Question

Define and explain the following terms:

Direct capitalization

Direct comparison

Staged financing

Answer 1

Estimating the value of real estate is necessary for a variety of endeavors, including financing, sales listing, investment analysis, property insurance, and taxation. But for most people, determining the asking or purchase price of a piece of real property is the most useful application of real estate valuation.

Technically speaking, a property's value is defined as the present worth of future benefits arising from the ownership of the property. Unlike many consumer goods that are quickly used, the benefits of real property are generally realized over a long period of time. Therefore, an estimate of a property's value must take into consideration economic and social trends, as well as governmental controls or regulations and environmental conditions that may influence the four elements of value:

• Demand: the desire or need for ownership supported by the financial means to satisfy the desire
• Utility: the ability to satisfy future owners' desires and needs
• Scarcity: the finite supply of competing properties
• Transferability: the ease with which ownership rights are transferred

Value Versus Cost and Price

Value is not necessarily equal to cost or price. Cost refers to actual expenditures – on materials, for example, or labor. Price, on the other hand, is the amount that someone pays for something. While cost and price can affect value, they do not determine value. The sales price of a house might be $150,000, but the value could be significantly higher or lower. For instance, if a new owner finds a serious flaw in the house, such as a faulty foundation, the value of the house could be lower than the price.

Market Value

An appraisal is an opinion or estimate regarding the value of a particular property as of a specific date. Appraisal reports are used by businesses, government agencies, individuals, investors, and mortgage companies when making decisions regarding real estate transactions. The goal of an appraisal is to determine a property's market value – the most probable price that the property will bring in a competitive and open market.

Market price, the price at which property actually sells, may not always represent the market value. For example, if a seller is under duress because of the threat of foreclosure, or if a private sale is held, the property may sell below its market value.

1. Direct capitalization

The direct capitalization method is obtained by taking the income recorded over time and dividing it by the respective capitalization rates taken over the same period. The cap rate is obtained by dividing the net operating income by the value of the assets.

Often called simply the income approach, this method is based on the relationship between the rate of return an investor requires and the net income that a property produces. It is used to estimate the value of income-producing properties such as apartment complexes, office buildings, and shopping centers. Appraisals using the income capitalization approach can be fairly straightforward when the subject property can be expected to generate future income, and when its expenses are predictable and steady.

Appraisers will perform the following steps when using the direct capitalization approach:

• Estimate the annual potential gross income.
• Take into consideration vacancy and rent collection losses to determine the effective gross income.
• Deduct annual operating expenses to calculate the annual net operating income.
• Estimate the price that a typical investor would pay for the income produced by the particular type and class of property. This is accomplished by estimating the rate of return, or capitalization rate.
• Apply the capitalization rate to the property's annual net operating income to form an estimate of the property's value.

Gross Income Multipliers

The gross income multiplier (GIM) method can be used to appraise other properties that are typically not purchased as income properties but that could be rented, such as one- and two-family homes. The GRM method relates the sales price of a property to its expected rental income. (For related reading, see "4 Ways to Value a Real Estate Rental Property")

For residential properties, the gross monthly income is typically used; for commercial and industrial properties, the gross annual income would be used. The gross income multiplier method can be calculated as follows:

Sales Price ÷ Rental Income = Gross Income Multiplier

Recent sales and rental data from at least three similar properties can be used to establish an accurate GIM. The GIM can then be applied to the estimated fair market rental of the subject property to determine its market value, which can be calculated as follows:

Rental Income x GIM = Estimated Market Value

2. DIRECT COMPARISION METHOD

The sales comparison approach is commonly used in valuing single-family homes and land. Sometimes called the market data approach, it is an estimate of value derived by comparing a property with recently sold properties with similar characteristics. These similar properties are referred to as comparables, and in order to provide a valid comparison, each must:

• Be as similar to the subject property as possible
• Have been sold within the last year in an open, competitive market
• Have been sold under typical market conditions

At least three or four comparables should be used in the appraisal process. The most important factors to consider when selecting comparables are the size, comparable features and – perhaps most of all – location, which can have a tremendous effect on a property's market value.

Comparables' Qualities

Since no two properties are exactly alike, adjustments to the comparables' sales prices will be made to account for dissimilar features and other factors that would affect value, including:

• Age and condition of buildings
• Date of sale, if economic changes occur between the date of sale of a comparable and the date of the appraisal
• Terms and conditions of sale, such as if a property's seller was under duress or if a property was sold between relatives (at a discounted price)
• Location, since similar properties might differ in price from neighborhood to neighborhood
• Physical features, including lot size, landscaping, type and quality of construction, number and type of rooms, square feet of living space, hardwood floors, a garage, kitchen upgrades, a fireplace, a pool, central air, etc.

The market value estimate of the subject property will fall within the range formed by the adjusted sales prices of the comparables. Since some of the adjustments made to the sales prices of the comparables will be more subjective than others, weighted consideration is typically given to those comparables that have the least amount of adjustment.

Direct comparison applies a direct comparison ratio to the related venture quantity and need not have any discounting interpretation. Direct capitalization capitalizes earnings by discounting using a cap rate (r-g) implied by a comparable ratio.

3. STAGED FINANCING

Staged financing is a widely adopted form of investment in venture capital. In an environment where an entrepreneur faces an imperfect capital market and an investor faces uncertainty and moral hazard, we study how staged financing is used to mitigate moral hazard and to reduce risks.Staged financing is very popular in reality, especially in venture capital financing. Over 90% of venture capital is invested through staged financing.

Staged financing means that a VC agrees to a total investment but invests portions of the total in stages. The VC has the option to abandon the project anytime without a penalty. Evidence shows that over 90% of all VC-backed firms are financed by staged financing. No matter which development stage the firm is in when a VC starts her investment, she generally invests in stages. Staged financing can be implemented by milestone strategies and by various forms of convertible securities, debt, and equity. The key to staged financing is that a VC has the option to stop further investments at anytime. For example, if staged financing is implemented by a convertible security (in this case, staging is a phenomenon and the convertible security is the instrument), investment is made in the form of debt, but the VC has certain rights, including the right to convert her investment into equity at anytime. Staged financing is believed to be used for and shown in theory to be capable of reducing risks and mitigating agency problems. It is an empirical question to see if indeed staged financing is a mechanism in handling both risks and agency problems or either. A key choice variable in staged financing is the initial investment. The choice of this variable may depend on the firm’s risk situation and the severity of potential agency problems.