Real Estate Finance

Valuation of Income Properties and

Investment Analysis

K. S. Maurice Tse
Faculty of Business and Economics
The University of Hong Kong
ktse@hku.hk

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 Contents

◼ Hedonic Pricing Approach

◼ Cost Approach
◼ Sales Comparison Approach
◼ Projected NOI Approach
◼ Real Estate Investment Performance

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 I. Hedonic Pricing Model for Residential Real Estate
◼ Hedonic pricing model:
◼ Selling price (V) of a residential property is a function of its
environmental variables such as locational factors (L), structural
factors (S), and neighborhood factors (N) of the property.
V = V (L,S,N)
◼ V is the property’s selling price as a function of L, S, and N.
◼ Problem of hedonic pricing
◼ Does not indicate exactly what variables to incorporate into the

estimation process.
◼ Does not indicate the exact functional form of the valuation process.

◼ ad hoc approach.

◼ Advantage of hedonic pricing

◼ Tell us how each of the different environmental factors may impact

the market price of a property.

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 Case Study on Hong Kong Island

◼ As a case study, MCC (Mok, Chan and Cho) examined the pricing
function for properties lying within a captured zone of 300-meter
radius from every MTR exit between Central and Chai Wan on
Hong Kong Island for the month of August 1990.

◼ They identified 1,027 transactions for the month of August 1990.

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Case Study Contd
◼ MTR Map: Hong Kong Island 1990

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 Case Study Contd
◼ “Transacted” properties lying within a captured zone of 300-meter
radius from every MTR exit between Central and Chai Wan on Hong
Kong Island

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 Locational Factors
◼ CBD (Central Business District)
◼ “Central, Admiralty, Wan Chai, and Causeway Bay” are
considered collectively the CBD.
◼ Distance from the CBD is measured by the distance
between the property and the MTR exit at Causeway Bay.

◼ STORY
◼ The higher the floor, the higher the market value of the flat.

◼ SEAVIEW
◼ This variable is set equal to one whenever a flat has at least
one window with a harbor view, zero otherwise.

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 Structural Factors
◼ GFA
◼ This variable, the gross floor area, is used as a proxy
for indicating the number of bedrooms, living room,
dining room, and family room of a unit.

◼ AGE
◼ This variable serves to capture the physical
condition of a property.

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 Neighborhood Factors
◼ SCHOOL
◼ The school zone includes Tin Hau, Fortress Hill, North Point, and
Causeway Bay.
◼ For property falling in this school zone, the variable is set equal to
one, otherwise zero.

◼ BGESTAT (BIG ESTATE)

◼ For properties belonging to an estate with 10 or more towers (Big
Estate), the variable is set equal to one, zero otherwise.

◼ SPORTF
◼ For estate with entertainment and/or sport facilities such as
swimming pools, tennis/squash courts, sauna, or nearby clubs, the
variable is set to one, zero otherwise.

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 Hedonic Pricing Function
◼ Multiple Regression Analysis
𝑃𝑖𝜆 − 1
𝜆
𝐶𝐵𝐷𝑖𝜆 − 1 𝑆𝑇𝑂𝑅𝑌𝑖𝜆 − 1 𝑆𝐸𝐴𝑉𝐼𝐸𝑊𝑖𝜆 − 1 𝐺𝐹𝐴𝑖𝜆 − 1
= 𝛽0 + 𝛽1 + 𝛽2 + 𝛽3 + 𝛽4
𝜆 𝜆 𝜆 𝜆
𝜆 𝜆 𝜆 𝜆
𝐴𝐺𝐸𝑖 − 1 𝑆𝐶𝐻𝑂𝑂𝐿𝑖 − 1 𝐵𝐺𝐸𝑆𝑇𝑖 − 1 𝑆𝑃𝑂𝑅𝑇𝑖 − 1
+ 𝛽5 + 𝛽6 + 𝛽7 + 𝛽8 + 𝜀𝑖
𝜆 𝜆 𝜆 𝜆

◼ Pi is the transaction price for the ith unit and this equation was
estimated using:

◼ l = 1 for all variables

◼ l = 0 for the dependent variable
◼ l = 0.71 for the dependent variable and l = 1 for all independent
variables
◼ l = 0 for the dependent and all continuous independent variables

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Regression
Results
◼ What do the
results mean??
◼ What is the
pricing
function like??

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 Application What does it mean??
◼ Price = 1823 – 29.5*DCBD + 7.066*Story
+ 106.82 * SEAVIEW – 0.0808 GFA
– 20.115 AGE + 16.155 SCHOOL
+ 75.426 BGESTAT + 117.24 SPORTF
◼ What is the estimated market price of a flat with the following
information listed for sale?
◼ Distance from CBD = 2 km
◼ Story = 25 Estimated market
◼ Sea view = yes price = $1,698 per
◼ Gross floor area = 1,300 sf square feet
◼ Age = 10 years
◼ School District = yes
◼ Big Estate = no
◼ Sport facilities = yes
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 Comments
◼ Robustness with respect to time.
◼ What about other parts of the city?

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 Contents

◼ Hedonic Pricing Approach

◼ Cost Approach
◼ Sales Comparison Approach
◼ Projected NOI Approach
◼ Real Estate Investment Performance

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 II. Cost Approach
◼ Rationale for Cost Approach
◼ An 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.

◼ New Property:
◼ Determine the construction cost of the building and
add to it the market value of land.

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II. Cost Approach Contd.
◼ Old Property:
◼ First estimate the cost of replacement.
◼ Reduce the cost by estimating
◼ Physical deterioration
◼ Functional or structural obsolescence due to the
availability of more efficient layout designs and
technological changes that reduce operating costs
◼ External obsolescence that may result from changes
outside of the property such as excessive traffic, noise,
or pollution.

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 II. Cost Approach Contd.
◼ Complications for income producing properties:
◼ Structural design

◼ Equipment variations

◼ Locational influences.

◼ Most useful when the structure is relatively new and

depreciation or obsolescence does not present serious
complications.
◼ May be the only method available when there are very few
sales and market data are scarce.
◼ Example: Estimation of the value of a 15-year old small office
complex.

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Example: The value of a 15 years old small office complex
◼ Step 1: Collection of Information as if the office was new.
Small Office Complex: 36,750 square feet; projected life 50 years
Component Cost ($000) PSF
Excavation-back fill $3,150
Foundation 4,725
Framing 16,050
Corrugated steel exterior walls 26,775
Brick Façade (front)-glass 5,100
Floor finishing, concrete 6,100
Floor covering offices 1,750
Roof trusses, covering 11,504
Interior finish offices 5,740
Lighting fixtures, electrical work 8,340
Plumbing 11,450
Heating-A/C 15,750
Interior cranes, scales 13,906
Loading docks, rail extension 9,600
Onsite parking 17,600
Subtotal 157,500 $4,286
Architect, attorney, accounting $20,000
Construction interest 12,500
Builder profit 25,000
Subtotal 57,500

Land Cost (by comparison) 35,000

Value per cost approach 250,000 $6,800

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 Example: Estimate the value of a 15 years old small office
complex Contd.
◼ Step 2: Estimates of Depreciation and Obsolescence on
Improved Property (15 years old)
o Replacement cost estimate (excluding land) $215,000
o Repairable
Interior finish 2,550
Floor covering 520
Lighting fixtures 1,700
o Total 4,770
o Non-repairable
15 years divided by 50 years (age) 30%
o Functional obsolescence
o Layout design (inefficiency)
Increasing operating cost (annually) 1,560
o External obsolescence
Loss in rent per year 400
o Land Site value by comparison 35,000
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 Example: Estimate the value of a 15 years old small office
complex Contd.
◼ Step 3: Adjustment of Replacement Cost Estimate
o Replacement cost at current prices 215,000
Less: Repairable physical depreciation 4,770
Subtotal 210,230
o Non-repairable physical depreciation, 30% 63,069
o Functional obsolescence
$1,560 (35 years, 10%) 15,044.9
o Economic locational obsolescence
$400 (35 years, 10%) 3,857.7
o Add: Site/Land Value 35,000
o Value per cost approach 163,258.4 (or $163,000)

1 − 1.1−35 1 − 1.1−35
15,044.9 = 1,560 × 3,857.7 = 400 ×
0.1 0.1

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 Contents

◼ Hedonic Pricing Approach

◼ Cost Approach
◼ Sales Comparison Approach
◼ Projected NOI Approach
◼ Real Estate Investment Performance

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 III. Sales Comparison Approach
◼ Sales comparison approach is based on data provided from
recent sales of properties that are highly comparable to the
property being appraised.

◼ Rationale for Sales approach:

◼ An informed investor would never pay more for a property

than what other investors have recently paid for comparable

properties.

◼ Adjustments must be made to account for the differences

between the property being appraised and recent sales of
comparable properties in:

◼ Size, Scale, Location, Age, Quality of construction

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 III. Sales Comparison Approach Contd
◼ There are two ways to handle the adjustment.
◼ Adjustment 1:
◼ Adjust the price per square foot paid for each comparable to

determine the market value for the subject.

◼ Adjustments are made relative to the property being
valued.
◼ Positive features that comparables possess relative to the
subject property require negative adjustments and
negative features require positive adjustments.
◼ Very subjective!!

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 III. Sales Comparison Approach Contd
◼ Adjustment 2:
◼ Adjust the relationship between gross rental income and sale
prices on the comparable by developing the Gross Income
Multipliers (GIM) for the comparable properties.
Sale Price
GIM =
Gross Income

◼ For subject property, gross income is estimated based on the market

data on comparables.
◼ For the comparable properties, the gross income should be annual
income at the time the property is sold (what it will be during the
first year for the purchaser).
◼ The gross income for the subject will be for the first year of
operation after the date for which the property is being appraised.
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 III. Sales Comparison Approach Contd
◼ The GIM is based on prices before adjustment for the
date of sale, location, and so on.
◼ These factors would affect both the gross income and
the price of the property.
◼ When developing the GIM, some appraisers use
◼ Potential gross income (assume all the space is

leased) or
◼ Effective gross income (potential gross income less

vacancies).
◼ The results should be similar if the appraisers are
consistent with their use of gross income measure.
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Example

◼ Consider the following example on the

development of the sales comparison approach for
estimating the value of a small office with three
comparable properties.

◼ Value is determined as of December 2011.

◼ Data

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 Example Contd: Data
Market Area Analysis and Sales Data (Market Approach)
Comparable Properties
Item Subject Property 1 2 3
Date Sep/2010 Jan/2011 Dec/2011
Price $355,000 $375,000 $413,300
Gross Annual Rent $58,000 $61,000 $69,000
Gross Area sf 13,300 14,500 13,750 15,390
Percent leasable sf 90% 91% 93% 86%
Price per sf $24.48 $22.27 $26.86
Rent per sf $4.00 $4.44 $4.48
Proximity to subject 2 miles 2.5 miles 0.5 mile
Frontage sf 300 240 310 350
Parking spaces 130 140 130 155
Number of floors 2 2 2 2
Number of elevators 1 1 1 1
Age New 3 yrs 4 yrs 2 yrs
Exterior Brick Brick Stucco Brick
Construction Average Average Average Average
Landscaping Average Average Average Average
Remark: The subject property is at the best location, and locations further away are less
desirable.
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Example Contd: Adjustments from Comparables
to Subject Property
Comparable Properties
Item 1 2 3
Price ($000s) $355,000 $375,000 $413,000
Gross Square ft 14,500 13,750 15,390
price per sf $24.48 $22.27 $26.86
Adjustments
Date -- +4% --
Percent leasable sf -5% -10% +5%
Location +7% +12% +5%
Frontage +10% -8% -10%
Age of Structure +8% +10% +6%
Net Difference +20% +8% +10%
Adjusted Price $426,000 $405,000 $454,000
Adjusted Price per sf $29.38 $29.45 $29.54
Estimated price per square foot for subject = $29.50
Indicated market value = $29.50 * 13,300 sf = $392,350

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 Example Contd: Development of GIM
(Comparable Properties)
Comparable Properties
Item 1 2 3
Date of Transaction Sep/2010 Jan/2011 Dec/2011
Price $355,000 $375,000 $413,300
Current Gross Income $58,000 $61,000 $69,000
GIM 6.12X 6.15X 5.99X
◼ Rather than simply averaging the GIMs, the appraiser would normally
give more or less weight to a particular comparable when choosing a
rate to apply to the subject property.
◼ Appraiser may believe that the third comparable property should be
given most weight because it was the most recent sale.
◼ Experience and the judgment of the appraiser is important
◼ Suppose the appraiser chooses a GIM of 6X for the subject property,
then the appraised value of the subject property =
$59,185 * 6 = $355,110.
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 Contents

◼ Hedonic Pricing Approach

◼ Cost Approach
◼ Sales Comparison Approach
◼ Projected NOI Approach
◼ Real Estate Investment Performance

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 IV. Projected NOI Approach
◼ Assumption: Real estate investors will pay a price reflecting
the income potential of the property.

◼ It involves as a first step the development of the operating

income statement.

◼ Data needed for estimating expected rents:

◼ Surveys on comparable properties.

◼ Estimates must be made for normal vacancy and collection

losses based on economic conditions expected to exist at the
time of appraisal.

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 IV. Projected NOI Approach
◼ The model

NOI1 NOI 2 NOI 3 NOI T + VT

Value = + + + ....... +
(1 + k ) (1 + k ) (1 + k )
1 2 3
(1 + k )T

◼ Assumption:
◼ Constant growth rate of operating rental income
◼ Growth rate = g
NOI1
◼ NOI2 = NOI1 (1+g)
V=
k−g
◼ NOI3 = NOI1 (1+g)
2

◼ NOI4 = NOI1 (1+g)

3

◼ …..

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 Projected NOI

◼ What is NOI?

◼ NOI = Rental Revenue

– Management Fee
– Maintenance Fee
– Government Rent and Rate

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 Example
◼ Consider the estimate of the value of the property by estimating
the cash flows (NOI) over the 5-year holding period.
◼ The growth rate of NOI is 3% per year and the discount rate is
13%.

Year Cash Flow

NOI 500000  (1.03) 5
1 $500,000 V5 = 6
=
2 $515,000 k−g .13 − .03
3 $530,450
4 $546,364
5 $562,754 + 5,796,370

◼ Value of the property based on projected NOI at year 6

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 Contents

◼ Hedonic Pricing Approach

◼ Cost Approach
◼ Sales Comparison Approach
◼ Projected NOI Approach
◼ Real Estate Investment Performance

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 V. Real Estate Investment Performance
◼ 1. Real Estate Return
◼ The market approach to measuring real estate return is
called property yield.
◼ The property yield is defined as the ratio of annual rental
income to property price:

𝐴𝑛𝑛𝑢𝑎𝑙 𝑅𝑒𝑛𝑡𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒

𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑌𝑖𝑒𝑙𝑑 =
𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑃𝑟𝑖𝑐𝑒

◼ This ratio is similar to the dividend yields for stocks reported

on the newspaper.
◼ Problem: Too Simple. But Easy to Use and Understand.

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2. Constant Rental Income Growth Model
◼ Assume that the rental income grows at a constant growth
rate g for the indefinite future.
◼ Then the value of the property is given by the following
familiar model.

NOI1 NOI1
V= k= +g
k−g V
Expected Price
Property Appreciation
Yield for
next period

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 Discussion
◼ Many real estate agents would tell you,

“You should buy the property now because the

property yield is high and it is definitely a good
investment.”

◼ How would you comment this statement??

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 What do past data say ??
Property Yield (Annual Income/Property Price)
Year Property Yield Rental Income Growth Price Growth
1981 8.0 18.2 22.3
1982 9.6 3.2 -13.5
1983 10.3 -8.7 -14.8
1984 10.4 -3.6 -4.4
1985 9.8 5.6 11.6
1986 9.7 8.8 10.4
1987 8.6 9.6 22.6
1988 8.3 16.2 21.6
1989 8.3 26.6 26.5
1990 8.2 10.0 11.0
1991 6.4 8.2 37.8
1992 4.9 9.3 41.8
Source: Property Review

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 Discussion
◼ What is the relationship between property yield and
property price, short-term and long-term??

NOI1 NOI1
V= k= +g
k−g V

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 End of
◼ Valuation of Income Properties

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Major Recent Transactions in 3rd and 4th Quarter of 2016
Office
Use Office Office Office Retail (transaction
aborted)
Retail shops Kwun Tong
Property EIB Centre Golden Centre Stelux
at Zenith View

District Sheung Wan Sheung Wan San Po Kong Wanchai Kwun Tong

Gross Area 按一下以編輯母片標題樣式

73,855 s.f. 156,000 s.f. 338,382 s.f. 26,122 s.f. 144,780 s.f.

Price $1.086 Billion $4.368 Billion $2.2 Billion $560 Million $1.875 Billion

Unit price $14,700 psf. $28,000 psf. $6,500 psf. $21,400 psf. $12,950 psf.

Monthly
$1.9M $7M $3.4M Approx. $1.1M $5.4M
income

Yield Approx. 2% 1.9% 1.9% 2.3% 3.4%

Street shops
Property close Proposal
To be next to
Remarks to Bonham disapproved at
Confirmed Sunlight
Trade Centre EGM
Tower

6/4/2019 42
 Properties on market in 4th Quarter 2016
Use Office Vertical Retail Retail
Property Honest Building Zing! Nob Hill Square
District Causeway Bay Causeway Bay Kwai Chung
Year of
1978 2011 2002
Completion
GRA (sq.ft.) 48,101 79,051 97,175

Asking Price
按一下以編輯母片標題樣式
Car park space -
$1.25 Billion
-
$2 Billion
43
$880 Million
($/sq.ft.) @$25,987 @$25,300 @$9,055
1.4% (passing) 1.6% (passing)
Yield 3.4%
1.9%* (fully occupied) 2.5%* (fully occupied)
Occupancy 90.5% 72% 100%
Monthly Rent $1.48M ($34 psf.) $2.96M ($52 psf.) $2.5M ($25.7 psf.)
- Inspected - Vendor (Pamfleet)
- Inspected
- Good location, but bought in 2015 for
- F&B driven
limited enhancement $648M
- Tenant profile does
Remarks potential. Low - Mature
not fit our portfolio
headroom neighborhood
* Assume fully let at - Low enhancement
* Assume G/F+M/F monthly
passing unit rent potential
6/4/2019 rent $500,000 (@$105 psf.) 43
Properties on Market - Pemberton
Sheung Wan
Office + F&B floors
57,779 (GFA)
Area (sq.ft.)
70,616 (GRA)
Year of Completion 1984 (Renovated in 2005)
Asking Price ($/sq.ft.) $1 Billion @$14,160 (GRA)
按一下以編輯母片標題樣式 Yield
2.7% (passing)
2.8%* (fully occupied)
Occupancy 96%
Monthly Rent $2.2M
Unit Rent (per leased GRA) $32.6 psf.
*at passing unit rent

- Not much Capex cost required

Pros - Synergy with other Sheung Wan properties
(manpower)

- Low asset enhancement potential

Cons
- Rental improvement appears limited

6/4/2019 44
 Properties on Market - 148 Electric Road
North Point
Office
197,372 (GFA)
Area (sq.ft.)
222,920 (GRA)
Carpark Space 74 (3 car lifts)
Year of Completion 2000

按一下以編輯母片標題樣式 Asking Price

Yield
$2.85 Billion @$12,780 (GRA)
2.67% (passing)
2.73%* (fully occupied)
Occupancy 98%
Monthly Rent $6.35M
Unit Rent (per leased GRA) $29.1 psf.
*at passing unit rent

- Size and tenant profile suits our portfolio

- Assuring land value
Pros
- Attractive pricing vis-à-vis en-bloc office
properties such as AIA Tower in North Point
- Low asset enhancement potential
Cons
- Unsatisfactory building provisions

6/4/2019 45
Properties on Market - Marina Square (West Wing)
Ap Lei Chau
Retail
Area (sq.ft.) 217,108 (GFA)
Car park space 96 + 20 (lorry)
Year of Completion 1993
Asking Price $3 Billion @$13,820

按一下以編輯母片標題樣式
3.1% (passing)
Yield
3.9%* (fully occupied)
Occupancy 79.4%
Monthly Rent $7.8M
Unit Rent (per leased GFA) $45.2*at passing unit rent
psf.
- 20% vacancy mainly on G/F
- Plenty of AEI potential
Pros
- Beneficiary of MTR South Island Line (East)
(target opening end-2016)

- High level of Capex required

- DMC provisions need to be clarified
- Vendor’s selling intention unclear
Cons - Local residents and district council appear
difficult and sensitive to changes in the mall
- Likely an asset deal which means 8.5% stamp
duty expenses on top of consideration
6/4/2019 46