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Valuation Fundamentals III
- Land Values as the Residual
a) Consider a retail building that is expected to generate NOI of $250,000 forever into the future. If the required rate of return on this investment is 10 percent, what is the current value of the property?
Question: What is the market cap rate here? Why is the same as the discount rate?
Suppose that the building on this property costs $2 million to construct. What is the value of the land?
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The total value of the property is simply the land value plus the depreciated value of the improvements: V = L + B. This allows us to write:
Thus, the land value is simply the residual , or the total property value less the value of the improvements:
Suppose now that the retail building is suddenly expected to generate annual NOI of $260,000. What is the property’s total value?
What is the building’s value?
What is the land value?
Notice that all of the value difference is actually attributable to the land, not the building, because the NOI change has not affected the building’s construction cost.
b) This idea can also be used to determine a property’s highest-and-best use. Suppose that there are three total options for this property:
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- Mortgage-Equity Capitalization
Thus far, we have estimated the value of a property as the present value of the cash flows the property will generate. Alternatively, we can estimate the present value of the cash flows to equity holders and then add in the value of the mortgage:
V = M + E
a) Consider a property that is expected to generate $100,000 cash flows in each of the next 6 years. At the end of the 5-year holding period, it is expected to be sold at a terminal cap rate of 11% (V 5 = $909,091). The appropriate market discount rate is 13%.
Based off of these assumptions the current value of the property is:
Suppose that a lender will provide $738,659 in financing at 8. percent interest over 20 years:
Annual debt service =
Balance due at the end of the fifth year =
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The investor’s cash flows are as follows:
Suppose that this investor has an equity discount rate of 20%. This is higher than the one used before because of _______________.
The PV of this project is therefore:
To this investor, the value of this property is:
This is his investment value.
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c) Market Value vs. Investment Value
So far, we have talked about the market value of the property.
Alternatively we can think of the property’s investment value:
Note that you should
Buy or hold if IV > MV
Sell if IV < MV
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- Comparing Going-in and Terminal Cap Rates
b) Question 1: How are cap rates and market values affected by changes in (space) market supply and demand?
c) Question 2? How will cap rates and values be affected by changes in capital market conditions (market interest rates)?
