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CRE Valuation Theory

The purpose of this part is to provide the theory on Commercial Real Estate (CRE) and real estate valuation in general. First of all, the purpose and definitions of valuation are presented in this chapter. Secondly, the existing valuation methods are presented – income approach, comparable sales approach and the cost approach. Lastly, the connection to the market is presented and discussed.

Purpose of valuation and valuation definitions

The definition of real estate and real property is essential to define before we get in to valuation. According to Appraisal institute (2008) the distinction between real estate and real property is fundamental to appraisal. Real Estate is defined a physical land together with the tangible appurtenances affixed to the land (e.g. structures). It is immobile and includes the following tangible components (e.g. Land, trees, minerals, buildings, site improvements). Real property is the interests, benefits, and rights inherent in the ownership of real estate. Appraisal is the act or process of developing an opinion of value.
Usually, appraisals of Market Value are the most common assignments. Otherwise the appraisers are requested to develop opinions on other types of values. The planned use of an appraisal is the appraiser’s intent of how the client and other possible users will use the appraisal report. According to the future use of the appraisal report the appraisal problem has to be defined. The possible uses of the appraisal are transfer of ownership, financing a credit, litigation, investment counseling, decision making, and accounting (Appraisal institute 2008). According to International Valuation Standards Committee valuations are developed on the basis of Market Value of an asset or on the bases other than market value. Furthermore, central to all the valuations is the concept of market, price, cost and value. Price pertains to the actual exchange of the good or service; cost reflects the expense of producing the good or service; value represents the price most likely to be concluded by the buyers and sellers of a good or service that is available for purchase. According to Appraisal institute (2008) the Market value is defined as follows:
Market value is the most probable price, as of specified date, in cash or in terms of equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in the competitive market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress.
However, there are three broad valuation methods to that are used to determine the market value: Sales comparison approach, income approach and cost approach Appraisal Institute (2008). According to Norlund and Lind (2008) valuations are usually done in several steps and the method used in the first basic step has to be distinguished from the method used for making adjustments for remaining difference in characteristics. Authors claim that in the first step two dimensions are used for categorization of the valuation method – the strategic values used (price, income or cost) and in what way is the connection to the market made (using transactions or the knowledge about the actors on the market):
-Price: a forecasted price is linked to the hypothetical price in the market (very similar transacted objects or through normalization with a physical measure like area) -Income: an income variable and prices on the market are used -Cost: a link between cost and prices is used in the valuation Authors Norlund and Lind (2008) claim that the connection to the market can be made in two basic ways. First way is through observed transactions. In other words it is called “sales comparison approach”. Second way is through the knowledge about the actors on the market. Authors Norlund and Lind ( 2008) claims that many of the markets are heterogeneous and the appraiser can use opinions of other market participants to connect the information about the characteristics of the property to the estimated market value. Thus this approach is called “actor based approach”.

Valuation methods

The income approach

Geltner, Miller Clayton, & Eichholtz, (2007) claims that in order to understand fundamentally the situation in the micro level in most real estate activity, the return expectations, the investors goal, and the prices or values of assets has to be analyzed.
The prices investors pay for properties determine their expected returns, because the future cash flow the properties can yield is independent of the prices investors pay today for the properties.

Relationship between investor return expectations and asset prices

The analysis of the link between asset prices and returns that are based on the operating cash flow potential gained an acceptance between academia and the professionals. Also, it might protect from the common boom and bust cycles in the real estate market. Furthermore the process consists of three steps:
• Forecast the expected future cash flows
• Ascertain the required total return
• Discount the cash flows to present value at the required rate of return
DCF and how to use it where:
= Net cash flow generated by the property in period T
=Expected average multi-period return (per period) as of time zero (the present), the opportunity cost of capital (OCC) for this investment, expressed as the going in IRR
T=The terminal period in the expected investment holding period, such that would include the resale value of the property at that time, in addition to normal operating cash flow.

Proformas and cash flow projection

Geltner, Miller Clayton, & Eichholtz (2007) claims that cash flow forecast has to be taken seriously. The fundamental earning potential of a property is essential for making investment decisions. However, since nobody can accurately forecast the future the estimate can be biased and unrealistic. Nevertheless, the cash flows are still projected usually for 10 years due to the fact that properties are long lived and investors hold properties for long periods in order to minimize the transaction costs. Furthermore, even if the property is being sold shortly it has to generate operating income over the long term. A complete proforma in real estate investment analysis includes two categories of cash flows:
– Operating cash flows – results from normal operations of the property
– Reversion cash flows – occurs at the time of sale of an asset

Potential gross income and market rent projection

Geltner, Miller Clayton, & Eichholtz (2007) potential gross income is usually the operating income that the property can earn if it is fully rented. Although, in practice it is same as rent roll, especially for properties with long-term leases. The projection of the potential gross income will involve two different calculations in case of existing and expired leases:
– Revenue will be calculated according to the existing leases
– Revenue will be a function of the future leases
Thus, the supply and demand of the space market has to be taken into consideration to project a rent roll as well as the circumstances of a particular building. Therefore, it is essential to estimate the current and future market rents levels for property valuation. There the rent comps analysis is important, where the recent singed leases are compared to the leases signed in a similar building.

Vacancy Allowance and effective gross income (EGI)

Geltner, Miller Clayton, & Eichholtz (2007) no one can realistically expect that a property can be fully leased, thus vacancy allowance is a ratio that shows the expected effect of vacancy. Usually it is a percentage of the potential gross income (PGI). It can be calculated by forecasting the possible vacancy period that is associated with every lease of the space of the building. Furthermore, the projected long term average vacancy percentage calculated has to be compared to the typical vacancy in the local market of the similar buildings and adjusted accordingly if it differs much. Moreover, the existing vacancy allowance tends to increase as the building age. Lastly, to get the effective gross income (EGI) the potential vacancy allowance has to be subtracted form the potential gross income (PGI).

Operating expenses

Geltner, Miller Clayton, & Eichholtz (2007) proforma is a cash flow statement but not the detailed an accrual income statement. Thus the depreciation is not a cash outflow per se. However, operating expenses typically include: property management and administration, utilities, insurance, regular maintenance and repair, and property taxes.

Net Operating Income (NOI)

Geltner, Miller Clayton, & Eichholtz (2007) due to the common use the net operating income (NOI) and net cash flow (NCF) or operating profit (OP). It calculated by subtracting operating expenses (OE) from the possible revenues such as rental revenue, other income, and expense reimbursement). However the net cash flows are calculated by subtracting capital improvements (CI) from the net operating income (NOI).

Capital Improvement Expenditures (CapEx)

According to Geltner, Miller Clayton, & Eichholtz (2007) capital improvement expenditures refers to the expenditures for long-term improvements to the physical quality of the property. Usually it is replacement of heating, ventilation, cooling (HVAC) system, roof replacement, and adding a parking lot. Furthermore, there are other capital expenditures such as leasing costs that include improvement expenditures (TIs) and leasing commissions that are pay for leasing brokers. Capital expenditures are typically 10-20% a year of the net operating income (NOI). Moreover, it will be less in the new buildings and more in the old and will increase as the building age as well as very old buildings are close to redevelopment and not worth of major capital improvements.

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Reversion Cash Flows

According to Geltner, Miller Clayton, & Eichholtz (2007) the best way to forecast the resale price of the property is to apply direct capitalization to the end of proforma projection period. For example for the 10 year proforma period analyst projects 11 NOI which then will be divided by reversion cap rate (also known as going-out cap rate). This process allows to calculate the resale price if the cap rates and NOI projections are realistic.

Discount rates: The opportunity cost of capital

According to Geltner, Miller Clayton, & Eichholtz (2007) the higher discount rate should be applied to more risky cash flows. The main reason is that such cash flows has higher cost of capital in the asset markets. The discount rate or total return which was earlier labeled r can be divided into a risk-free (and risk premium (RP) component:
– risk free – accounts for the time value of the money
– risk premium – accounts for a risk investing in the certain property, it can also be called opportunity cost of capital (OCC)

NPV investment decision rule

Geltner, Miller Clayton, & Eichholtz (2007) claims that the discounted cash flow valuation procedure can be combined with net present value (NPV) rule. Net present value in an investment object is defined as the present dollar value of what is being obtained minus the present dollar value of what is being lost. According to the authors, in order to make a good investment decision the steps have to be taken:
– Maximize the NPV across all mutually exclusive alternatives
– Never choose an alternative that has: NPV<0
The beauty of the NPV rule is that it is based on the fundamental wealth maximization principle. To better understand the relation between discounted cash flow (DCF) and net present value (NPV) by applying it to the simple decision: If buying: NPV = V – P
If selling: NPV = P – V
Where: V = Value of property at time zero (e.g. based on DCF)
P = Selling price of property (in time – zero equivalent $)

The sales comparison approach

According to Appraisal Institute (2008) an appraiser develops an opinion of value by analyzing the properties that are similar to the subject property. He usually analyses closed sales, listings or pending sales of properties. Moreover, the comparative analysis is fundamental to the valuation process. Usually the estimates of rents, expenses, land value, cost, depreciation and other parameters may be derived using comparative analysis. According to Pagourtzi, Assimakopoulos, Hatzichristos & French (2003) the comparable sales approach is the most widely used.
Unfortunately, according to Pagourtzi, Assimakopoulos, Hatzichristos & French (2003) the sales comparison approach is heavily dependent on availability, accuracy, completeness, and timeliness of sale transaction data. However, when conducting the comparable sales analysis the appraiser selects few recent similar properties from the recent transaction data. Since real estate is heterogeneous no two properties are exactly the same. In this case an appraiser must adjust the price of each comparable to account for differences between the subject and the comparable such as size, age, quality of construction, selling date, surrounding neighborhood.
It is viewed as a four-part process:
– -Finding most of the comparable sales
– -Adjusting the prices of the comparable to match the characteristics of the subject property
– -Using several estimates of value to arrive at an estimate of market value
– -Presenting the results according to the standards

DCF shortcut – direct capitalization

Lind (2008) claim that the connection to the market can be made in two basic ways. First through direct capitalization or Gross Income methods where a relation between net operating income and price, or between rent and price is found in a set of transaction of similar properties. Second, discounted cash flow (DCF) analysis where data in the cash flow is derived from knowledge of the actors on the market. Third, direct capitalization based on knowledge of yields demanded by actors.

The cost approach

Appraisal Institute (2008) in the cost approach is a process where the set of procedures to calculate a value indication. First, the cost to construct a reproduction of (or replacement for the existing structure is estimated. This estimation also included the margin for the contractor. Secondly, the depreciation is taken to the account. Thirdly, the cost of land has been added. Lastly, to indicate the free simple value of the subject property the adjustments may then be made in order to reflect the value of the property interest to be appraised. The cost approach is applied when the properties are specialized and rarely sold on the open market and it would impossible to access its value by referring to similar properties (Pagourtzi, Assimakopoulos, Hatzichristos & French, 2003).

Relation to appraisal principles


According to Appraisal Institute (2008) a knowledgeable buyer will not pay more for a property that costs to buy a similar property and improve it to the required state. Furthermore, in the cost approach the existing properties as substitutes of property being appraised. And their value is measured according to the value of the new, optimal property.


According to Appraisal Institute (2008) the value of an individual component of the property is measured in terms of property’s value increase as a whole. Furthermore, the value of the component can be also measured as the amount its absence would detract from the value.


According to Appraisal Institute (2008) there can be positive and negative externalities for the value of the real estate. The inflation or natural disasters can drive the cost of building a property. The value of the real estate will not necessarily rise. However, a completion of the sewer line may increase the value of the property, but would not the affect the cost.

Highest and Best Use

According to Appraisal Institute (2008) a vacant site can have one highest and best use, while the site with existing combination of site and improvements may have different highest and best use as improved. Moreover, the value of existing improvements is as much as they contribute to the overall value of the site. However, it may panelize the value if they have outlived their usefulness. Furthermore, the poor design of the building is worth less than its cost simply because of the functional obsolescence in it design.


According to Appraisal Institute (2008) the cost approach is a free simple value for those properties that are leased. It assumes stable income and vacancy. Also, the appraiser takes to the account the holding costs that are applicable through the holding period. Although, if the rents of the property are higher or lower than the market rents the occupancy of the property would be stabilized, but the value of the property itself may still require adjustment.
According to Lind (2008) there are two ways of how the cost approach connects to the market. First, through comparing the recently transacted properties. When the stable relation is found in observed transactions between (replacement) cost (increases) and price (increases). Secondly, through knowledge about what actors on the market think about the relation between cost (increases) and price (increases).
The appraiser himself will have to use his common sense and opinions of certain matters for dealing with issues like this. This gives the appraisers a certain freedom to create their own ways of handling this ambiguity. This also means that two appraisers valuing the same property at the same point of time will not come up with the same value.
The valuations carried out by appraisers should reflect the market value. This means that “the appraisers are estimating the contract price that a willing buyer and seller would agree in an arm’s length transaction on the open market”(N. Bywater 1998).
Before the investment is made investors are concerned about the major characteristics of an asset that is being considered as an investment. Investments also differ in their level of risk that the investors are willing to take. Usually, less and more risky investments bring possibility of less and more return. Investments can be divided into growth and income. The categorization of the approaches to valuation will bring more transparency to the valuation. And uncover what are appraiser are doing in the valuation process. It will also uncover and clarify what really is done when the property is being appraised using DCF method. This is really important for the appraiser in Europe, because it is perceived as the most popular appraisal method for the income producing properties (see e.g. McParland et al 2002, and Bellman 2012).

Table of contents :

1 Introduction
1.1 Background
1.2 Aim
1.3 Limitations
1.4 Method
2 CRE Valuation Theory
2.1 Purpose of valuation and valuation definitions
2.2 Valuation methods
3 Behavioral economics
3.1 The beginning of Behavioral Economics.
3.2 What is behavior economics?
3.3 The sub-disciplines of behavioral economics.
4 Recent trends
4.1 Progress of behavioral economics
4.2 Prospect Theory
4.3 Regret and Cognitive Dissonance
4.4 Anchoring
4.5 Representativeness
5 Behavior of Appraisers
5.1 Experts altered appraisal process
5.2 Anchors
5.3 Biases
5.4 Investor behavior
6 Results
6.1 Commercial real estate appraisal as perceived by different parties
6.2 Commercial real estate appraisal practice without borders
6.3 Outcomes of the interviews
7 Analysis
7.1 Connection to the market
7.2 Capitalization of NOI
7.3 Capitalization of fixed and variable rents
7.4 Pressure on investors
7.5 CAPEX or life cycle
7.6 Banks position in Investors and appraisers relationships (LTV covenant)
7.7 Business cycles
7.8 Thought process
8 Conclusions


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