DCF or Direct Cap

[Tom Hildebrandt]

Steve Santora

My God, are you ill? I go away for a vacation and Steve S. is quoting USPAP as a definitve source of appraisal practice! My heart can not stand it

I agree with Paul and you, the issue is what and how does a particular buyer for a property see the market and analyze it. Some use GIM, some direct cap and some DCF. In large part our decisions on how to analyze these properties are defined by our judgemnts on just these issues.

Hate to keep going back to my case before the NCAB, but that is exactly the issue. This property was being pursued by mid level investors. They recognized this property is not just another piece of dirt in the northwest part of our county, but rather that it was unique because it was by the airport. They were offering in the range of $60-70,000 P/A. the airports appraisers seem to believe that there is nothing special about this property, and valued it like just any piece of dirt. In my opinion, they compounded their error by not recognizing the blight imposed by the airport.

The key in this is the judgment of the appraiser in deciding what the market is, if you assume the only market for this property is a local industrial user, you end in a range of $25,000 to $40,000. If you feel that the property is unique because of the airport (but without blight) $45,000 - $70,000 is a reasoanble range. If you feel ther is blight, the range is from $70,000 to $100,000. Each view is accurate, given the perspective from which it is viewed.

Of course, the property history shows that one set of value is too low, and the upper end of the range is a hypothetical, hence the NCAB case.

Why the NCAB has a tough time with this is that they believe market value is an absolute. As a corporate group, they have no academic or intellectual rigor, they are just a bunch of good old boys on the political power trip and gravy train.

But you caught me late at night and in a mood to ramble.

Gosh, Steve Santora, actually quoting USPAP in support of his position, I must be hallucinating!

Best regards

Tom Hildebrandt GAA

 

[Fred]

"My God, are you ill? I go away for a vacation and Steve S. is quoting USPAP as a definitve source of appraisal practice! My heart can not stand it ..Gosh, Steve Santora, actually quoting USPAP in support of his position, I must be hallucinating!"

Now that's too funny. Tom, Pretty soon I'll have to supporting my work with the RICS code of 1834.
I do not have a problem with "USPAP." However, thee are some problems with what the ASB's have been trying to do to it since 1998. Making a mess. I like:
-correctly employed recognized methods...fine
-communicate with sufficient info and don't mislead...fine
Pre-1999 had some other classics, e.g.: each item must be addressed in the depth and detail required by its significance. That one pretty much covers reporting.

In the prior post, I meant to point out that SMT-2 is in its pristine, 1991, mint condition; one of the few things that has not been changed in the Kaiser era. Who knows, maybe as a parting shot, Ken will slip a few goodies into the next exposure draft, changing,
"DCF analysis is an additional tool available to the appraiser and is best applied to value estimates in the context of other approache" to
"DCF analysis is an additional tool available to the appraiser and is best applied to value estimates in the context of other approache, GIVEN THE SCOPE OF WORK NECESSARY"

 

[Bill_FL]

OK, I have read this thread and have found some very flawed thinking. Nope, I wont quote USPAP, I wont even quote anyone by name in here, but I think I read:

...any method used to convert an estimated single year's income into an indication of value using the appropriate income factors is considered direct capitalization....

What is a GIM?

Also, Paul Ness, I guess you must specialize in a market segment of higher end properties. Most of the small investors I know for smaller commercial investments look at gross. Very few use NOI. That sais, most of the investors I have talked with that do purchase larger investments actually look at equity yeilds, not Ro's.

I have said it before in here, and I will say it again. I think that as appraisers most of us tend to use alot of fancing names and formulas fro some pretty simplistic problems. Again, I think it is more about impressing the reader of the appraisal than measuring what the typical participant in the given market is doing.

 

[Fred]

Bill,
GIM is Gross Income Multiplier.

 

[Bill_FL]

Steve,

I know what a GIM is, it was a retorical question. Actually, I picked a bad example to post above because it correclty mentions a factor. elsewhere in this post, someone said that any measurement of a property's annual income was a direct cap. I asked about a GIM as that is also a measurement of a property's annaual income.

 

[Paul Ness MAI]

Bill, you are absolutely correct about different levels of analysis buyers use for various sizes and types of property, and the appraiser's income analysis should reflect a typical buyer's due diligence.

Having said that though, I have found very few investors exclusively hang their hat on a GIM for anything greater than maybe a 5-10 unit apartment. If they (or any appraisers) do use GIM, they must be knowledgable enough to realize they must examine expense ratios as part of that analysis. Now if you're talking about something smaller than that, then GRM is probably ok since expense ratios are likey fairly consistent. One way to tell is to see how tight the range is for GIM's or GRM's you have.

Go to www.creonline.com (links for both resi and comm investors' forums) and ask investors if they rely on GIM or direct capitalization of NOI. I visit that page often, and even many small investors know what equity dividend they require, and some post questions from time to time as to how to build that into a direct cap rate. At the other end of the spectrum, I agree that large investors look at equity yields based on ATCF.

Finally, don't confuse what I said earlier regarding direct cap. I did not say that <<any measurement of a property's annual income was a direct cap>>. I said that capitalizing a single year's net operating income into value by definition is direct cap as opposed yield cap, regardless of the method used to formulate a direct cap rate (simple band-of-investment vs Ellwood). That was the original debate here. Your rhetorical question implied that GIM is a form of capitalization. It is obviously not, rather it is a multiplier.

 

[Fred]

Paul and forum:
I am glad that Paul brought the discussion back to square one: DCF and Direct Cap, by definition. Several have posted that converting one year of income is, by definition, Direct Cap. This is sort-of true. It is sort-of true the same way that a duck, by definition, has feathers. The feathers alone may not be enough to assure that we have duck. It may have to walk, talk and quack like a duck as well. Similarly one year of income many occur until some date several years hence and that would entail discounting. One year is always the same thing as Year One.

To get a more complete picture and to clarify what these methods entail, by definition, here are a couple of definitions.
<span style='color:darkblue'>
From The Dictionary of Real Estate Appraisal.

"Direct Capitalization
1. The method used to convert an estimate of a single year's income expectancy or an annual average of several years income expectancies into an indication of value in one direct step, either by dividing the income estimate by an appropriate rate or by multiplying the income estimate by an appropriate factor.
2. A capitalization technique that utilizes capitalization rates or multipliers extracted from sales. Only the first year's income is considered. Yield and value change are implied but not identified....

Yield Capitalization
The capitalization method used to convert future benefits to present value by discounting each future benefit at an appropriate yield rate or by developing an overall rate that explicitly reflects the investments income pattern, value change and yield rate."</span>

My Comments
1. Please note. Per the dictionary, Direct Cap applies extracted rates or multipliers to the first year of income in a single step (hence direct). So Direct Cap means no extra intervening steps, like executing the Ellwood formula - by definition!

2. Please note. Per the dictionary, Yield Cap includes the use of implied, equivalent overall rates (like Ellwood) from a multi-year scenario - by definition!

3. It seems obvious that the scenario I described of an appraiser using 10 years of projected income, value, etc. is not Direct Cap, by definition, as long as one looks at all of the relevant definitions; and does not just take one part of the definition of out of context.

Amidst the flame that came my way earlier in this thread were several comments that I apply ideas that are completely outside the realm of generally accepted appraisal practice. The fact is that I was applying the literal text of the Dictionary of Real Estate Appraisal.

This is adding to the topic, Paul, but I do not understand the basis of your position expressed in the statement,
"Your [Bill's] rhetorical question implied that GIM is a form of capitalization. It is obviously not, rather it is a multiplier"
The preceding text definition of Direct Cap includes both rates and multipliers (factors) and only refers to income, making no distinction between gross or net (or the several forms of each).

 

[Terrel L. Shields]

Got my eyes opened recently when I appraised a Car wash. Borrower reamed me from one end to the other. I held my ground but I decided I needed back up and bought a book of how to appraise a carwash by an investor type who had owned a number of them and who worked with an appraiser for 20 years.

It finally boiled down to his assertion that 2.75 was THE multipler to consider against GROSS income. He made his case that gross income figures were far more reliable than expense figures because many people pad expenses with things like the depreciation on the new truck, etc.

The income of the subject was $65,000 or $178,750 would be the value.

My appraisal? $180,000. The subject had been purchased one year ago for $140,000 and a rebuilt auto wash bay ($25,000) had been installed.

I think the Direct Cap approach is often far more reliable than DCF where year to year income is relatively stable. A wasting asset like oil well production on the other hand is likely much better appraised using forecast production and prices and discounted cash flows.

 

[Paul Ness MAI]

Steven, In this instance you are correct. My statement was wrong that application of a GIM is not capitalization. Thank you for correcting me.

 

[Bill_FL]

Steven and Paul,

I too went back and did some rereading and found whre the AI defines a GIM as being a method of direct cap. I wish they would make up their minds though. In one breath it is a unit of comparison in the Market approach and in another it is a method of Direct Cap in the Income approach. Typically, FNMA and bankers tend to consider any measurement of or valuation based on income to be an income approach.

Personally, I think a DCF is most appropriate when income and/or expense levels are not consistent. To me, if the property (and I guess similar types of properties) has stabilzed income and expenses, than a direct cap would be most appropriate.