Valuation Practice

Sample Solution

Real Estate Exercise Answers and Explanations

Please note: These answers are based on the information provided in the questions and may not be exhaustive. It is always recommended to consult with a qualified professional for specific real estate advice.

Question 1:

Analysis of Cap Rates:

Transaction 1:

• Purchase price: $3.4 million
• Building size: 1,700 sq ft
• Price per sq ft: $2,000
• Initial gross rent: $9 psf
• Annual gross rent: $180,000 (1,700 sq ft * $9 psf * 12 months)
• Renovation cost: $300,000
• Effective gross rent: $150,000 ($180,000 - $300,000 / 80 years)
• Cap rate: 10% ($150,000 / $3.4 million)

Transaction 2:

• Purchase price: $4.18 million
• Building size: 1,900 sq ft
• Price per sq ft: $2,200
• Gross rent: N/A (property is vacant)
• Cap rate: N/A (no rent information)

Direct Capitalization Valuation:

• Estimated gross rent for Mr. A's property: $144,000 (1,800 sq ft * $8 psf * 12 months)
• Market cap rate based on Transaction 1: 10%
• Estimated market value: $1.44 million ($144,000 / 0.1)

Full Answer Section

Assumptions:

• The two transactions are truly comparable in terms of location, quality, and amenities.
• The rent in Transaction 1 reflects the current market conditions.
• The cost of renovations in Transaction 1 was reasonable and necessary.

Question 2:

Information Needed:

• Building age and condition
• Tenant creditworthiness
• Remaining lease term
• Operating expenses
• Market vacancy rate for similar properties
• Recent sale transactions of comparable properties

Market Cap Rate Valuation:

• Market value = Net Operating Income (NOI) / Market Cap Rate
• Calculate NOI by deducting operating expenses from gross rent.
• Use the market cap rate of 3.4% for similar properties.

Investor A's Required Return Valuation:

• Discounted Cash Flow (DCF) analysis is suitable for this scenario.
• Estimate future cash flows (rent) based on the lease term and assumptions about rent growth.
• Discount the cash flows to present value using Investor A's required return of 9%.
• The sum of discounted cash flows represents the estimated market value.

Market Discount Rate Comparison:

• Compare Investor A's required return with the market cap rate.
• A higher required return suggests Investor A is seeking a higher return for the perceived risk.

Impact of Building Defect:

• The value of the property would decrease depending on the severity and cost of rectifying the defect.
• The cap rate might need to be adjusted to reflect the increased risk.

Question 3:

Comparing Rates of Return:

• Calculate the annualized return for the bond: 3% x 5 years = 15%
• Calculate the Internal Rate of Return (IRR) for the leasehold property using DCF analysis.
• Compare the IRRs to determine the better investment based on expected returns.

Client Advice:

• Consider factors like risk tolerance, investment goals, and liquidity needs before advising your client.

Required Return vs. Investment:

• If the IRR of the leasehold property is less than 10%, it may not be a good investment for your client given their required return.

Question 4:

ABC Co's Interest:

• ABC Co has a leasehold interest with fixed rent below market value.
• The value of their interest depends on the remaining lease term and the difference between contracted and market rent.

Valuation of ABC Co's Interest:

• Use DCF analysis to discount the difference in rents to present value.

PQ Co's Present Interest:

• Market value = Building value + Reversion value
• Building value = Market value per sq ft x Building size
• Reversion value = Present value of future net income after lease expiry, discounted at the market cap rate of 4%.

Compensation to ABC Co:

• Negotiate a compensation amount that reflects the present value of the remaining leasehold interest.
• Consider market factors and legal implications.

Question 5:

Evaluating Proposals:

• Calculate the Net Present Value (NPV) of