 .20 X 7.00 .35 X 3.00 $5.45 psf Utility functions - Same as above but also assign a utility value. The result of a utility function is not a value, but is used to rank investment opportunities. Debt coverage ratio - Ranking investments based upon safety in cash flows as measured by debt coverage ratio (Io divided by debt service). Copyright Ted Whitmer. All rights reserved. Cost 52 Cost Sensitivity y analysis y y Measures how a change in 1 assumption affects the analysis y Examples {p projected j rental rates { vacancy rates { expense ratios { price i change h y Example- change in Re on change in gross income y Example- change in Re on change in OER Copyright Ted Whitmer. All rights reserved. Cost 53 Cost Scenarios y Measures sensitivity y of a p performance y y y y variable to concurrent changes in a group of variables { For example, “pessimistic”, “most likely” & “optimistic” p Expected return - assign a probabilities to possible outcomes & weight it out Variance & standard deviation { Variance is a measure of degree of spread among a set of values { Standard deviation is square root of variance Ù 1 standard d dd deviation i i = 68% Ù 2 standard deviations = 95% Ù 3 standard deviations = >99% { the higher the standard deviation > risk Expected PV is weighting out values from various scenarios Can use standard deviation with expected value al e to establish range of value al e within ithin confidence intervals Copyright Ted Whitmer. All rights reserved. Cost 54 Cost Breakeven ratio y It is used to determine the margin of safety that exists until CF = 0 {DCR = 1 {Re = 0 y BER = (OE + DS) / PGI y It results lt iin a % occupancy to break even y Note N t it is i calculated l l t d on PGI & not EGI!!! Copyright Ted Whitmer. All rights reserved. Cost 55 Cost Breakeven point p y Point at which EGI = debt service + expenses y To derive occupancy: {BE occupancy = (OE + DS)/annual rent per unit y “Unit” can be an apartment unit, u t, ssf,, cub cubicc ft, t, etc. y You can easily calculate this once you have the “breakeven ratio ” Just multiply the ratio ratio. by the total units (This is my suggested way.) Copyright Ted Whitmer. All rights reserved. Cost 56 Cost Absorption A subdivision has 100 proposed lots that will sell for $40,000/lot. The lot represents approximately 25% of total home value. Qualify at 2 times household income with income ranging from $25,000 to $200,000 per family. Given a supply of 300 lots competing with the subject and 1,000 new families in the next year. How many months should it take to absorb the subject, assuming 20% of the families qualify for the subject price range, and the subject is in an average competitive position? Capture rate = % of total potential market absorbed in the subject = lots in subject sold per period ÷ total lots in market Absorption = total families per time period moving into area x % in subject price range x capture rate 100 families X 20% qualify = 200 lots per year 300 lots existing + 100 proposed = 400 lots Subject capture rate = 100/400 = 25% Absorption = 200 X 25% = 50 lots per year Sell Out = 100 lots/ 50 lots = 2 years Calculation of Feasible Rents Feasible rents are a function of cost and rate of return. In its simplest form a project is feasible when the income generated produces the required return on cost. The cost includes direct, indirect and profit as well as land cost. The rate of return is either to a particular investor, class of investors or the market in general. Overall rates from sales of existing buildings can be used for indications of return rates. However, if the properties are older the range of rates may be on the higher end of the rates that should be used for analysis of a proposed project, unless there are indications of risk that make the project higher risk than with an existing property. There are two examples of feasible rent calculations following. One is for a property that leases 90% of gross building area and the other for a property that can lease 100% of gross building area. Another example of calculation of feasible rents with different rates of increase to various components is included. Copyright Ted Whitmer. All rights reserved. Cost 57 Cost When Market Rent Exceeds Feasible Rent (Good Market Conditions for Building) y If the rental rates in the market exceed the feasible rental rate, then one, two, three or all of the f ll following willll hhappen … y land values will increase at a very rapid p rate ((land owners will take their cut of the market) y improvement costs will increase (subs will take their cut) y there will be continued construction (developers will be smiling) y rates could increase and this would cause costs to increase, slowing l i bbuilding ildi (the ( h Federal Fd l Reserve gets involved) Copyright Ted Whitmer. All rights reserved. Cost 58 Cost When the Market Softens … y Feasible rent will exceed market rent & market rent will decline at a rapid rate y Land values will dive & decrease at a faster rate than will buildings y The highest & best use of land will change from “office” to “hold for p future office development” y Land will be a negative carry with a risky reversion pushed out. The mechanics of discounting can cause land to be worth 1/2 in one d what day h t it was th the dday bbefore. f Copyright Ted Whitmer. All rights reserved. Cost 59 Cost Feasible Rent Calculation 90% Efficient Building 90% [Is usually 100% for retail & apartment] Efficiency Ratio (Rentable/GBA) Cost psf of GBA Land Cost per GBA Total Cost - Land & Bldg $ $ $ Capitalization Rate Range in the Market Feasible NOI Required per GBA Feasible NOI Required per Rentable Area $ $ Expenses: All expenses expressed as a $ amount All expenses expressed as a % amount of EGI Net Effective Gross Income Required on Rentable Vacancy & Collection Loss as a % Gross Rent psf of Rentable Area Required 40.00 [If the cost are given in $ overall, convert to psf] 28.31 [Convert land cost to cost psf of GBA] 68.31 11.50% [Use the lower to middle end of market rate range becaus the building would be new.] 7.86 [This is the Total Cost x Ro] 8.73 [This is above feasible rent on GBA divided by efficiency ratio] $ 2.58 8.00% 12.30 7.00% 13.22 $ $ Inflation to Land and Building [Add all expenses given on a $ amount & convert to psf] [Add all expenses given on a % amount of EGI] [(Feasible net rent + expenses psf)/(1 - % expenses)] [Net effective rent required divided by (1 - vacancy) 3.00% Gross Market Rent psf of Rentable Expected Growth in Market Rent $ Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 10.50 7.00% Market Rent $11.24 $12.02 $12.86 $13.76 $14.73 $15.76 $16.86 $18.04 $19.30 $20.66 Feasible Rent $13.62 $14.03 $14.45 $14.88 $15.33 $15.79 $16.26 $16.75 $17.25 $17.77 Is feasible when Market > Feasible Feasible The above analysis is simplistic, but illustrates the feasibility problem with every development. The land value may be derived after an appraisal or be based upon an asking price, etc. The costs include all direct, indirect costs and profit. This research could take a significant amount of time. The rate of return used to calculate net operating income needed may be after significant market analysis or may be based upon capital return requirements to the developer, the debt investor(s) and possibly equity investor(s). The expense analysis would take considerable study. The above analysis adds all percentage (of EGI) expenses and dollar expenses. The net effective gross income required is calculated by dividing the Io required plus dollar expenses by one minus all the percentage expenses added up. Finally, the gross potential income required is determined by dividing the EGI required by one minus the vacancy and collection loss rate used. Copyright Ted Whitmer. All rights reserved. Cost 60 Cost The gross income required is compared to the market rental rate which also would require a market study specifically applied to the proposed property. The feasible rents necessary over time (increases to) could be broken out to components such as land and building and even more detailed. The market rent would increase depending upon expectations of inflation and relative price increases for the particular product. If a project is not feasible, the market rent increases have to outpace feasible rent increases or a property would never be built. The project is feasible when market rent is equal to or greater than feasible rent. However, because of the lag time from construction to occupancy, the time to build would be backed off by the construction time anticipated. Furthermore, the developer would try to prelease or sale much of the property to beat competition to the market. Feasible Rent Calculation 100% Efficient Building 100% [Is usually 100% for retail & apartment] Efficiency Ratio (Rentable/GBA) Cost psf of GBA Land Cost per GBA Total Cost - Land & Bldg $ $ $ Capitalization Rate Range in the Market Feasible NOI Required per GBA Feasible NOI Required per Rentable Area $ $ Expenses: All expenses expressed as a $ amount All expenses expressed as a % amount of EGI Net Effective Gross Income Required on Rentable Vacancy & Collection Loss as a % Gross Rent psf of Rentable Area Required 40.00 [If the cost are given in $ overall, convert to psf] 28.31 [Convert land cost to cost psf of GBA] 68.31 11.50% [Use the lower to middle end of market rate range becaus the building would be new.] 7.86 [This is the Total Cost x Ro] 7.86 [This is above feasible rent on GBA divided by efficiency ratio] $ 2.58 8.00% 11.35 7.00% 12.20 $ $ Inflation to Land and Building [Add all expenses given on a $ amount & convert to psf] [Add all expenses given on a % amount of EGI] [(Feasible net rent + expenses psf)/(1 - % expenses)] [Net effective rent required divided by (1 - vacancy) 3.00% Gross Market Rent psf of Rentable Expected Growth in Market Rent $ Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 10.50 7.00% Market Rent $11.24 $12.02 $12.86 $13.76 $14.73 $15.76 $16.86 $18.04 $19.30 $20.66 Feasible Rent $12.57 $12.94 $13.33 $13.73 $14.14 $14.57 $15.01 $15.46 $15.92 $16.40 Is feasible when Market > Feasible Feasible Copyright Ted Whitmer. All rights reserved. Cost 61 Cost The following is calculation of feasible versus market rent with different component parts of the land and building changing over time. Calculation of Feasible Rent With Different Growth (%) Components Labor Materials Indirect costs Profit Land Total cost Ro from market Feasible rent Market rent Rent increase Increases--> Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 $40.00 $15.00 $18.00 $12.00 $20.00 $105.00 9.50% $9.98 psf psf psf psf psf psf Expected Increase 3.00% 2.50% 2.00% 1.50% 6.00% [Based upon psf of building area] psf [Total cost psf times Ro from market] $8.50 8.00% 3.00% 2.50% 2.00% Labor Materials Indirect $41.20 $15.38 $18.36 $42.44 $15.76 $18.73 $43.71 $16.15 $19.10 $45.02 $16.56 $19.48 $46.37 $16.97 $19.87 $47.76 $17.40 $20.27 $49.19 $17.83 $20.68 $50.67 $18.28 $21.09 $52.19 $18.73 $21.51 $53.76 $19.20 $21.94 1.50% 6.00% Profit $12.18 $12.36 $12.55 $12.74 $12.93 $13.12 $13.32 $13.52 $13.72 $13.93 Land $21.20 $22.47 $23.82 $25.25 $26.76 $28.37 $30.07 $31.88 $33.79 $35.82 Total $108.32 $111.76 $115.33 $119.05 $122.91 $126.92 $131.09 $135.43 $139.95 $144.64 Ro 9.50% 9.50% 9.50% 9.50% 9.50% 9.50% 9.50% 9.50% 9.50% 9.50% 8.00% Feasible Market Rent Rent $10.29 $9.18 $10.62 $9.91 $10.96 $10.71 $11.31 $11.56 $11.68 $12.49 $12.06 $13.49 $12.45 $14.57 $12.87 $15.73 $13.29 $16.99 $13.74 $18.35 Feasible Copyright Ted Whitmer. All rights reserved. Cost 62 Cost