ARE144_chap_10_bf13ed_v2_KEY - 1 Managerial Economics (ARE)...

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1 Managerial Economics (ARE) 144 University of California, Davis Instructor: John H. Constantine KEY—Handout: Chapter 10, Valuation of Income Properties: Appraisal and the Market for Capital CORRECTED: (1) What is the economic rationale for the cost approach? Under what conditions would the cost approach tend to give the best value estimate? The rationale for using the cost approach to valuing (appraising) properties is that any informed buyer of real estate would not pay more for a property than what it would cost to buy the land and build the structure. The cost approach is most reliable where the structure is relatively new and depreciation does not present serious complications. (2) What is the economic rationale for the sales comparison approach? What information is necessary to use this approach? What does it mean for a property to be comparable? The rationale for the market approach (otherwise known as the sales comparison approach), lies in the principle that an informed investor would never pay more for a property than what other investors have recently paid for comparable properties. The sales comparison approach to valuation is based on data provided from recent sales of properties highly comparable to the property being appraised. For a property to be comparable, the sale must be an “arm’s-length” transaction or a sale between unrelated individuals. Sales should represent normal market transactions with no unusual circumstances, such as foreclosure, sales involving public entities, and so on. (3) What is a capitalization rate? What are the different ways of arriving at an overall rate to use for an appraisal? An overall rate or overall capitalization rate is the rate on the overall property (debt and equity). One way of arriving at an overall rate is to use the band of investment approach. This is based on taking into consideration the investment criteria of both the lender and the equity investor involved in a project. This is done by taking a weighted average of the equity dividend rate expected by the investor and the mortgage loan constant (expressed on an annual basis) required by the lender. Two different ways of arriving at an overall rate are the direct capitalization approach and the present value method. (4) If investors buy properties based on expected future benefits, what is the rationale for appraising a property without making any income or resale price projections? Using the direct capitalization approach, this technique is a very simple approach to the valuation of income producing property. The rationale is based on the idea that at any given point in time, the current NOI produced by a property is related to its current market value. A survey of other transactions including sales prices and NOI (NOI ÷ sales prices) indicates the cap rate that competitive investments have traded for. This survey provides cap rates that indicate what investors are currently paying relative to current income being produced. A parallel in equity securities markets would be earnings yield (or earnings per share ÷ price) or price earnings multiples (Price ÷ earnings per share).
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ARE144_chap_10_bf13ed_v2_KEY - 1 Managerial Economics (ARE)...

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