Chapter 25
CONSULTING
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Real estate appraisals may involve valuation, consulting (analysis or evaluation), or both. In valuation assignments, a specific type of value is sought; in consulting assignments, values are estimated with valuation techniques or other methods and used in making real estate decisions. Consulting may be either general or specific in nature. Valuation and consulting services related to value are covered by the Appraisal Institute of Canada's Code of Professional Ethics and Standards of Professional Practice.
Specific consulting assignments include highest and best use studies, market studies, marketability studies, rent studies, absorption analyses, feasibility studies, and other studies that have a specific analytical objective. In more general assignments, practitioners provide clients with unbiased advice regarding real estate decisions. This advice may help clients set goals, establish an analytical framework for real estate investment, or finalize real estate decisions.
Many real estate valuation assignments call for consulting services. In conducting a market value appraisal required for mortgage loan purposes, an appraiser may also provide data and advice that can be used to structure the specific terms of the mortgage.
Buyers and sellers who wish to establish market value for transaction purposes are usually interested in other market facts as well, e.g., high and low market price indicators, the frequency of offers and sales, and the average length in time for market exposure of properties before sale. This information can help investors finalize their decisions.
Although valuation and consulting are closely associated, consulting has long been considered as distinct from the appraisal function. While some professional real estate organizations have traditionally conferred a special designation on members who demonstrate the training and experience required to perform analytical assignments, the Appraisal Institute of Canada has elected not to create a separate designation for this purpose.'
RELATIONSHIP OF CONSULTING TO VALUATION
Valuation studies are primarily microeconomic analyses because they focus on valuing identified interests in specified real estate as of a given date. Broad economic trends and forces are considered, but the analyst concentrates on a specific parcel or parcels of real estate.
Consulting, on the other hand, may include macroeconomic analyses, microeconomic analyses, or a combination of both. It may relate to broad market categories or to a given parcel or parcels of real estate. Valuation assignments always include the identification and definition of one or more types of value. In consulting assignments the nature and scope of the services being performed must be explained, but a particular type of value may not be specified because a value estimate may not be sought. Appraisers must clearly distinguish between valuation and consulting assignments to avoid confusion and possible misunderstanding.
Market Value and Investment Value
When the word value is applied to real estate, it must be qualified. The statement "The value of your property is $150,000" is not specific enough to be meaningful to real estate professionals. If, however, an appraiser says, "Your property is estimated to have a market value of $150,000" an explicit meaning is conveyed. Of
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necessity, appraisers refer to market value, insurable value, liquidation value, and other precisely identified and defined types of value. Consulting assignments frequently call for estimates of market value or investment value as well as associated analyses that will enable a client to make one or more real estate decisions. Just as appraisers must distinguish between valuation and consulting assignments, they must also distinguish between market value and investment value.
Market value can be called "the value in the marketplace"; investment value is the specific value of goods or services to a particular investor (or class of investors) based on individual investment requirements. Market value and investment value are different concepts; the values estimated for each may or may not be numerically equal depending on the circumstances. Moreover, market value estimates are commonly made without reference to investment value, but investment value estimates are frequently accompanied by a market value estimate to facilitate decision making.
Market value estimates assume no specific buyer or seller. Rather, the appraiser considers a hypothetical transaction in which both the buyer and the seller have the understanding, perceptions, and motivations that are typical of the market for the property or interests being valued. Appraisers must distinguish between their own knowledge, perceptions, and attitudes and those of the market or markets for the property in question. The special requirements of a given client are irrelevant to a market value estimate.
In contrast, the goals of a specific investor are directly related to investment value, as are the advantages or disadvantages of a particular property or real estate situation to that investor. An appraiser may be asked to analyze a series of investment opportunities or possible decisions and evaluate them in terms of their benefits to a given client. Even decisions involving a single parcel of real estate will normally require the evaluation of other possible decisions and an analysis of how each possibility may affect the decision being considered.
For example, an appraiser may be asked to consider whether a parcel of land that is adjacent to the client's industrial property is worth $500,000, the price being asked by its owner. Market analysis indicates that the property is overpriced in comparison with other properties and that its market value is $400,000. However, the client's successful business must be expanded and it will have to be relocated if the additional land is not acquired. If the existing operation is moved, disruption of business and other factors will create a loss of more than $100,000. Because this loss exceeds the difference between the property's market value and its asking price, it might be concluded that the property has an investment value of $500,000 or more to the client in question.
Each voluntary purchase or sale of real estate is based on an investment value decision made by the parties to the transaction. Thus, the market is made up of transactions in which willing participants make investment decisions.
The transaction price of a property varies with the bargaining strength and motivation of buyers and sellers and with the number of opportunities available to these market participants. Ultimately, a property's market price reflects the interaction of those who create market supply and demand. Depending on the circumstances of the buyer and the seller in each case, the transaction price at a given moment can be expected to fluctuate above or below the property's value at perfect market equilibrium. Sellers are normally expected to accept a price that equals or exceeds investment value, while buyers will pay a price that does not
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exceed investment value. Market value estimates synthesize these transactions without considering any particular buyer or seller.
The field of real estate consulting is diverse, so the remainder of this chapter focuses on the techniques used by investors, developers, lenders, and real estate professionals to estimate investment value. Although these techniques can be applied in various types of valuation assignments, they are especially useful in providing clients with specific advice for real estate decision making.
COMMON MEASURES OF INVESTMENT PERFORMANCE
Great strides have been made in the field of real estate consulting since the 1950s. The analytical tools used in consulting now generally parallel the techniques used in other investment fields. However, some measures of investment performance are particularly applicable to real estate. These measures are not individually perfect, but as a collection of tools they have proven effectiveness. They reflect a common market understanding and are useful in typical real estate applications.
It is beyond the scope of this text to explore all analytical techniques, but a basic understanding of the most common measures of investment performance is considered essential to both valuation and consulting.
Simple Ratios
For many years, investors have used simple ratio relationships to compare and evaluate the returns from investment properties. One of the most common relationships is the overall rate of return, which is the ratio between the net earnings of a given parcel of investment real estate and the price or value of that parcel. It is expressed as R in the formula
R
V
Other formulas employ simple gross income or net income multipliers. In these formulas, the price or value of a property is expressed as a multiple of its potential gross or effective gross earnings, or as a multiple of its net earnings. This multiple is the reciprocal of the overall rate.
Each of these measures can be an effective tool of comparison when applied to very similar properties. Comparing the gross incomes of investments reflects differences among properties to a degree, but measures of investment performance that relate to net income produce better results.
Unfortunately, simple measures of investment performance incorporate many factors that may require specific analysis in a consulting assignment. For example, if an overall rate is used alone, future changes in net incomes, terminal investment values, financing structures, the effects of income taxes, and other elements that may be crucial to a particular property decision are not considered. The overall rate may reflect the combined effect of these and other factors but, in its simple form, it does not consider these factors individually. Therefore, the overall rate and related simple measures of comparison can be misunderstood or misapplied in some situations.
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Payback Period
As a measure of investment return, the payback period is seldom used alone, but it is commonly employed in conjunction with other measures. The payback period is defined as the length of time required for the stream of cash flows produced by an investment to equal the original cash outlay. The breakeven point is reached when the investment's cumulative income is equal to its cumulative loss. The payback period can be calculated from either before or aftertax cash flows, so the type of cash flow selected should be identified. The equation for payback period may be expressed as follows:
Equity capital outlay
PB =
Annual.net equity cash flows
This measure of performance is used by investors who simply want to know how long it will take them to recapture the dollars they have invested. In theory, an investment with a payback period of three years would be preferable to one with a payback period of five years, all else being equal. Similarly, an investment that will return the investor's capital in six years would be unacceptable to an investor who seeks investment payback within four years.
For an equity investment that is expected to produce equal cash flows, the payback period is simply the reciprocal of the equity capitalization, or equity dividend, rate.
PB
R E
If annual equity cash flows are not expected to be equal over the payback period, the equity cash flows for each year must be added until they equal or exceed the equity capital outlay; this point indicates the year in which payback occurs.
Although the payback period is simple and easily understood, it has a number of drawbacks. First, it measures the amount of time over which invested money will be returned to the investor, but it does not consider the time value of the money invested. A fiveyear investment payback for a $100,000 investment that pays $10,000 in Year I and $90,000 in Year 5 is not distinguished from the payback for a $100,000 investment that pays $90,000 in Year 1 and $10,000 in Year 5. The time value of money allows the first investment to use an additional $80,000 (i.e., the difference between the $90,000 paid in the second investment and the $10,000 paid in the first investment) from the second year through the fifth .2 Another shortcoming of the payback period is that it does not consider the effect of any gain or loss of invested capital beyond the breakeven point and does not specifically account for investment risks. An investment with a threeyear payback may be far more risky than another investment with a fiveyear payback, but the shorter period generally appears preferable. Thus, this measure of performance should only be used to compare investments with similar investment characteristics or in conjunction with other performance measures in carefully weighted applications.
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Investment Proceeds per Dollar Invested
Investment proceeds per dollar invested is a simple relationship calculated as the anticipated total proceeds returned to the investment position divided by the amount invested. The resulting index or multiple provides a crude measure of investment performance that is not timeweighted. It is sometimes used to compare very similar investments over similar time periods.
Profitability Index
Although measuring the investment proceeds per dollar invested is too imprecise for general use, a refinement of this technique is commonly applied. A profitability index (Ph, or benefit I cost ratio, is defined as the present value of the anticipated investment returns (benefit) divided by the present value of the capital outlay (cost). The formula is as follows:
Present value of anticipated investment returns
P/ = __ ___
Present value of capital outlay
This measure employs a desired minimum rate of return or a satisfactory yield rate. The present value of the anticipated investment returns and the present value of the capital outlay are calculated using the desired rate as the discount rate. If, for example, the present value of the capital outlay discounted at 10% is $12,300 and the present value of the benefits is $12,399, the profitability index, based on a satisfactory yield rate of 10%, is $12,399/$12,300 = 1.008.
A profitability index greater than 1.0 indicates that the investment is profitable and acceptable in light of the chosen discount rate. A profitability index of less than 1.0 indicates that the investment cannot generate the desired rate of return and is not acceptable. A profitability index of exactly 1.0 indicates that the opportunity is just satisfactory in terms of the desired rate of return and, coincidentally, the chosen discount rate is equal to the IRR. The discount rate used to compute the profitability index may represent a minimum desired rate, the cost of capital, or a rate that is considered acceptable in light of the risks involved.
This refined measure of investment performance considers the time value of money which is not considered in calculating the proceeds per dollar invested. A profitability index is particularly useful in comparing investments that have different capital outlay requirements, different time frames for receiving income or other investment returns, and different risk characteristics.
A profitability index is commonly used in conjunction with other measures, particularly net present value. When combined, these measures provide special insights into the investments under consideration. Like all other measures of investment performance, a profitability index is not generally used alone in making investment decisions. A common rule of thumb for investors is that the profitability index of an investment should be at least 1.0, i.e., the present value of the benefits divided by the capital outlay should be equal to or greater than one.
Net Present Value
Net present value (dollar reward) is defined as the difference between the present value of all expected benefits, or positive cash flows, and the present value of capital
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outlays, or negative cash flows. Net present value (NPV ) is simply the present value of anticipated investment returns minus the present value of the capital outlay. This measure, like a profitability index, is based on a desired rate of return. It is computed using the desired rate as a discount rate and the result is viewed as an absolute dollar reward. The reward (or penalty) is expressed in total dollars, not as a ratio. The formula is as follows:
CF,CF2CF n
NP V= CFO + + ... + CO
1 (1 + i)(1 + i )2(1 + i)n
where i is the applicable discount rate and n is the number of periods in the analysis. This formula calculates the difference between the present value of all investment returns and the amount of the original capital investment. The dollar reward is simply NPV at a stipulated discount rate. A positive NPV indicates a reward; a negative NPV indicates a penalty. An NPV of zero indicates that the chosen discount rate coincides with the IRR.
A number of decision rules can be established for applying the NPV. For example, assume that a property with an anticipated present value of $1,100,000 for all investment returns over a 10year holding period can be purchased for $1,000,000. If one investor's NPV goal is zero, this investment exceeds that criterion. It also meets a second investor's goal for an NPV of $100,000, but it would not qualify if the goal were $150,000.
Net present value does consider the time value of money and different discount rates can be applied to different investments to account for general risk differences. However, this method cannot handle different required capital outlays. It cannot differentiate between an NPV of $100,000 on a $1,000,000 capital outlay and the same NPV on a $500,000 capital outlay. Therefore, this technique is best used in conjunction with other measures.
TimeWeighted Rate
A timeweighted rate is technically an average of all actual, instantaneous rates over a period of time. It is similar to the rate of growth for capital invested in a mutual fund in which all dividend income is automatically reinvested. The timeweighted rate, which is also known as the unitmethod rate or the shareaccounting rate, is used primarily to measure the performance of a portfolio manager, not the performance of the portfolio itself.
Discounted Cash Flow
Discounted cash flow (DCF) analysis provides appraisers and other investment analysts with the most detailed, precise means of considering the amounts and timing of investment cash inflows and outflows over the life of an investment. With this procedure, any series of cash inflows and outflows over any specified time frame at any rate of return can be analyzed and the present value of the investment's anticipated performance can be measured.