S.E.C. Real Estate Observer

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Part I

In regard to the pricing of real estate, many of us have heard the saying, “I’ll pay your price if you accept my terms.” Although in some situations, that statement may be true, and special terms may allow for the structuring of a successful transaction, it is equally important when preparing to market a property to have the property realistically valued. The development of an effective price may be accomplished by utilizing the capitalization of the income method for income-producing property, namely the “Cap Rate,” and by comparative sales analysis for non-income producing real estate. Likewise, it is important to have “thoroughly counseled” a client so as to take into consideration the “benefits objective vs. value.” A review of the valuation alternatives and considerations are addressed as noted in this article.

Valuation Applying DCR (Debt Coverage Ratio): This may be an exceptional tool in setting the value of an “income property.” Lenders set the DCR, which is adjusted from time to time, by what is currently reflected in the market and by the class of the property. This relates to the ratio by which the NOI (Net Operating Income) covers the potential debt service (a 1.25 DCR denotes that the l.0 covers the debt service and the .25 is the lenders safety margin). EXAMPLE:

Assumptions:

Lender’s DCR (Debt Coverage Ratio) 1.25. DCR relates to the ratio of D.S. (Debt Service) to NOl. Thus, $70,000 NOI divided by 1.25 DCR = $56,000 DS (Lender’s Allowable Annual Debt Service)

Potential Loan: $750,000 @ 7% interest for a 25 year term = $63,241 annual debt service
Lender’s Allowable D.S. is 1.25 DCR divided by NOI = $56,000 Lender’s allowable D.S.
Result: A potential “negative cash flow”: $ 7,241 Excess D.S. over allowable D.S.

THIS INDICATES THAT EITHER THE PROPERTY VALUE IS SET TOO HIGH, THE PURCHASER NEEDS TO ADD MORE EQUITY, OR THE MORTGAGE TERMS NEED TO BE MODIFIED IN ORDER TO ACHIEVE THE LENDER’S “DCR.”

Using this data, we can estimate what LTV (Loan to Value) the lender may be willing to accept:
Using a financial calculator (or using the loan amortization tables), we can estimate what the lender’s acceptable allowable D.S. will be to determine the acceptable dollar amount of a loan (This example uses the HP12c calculator.).

Lender’s Allowable Annual DS $56,000 divided by 12 months = $4,666.66 (monthly D.S.).
Insert in calculator mo. DS $4,666.66, hit PMT (Payment) and (CHS) change of sign to read (-) $4,666.67. Insert interest at 7%: (hit 7; then, hit blue key “g” and “i” key).
Next, insert years of mortgage term (hit 25; then, hit blue key “g” and “n”).
Finally, hit the “Present Value Key” (PV).
This indicates the maximum amount of mortgage allowable is $664,123.80.

NOTE: You can also refer to a mortgage table to calculate the potential D.S. and mortgage amount.
ESTIMATING THE POTENTIAL PROPERTY VALUE BASED ON ALLOWABLE MORTGAGE: $664,123.80 allowable mortgage divided by 75 (75% LTV) = $885,498 POTENTIAL PROPERTY VALUE.

Thus, you can use this analysis to illustrate to the property owner that the market value is “too high” for the market based on what the mortgage terms that would be available to a potential purchaser. Furthermore, you can state that most likely a potential purchaser will not “increase the amount of equity” in order to achieve the lenders DCR since that would reduce the amount of return a purchaser could receive on the investment by adding additional equity. This illustrates what the “real world” is to a potential seller. Hopefully, the owner will agree to a “value that may reflect the current market” based on “potential current financing.”

Appraisal: When the “effective” market value of a client’s property is uncertain, whether the property is an “income property,” a non-income property, or either due to the nature and/or location of a property, it would be appropriate to suggest that the subject property be “appraised by a “M.A.L” appraiser. Thus, you can advise the property owner that the appraiser would develop the potential value based on the nature of the property, its location and market conditions, as well as comparable sales, and that you would be willing to “list the property at the appraiser’s valuation number.” If the property owner agrees to have the property appraised, you know that you have a motivated owner who is willing to be reasonable so as to achieve a successful transaction. However, if the owner refuses to have the property appraised and/or insists on a valuation that is either too high or speculative, this is a good indication that you should “not” accept the marketing of the property. You probably would not be putting your talents to good use; therefore, you should move on to work with another property owner who would be realistic. All that you have to offer to a client is “your time and knowledge”; thus, you should use both wisely.