Real Life Real Estate Valuation and Appraisal - Research Paper Example

Real Life Real Estate Valuation and Appraisal Abstract Considering the development and high interests of many investors in the real estates business it is important to have its deeper understanding and analysis. This report will study and establish factors in valuation of real estate in real life. It will outline the operations on the investments in real estate business which at some instances are complex, the uses of the investments and more so cover development markets in its aspect. Various methods will be employed in the study of all these aspects of real estates valuation and appraisal. It analyzes three investment options in Scotland. Table of Contents Abstract……………………………………………………………………1 Table of contents…………………………………………………………..2 1 Introduction…………………………………………………………..…..3 2 Valuations and Appraisal…………………………………………...…….6 2.1 Value and Price in Real Estate Business………………………..…6 2.2 Definition of Values in Real Estates Business……………………6 2.3 Valuation Approaches…………………………………………....7 2.3.1 Income Approach…………………………………………7 2.3.2 Cost Approach……………………………………………8 2.3.3 Sales Comparison Approach…………………………….8 2.3.4 Traditional Method approach……………………………8 3 Valuations of Projects Using………………………………………. ……10 3.1 Discounted Cash Flow…………………………………………..10 3.1.1 Discrete Cash Flow……………………………………..10 3.1.2Continuous Cash Flow…………………………………..11 3.2 Example in Use of DCF………………………………………….11 4 Actual Projects Appraisal Using DCF…………………………………….14 Conclusion…………………………………………………………………..18 Appendix…………………………………………………………………….19 References……………………………………………………………………20 1 Introduction A real estate that is synonymous to real property or realty is a word used to describe land and or with its developments like buildings or any other development that lay on it. Its aspects are well stipulated in the law of many countries in the world. In law the real property is clearly distinct from personal property. A real property is immobile, that is any investment whose title is only transferable along with the land such as the land itself and any thing that is permanently fixed to it for example minerals, buildings trees among others on the other hand personal property is movable with the owner retaining title not necessarily along with the land. Although it is believed to be not true theory some scholars gave that the word real property coinage came from a Spanish word real which means a king it puts that all the land belonged to the king and the people using it had to pay taxes to the king for its use either directly or indirectly. Real estate has become one of the biggest aspects in recent times and owing to the ever increasing interests in private property ownership it is known as commercial real estate. The required substantial investment in real estates and the unique nature of each has necessitated the development of key distinct fields in development of its industry (Rees, and Hayward, 2000) some of these are; Valuation and appraisal –services offered by experts in this sector Development –fixing or replacing investments such as buildings on land to increase its utility. Corporate real estate- achieving the goals of a corporation by managing its real estates Property management-controlling and organizing the functions of a real estate for a given party Brokerage- effecting or facilitating real estate business transaction through mediation. Net lease-the tenants of a real estate sharing the property among themselves A business entity can deal with one or more of the above fields in a certain kind of real estate business such as commercial, residential or industrial property. It is clearly evident that almost all businesses in construction relate to real estate (Isaac, 2002). Real estate valuation and appraisal is development of market value opinion of real property in business concept. Different property investments are usually distinctly identical given the fact that even if they are of the same model they can never be in the same location at a time, this situation shows the significance of the need to make appraisals and valuations of real estates to determine their nature as an investment. This lack of centrality in real estate investments makes them to lack market based prices arising the need for an expertise in the matter. (Rees and Hayward, 2000) The appraisal is usually undertaken by an approved valuer, whereby in many countries the valuers are legally certified, for example in Britain the valuer is known as valuation surveyor. However in various cases real estate valuers do not have certifications. The best use of a real property in the existing market validates the opinion of a valuer. A good example of a company in the valuation and appraisal of real estates is the Ryden Lettings based in Scotland it is one of the most reputed companies in letting and management of property they have letting offices branched un Glasgow and Edinburgh. The staff of Ryden is constituted of mostly professional appraisals and valuers. Ryden has founded its success in application of modern techniques in its operations as well as employing older values of the valuation and appraisal and valuation business. The company has a presently thriving business in residential properties. (News & Press 2010) Another prolific company in the real estates business is the Jones Lang LaSalle Global, according to this company’s case study the real estate business is moving a step further by becoming global energy use sensitive and environmental friendly this is given as an example by the Empire State Building Constructed in New York whose design ensures that energy usage cost is minimized by about $4.4 million thus making it more manageable and sustainable on the other hand it reduces carbon emissions in the atmosphere by 38%. This company partnered with Clinton Climate initiative, the Johnson Controls and Rocky Mountain Institute to devise methods and come up with a set of standards that can be taken by other construction businesses in the world. In another case in Scotland Jones Lang LaSalle are involved in a project to develop renewable and environmental friendly wind energy on a farm that covers25 000 acres in the Scottish highlands: a project led by a team of professionals in the energy field (Jones Lang La Salle 2009). 2 Valuations and Appraisal 2.1 Value and Price in Real Estates Market value and price are two distinct factors in appraisals of real estates. A market price is the worth offered for a given property in a specific transaction and may be affected by factors such as the interests of the buyer or prior agreements between the buyer and the seller; this would at some instances make the market price either higher or lower than the market value of a property. On the other hand market value is not affected by these factors. (Lins, Marcos Pereira Estellita et al. 2005) 2.2 Definition of Values in Real Estates Business In the field of real estate appraisal there are various definitions of the term value. The terms that are used in most a case in definition are; Investment value- this is the worth of a given investor in real estates and it is in many circumstances greater than the market value. Market value-this is the worth of the property in question in a competitive auction setting it is also known as fair value or open market value. According to the IVS it is the price that a property would exchange for on the same date of valuation whereby a buyer and a seller who are sound of mind and acting out of their will transact due to a prior fair marketing procedures (Cadman, Wilkinson and Reed, 2008) Value in use- NPV is given as the amount of cash flow that an investment produces for the investor at that given time; it is usually given by the value of a single user and is smaller than the market value. Liquidation value-this is a value given for an asset in different measures according to the authority of jurisdiction in the instance of bankruptcy. It usually analyzed as forced liquidation in appraisals. Insurable value-this is the value of an asset that is insured and is usually not inclusive of the site of the property. 2.3 Valuation Approaches There are three main approaches to valuation in real estate business which are usually independent to each other; in addition we have traditional methods of valuation. They are; 2.3.1 Income approach Considered as the most useful approach for valuation of properties that generate income it is applied in commercial properties where enough valuing data exists to provide for required variables. It directly shows features of ordinary market players and takes any income generated even if continuously as a capital. It employs Net Operating Income (NOI) in valuation, for example the use of Discounted Cash Flow (DCF) models which is applied in large income producing investment valuations. This approach enables establishment of the current value of a property by using the discount rates and the expected future cash flows. (Baum and Mackmin, 1995). 2.3.2 Cost approach Also known as summation approach , it has its based on the concept that real property’s value can be gotten by summing the lands value and the current value of the developments on it that is the depreciated value. It is known to be more useful when dealing with new developments rather than old ones and it’s the only applicable approach in cases such as public amenities. In most a cases this approach engages sales comparison approach for example in determining cost of a building one has to put into consideration the material cost, labor cost and land values which can only be determined by comparison of relevant data. 2.3.3 Sales comparison approach This method applies the idea of substitution whereby the appraiser measures and interprets the events of the market. The general assumption in this approach is that a reasonable buyer would not pay for a property more than a property of the same nature would go for. To enhance equal valuation the valuer should have sufficient data on the current sales of similar properties and follow the following steps in valuation, ensure they have needed standards of comparison, ensure the data they obtain is always correct and lastly make sure that value indications that conflict are reconciled. 2.3.4 Traditional approaches There have been grouping of valuation in the United Kingdom as per he following outlined methods: Investment method This is a comparison method since its variables are given by the market; it is employed in commercial and residential property that generates income. To ehance this method of valuation the estimated rental value, market given equivalent yield and passing income has to be known. Comparable Method This is the best example of sales comparison approach discussed earlier; it is applied where there is a very explicit evidence of immediate prior sales. Residual approach This method does not require many procedures since it is only applied in an empty land or one ready for development or redevelopment. Profits method This method is used in valuation of properties generating small incomes at a time for example hotels. Capitalization is carried out on the operations for three years using a relevant yield on the bases of the income statement of the property in question. Cost method This is the method is only applicable to the properties that are not sellable or bought on the market. 3 Valuations of Projects Using DCF The commonly used method in valuation of real properties is the discounted cash flow method. Other methods such as valuation ratios are a mere resemblance of DCF. In appraisal value of a property is defined as the benefits that the said property brings to the investor (Pietersz, 2009). This method abbreviated as DCF uses the principle of time value for money to make valuation of a property. The current worth of a property is estimated by discounting all foreseen or simply future cash flows. It employs weighted average cost of capital abbreviated as WACC to obtain discount to be applied on cash flows. This principle argues that Money has time value; that is, the delay in cash is a cost since it should have been profitably invested during the period of delay. This rate of discounting is taken to be free of any risk. The future cash flow usually exhibits some degree of risk of never coming to be therefore there is need to compensate the investor for that risk (Alastair, Hutchison 2005) 3.1 Discounted Cash Flow There are two types of cash flows these are; 3.1.1 Discrete cash flows In these kinds of cash flows present value is obtained from the Future Value FV which is given as DPV=\frac {FV}{(1+i)^n}={FV}{(1-d)^n} Where DPV is the value future cash flow presently FV is a given future nominal value of cash flow obtained as FV=DPV\cdot(1+i)^n i is the provided rate that covers for the delay and risk d is discounting rate given as i/(1+i) this should be subtracted at the beginning of the year not added at the end. n is the number of years of possible investment prior to determination of the future cash flows. There is an assumption in this way of determination that during the whole period of cash flows the rate remains the same. 3.1.2Continuous Cash Flows In these kinds of cash flows integration replaces summation in the discrete flows formula. 3.2 Example in Use of DCF A customer purchases a property at the beginning of the year at a cost of 1 000 000.she projects to sell the house for 1 500,000 at the end of the third year. The profit that she will accrue after the third year can be gotten by direct subtraction, that is 1 500 000-1 000 000 = 500 000 500 000 is the profit at the end of three years whereby it can be used to get the internal rate of return by amortizing the value for the years considered which gives an internal rate of return of about 14.5%. Computed as A =P (1+r) ^ Where A is the total amount after three years P is the purchasing price r is the internal rate of return ^ is the number of years projected. 1 500 000 =1000000(1+r) ³ therefore r = 0.145 Considering that three years are over since she bought the property then it is necessary to discount all cash flows from the sale, considering the risk in her investment. At the time when she purchases the property she could have opted to invest her money in treasury note which are usually guaranteed and can be put into liquidity any time she wanted, the governments notes which are considered risk free go at a rate of 5%. Since the money given in future is not as worth as the one given presently according to the principle of time value for money then we find the present value of the property using the DPV formula explained earlier we obtain the present value to be 1 295 800 approximately. The net present value is present value less the purchasing price, that is 1295 800 – 1000000 = 295 800. There are a lot assumptions and uncertainties in consideration of this investment these are that: the investor has deducted the expenses incurred on her investment in that three years period of investment, other factors such the locality of the property will not adversely affect the sale of the property, price appreciation will be either positive or stable as not to lower the expected selling price, and lastly there will be still be an existence of a good market liquidity of the property. People making these kinds of investments are risk sensitive people who would rather have low returns in their investment than risk losses. It should be noted that when an appraisal is considering many different future cash flows then they should account for all of them in discounting and getting the net present value. (Baum and Crosby, 2008) 4 Actual Projects Appraisal Using Discounted Cash Flow Scotland is a state in the United Kingdom and features highly in real estates business in the world with more than 570 overseas companies situated here. More than half of these real estate companies are from US and Canada. The interests in the localities of Scotland can be attributed to the serene it nature. Many international companies explore opportunities of securing an accommodation to set up their offices or other form of quarters in the cities or townships in Scotland. It is clearly evident that suitable locations for accommodation in town centers are no longer available are extremely rare to get therefore many valuers consider localities that are on the edge of these townships so as not to forego the benefits of being near the town such as availability of labor and other factor of production. Location of any accommodation in the outskirts of townships such as Edinburgh city, Glasgow and Aberdeen is perfectly feasible for any form of business. Below is consideration of three localities with different offers for investment. The locations of accommodation are considered to be of same suitability apart from the value of the investment (Reed Business Information Ltd, 1999). One George Street Glasgow A listed façade office development located in the centre of Glasgow and HF Ltd have already leased 1,144 m2 at £317.54 per square meters on a 15 years lease with 5 yearly rent reviews. The development contains a total of 11,800 m2 (127,000 ft2) of flexible space over nine floors. The developers are seeking to let the remaining space to tenants and sell as an investment. Current market capitalization rate for this property is around 7.25%, resulting in an implied growth rate of 3.15% per annum. A 10% target rate of return is assumed. The heritable interest price to be paid to acquire the property on One George Street, Glasgow is given as The amount of space to be rent is 11,800- 1144 = 10,656 m2 10656*317.54 = 3,383,706 + 0.05725*3,383,706 = 3,577,423 Year MR Rental Growth Expected MR PV/£ YP DCF @ 3.15% @ 10% 0 1.0000 5 3,383,706 1.1320 3,803,624 0.6209 2,361,670 10 3,383,706 1.3220 4,473,173 0.3855 1,724,408 15 3,383,706 1.5436 5,223,237 0.2394 1,250 443 Valuation 5,336,520 Refurbishment costs=950,000 Disposal costs=2.5*3, 383,706 = 84,592 Net value =5, 336,520 – (3, 577423+950,000+84,592) = 724,504 One Quarter mile Square, Edinburgh A building (designed by Foster and Partners) contains nearly 10,000 m2 (105,000 ft2) of high quality office space and 1,362 m2 (14, 660 ft2) of space with consent for retailing. This newly completed building was the first office building completed and is available to let although 1,362 m2 of the lower floor is now let to Pure Gym at £165 per m2. The rent, quoted on a net basis, is index-linked to the CPI for the duration of the 35 years lease and paid annually in arrears with the first installment due on 1st November 2010. The developers are seeking to let the remaining space to tenants and sell as an investment. You estimate a current gross initial yield of 6.85% and an implied growth rate of 2.45% per annum assuming a suitable target rate of return of 9%. Price to be paid for heritable interest to acquire the accommodation The amount of space available is 10,000- 1,362 = 8,638 m2 8,638 *165 = 1,425,270 + 0.05725*1,425,270 = 1,506,866 DCF valuation Cost of refurbishment = 750,000 Disposal costs = 0.025*1,425 270 = 35632 Investment worth =3, 381,115 – (1,506,866+750000+35632) = 1, 088,617 4.3 Gateway: Aberdeen. The accommodation in Aberdeen is a pre-designed development opportunity. The development site is fully serviced and located within an out-of-town business park, and has full planning permission for 14,544 m2 (156,555 ft2) of top quality business space spread over three storeys. Provisional negotiations reveal that the developers are prepared to lease the company the land on a long term grassum lease (99 years) for £3,600,000 on 27th January and undertake the development on our behalf. They estimated the development can be ready for occupation within 20 months of taking the lease and will cost £1,285 per m2 (of gross internal floor area) to develop the unit with current best practice sustainability and client specific features. The construction costs also include internal fitting out and external works but exclude professional fees, finance costs and developer’s return. The company expects to fund the development using equity capital at an expected return of 14%. Accommodation space available is 14,544 m2, land lease is 3,600,000 Total cost of development is given by 14544*1,285 +3,600,000 = 22, 289,040 The expected return is 14/100*22, 289,040 = 3, 120,466 Purchase costs = 0.0225*22, 289,040 = 501,503 The price for heritable interests in the accommodation is given by 22, 289,040+501503 = 22, 790,543 Refurbishment costs = 900,000 Disposal costs= 0.025*22289040=557,226 Investment worth = 3, 120,466-(501,503+900,000+557226) = 1, 161,737 On the recommendation to the company it is evident considering the worth of each investment that the best option in is the Aberdeen accommodation. Conclusion Considering the growing interest in the real estates business there should be a greater definition of the roles of the valuers and appraisals that should be well regulated by relevant jurisdictions. Investors should be keen in engaging the services of appraisers to ensure a sound decision in the event of making an investment. Researchers in real estates appraisal should come up with other factors to be considered and define them well and separately from monetary value in real property. Appendix APV………………………………………..Adjusted Present Value DCF…………………………………………Discounted Cash Flow DPV…………………………………………Discounted Present Value FV……………………………………………Future Value FTE…………………………………………Flow to Equity TCF………………………………………….Total Cash Flow WACC……………………………………….Weighted Average Cost Of Capital References Alastair, A, Hutchison, N (2005). "The reporting of risk in real estate appraisal property risk scoring" Journal of Property Investment & Finance (Emerald Group Publishing) 23 (3): 254–268. Retrieved on January 16 2010 from doi:10.1108/14635780510599467 Assimakopolulos, V, Pagourtzi, E & Hatzichristos, T (2003) Real Estate Appraisal: A Journal of Property Investment& Finance, Volume 21 Retrieved on January 15 2010 from http://www.emeraldinsight.com/Insight/viewContentItem.do;jsessionid=5573B54C3FF6B123A9AE2A5B2FA1387D?contentType=Article&contentId=845184 Baum, A. and Mackmin, D. (1995) The Income Approach to Property Valuation (3rd Edition). Routledge, London Baum, A. and Crosby, N. (2008) Property Investment Appraisal, 3rd Edition, Blackwell Publishing, Oxford. Brown, G. and Matysiak, G. (1999) Real Estate Investment: A Capital Market Approach. Financial Times, London Cadman, D., Wilkinson, S. and Reed, R. (2008) Property Development, 5th Edition, Routledge, Oxon. 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(2002) Property Valuation Principles, Palgrave, London Lins, Marcos Pereira Estellita et al. (2005). "Real Estate Appraisal: A Double Perspective Data Envelopment Analysis Approach". Annals of Operations Research (Springer) 138 (1): 79–96. Retrieved on January 15 2010 from doi:10.1007/s10479-005-2446-1 Pietersz, G, (2009) DCF Valuation. Retrieved on January 16 2010 from http://moneyterms.co.uk/dcf/ Reed Business Information Ltd. (1999), Estates Gazette:ISSN:0014-1240: Retrieved on January 26 2010 from http://www.faqs.org/abstracts/Real-estate-industry/Testing-times-Independent-minded.html Rees, W. and Hayward, R (ed.) (2000) Valuation: Principles into Practice (5th edition). Estates Gazette, LondonS Sayce, S. Smith, J., Cooper, R. and Venmore V. (2006) Real Estate Appraisal: from value to worth, Blackwell Publishing, Oxford. Read More