Post-Registration Phase Course 6 - Real Estate as an Investment Strategy: Commercial Properties - Advanced

Citation preview

COURSE : PSTC-2050A

REALESTATEAS AN INVESTMENT STRATEGY- COMMERCIALPROPERTIES ADVANCED- ELEARNING This course will present modules on real estate as an investment strategy focusing on large-scale complex commercial investment properties. The six modules in the course will first provide a refresher on key sections and components of trading in commercial Real Estate that were covered in the Pre-Registration phase of the Real Estate Salesperson Program. Each module will then delve deeper into the special considerations and specialized knowledge required for trades involving larger more complex investment properties. The modules will explore various topics, such as key capitalization techniques in investment analysis, the importance of assessing the financial aspects of a property using operations cash flow and sales process cash flow analysis, estimating the value of an investment based on its future cash flows, and how to calculate different types of rents in commercial real estate.

V7

Module 1: Understanding Investment Valuations Disclaimer: This is a reference document which contains pages from the Accessible eLearning module. You should complete the eLearning module to proceed to the next step. Please note that the accessible module on the LMS only contains the interactive pages and you need to go through the content of this document thoroughly to attempt the interactive activities in the module. Please use Adobe Acrobat Reader (Recommended version 9 or above) to navigate through this PDF. Real Estate Salesperson Program ©2021 Real Estate Council of Ontario. All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or in any means – by electronic, mechanical, photocopying, recording or otherwise without prior written permission, except for the personal use of the Real Estate Salesperson Program learner.

© 2021 Real Estate Council of Ontario

Module 1: Understanding Investment Valuations In Real Estate as an Investment Strategy: Commercial Properties – Fundamentals, you learned about general key capitalization techniques that you can use in investment analysis and how to apply various methods to develop a capitalization rate. This module reviews and expands on these concepts, as they apply to large and complex investment properties. Topics include tools for income capitalization, which is the process of converting net operating income (NOI) into an indication of value. It also covers overall capitalization rates (OCR), equity capitalization rates (ECR), and terminal capitalization rates (TCR). It further examines differences between split rate capitalization and residual methods, as well as between direct and yield capitalization. To check your understanding of this module, you must complete all the activities in the online module. The contents of the thumbnails Accessible PDF.

and References from the module are added to support your learning throughout this

© 2021 Real Estate Council of Ontario

Menu: Understanding Investment Valuations

Number of Lessons

Lesson Number

8 Lessons

Lesson Name

Lesson 1

Considerations and Tools for Income Capitalization

Lesson 2

Overall Capitalization Rates

Lesson 3

Equity Capitalization Rates

Lesson 4

Terminal Capitalization Rates

Lesson 5

Split Rate Capitalization and Residual Methods

Lesson 6

Yield and Direct Capitalization

Lesson 7

Summary Practice Activities Module Summary

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 1 of 16

Lesson 1: Considerations and Tools for Income Capitalization

This lesson considers factors that determine a property’s value, including the differences and relationship between investment and market value. It reviews steps to determine net operating income (NOI) and cash flow before tax (CFBT) and the tools available to you to make and/or confirm these calculations.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 2 of 16

This lesson will focus on investor’s unique motivations when considering a property’s value. This lesson will also equip you to determine a property’s net operating income (NOI) and cash flow before tax (CFBT). You will also learn about the tools to use when applying capitalization techniques. A firm understanding of the impact of these concepts and tools will enhance your ability to estimate value and to advise on investment properties of interest. Upon completion of this lesson, you will be able to: • Identify differences between market value and investment value

© 2021 Real Estate Council of Ontario

• Review the steps used to arrive at a property’s net operating income and cash flow before tax • Identify the calculators and software available for completing capitalization techniques Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 3 of 16

This topic provides an overview of the difference between market value and investment value, both of which should be considered when representing an investor. When discussing a property’s investment value with an investor, your role is to factor in their stated requirements, rather than to provide your own opinion of investment value.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 4 of 16

Investment Value: An Overview Despite investment analysis’ emphasis on mathematical calculations in determining value, each investor has unique needs. Investment value can be determined based on a particular investor’s individual requirements and circumstances. A “typical” investor does not exist, as each has a different level of risk that they are willing to take when making investment decisions. To best represent your clients, it is crucial to have initial conversations to determine an investor’s unique perception of investment value. While some may be comfortable with (and even

© 2021 Real Estate Council of Ontario

seek out) a high degree of risk, others prefer “safer” investments. The reasoning behind risk preferences is often linked to hidden traits and/or past events, such as: • The level of success achieved through past speculative venture(s) • Comfort with specific investment properties or trading areas due to extensive experience with them • Personal values, such as the status associated with a certain investment or a preference for sole ownership over shared • Personal preferences, such as aesthetic appreciation for one building’s design over another’s, subjective assessments of “deal breaker” property characteristics, or a reliance on certain areas of market research All these unique factors complicate what could otherwise be considered a straight-forward decision. A commonality between many investors, however, is their reliance on the guidance from informed professionals. In providing this guidance, your role is to help investors determine reasonable alternate proposals, forecast relevant financial data, and provide meaningful summaries to arrive at a logical conclusion. Your knowledge of the investor as an individual, in addition to familiarity with their investment profile, will enable you to select, show, and market appropriate properties effectively.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 5 of 16

Market Value: An Overview Market value is the probable selling price of a property in a competitive market. Appraisers, when estimating market value, are bound by rigid analysis criteria and all forecasts must be supported by market data. Determining market value begins with the completion of a reconstructed (stabilized) worksheet that forecasts income and expenses. A reconstructed worksheet is a document with revisions to the owner’s income and expense analysis to accurately portray a typical property.

© 2021 Real Estate Council of Ontario

An appraiser will factor in realistic expenses an investor should expect for a specific type and class of property. Ultimately, an appraiser seeks to forecast the optimum level of income possible for a property, assuming it is used to its highest and best potential. Since the highest and best use of a property can change over time, it is important that this is reassessed each time a property is valued, and that investment advice is adjusted accordingly. An accurate market value appraisal should have the following characteristics: • The forecasting period spans 10 years or at least a period that allows for net operating income (NOI) to stabilize. • The ownership period should at least exceed the period it takes to reach stabilized operations, where nonmarket leases expire, and any unusual expenses are no longer occurring. An unusual expense item is one that is not typically encountered in the day-to-day operation of the building but is necessary for the efficient and profitable operation of the building. For example, replacing HVAC equipment, repaving the parking lot, redecorating the lobby, and replacing furniture. • The reconstructed worksheet generally conforms to a typical example for the specific type and class of property. • The valuation is based on the forecasted NOI and cash flow before tax (CFBT) after debt service. • Optionally, some expenses that are not on the financial statement may be included, such as reserves for replacement. These are usually replacement of capital equipment and maintenance items such as replacing windows, updating the HVAC systems, resurfacing the parking lot and repainting the lines, and replacing and refurbishing elevator equipment. The salesperson’s knowledge of market value holds significant influence for investors. However, in your discussions with an investor, you should be careful not to misrepresent market value. While it is the probable selling price of a property in a competitive market, it is not a guaranteed price projection. This is an important distinction to make to avoid misleading clients.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 6 of 16

Differentiating Market Value and Investment Value Aspects of market value and investment value are sometimes combined when the differences between them are not made clear to investors. The following two sections contain information on differences between these valuation terms.

Market value versus investment value The key distinction between market value and investment value lies in its focus on the “typical” investor versus the “individual” investor, respectively. Market value assumes that a property is sold in a competitive market with a focus on a typical investor and that it is given reasonable (or average) exposure to the marketplace. Both the seller and the buyer are presumably knowledgeable of the marketplace and act without duress in their own best interest. Conversely, investment value assumes that a property’s value can vary, based on an individual investor’s requirements. Emphasis is placed on aftertax cash flow and tax liability unique to each investor. Challenges can arise when there is a discrepancy between market value and investment value.

© 2021 Real Estate Council of Ontario

An example A 100-unit apartment building is for sale. The market capitalization rate for comparable buildings sold is five per cent. Market capitalization rate is a capitalization rate derived from market research; in other words, it is the analysis of the net operating income (NOI) in relation to the sold price of similar properties. Based on comparable sales, a five per cent capitalization rate is what other buyers find acceptable, on average. This, when used to capitalize the NOI, would result in an estimate of the building’s market value for a typical investor. However, an individual investor client expects a return on investment or capitalization rate of seven per cent. This personal expectation, when used to capitalize NOI, would result in the individual’s investment value. To appease the investor requirement for an inflated return on their investment, the property must be sold for less than its market value. This may or may not be possible.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 7 of 16

During initial discussions with a salesperson, an investor explains that they are reluctant to make a mid- to high-risk investment due to previous financial losses incurred by them from a poor investment decision. The investor states that the cash flow before tax (CFBT) for a given property is key information they will want to know about a potential investment property. The investor hopes to purchase a property with a 4.5 per cent capitalization rate. During research on the investor’s behalf, the salesperson determines that comparable properties have sold at an average rate lower than four per cent. Based on the scenario, which of the following statements are correct? There are three options. There are multiple correct answers.

1

Investment value is reflective of the investor’s propensity for risk and return expectations.

2

Market value is reflective of the investor’s interest in cash flow before tax (CFBT).

3

Market value is reflective of the data collected on comparable sales.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 8 of 16

This topic reviews the steps used to arrive at a property’s net operating income (NOI) and cash flow before tax (CFBT). It also addresses vacancy and credit loss due to income.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 9 of 16

OPERATIONSCASH FLOWWORKSHEET CllENTNAMf'

ACQUISfflOH PRICI

lnvest0( McKay

162.500

OownP")'fflent

+

• Cost of Acquiswon

l'AOf(RTY lCXATION

379 WayfafefRoad,SOuthgate

--..

---

+

'°"''

l'.OPUTY TYPf'

Retail MORlGAG.!OffAIU 8lGIMMING

....,.a

,...,,_.

487,500

""""

MIOll:JIZATION

5/25

,.

iNltRf.ST

• OF PAYMfHt'S

PU.YEAR

12

487,500

~LOE8T

PAVMfHT

"""" 45,585

3,798.74

8.25%

16,250

= 178,750

• lr'IYHtmenl Dl PurthDU

r""""". TAXAILI INCOM.f'

....

......~ 142,500

Potenbal Rental lnoome

. '

-Vouncy & Credit losses •Ufear,te RCfltol ltlccme

- 7,125

= 135,375

3,500

+ 3,500

= 138,875

·Opcrotii,gEiq>cnHS

- 51,383

- 56,653

- 59,716

=80,367

=75,097

= 79,159

•HetOpcrotii,glr'IOOme

-HonOper.-tingbpei,ses ·lnte..Ht:1•Mortg,,gc

-0 - 39,315

Mc:lrtMc

-Amortiution of Lo.anf.eH

•

- 14.250

= 128.250 = 131,750

•lntetHt:~

" "

- 14,250

•Income Bef-orcCCA ·CCA

--•Real Estotcla;ic.ablc lr'IOOl'ne xM,.ginnl lox Rate

+

-0 - 38,787 -0

-0

-0

-0

-0

= 41,052

• 36.310

= 40,945

- 9.328

- 18.282

- 17,551

= 31,724

• 18,028

• 23,394

.... .,... x0.A2

CASHfLOWS

" m

D

•

--X0.42

Het Opcrotii,g lr'IOOl'ne

80.367

75,097

79,159

-Aonuol Debt S-e

- 45,585

- 45,585

- 45,585

= 34,782 - 13.324

= 29,512

=33,574

•:111,a

•:n.M

" n

-0 - 38,214

-0

x0.42

•Gash R°"" Before Taxes

----loxU-,bility(Une

18)

- 7,572

--

142,500

= 128,250 +3,500

"

"

YfN