In This Issue:

Discounted Cash-flow Analysis

The market value of income-producing real estate is derived from two sources, namely the annual cash flow during ownership and the proceeds from resale at the end of the holding period. Discounted cash-flow analysis (DCFA) is an often-used technique for the conversion of such future benefits into an opinion of present value.

The use of DCFA was a laborious undertaking before computer-generated spreadsheets became widely available. If changes were made in the underlying assumptions, the task became even more daunting. Since computerization, the utilization of DCFA has become both far easier and more widespread.

The DCFA is a particularly important tool when cash-flow forecasts vary significantly during the period of ownership. Such variance may be attributable to unstabilized occupancy, significant lease expiration(s), and contract-rental rates significantly above or below market rates.

The DCFA tool is also useful to investors performing sensitivity analyses and solving for rates of return under specific sets of assumptions. Further, DCFA can be used to value partial interests (e.g., the mortgage interest and the equity interest).

Criticism of DCFA generally is based on the assertion that the numerous assumptions required are speculative forecasts that may or may not come to pass. However, such arguments are not well founded. Investors and lenders do in fact make such forecasts in arriving at pricing decisions. Thus, the proper use of the DCFA technique mirrors the thought processes of market participants.

The basic structure of the DCFA model reflects revenue, expenses and nonrecurring costs on a year-by-year basis. Application of the discount rate to such residuals results in the present value of the annual cash flow. The reversionary component is estimated by capitalizing net operating income (NOI) at the end of the holding period, deducting the cost of sale and applying the discount rate. The value estimate is thus the sum of the present worth of the annual cash flows and the reversion.

As noted above, numerous assumptions are necessary in the application of DCFA.

Current market rental rates: Such estimates are typically based on lease rates of similar properties and on recent leases within the property being valued.

Forecast absorption of currently vacant space until stabilization: Absorption is heavily influenced by the degree of equilibrium between supply and demand. This becomes particularly challenging during periods of considerable disequilibrium. Further, the timing of lease-up should be consistent with the characteristics of the property being valued.

For example, it is illogical to conclude that ownership of a single-tenant building will achieve revenue from lease-up on a gradual basis. In such a situation, revenue can be more realistically assumed to commence at the end of the forecast absorption period.

Lease expiration dates and the relative probability of renewal: Serious consideration must be given to the prospects for renewal of each tenant, particularly major tenants.

Forecast annual increases or decreases in market rent and expenses: The assumptions regarding rental increases are particularly important during periods of disequilibrium. One might conclude that rental rates will remain "flat" until balance returns and that "spikes" are likely once equilibrium returns to the market in which the property competes.

Lease concessions and tenant inducements (if any): Concessions are generally much higher during periods of limited unfulfilled demand. These may take the form of free rent, moving allowances and inordinately high tenant improvement allowances.

Existing contract rental rates and specified annual changes in same: Application of DCFA essentially requires that the specific terms of each lease be modeled.

Renewal-option terms: The relative attractiveness (or lack thereof) of renewal options from the tenants' perspective typically influences the probability of renewal.

Contractual and market-based expense recoveries: The reliability of the DCFA depends on the accuracy of the tenant-by-tenant recovery inputs.

Vacancy and credit loss: In DCFA models, vacancy and credit loss typically reflect structural vacancy. The model generally is based on the greater of unstabilized occupancy/expirations or general (structural) vacancy.

Fixed and operating expenses: Such estimates are based on both actual expenses of the property and expenses for comparable properties.

NOI: NOI is simply the residual difference between effective gross income and expenses on a year-by-year basis.

Non-annually occurring capital expenditures, including replacements, tenant improvements and leasing commissions: Capital expenditures include components such as roofs, HVAC (heating, ventilating and air-conditioning) systems, parking lot repairs and deferred maintenance. Tenant improvements and leasing commissions occur during absorption to stabilized occupancy and upon lease expirations.

"Exit" overall capitalization rate: This is the rate at which the reversion year NOI is capitalized. It is often greater than the "entrance" overall rate based on the logic that
  (a) the property will be older at the time of reversion and
  (b) market conditions at the time of reversion cannot be divined with any degree of certainty.

Selling costs at the end of the forecast holding period: This figure is reflected as a percentage and includes brokerage commission, as well as closing costs.

Discount (yield) rate: This rate is often derived from interviews with market participants and from published surveys of such investors.

DCFA is a valuable tool for valuation professionals, lenders and investors. Its proper usage depends on careful investigation of both the intrinsic elements of the property being valued and the expectations of investors for similar properties.

Entrepreneurial Profit

Entrepreneurial profit is defined as "a market-derived figure that represents the amount an entrepreneur receives for his or her contribution to a project and risk; the difference between the total cost of a property (cost of development) and its market value (property value after completion), which represents the entrepreneur's compensation for the risk and expertise associated with development" (The Appraisal of Real Estate, 13th edition). The operative word in the foregoing is "receives," in contrast with the term "entrepreneurial incentive," which represents what an entrepreneur expects to receive. The latter is prospective while the former is an accomplished fact.

The above source further differentiates profit into the following categories:

Project profit: The total remuneration for entrepreneurial coordination and the assumption of risk.

Entrepreneurial profit: The portion of the project profit attributable to the entrepreneur as distinct from the efforts of the developer,

Developer's profit: Compensation for the efforts of one other than the original entrepreneur.

Contractor's profit: An amount typically included as project overhead; not generally reflected in entrepreneurial reward.

In terms of the components of market-value hierarchy, entrepreneurial profit generally has last claim of all the agents of asset creation (i.e., behind materials, labor, land and capital).

In practice, developing opinions of appropriate entrepreneurial profit may be made difficult by the need to accurately abstract the other forms of profits described previously. Similarly, the estimation of entrepreneurial profit at various points in the developmental process can be quite difficult (i.e., at what point and to what degree is such profit earned?).

Because entrepreneurial profit has last claim on overall project profit, it cannot be said to exist unless the project in question is economically feasible.

Real Estate in the Current Economic Downturn

The current recession has negatively affected virtually all asset classes, including income-producing real estate (alternately referred to simply as "real estate," "income property" and "commercial property"). The following describes some of the reasons for decline, general investment characteristics of such property and likely changes as income property emerges from the current recession.

Real estate "bubbles," including that which recently occurred, involve high degrees of leverage (loan-to-value ratios), excessive and inexpensive debt capital and aggressive assumptions regarding revenue growth, all of which result in unsustainably high valuations.

One must also appreciate the fact that commercial real estate is directly influenced by an almost unknowable number of variables extrinsic to property. Such variables are local, national and international in nature.

One key variable is consumer spending, which accounts for more than two-thirds of U.S. economic activity. When consumer spending contracts, demand for retail property also declines.

A significant determinant of demand for commercial property is the growth or contraction in employment. Job growth and the resulting growth in spending by both consumers and businesses increase demand for office, retail, multifamily and industrial space.

In severe recessionary periods, it becomes quite apparent that commercial real estate has no intrinsic value. Rather, its value is proportional to the degree to which it satisfies the needs of users of such properties. Thus, the notion that real estate is a "hard asset," with all that this term implies, is spurious.

A significant but common, error in income property market analyses is the failure to fully consider the impact of marked decreases in demand. Many market participants place an inordinate focus on current and likely future changes in supply. However, the recession of 2001, as well as the current one, caused just such a demand contraction. Immediately prior to the onset of these recessions, supply and demand were in equilibrium.

In the aftermath of the current recession, we will likely see fundamental changes in the buying, selling and financing of income property.

Buyers will require higher investment returns for the following reasons:

Loan-to-value ratios will be lower as lenders seek to reduce their exposure to risk.

Interest rates will increase due to the massive increase in debt issued by the federal government. Because mortgage debt is tied to Treasury notes of similar term, increases in Treasury rates will result in higher rates for income property debt.

Yields on alternative investments (e.g., corporate bonds) will also increase. To compete for capital, real estate yields must increase accordingly.

Expectations of growth in income and value over the holding period will be tempered downward. Few observers expect robust increases for the foreseeable future.

The securitization of real estate debt must also change in order for such debt to return to favor with investors, Specifically, originators of securitized debt may be compelled to retain "B-piece" positions in such issues; investors will demand this alignment of interests. Heretofore, originators typically had no exposure to defaults on loans they made.

While commercial real estate will almost certainly be subject to "bubbles" at some point in the future, the recently learned hard lessons will likely temper expectations for commercial real estate for years to come.

Indirect Costs

Indirect costs, also called "soft costs," are "expenditures or allowances for items other than labor and materials that are necessary for construction but are not typically part of the construction contract. Indirect costs may include administrative costs; professional fees; financing costs and the interest paid on construction loans; taxes and builders' or developer's all-risk insurance during construction; and marketing, sales and lease-up costs incurred to achieve occupancy or sale"
(The Appraisal of Real Estate, 13th edition).

Indirect costs may be fixed, variable or semi variable. In order to comprehensively estimate such costs, a detailed breakdown is recommended.

When relying on cost-estimating services, the valuation professional must clearly understand which indirect costs are included or excluded. When relying on actual and/or budgeted project costs, care also must be taken to ensure the accurate estimation of indirect costs.

Like the physical components of a property, both indirect costs and entrepreneurial profit depreciate over the economic life of the asset.

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