FIN 591 Week 2 Real Estate Valuation Methods Example

Is Mission Oaks Worth $16.8 Million? Valuing a San Antonio Apartment Complex by Direct Capitalization, a Ten-Year Discounted Cash Flow, Comparable Sales and Replacement Cost

[Student Name]

University of Phoenix

FIN/591: Real Estate Investment

Week 2 Assignment

[Instructor Name]

[Date]

Mission Oaks Apartments, the comparable sales and all figures are composites written for a model paper; valuation methods and research findings come from the sources listed.

The broker's asking price for Mission Oaks, the composite 120-unit apartment community in San Antonio, is $16.8 million, or $140,000 a unit, based on net operating income of about $965,000 and a 5.75 percent cap rate. The family office's analyst was asked to value the property independently before any offer. A price is what a seller hopes for; a value is what the evidence supports, and the gap between them is where negotiation begins. This paper estimates value by four methods.

Checking the Income

The seller's statements show property taxes of about $300,000, based on the county appraisal district's current assessed value. Texas assessors often raise values after a sale to reflect the price paid. At an assessed value near the purchase price and the local tax rate of about 2.1 percent, taxes could rise to about $350,000. The analyst also raised the vacancy allowance from 7 to 8 percent, reflecting concessions at new buildings nearby. Adjusted net operating income is about $895,000, roughly $70,000 below the seller's figure.

Direct Capitalization

Four sales of similar older apartment communities in San Antonio over the past year closed at cap rates between 5.9 and 6.3 percent, averaging about 6.1 percent. Applying 6.0 percent, slightly below average for Mission Oaks' better location near a major employment corridor, to the adjusted income gives a value of about $14.9 million. Applying it to the seller's unadjusted income would give about $16.1 million. Each quarter point of cap rate changes value by roughly $600,000, which shows how sensitive direct capitalization is to a single assumption and why the cap rate must come from real sales rather than a broker's opinion. The analyst also checked that the four sales occurred after rates stabilized in 2024, so they reflect today's financing costs.

Ten-Year Discounted Cash Flow

The discounted cash flow projects income for a ten-year hold. Rents grow 3 percent a year after a slow first year as new supply is absorbed, expenses grow 3 percent with insurance rising faster, and the property sells at the end of year ten at a 6.25 percent cap rate applied to year eleven income, less 2 percent selling costs. Discounting at 8.5 percent, a return investors currently seek for older apartments, gives about $16.1 million using the seller's income and about $15.0 million using the adjusted income. The discounted cash flow captures rent growth that direct capitalization only implies, but it depends on the exit cap rate, which supplies more than half of the value (Geltner et al., 2014).

Comparable Sales

The four comparable sales ranged from $128,000 to $147,000 per unit. The analyst adjusted each for age, unit size, location, condition and amenities. The $147,000 sale was a newer property with a pool and fitness center, adjusted down about 8 percent; the $128,000 sale had deferred maintenance, adjusted up about 6 percent. Adjusted prices cluster around $133,000 to $138,000 per unit, indicating about $16.0 to $16.6 million for Mission Oaks. Comparable sales reflect what buyers actually paid, but each sale has its own circumstances, and four is a small sample. One of the four was bought by an investor completing a tax-deferred exchange under a deadline, who may have paid more to close in time, so the analyst gave it less weight.

Replacement Cost

Land for a comparable site would cost about $1.8 million. Building 120 similar units today would cost about $230,000 each, or $27.6 million, including construction, fees and financing during construction. Mission Oaks is 21 years old, with physical depreciation of about 35 percent and some functional obsolescence in its dated kitchens and lack of in-unit laundry in half the units, together about 40 percent. Depreciated replacement cost plus land is about $18.4 million, well above the other methods.

Why the Cost Approach Runs High

The gap shows that, at current rents, building a new complex like Mission Oaks would not pay; developers need rents well above Mission Oaks' to justify new construction costs. That is useful information: once the current wave of new buildings is absorbed, few competitors will be added at this price point, which supports rent growth for older properties. But buyers of income property pay for income, so the cost approach deserves little weight in setting value (Brueggeman & Fisher, 2018).

Physical Condition and Capital Needs

Valuation also depends on what the buyer must spend after closing. A property condition report found roofs on four of ten buildings within five years of replacement, about $380,000 in total, and aging water heaters in many units. Those needs are not in net operating income, which excludes capital spending beyond small annual reserves, but they reduce what a buyer should pay. The analyst subtracted the present value of near-term capital needs, about $350,000, from each income-based value, which is one reason the reconciled range sits below the seller's price.

Unit Mix and Rent Comparison

A rent survey of six nearby properties showed that Mission Oaks' two-bedroom units rent about $90 below similar older properties, while its one-bedroom units are at market. That gap is the basis for the renovation plan, since updated kitchens and flooring could close it. The analyst did not include the gap in the as-is value, treating it as an opportunity the buyer must pay to capture.

The Gross Rent Multiplier

At $16.8 million, the price is about 8.6 times gross potential rent. Recent comparable sales averaged about 8.2, another sign that the asking price is somewhat high.

Sentiment and Cap Rates

Clayton et al. (2009) found that investor sentiment, not only fundamentals, helped explain movements in commercial real estate cap rates. The seller's 5.75 percent reflects optimism about rent recovery that recent sales do not yet show, which argues against paying for that optimism in advance.

Reconciliation

The income approaches deserve the most weight for an apartment property bought for income: direct capitalization at about $14.9 to $16.1 million and the discounted cash flow at about $15.0 to $16.1 million, depending on the income used. Comparable sales support about $16.0 to $16.6 million. The cost approach, at about $18.4 million, receives little weight. The reconciled value as the property operates today is about $15.5 to $16.2 million, below the asking price.

The Offer

The analyst recommended an opening offer of $15.6 million and a ceiling of about $16.25 million, with the possibility of paying more only if the renovation plan studied in later weeks shows a clear path to higher income.

Conclusion

The seller's $16.8 million rests on income that will fall when taxes are reassessed and on a cap rate below recent sales. Direct capitalization, a ten-year discounted cash flow and comparable sales point to about $16 million, while replacement cost runs higher and mainly shows that new competing buildings are unlikely soon. An offer near $15.6 million with a ceiling near $16.25 million follows from the evidence.

References

Brueggeman, W. B., & Fisher, J. D. (2018). Real estate finance and investments (16th ed.). McGraw-Hill Education.

Clayton, J., Ling, D. C., & Naranjo, A. (2009). Commercial real estate valuation: Fundamentals versus investor sentiment. The Journal of Real Estate Finance and Economics, 38(1), 5-37. https://doi.org/10.1007/s11146-008-9130-6

Geltner, D. M., Miller, N. G., Clayton, J., & Eichholtz, P. (2014). Commercial real estate analysis and investments (3rd ed.). OnCourse Learning.