Apartment Investing Case Study

In this article we are going to conduct an investment analysis on a 140 unit apartment building acquisition. We’ll walk through the process of forecasting cash flows and also explain the calculations needed to determine investment value. Read on as we take a deep dive into the world of apartment investing.

Apartment Investment Case Study Objectives

First, before we jump into the details of this investment analysis, let’s quickly go over our objectives. Here’s what we’ll accomplish in this case study:

• Forecast the before tax cash flows over a 5 year holding period for a 140 unit apartment building.
• Calculate the maximum supportable loan amount based on the debt service coverage ratio and the loan to value ratio.
• Calculate the gross rent multiplier.
• Calculate the cash on cash return.
• Calculate the debt service coverage ratio.
• Complete a discounted cash flow analysis to determine the levered and unlevered internal rate of return (IRR) and net present value (NPV).
• Stress test the vacancy rate to analyze how it impacts cash flow.
• Stress test the vacancy rate to analyze how it impacts the debt service coverage ratio.
• Stress test the loan interest rate to analyze how it impacts the debt service coverage ratio.

Apartment Investment Case Study Scenario

An investor is considering buying an apartment building with 140 units offered for sale at $16,500,000. The subject apartment building has the following unit mix: 

Additionally, the following assumptions are also being made by the investor in order to construct a 5-year cash flow proforma:

Vacancy and Credit Loss
In the current market, vacancy and credit losses are running at 9%. Due to the improving market conditions as well as the investor’s prior experience leasing and operating multifamily buildings, it’s expected that vacancy will steadily decline over the next 5 years to 5%.

Potential Rental Income
Potential rental income is based on the above unit mix. The 1-bedroom and studio rental rates are expected to increase at 2% annually. The 2-bedroom units are also expected to increase at 2% annually.

Financing
After a preliminary discussion with a relationship manager at a local bank it’s determined that a loan can be extended based on the lesser of a 1.25x debt service coverage ratio or 80% loan to value. Additionally, assuming the underwriting process doesn’t reveal any red flags, it’s expected that the loan will be based on a 20 year amortization and a 6% interest rate.

Operating Expenses
The following table breaks out historical operating expenses for the property as well as projected increases over the holding period.

Reserves for Replacement
In addition to the above operating expenses a reserve for replacement of $250 per unit will also be included in this analysis.

Sales Price and Cost of Sale
The projected sale price is estimated by applying a conservative 3% annual growth rate to the acquisition price of the property over the 5 year holding period. Additionally, a 6% cost of sale is factored into the net sales proceeds to account for selling costs.

Acquisition Costs
In addition to the $16,500,000 purchase price, an additional $50,000 is factored in to account for closing costs.

Discount Rate
For the purposes of this case study we’ll assume that the investor’s discount rate, or required rate of return, is 15%.

Apartment Investment Proforma

Using the above assumption we can now build a proforma for the proposed apartment investment property. This can be accomplished in Excel in a few hours, or in our case we did this entire analysis in less than 10 minutes.

Now that we have a 5 year proforma, let’s take a look at what the maximum supportable loan amount is based on these cash flows. Using the above 1.25x DSCR and 80% LTV assumptions we get the following:

As shown above, the maximum loan analysis based on year 1 proforma NOI is about $12,250,000. Assuming we can get this loan amount approved at the 6% rate amortized over 20 years, this is the updated proforma:

You’ll notice that the debt we added to the property reduced our cash flow significantly, however, this also reduces our equity requirement and therefore improves yield. We’ll discuss this in more detail below, but first let’s take a look at some quick ratios:

Year 1 cash on cash return is 6.14%. At first glance this is well below our target rate of return of 15%, However, because the cash on cash return only takes into account a single year instead of the entire holding period, the IRR and NPV below will be much more relevant for our purposes.

The gross rent multiplier is 7.58x, which taken by itself doesn’t mean much. However, assuming we have some other submarket data to compare this to we can check whether or not it’s in line with comparable properties. The important take away here is to check whether or not the gross rent multiplier is abnormal, and if so, to further investigate why.

The debt service coverage ratio is in line with the bank’s requirement of 1.25x and improves over the holding period. This is partially due to our assumption of increasing occupancy over our investment horizon, as well as increasing rental rates. We’ll stress test these assumptions further below, but at first glance the DSCR is adequate for this deal.

Finally, the breakeven occupancy on this property is just under 79%. This means total vacancy can go up to 21% and the property will still produce enough cash flow to cover expenses and debt service. Good to know.

Apartment Discounted Cash Flow Analysis

Screening this property with the above ratios is a good starting point, but ultimately a full discounted cash flow analysis should be completed to determine IRR and NPV:

As you can see above, the levered internal rate of return comes in at 18.65%. While the above Year 1 cash on cash return didn’t meet our required rate of return of 15%, the full discounted cash flow analysis shows that the yield on this investment comfortably exceeds our target return. In fact, the net present value tells us that we can pay about $650,000 over the asking price and we’ll still achieve our target yield. This can come in handy during negotiations, especially in a competitive bidding situation.

Apartment Investment Sensitivity

So after a quick first pass it appears that this potential acquisition meets our target yield based on some reasonable assumptions. However, what if our assumption of a declining vacancy rate, from 9% in Year 1 to 5% in Year 5, turns out to be overly optimistic? Let’s take a look at what we deem to be a worst case scenario – that the market vacancy rate actually deteriorates after we acquire the property to 15%, rather than the current 9%. How will this impact our IRR?

While a worse than expected vacancy rate does reduce our cash flow, it turns out that we’d still achieve our target yield of 15%. What about the debt service coverage ratio? Will a higher than expected vacancy rate violate our 1.25x DSCR loan covenant? Let’s take a look at what happens to the debt service coverage ratio as we move from a 6% vacancy rate all the way up to a 20% vacancy rate:

As shown above, in Year 1 we actually can’t support a 1.25x DSCR requirement at a vacancy rate of 10%. While this does improve over the holding period, this could be problematic for us if the market turns out worse than expected. This could also be discovered during the loan underwriting process, resulting in a lower loan amount or stronger loan covenants. This information might come in handy during negotiations.

Next, let’s take a look at how sensitive our DSCR is to our loan interest rate. This is useful in understanding how much wiggle room there is in negotiating the interest rate with our bank, as well as understanding how capital market conditions might affect the buyer of our property at the end of the holding period.

As shown above, 6% appears to be the upper limit loan interest rate based on Year 1 cash flow. Once the rate gets beyond 6% it starts eating into our 1.25x DSCR requirement. However, in subsequent years, assuming we hit our projections, the property can support a much higher interest rate based on the same loan amount. This provides some cushion toward the end of our holding period, in case the then prevailing market conditions change and interest rates rise.

Conclusion

While there are several different angles you can look at when underwriting a potential acquisition, this simple case study illustrates a few core concepts. First, sizing up a loan amount based on proforma cash flow. Second, calculating and interpreting several quick but useful ratios. Third, understand whether or not an acquisition meets a target yield. And finally, understanding how changes in our assumptions affect our resulting cash flow and underwriting ratios. While there are several additional layers of analysis we can dive into for a property like this, the above analysis gives us a good starting point for screening this particular property.

 

Source: Apartment Investing Case Study

https://www.creconsult.net/market-trends/apartment-investing-case-study/

Difference Between Market Value and Investment Value in Commercial Real Estate

Value is traditionally defined as the power of a good to command other goods or services when exchanged. Within this broad definition of value, there are various types of value given to real property, such as investment value, market value, insurable value, assessed value, liquidation value, or replacement value. In this article we’ll go over different types of real estate value, and then zero in and focus on the difference between investment value and market value, which is often confused by commercial real estate professionals.

Types of Real Estate Value

First of all, let’s briefly go over several common types of commercial real estate value, then we’ll dive into the difference between investment and market value and clarify with an example.

Market Value is what’s typically meant when referring to a property’s value and is the value used for loan underwriting purposes. The Appraisal Foundation has a specific definition for market value as published in the Uniform Standards of Professional Appraisal Practice (USPAP). According to the Appraisal Foundation, market value is the most probable price a property would bring in a competitive and open market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimuli.

Investment Value refers to the value to a specific investor, based on that investor’s requirements, tax rate, and financing.

Insurable Value – This covers the value of the portions of a property that are destructible for the purposes of determining insurance coverage.

Assessed Value – Assessed value is the value determined by the local tax assessor to levy real estate taxes.

Liquidation Value – Liquidation value establishes the likely price that a property would sell for during a forced sale, such as a foreclosure or tax sale. Liquidation value is used when there is a limited window for market exposure or when there are other restrictive sale conditions.

Replacement Value – This is the cost to replace the structure with a substitute structure that is identical or that has the same utility as the original property.

A property can have any of the above types of value at any given time, with no two values necessarily being the same. This is an important point to remember when trying to understand the value of a commercial real estate property. This is especially true when determining market value and investment value.

Approaches to Market Value

Market value is what’s determined by an appraisal. During the commercial loan underwriting process, most lenders will require a third-party appraisal in order to determine a market value estimate, which is then used to find an appropriate loan amount and collateral value.

How do appraisers determine market value? First, before a market value can be estimated by an appraiser, the highest and best use for the property must be determined. The highest and best use is the legal use of a property that yields the highest present value. This process usually begins with evaluating the zoning laws to understand the legally permitted uses for the property.

Once the legally permitted uses are understood, the physically possible uses are then considered, within the bounds of the zoning ordinances. This takes into account the physical limitations of the property such as topography, size, layout, etc.

Finally, the financial feasibility is considered for all of the uses that are legally permissible and physically possible. The financially feasible use that produces the highest financial return is the highest and best use.

Once the highest an best use is determined, the appraiser can then determine market value. Appraisers may use three basic approaches to estimate market value: the sales comparison approach, the cost approach, and the income approach, using either the Direct Capitalization Method or the Discounted Cash Flow Model. We discuss each of these approaches in detail here, but below we’ll briefly summarize.

Sales Comparison Approach
The sales comparison approach links the value of a property to prices that recent buyers have paid for similar properties. In reality no two properties are exactly alike, but this approach can provide a reasonable estimation of value when there is a large quantity of recently sold comparable transactions.

Income Capitalization Approach
The income based approach to market value derives property value from the income it produces. The two methods used to value a property based on income are the direct capitalization method and the discounted cash flow valuation method.

Cost Approach
The cost approach bases value on the cost of reproducing a property, less any accrued depreciation. Accrued depreciation can come from three sources: physical deterioration, functional obsolescence, and external obsolescence. Once the replacement cost is determined and the accrued depreciation is netted out, the cost is added to the value of the land to determined an appropriate value based on cost.

Reconciliation of Value
In a full appraisal the above values are typically reconciled by using a weighted average to determine the final value estimate. For example, it may be determined that a higher weight should be given to the income approach because the available comparable sales data is weak, and as such this would be reflected in the final reconciled market value.

Approaches to Investment Value

While the market value process is usually used in appraisals for loan underwriting purposes, when deciding how much to pay for a property, investors also consider how much a property is worth. Investment value is the amount that an investor would pay for a specific property, given that investor’s investment objectives, including target yield and tax position.

Because investment value depends on an investor’s investment objectives, investment value is unique to the investor. As such, different investors can apply the same valuation methods and still come up with different investment values. Investors can choose from a variety of valuation methods when determining investment value, unlike appraisers who have to adhere to strict procedural guidelines. The following are the most common measures of investment value:

Comparable Sales (Comps) – This is the same sales comparison approach mentioned above that is used by appraisers. Typically investors will compare similar properties on a per square foot or per unit basis.

Gross Rent Multiplier – This is a simple ratio that measures investment value by multiplying the gross rents a property produces in a year by the market based Gross Rent Multiplier (GRM). The gross rent multiplier is usually derived from comparable properties within the same submarket.

Cash on Cash Return – The cash on cash return is another simple ratio used to determine investment value. It’s calculated by taking the first year’s proforma cash flow before tax and dividing it by the total initial investment.

Direct Capitalization – This is the same direct capitalization approach mentioned above that is used by appraisers. Capitalizing the income stream of a property is a very common and simple way to determine both market and investment value for a commercial property.

Discounted Cash Flow – The discounted cash flow model is used to find an internal rate of return, net present value, and a capital accumulation comparison. While the simple ratios above are quick and easy, they do come with several built-in limitation that are solved by a discounted cash flow analysis.

Investment Value vs Market Value

As shown above, market value is essentially the value of a property in an open market and is what’s determined by an appraisal. Investment value, on the other hand, is determined by an individual investor based on that investor’s unique investment criteria and goals.

Let’s take a quick example to illustrate this difference. Suppose an individual investor is contemplating the acquisition of a small apartment building and has projected the following cash flows:

As shown above, using the investor’s discount rate of 10%, the property generates a levered NPV of $210,820. This property is under contract with a total purchase price of $1,200,000 but the above analysis implies the investor could pay up to $1,410,820 and still achieve the target yield. Check out the intuition behind IRR and NPV to learn more about how this works.

The above levered analysis assumes that the investor can obtain a $960,000 loan (80% loan to value), amortized over 20 years at 5%. But suppose that during the underwriting process the bank orders a third-party appraisal and it comes in at $1,000,000 rather than the $1,200,000 the investor is paying. This also reduces the supportable loan amount to $800,000 (based on an 80% LTV) rather than the anticipated $960,000. Unfortunately, in this scenario it turns out that the seller refuses to sell for less than $1,200,000. In other words, this is an above market transaction where the investment value is higher than the market value. Does it still make sense to do the deal?

Let’s take a look at what the new cash flows look like to the investor in this new loan scenario:

As shown above the new loan amount reduces the yield to 16% from 22%. But this still exceeds the investor’s required return of 10%. So, does it make sense to do the deal? As always, it depends.

In most cases the investment value and the market value should be approximately equal, but sometimes these two values will diverge. On the one hand investment value can be higher than market value. This can happen when the value to a particular buyer is higher than the value to an average, well-informed buyer. For example, this might be the case when a company expands to a new building for sale across the street, paying more than market value in order to keep competitors out of the sub-market. The additional value over and above the market value provides a strategic advantage and therefore might be justified. In the case of an investor, investment value could sometimes be higher than market value due to favorable financing terms or tax treatment that is non-transferable.

On the other hand, investment value can be lower than market value. This might be the case if the particular asset class in question is not a property type that you specialize in. For example, if you are primarily a multifamily developer, then decide to evaluate a site for possible hotel development, your internal investment value may be less than the market value due to the steeper learning curve costs involved. Additionally, investment value could be lower than market value if you require an above-average return based on your existing portfolio mix. In these cases it can sometimes be tempting to pursue a deal even though investment value is less than market value. In these cases think carefully before getting distracted by something that might not make sense.

Conclusion

The safest policy is of course to make sure a transaction makes sense both from an investment value perspective as well as a market value perspective. Keep in mind that investment value is much more subjective than market value, and as such it can be abused. To avoid falling victim to investment value abuse, it’s best to always estimate market value whenever a relevant market exists.  Be especially skeptical if someone claims that investment value differs from market value in a way that supports his or her sales pitch. They might be right, but as the saying goes, trust but verify.

 

Source: Difference Between Market Value and Investment Value in Commercial Real Estate

https://www.creconsult.net/market-trends/difference-between-market-value-and-investment-value-in-commercial-real-estate/

Price Gap Between Rent and Home Ownership in Chicago

The price gap between average apartment rents and the cost of owning a home in the Chicago metro area is widening, providing landlords with leverage to push rents even higher.

According to a recent report by RentCafe, the average rent in Chicago is now $2,215 per month. This is significantly higher than the cost of owning a home, which is currently $1,950 per month, including mortgage payments, property taxes, and insurance.

The widening price gap is being driven by a number of factors, including rising interest rates and strong home values. As interest rates have increased, the monthly cost of owning a home has become more expensive. At the same time, home values in Chicago have continued to rise, making it even more difficult for first-time homebuyers to enter the market.

The widening price gap is giving landlords more leverage to push rents. With fewer people able to afford to buy a home, demand for rental housing is increasing. This is putting upward pressure on rents, and landlords are starting to see more success in raising rents.

The widening price gap is also having an impact on multifamily net operating income (NOI). NOI is the money that a multifamily property generates after paying all of its operating expenses. As rents increase, NOI also increases. This can help to offset the higher commercial mortgage interest rates that landlords are facing.

In the long term, it is unclear whether the widening price gap between rent and home ownership will continue. However, in the short term, it is likely to continue to put upward pressure on rents and boost multifamily NOI.

Bottom Line

The price gap between rent and home ownership in Chicago is widening, providing landlords with leverage to push rents even higher. This is being driven by rising interest rates and strong home values. The widening price gap is also having an impact on multifamily NOI, which is likely to increase in the short term.

https://www.creconsult.net/market-trends/price-gap-between-rent-and-home-ownership-in-chicago/

Net Operating Income (NOI): A Beginner's Guide

Understanding Net Operating Income (NOI) is essential in commercial real estate. Without a firm grasp of net operating income, commonly referred to as just “NOI”, it’s impossible to fully understand investment real estate transactions. In this article, we’ll take a closer look at net operating income, discuss the components of NOI, and also clear up some common misconceptions.

What is Net Operating Income (NOI)

Net operating income (NOI) is the most widely used performance metric in commercial real estate. What is NOI in real estate? The net operating income is defined as the total operating income for a property minus the total operating expenses for a property.

The net operating income is useful because it describes a property’s ability to generate income without considering its capital structure. Since different owners will have different capital structures and financing costs, the NOI enables evaluation of property performance before taking any of these owner-specific factors into account.

The net operating income is often referred to as “the line” because operating expenses are calculated “above the line” while capital expenditures and leasing costs are “below the line” items.

Net Operating Income Formula

Net operating income (NOI) is the income generated by a property minus all expenses incurred from operations. The basic net operating income formula is as follows:

Depending on the property type or the parties involved, there is often some nuance in how the net operating income is calculated. For example, a multifamily property will have property-specific line items such as the loss to lease, while an office building will have line items for tenant reimbursements. In any case, at a high level, the net operating income formula is the same and measures operating income minus operating expenses.

NOI Meaning

NOI means Net Operating Income and measures the net income generated by a property before considering any owner-specific expenses such as financing. Net operating income is positive when effective gross income exceeds operating expenses, and negative when operating expenses exceed effective gross income.

For the purposes of real estate analysis, NOI can either be based on historical financial statement data, or instead based on forward-looking estimates for future years, which is also known as a proforma.

Net operating income measures the ability of a property to produce an income stream from operations. Unlike the cash flow before tax (CFBT) figure calculated on a real estate proforma, the net operating income figure excludes any financing or tax costs incurred by the owner/investor. In other words, the net operating income is unique to the property, rather than the investor.

Net Operating Income and Lease Analysis

The vast majority of commercial real estate income is generated by contractual tenant leases. Before we go over each of the components of NOI in more detail, let’s first take a quick detour into the world of commercial real estate leases.

Lease analysis is the first step in analyzing any income-producing property, since it identifies both the main source of income and who pays for which expenses. As you can see from the net operating income formula above, understanding this is essential to calculating NOI.

While there are many industry terms for different real estate leases, such as the modified gross lease, triple net lease, or the full-service lease, it’s important to understand that these terms can have various meanings depending on who you are talking to and which part of the world you are in. That’s why it’s critical to remember that the only way to understand a lease is to actually read it.

At a high level, leases can be viewed on a spectrum of possible structures.

On the one hand, you have absolute gross leases where the owner pays all the operating expenses related to the property. On the other hand, you have absolute net leases, where the tenant is required to pay all operating expenses. Everything else falls in between these two extremes and is considered a negotiated or hybrid lease.

How to Calculate Net Operating Income (NOI)

Calculating net operating income is relatively straightforward once you break out each of the individual components. The major components of net operating income consist of potential rental income, vacancy and credit losses, other income, and operating expenses.

Potential Rental Income – Potential Rental Income is the sum of all rents under the terms of each lease, assuming the property is 100% occupied. If the property is not 100% occupied, then a market-based rent is used based on lease rates and terms of comparable properties.

Vacancy and Credit Losses – Vacancy and credit losses consist of income lost due to tenants vacating the property and/or tenants defaulting (not paying) their lease payments. For the purposes of calculating NOI, the vacancy factor can be calculated based on current lease expirations as well as market-driven figures using comparable property vacancies.

Effective Gross Income – Effective Gross Income (EGI) in the net operating income formula above is simply potential rental income less vacancy and credit losses. EGI is the amount of rental income that the owner can reasonably expect to collect from a property.

Operating Expenses – Operating expenses include all cash expenditures required to operate the property and command market rents. Common commercial real estate operating expenses include real estate and personal property taxes, property insurance, management fees (on or off-site), repairs and maintenance, utilities, and other miscellaneous expenses (accounting, legal, etc.).

Net Operating Income – As shown in the net operating income formula above, net operating income is the final result, which is simply effective gross income minus operating expenses.

Although these are the high-level line items used to calculate NOI, the format of a real estate proforma can vary widely depending on the property type, intended use, sophistication of the parties involved, and more. For more complicated net operating income calculations, you might consider using our commercial real estate analysis software.

What’s Not Included in Net Operating Income

It’s also important to note that there are some expenses that are typically excluded from the net operating income figure.

Debt Service – Financing costs are specific to the owner/investor and as such are not included in calculating NOI.

Depreciation – Depreciation is not an actual cash outflow, but rather an accounting entry, and therefore is not included in the NOI calculation.

Income Taxes – Since income taxes are specific to the owner/investor, they are also excluded from the net operating income calculation.

Tenant Improvements – Tenant improvements, often abbreviated as just “TI”, include construction within a tenant’s usable space to make the space viable for the tenant’s specific use.

Leasing Commissions – Commissions are the fees paid to real estate agents/brokers involved in leasing the space.

Reserves for Replacement – Reserves are funds set aside for major future maintenance items, such as a roof replacement, or air conditioning repair. While the textbook definitions of NOI usually exclude reserves from the NOI calculation, in practice many analysts actually do include reserves for replacement in NOI. For example, most lenders will include reserves for replacement into the NOI calculation for determining debt service coverage and the maximum loan amount. This makes sense because lenders need to understand the ability of a property to service debt, which of course has to consider required capital expenses to keep the property competitive in the marketplace. To see how much confusion and disagreement there is on this, just take a look at all the various answers you see here on this Reddit thread.

Capital Expenditures – Capital expenditures are expenses that occur irregularly for major repairs and replacements, which are usually funded by a reserve for replacement. Note that capital expenditures are major repairs and replacements, such as replacing the HVAC system in a property. This does not include minor repairs and maintenance which are considered an operating expense, such as replacing doorknobs and lightbulbs.

While many of the above items are almost always excluded from net operating income, it’s important to remember that some are open to interpretation depending on the context. Keep this in mind when building your own proformas and when evaluating NOI calculations performed by others.

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Net Operating Income Example

The following is an example of a typical real estate proforma that would be commonly used by lenders, investors, developers, brokers and appraisers. It breaks out how net operating income is calculated and presented for an example warehouse property.

The net operating income line is calculated by deducting vacancy and credit loss from potential gross income, then subtracting out all operating expenses. Notice that the debt service and replacement reserves are not included in the NOI calculation.

Net operating income projections like this are regularly created by appraisers and other commercial real estate professionals. Once you have a projection of net operating income you can then calculate property level metrics such as the capitalization rate, yield on cost, development spread, IRR, NPV, and more.

Conclusion

Calculating NOI is an important step in evaluating and valuing a property. Once you have an NOI figure, you can begin looking at various measures such as the cap rate or a maximum loan analysis. Then you can also move on to a more detailed analysis that includes a bottom-line cash flow figure and a full discounted cash flow analysis.

Keep the above NOI formula in mind when calculating and reviewing NOI figures, and also be aware of what’s included and excluded from NOI, and you’ll have a good framework for understanding net operating income for any property.

 

 

Source: Net Operating Income (NOI): A Beginner’s Guide

https://www.creconsult.net/market-trends/net-operating-income-noi-a-beginners-guide/

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How a Broker Price Opinion Works

The broker price opinion (BPO), also known as a broker opinion of value (BOV), is a popular way of estimating the value of a property. Typical reasons for ordering a broker price opinion include estimating value prior to purchase or sale, understanding collateral value when securing a new loan or refinancing, estimating liquidation value, buying out a partner’s interest in a property, among many others. In this article we’ll take a deep dive into the broker price opinion, review the three approaches to market value, and also clear up some common misconceptions about the broker price opinion.

Broker Price Opinion Template

Before we dive in, we have a handy broker price opinion template that you can use to build your own reports. It’s based on Microsoft Word, so you’ll be able to edit the details as you see fit. Grab it now, then follow along with the rest of the article.

Broker Price Opinion vs Appraisal

The primary difference between a broker price opinion and an appraisal is cost. Because a broker price opinion is less comprehensive, it is usually a fraction of the price of a full appraisal. It’s also important to note that an appraisal is provided by a third-party and is not biased in its estimate of market value. On the other hand, a broker price opinion is typically performed with the intent that the broker will ultimately win the listing, and as such the underlying motivations behind a broker price opinion may be different than that of an appraisal.

Broker Price Opinion State Regulations

It’s important to understand that regulations around broker price opinions are by no means uniform and vary by state. For example, some states only allow broker price opinions to be performed for very specific use cases such as an opinion on a competitive listing price, but not for other use cases such as a tax appeal. Different states have different regulations regarding broker price opinions and explicitly listing out all of these different regulations is beyond the scope of this article. It goes without saying that you should contact a lawyer before performing or ordering broker price opinions in your state to make sure you understand what, if any, restrictions exist.

Approaches to Market Value

The purpose of a commercial real estate valuation is to determine fair market value, which is the most probable price a willing and knowledgeable buyer would pay for a property given a reasonable amount of time to complete the transaction. Before we dive into the components of a typical broker price opinion report, let’s quickly go over the three primary methods used to determine market value.

Sales Comparison Approach
The sales comparison approach equates the value of a property to prices that buyers have historically paid for similar properties. Of course, in practice, no two properties are exactly alike. Typically the sales comparison approach takes into account comparable properties that were sold within the prior 6-12 months. This is arguably the most common method of real estate valuation and consists of the following steps:

1. Find comparable properties
2. Adjust the comparable properties found for each variance
3. Net the adjustments
4. Select the value, giving a greater weight to the properties with the most similarities

Overall the sales comparison method is most effective when the pool of available recently sold properties is large.

Income Capitalization Approach
The income based approach to market value is based on the idea that a property’s value is derived from the income it produces. The two methods used to value a property based on income are the direct capitalization method and the discounted cash flow valuation method.

The direct capitalization method simply converts a one-year stabilized net operating income (NOI) into a market value using a cap rate. This is done using the IRV formula which states that Value (V) = Income (I) / Capitalization Rate (R). To use this method you simply construct a proforma NOI and divide it by the appropriate cap rate (which is determined from recently sold comparable properties). If there aren’t any or enough recently sold comparable properties then the cap rate can be constructed using other methods such as the band of investment method.

The discounted cash flow valuation method is used when uneven cash flows are anticipated for a property. With uneven cash flows, the more simplistic direct capitalization approach does not take into account these variations in cash flow, and as such is not adequate.

Cost Approach
The cost approach bases value on the cost of reproducing a property, less any accrued depreciation. Accrued depreciation can come from three sources: physical deterioration, functional obsolescence, and external obsolescence.

Physical deterioration is the regular wear and tear that occurs due to exposure to the elements.

Functional obsolescence refers to the inablilty of an existing building to provide the same utility as a newly constructed building. For example, the ceiling height in an existing warehouse may not meet the requirements of modern day users, which could be easily accommodated with a newly constructed building.

External obsolescence refers to the loss of value due to external forces such as road closures, re-routed highways, traffic congestion, etc.

Once the replacement cost is determined and the accrued depreciation is netted out, the cost is added to the value of the land to determined an appropriate value based on cost. The reason why the cost approach is used is because a rational buyer would not pay more for an existing property than it would cost to construct a new building with equal utility. The primary limitation of the cost approach is that it does not reflect the forces of supply and demand, and as such, it is typically used when there is a lack of comparable properties.

Reconciliation of Value
In a full appraisal, and often times in a broker price opinion, the above values are typically reconciled by using a weighted average to determine the final value estimate. For example, it may be determined that a higher weight should be given to the income approach because the available comparable sales data is weak, and as such this would be reflected in the final reconciled value.

Also, it’s worth noting that in practice the cost approach is usually not considered in a broker price opinion. A broker price opinion typically only considers the sales comparison method and the income based approach.

Components of a Broker Price Opinion Report

While each individual broker price opinion report will vary based on the requirements of each specific property, the following components are commonly used in broker price opinion reports. Also, be sure to grab our broker price opinion template which includes sections for the below items.

Location Information – General information about the location of the property, including address, site map, aerial, building type and size.

Description of Site – More detailed information about the site, including ownership, visibility, and access.

Market Area Overview and Trends – Includes information about the market conditions of the trade area including employment growth, population growth, construction/development activity, trends in vacancy and lease rates, commentary on noteworthy local news, as well as a demographic summary and traffic count if applicable.

Subject Property Condition –  More detailed description of the subject property as well as commentary on its condition.

Tenant Information – A discussion of each of the tenants occupying the property including lease terms, lease expiration, industry, etc.

Current Comparable Listings – Photos and analysis of three or more current for sale listings of comparable properties.

Recent Comparable Sales – Photos and analysis of three or more recent comparable sales, including adjustments as well as a discussion of similarities and differences.

Proforma – A stabilized or multi-year proforma for the subject property showing Gross Potential Income, Expenses, and Net Operating Income (NOI).

Range of Market Values – This section should summarize the above sales comparison and proforma data by providing an estimated range of values based on the sales comparison approach and the income approach to value.

Broker Marketing Plan – While this section is not necessary, it is often included by the broker in hopes of winning the listing. This section includes a marketing action plan to market and ultimately sell the subject property.

Closing Thoughts on the Broker Price Opinion

The broker price opinion has become popular in recent years during the recession and banking crises, and due to the increased attention it will likely remain a popular way to estimate market value. While each individual broker price opinion will vary depending on the particular needs of the client and attributes of the property, the above framework should give you a good foundation for understand any broker price opinion.

Source: How a Broker Price Opinion Works

https://www.creconsult.net/market-trends/how-a-broker-price-opinion-works/

Akhan Semi

Absolute NNN Leased Industrial | Akhan Semiconductor
940 Lakeside Drive | Gurnee, IL 60031
Exp Commercial is proud to present to market an excellent opportunity to acquire an absolute NNN-leased state-of-the-art industrial manufacturing facility with zero landlord responsibilities at a below-market price with future upside in market rents and potential tenant expansion.
Listing Agent: Randolph Taylor 630.474.6441 | rtaylor@creconsult.net
https://www.creconsult.net/absolute-nnn-leased-industrial-akhan-semiconductor-gurnee-il/