𧠠How to Remember the Five Ethical Standards of RICS â (S.T.I.R.R)
E-Questions - Exams 2021, 2022, 2023
Question 1 - Definitions of valuation concepts (10 points)
Explain the following concepts, 2 points for each correct answer:
Market value (according to RICS) According to Rics, the market value is the estimated amount for which an asset or liability will be purchased on the valuation date.
- Between a willing buyer & Seller in a armâs length transaction
- After sufficient marketing and⊠đ
- All parties have acted knowledgeably, prudently and without compulsion.
Mortgage Lending Value (MLV) - Mortage Lending Value (MLV) is a long-term risk assessment tool used by (EU) banks in order to issue loans.
- The tool eliminates speculative aspects of the market, which protects the lenders in the market, but does not assert or equal the market value of the property.
- (Detailed application of MLV may vary from state to state and based on national legislation. E.g. â In Germany banks require individuals calculating MLV to be certified as per a national scheme.)
Residual site value (residual land value) GDV â Total Costs = Residual Site Value
It is the maximum amount that can be paid for a site including taxes,
transaction costs and professional fees.
Residual Land Value = (Gross Developed Value) - (Developers profit) - (Construction costs) - (Other Fees)
- A measure of the real estates income earning capacity at the end of the investment period.
- Exit Yield = Discount Rate - Growth Rate
- Exit Yield = WACC - Growth Rate
- Initial Yield (%) = (NOI Year One) / (Salvage Value Year n)
- Anchoring is a cognitive bias whereby an individual's decisions are influenced by a particular reference point or 'anchor'.
- In real estate, this occurrs when buyerâs or sellers use a previous market or time period as a reference point causing them to overpay for the asset.
- They have anchored their previous price expectations in a market or time that does not reflect the present market in question.
- Asymmetric information occurrs when stakeholders within a sector do not have access to or base their actions on the same information.
- Within real estate transactions, the seller has access to a lot more information than the buyer which leads to market imperfections.
- The primary driver behind asymmetric information is low transparency within the real estate sector.
- Employed by a real estate company or the company responsible for the accounts of the asset.
- Hired to follow the formats and requirements of the client but at the same time he is expected to do his valuations professionally and ethically and not let the client influence the valuation.
- Internal Valuers prepare and keep âthe booksâ up to date, so that, when external valuers come in and do a valuation, it speeds up the process.
âWhat-ifâ analysis (Give an example) - âWhat-if" analysis examines how the value/output is going to be affects due to the change in one or more input value.
- The general approach is to hold all input variables constant except one.
- This helps estimate the sensitivity of the output based on the changes in the input variable.
Question 2 - Parameters that determine risk in a propertys discount rate (4p)
Risk rate (risk premium or risk compensation or property risk) is one of the components of the discount rate in property valuations. What does the size of this risk rate depends on?
Property related risk parameters â
Discount Rate = Riskfree rate + (Property Related Risk)
Some property related risk parameters that determine risk: â Acronym F.L.A.P.T.
Question 3 - Write a short essay about your business ethics (4p)
Provide your own definition of business ethics and explain why it is important for the real estate companies to do business ethically.
Business ethics refers to the set of moral principles and values that guide the behavior of individuals and organizations. It involves making ethical decisions and taking responsible actions, even when faced with difficult situations that may challenge these principles.
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In most advanced economies, a substantial part of their GDP is made up by commercial real estate. If an industry does not act ethically, trust erodes and lies build up within the industry, which can lead to black-swan events at the tail end. The collapse of the soviet union is one example, but a more recent example is the 2008 financial crisis. By doing business ethically, real estate companies can also contribute to the overall health and stability of the real estate industry. Ethical behavior can help prevent fraud and other illegal activities that can undermine the industry's reputation and trustworthiness.
In summary, business ethics is important for real estate companies because it builds trust, protects their reputation, and ensures that they act responsibly and in the best interests of their clients. By doing so, they contribute to the stability and sustainability of the industry as a whole. (note that i mention a few of the keywords in the RICS ethical standards here)
Just try to do the right thing. The hard part is figuring out what the right thing is, given your set of circumstances and context.
Question 4 - DCF Calculation
A retail building has total area of 5000 square feet that is currently under the lease at $15 per square foot per year. Expenses on this building are $5 per square foot per year and are expected to stay constant. Vacancy and collection loss is estimated at 5% of potential gross income. Suppose the rents will develop with the rate of inflation that is 2% per year. Investor is going to hold the property during 3 years and then sell it. Discount rate is equal 10%. Expected growth of Net Operating Income in year 4 is 2%. Assume that all payments occur at the end of the period.
Given from Question đ
Calculation of DCF đ
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Donât miss NOI year 4 â $49 128,50*1,02
Otherwise mistakes will be made when calculating salvage value and initial yield
Answers â
Questions (2p) for each right answer | Answer |
a) What is the potential gross income of the building in year 3? | $Â Â 78 030,00 |
b) Â What is the effective gross income of the building in year 2? | $Â Â 72 675,00 |
c) Â What is the net operating income of the building in year 1? | $Â Â 46 250,00 |
d) Â What is the expected net operating income of the building in year 4? | $Â Â 50 111,07 |
e) Â What is the salvage value of the building at the end of the 3rd year? | $ 626 388,38 |
f) Â What is the market value of the building today? | $ 588 972,11 |
g) Â What is the initial yield rate? | 7,85% |
h) Â What is the exit yield rate? | 8% |
Question 1 - Definitions of valuation concepts (10 points)
a) Market value and Fair Value (according to RICS) (2p) â
Market Value - The estimated market value made by a valuer should be equivalent to the most probable transaction price between a willing buyer and seller on free market in an arms length transaction. Given a) proper marketing and b) information to both parties.
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Fair Market Value - Fair market value (FMV) is the price a product would sell for on the open market assuming that both buyer and seller are reasonably knowledgeable about the asset, are behaving in their own best interests, are free of undue pressure, and are given a reasonable time period for completing the transaction.
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Expropriation = Compulsory acquisition of land. When the government acquires private property from an unwilling seller for the good of society. The land must be bought at a premium or markup of 25%, since the seller is forced into the transaction. Eg. 1,25*(Market Value)
c) Â Operational leverage (2p) â
Operational leverage has to do with the time value of money and how it can be deployed over time.
Assume something costs 1 milj. SEK to construct today. Our cost of capital is 3%. If we deploy half of our capital year one and the rest year two. We get this calculation â (500 Tkr) /(1,03) + (500 Tkr)/(1,03) = 985 Tkr â 15 Tkr less than the initial cost of 1 milj Sek.
d) Scenario analysis and Sensitivity analysis (use an example) (4p) â
Scenario Analysis - Aims to asses different scenarios, usually three scenarios in perticular.
1. Most Likely Scenario
2. Optimistic Scenario
3. Pessimistic Scenario
Each scenario is assigned different input values corresponding with the scenario. Eg. Inflation, Growth, Rents, operational costs and discount rate is estimated for each scenario. See Example Below
Example đ â
Sensitivity Analysis - How sensitive is an output to changes of this input? Tests the effect of one input value changing. Ex. The interest rate, the discount rate or the debt to equity ratio. How the value changes based one input value changes.
Example đ Question 2 - How circumstances changes risk for a property and its discount rate
a) You are deciding on the discount rate to apply to a retail property in your valuation. Indicate whether you would increase or decrease your proposed rate in view of each of the following circumstances:
Discount Rate = Riskfree rate + (Property Related Risk)
b) Using the following assumptions what is the value of the property? (Same question in exam from 2022 and 2020)
- Exit Yield = Discount rate - Growth Rate â Exit Yield = 7%-2% â Exit Yield = 5%
- Initial Yield = (NOI Year one) / (Salvage Value) = 5,3% according to our calculation
Question 3 - RICS Ethical Standards & The major valuation approaches
a)Â Describe five RICS Professional and Ethical Standards. (5p)
Answer - The RICS Ethical Standards â
b)Â What are the three major valuation approaches? Explain at least two methods associated with these approaches. (5p)
Answer - The major valuation approaches â
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Income Approach - Valuation is based on the income of the property in question.
Method 1. Discounted Cashflow Method (DFC)
As the name suggests, we discount the cashflows of a property and calculate the salvage value into the present value of all cashflows and the salvage value of the property.
Method 2. Capitalisation Rate Method
Calculated by dividing a property's net operating income by its asset value, the cap rate is an assessment of the yield of a property over one year. For example, a property worth $14 million generating $600,000 of NOI would have a cap rate of 4.3%.
Value = NOI / (Cap Rate) â Or Cap Rate = NOI / Value
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Market Approach - Valuation based on comparable products in the market
Method 1. Comparable Sales Method
Assume an identical property was sold on the lot next to our property. The value of the sold property should, theoretically, be close to the value of our property.
(âMethod 2. Price Data Square Meter & Linnear Regressionâ)
Donât know what this method is called, but if there exists a lot of transaction data, such as price per sqm, number of rooms, floor etc. you can sort within the data and use linnear regression and get an average sqm price for an object in this area. This can then be used to calculate the estimated value of the object.
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Cost Approach - Replacement cost of the real estate in question.
If the real estate in question is not income producing or there arenât any comparable products in the market, this approach is the most feasibly one to use. For example, to value a church one could calculate the the cost to replace it and discount it.
Question 4 - Valuation & Transaction based indices
a)Â Explain the difference between valuation based indices and transaction-linked indices. (4p)
Valuation based indices vs transaction-linked indices â
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Valuation indices are based on valuations of properties instead of actual selling price data. Valuation based indicies are smoothed, logged and underestimate the actual selling price. This is due to the nature of how we value real estate and the methods we use. It is better to undervalue than to over-value real estate, atleast according to âförsiktighetsprincipenâ. One could argue that transaction based indices are âbetterâ or closer to reality. The main issues with transaction based indices usually comes down to data quality, transparency and the velocity of transactions.Sellerâs want to sell, when they can make a profit, this causes a discrepancy between the estimated value and the sale price. Without sufficient data, zero to no insight into commercial real estate transactions and long time periods between sales, reliable transaction based indices are hard âto findâ.
b)Â Explain how illiquidity and volatility on the real estate market affects the property valuation. (6p)
Overkill explanation of this phenomenon â
Real Estate is considered an illiquid market, meaning the asset-class is hard to liquidate, or in regular terms, it takes a long time to sell or buy a property. The illiquidity increases the risk of the asset-class. Furthermore, real estate is highly levered, meaning the asset-class is mainly financed by debt. This causes the asset class to be sensitive to market expectations and interest rates. In low rate markets, the prices can quickly skyrocket if the market assumes a low interest environment and the real estate sector seems stable.
Volatility = Risk, according to the capital asset pricing model, increased risk leads to higher expected return and an increased discount rate. The present value of real estate is connected to the discount rate, atleast according to our current income based valuation approaches. An increased discount rate leads to lower real estate valuations as we discount future cashflows with it.
When interest rates increase, the risk free rate increases and so does the debt payments for most real estate companies, meaning the risk is increased. Meaning all variables within the discount rate calculation increase. This has caused booms and bust cycles within the real estate sector.
Connected formulas:
Discount rate = (1+ Rf)*(1+Inflation) + Risk or â r = rf + i + riskPresent Value = Future Value / (Discount rate + 1)^n
Question 1 - Explain the following concepts (10 points):
a) Describe the international definition of market value and comment on two potential problems in this definition.(4p)
Market Value, international definition â
The estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an armâs length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsionâ - IVS and RICS Definition of market value
- Itâs an estimation of that point in time with a fictional transaction date and buyer.
- Proper marketing & acted knowledgeably are quite a lose terms.
b) Smoothing ni valuation context (2p)
The asset class is heterogenous, where previous transactions donât reflect well on a single asset, however we still use that data to estimate the value of real estate. This causes smoothing in the valuation the asset class as a whole.
c) Scenario analysis and sensitivity analysis (use an example) (4p)
Scenario analysis and Sensitivity analysis â
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Scenario Analysis - Aims to asses different scenarios, usually three scenarios in perticular.
1. Most Likely Scenario
2. Optimistic Scenario
3. Pessimistic Scenario
Each scenario is assigned different input values corresponding with the scenario. Eg. Inflation, Growth, Rents, operational costs and discount rate is estimated for each scenario. See Example Below
Example đ â
Sensitivity Analysis - How sensitive is an output to changes of this input? Tests the effect of one input value changing. Ex. The interest rate, the discount rate or the debt to equity ratio. How the value changes based one input value changes.
Example đ Question 2 - Risk parameters & Valuation approach Commercial, Church & School (10 points) đ
a) Risk rate (risk premium or risk compensation or property risk) is one of the components of the discount rate ni property valuations. What does the size of this risk rate depends on? (4p)
Property related risk parameters â
Discount Rate = Riskfree rate + (Property Related Risk)
Some property related risk parameters that determine risk: â Acronym F.L.A.P.T.
b) You have asked to cary out valuation of the following properties. Explain which valuation approach you will use it and why.
i. Income Producing Property (2p)
ii. A church (2p)
iii. A public School (2p) Can
i. Income Producing Property (2p) â
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Income Approach
Method: Discounted Cashflow model + Investment cost, would also calculate the payback time and IRR of the project.
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Cost Approach
Since the asset is not income producing, the cost of replacement method is the most sensible one to use in this scenario.
iii. A Public School (2p) â
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This one is quite circumstantial, if the school has burnt down â Replacement cost + Continued operations cost would be most sensible. We canât have children who donât go to school in Sweden. If itâs up and running, a market approach would be most feasible, since the compensatory payment is made to the operator on per student basis.
Question 3 - Uncertainty related to property valuations
There are many different types of uncertainty related to property valuations. Describe at least four of these uncertainties and how their effect on property valuations. (4p)
Four types of (4) Uncertainty in real estate valuations â
 1ïžâŁ
Market Uncertainty
Itâs impossible to know what the future holds or were the market is going. Example, knowledge workers wonât show up to offices anymore. Four years ago, no one would believe that a 50% drop in office building valuations would happen on manhattan, yet here we are.
2ïžâŁ
Economic Outlook
How will the national or global economy develop the coming 3 years? How will FED adress inflation? No real estate owner can predict these things, but they can prepare for the worst and run a tight ship. (Eg. lower OPEX)
3ïžâŁ
Legal
Real Estate is a highly regulated market. Knowing if, how and when a project will start, mostly comes down to the legal aspects of land use. Every aspect that is outside of a companies control is an uncertainty
4ïžâŁ
Vacancies
How well are the companies renting from us doing? Will they expand and move somewhere else? We cannot control the outcome of our tenants businesses, hence itâs uncertain how vacancies will develop the coming years.
b) Using the following assumptions what is the value of the property? (Same question in exam from 2022 and 2020)
- Exit Yield = Discount rate - Growth Rate â Exit Yield = 7%-2% â Exit Yield = 5%
- Initial Yield = (NOI Year one) / (Salvage Value) = 5,3% according to our calculation
Question 4 - Calculate WACC and Exit Yield + The Five RICS Ethical Standards
a) Given the following information, calculate the WACC and Exit Yield
Corporate Tax (Tc) | 30% | rD | 6% |
Growth (g) | 2% | rE | 16% |
Ru | 10% | WACC | ??? |
Target D/(D+E) | 60% | Exit Yield | ??? |
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WACC = 0,4*0,16 + 0,6*0,06*(1-0,3) = 0,0892 â 8,9%
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Exit Yield = WACC - g = 6,9%
Corporate Tax (Tc) | 30% | rD | 6% |
Growth (g) | 2% | rE | 16% |
Ru | 10% | WACC | 8,9% |
Target D/(D+E) | 60% | Exit Yield | 6,9% |
b) Describe five RICS Professional and Ethical Standards
The five RICS Ethical Standards â
How to value Hotels - Hotel valuation techniques
The Coke-Can Multiplier
50 rooms hotel where a soda can sells for $1.25
ADR Valuation - Average Daily Rate Technique
A hotel should generate one dollar in average daily rate per every thousand dollars in value per guest room
Average Daily Rate = Revenue Per Day * Rooms * 1000
ADR Value = (Average Daily Rate) * (number of rooms) * (1000)
RevPar
RevPar = Occupancy rate*Average Daily Rental Rate (ADR)
Occupancy rate = (Number of room nights sold) / (Potential rooms sold)
Complete Exam 2023 April
1. Explain some Market Value, Anchoring, Scenario & Sensitivity Analysis
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Explain the Following Terms
a) Market Value
b) Anchoring
c) Scenario Analysis & Sensitivity Analysis
d) Operational Leverage
2.
4. Valuations of a Hotel
Number of Rooms | 50 |
Daily Rate | 90 Dollars |
Occupancy | 85% |
Soda Can | 1,2 Dollars |
Coke Can Multiplier â 1,2*50*1 000 000 = 6 000 000 Dollars
ADR â 90*50*1000 = 4 500 000
RevPar â ADR*Occupancy = 4 500 000*0,9
Part B - Advanced: 40 points
Question 5 - (4 points)
Provide at least two reasons why house buyers from outside the particular housing market might pay a higher price then the local buyers.
Question 6 - (8 points)
Discuss for whom highly transparent property market might be beneficial and for whom it might not.
Question 7 - (10 points)
Discuss the problems in property valuation that are associated with booms and busts on the market.
Question 8. (10 points)
Suppose that you have performed simulation analysis with 100 trials for market value estimation of some property assigned to you and have received the following results table, histogram and descriptive statistics:
