Real Estate Valuation and the Asset Ledger
From UREWPS™ Business Plan: Appendix A
Understanding how real estate values are determined is an essential consideration when determining the value of real estate for acquisition, retention and liquidation. Having a reliable, reputable, accurate, consistent, and reproducible model for valuing real estate is required for ensuring that the Real Estate Assets Value published in the CuBitDAO™ Asset Ledger correctly reflects this crucial element of the value of CuBit™.
Processes for valuing real estate can be standardized across markets. However, the values themselves will vary from one market to another and even from one sub-market to another. During the periodic outside audits of the Asset Ledger auditors will look closely at how the CuBit™ real estate portfolio is valued, both in part and in whole. Auditors will need to have confidence in our valuation approach and be able to reproduce its results to validate the values we assert.
Let Me Count the Ways
Real estate value is determined through a variety of methods that account for factors such as market conditions, property characteristics, and future income potential. These methods help assess the worth of a property, whether for sale, investment, taxation, or financing purposes. Below are the primary approaches used to determine real estate value:
- Market Comparison Approach (Sales Comparison Approach)
- Tax valuation
- Economic valuation
Finally, there are automated valuation models (AVM) which show up on websites such as Redfin.com, Zillow.com and others. These models are typically employed by online real estate platforms, lenders, and investors to quickly provide value estimates. Automated Valuation Models (AVMs) use algorithms and large datasets to estimate a property’s value. However, they rely heavily on data inputs and are not as precise as professional appraisals. We reject using AVM on two grounds 1) the underlying models are proprietary code so the value formula is opaque and, 2) experience has shown that AVM models consistently overstate property values.
We don’t call out professional appraisals here as a distinct method of valuation because professional appraisers may use one or more of the above methods to determine a property’s fair market value. Appraisers are a reliable provider, not a distinct approach. We anticipate that independent appraisers will play a significant role in determining the value of real estate held in the CuBit™ portfolio.
Comparable Market Analysis
Market comparison approach is what most people are familiar with. Market comparison determines the value of a property by comparing it to similar properties that have recently sold in the same area. Adjustments are made for differences in features, such as location, size, and condition. This method is widely used for residential real estate, as it reflects current market trends. The process is often referred to as Comparable (or Competitive) Market Analysis (CMA) and the result is called the Fair Market Value (FMV). After all adjustments are made for condition, amenities, location, and some other factors the result is an assertion of a price per square foot, multiplied by the square footage of the property. This form of valuation is what most home buyers and home sellers see when a real estate agent or a home appraiser analyzes the value of a property.
“The sales comparison approach is typically regarded as the most reliable and accurate method for determining the value of single-family homes”
Tax Valuation
Tax valuation is based on the judgement of a government employee of the value of real estate relative to its highest and best usage, and sometimes relative to the prevailing market rates. The tax assessor considers improvements on the property, the path of growth, market trends, and recent sales of similar properties. In most jurisdictions the tax value is a significantly lower assertion of value than what the market is willing to pay. For practical purposes, the tax value is used primarily by taxing authorities to determine how much property taxes are owed by property owners. These tax assessments tend to act as a practical floor to support market valuations of property.
Economic Valuation
Economic valuation is the only valuation method standardized across all markets, because it is based on the mathematics of renting or leasing a property. Despite this potential for standardization, optimal economic valuation may vary considerably from one market to another and there are competing economic models.
The income capitalization approach values a property based on the income it generates. This method is commonly used for commercial real estate, apartment buildings, and rental properties. The net income a property generates (after expenses) is divided by the capitalization rate (cap rate), which reflects the expected return on investment, to arrive at the property’s value.
"The income approach is the method of choice for properties where income is the primary motivation for ownership, such as office buildings, apartments, or shopping centers"
For a fixed NOI, the lower the expected Capitalization Rate (Cap Rate) the higher the price you can afford to pay for the property. Unless the expected return involves the sale of the property, market valuation doesn’t typically factor into the economic valuation of a property. Tax value is factored in only because it determines how much real estate taxes may need to be taken out of the gross income to help in the ultimate determination of the NOI.
Cap Rate Abuses
Cap Rate is perhaps one of the most abused terms in commercial real estate. Buyers base their Cap Rate calculations on NOI, while sellers and unscrupulous or uneducated agents often base it on Gross Rental Income (see below).
Occasionally, an agent or seller will promote a Cap Rate that is based on pro forma (Latin for “the form it will take”) cash flows, which are fictional. Experienced investors never accept others’ calculation of the Cap Rate, instead, they run the numbers themselves and base them on the actual, verifiable income and expense numbers.
A simplified version of the income approach, the gross rent multiplier (GRM), is often used for small rental properties. It calculates the property’s value by multiplying the gross rental income by a multiplier derived from market conditions. GRM is quick but less detailed than the full income approach because it doesn’t factor in operating expenses.
Our Approach
The Company will typically use economic valuation as its primary driver to determine real estate value. This is appropriate since the focus is on the acquisition and management of revenue producing real estate. We will also rely heavily on professional appraisers and local real estate experts.
Increasing Economic Values
PropertyMangement.com reports that since 2000 rental rates have risen an average of 3.1% per year. This compares favorably to average real estate appreciation of 3.9% and inflation of 2.2% for the same periods. This implies that the Company’s economic models for returns generated are conservative and the actual results may outstrip projections.
If you hold expenses constant as a percentage of rent and maintain the same before tax Cap Rate expectations of the current model (4.2%), by the time you reach year 10 the $100k property now has an economic value of $136k.
The SFR Exception
Single family residential (SFR) properties, in contrast with other revenue producing real estate, may be valued using comparable market values. Where this occurs, it is the general policy of the Company to ensure that no superior lien is present and total capital for acquisition, rehab, and sale of a property will not exceed 70% of the FMV of a property. These two policies significantly mitigate many risks associated with buying, managing, and selling SFR.
Not all of the Company’s real estate deals will be based on acquisition and management of real estate. Some may be linked to lending operations secured by real estate. These efforts may produce one-time, or ongoing, revenues specific to real estate finance.
Avoiding Consumers
Financial partnering operations of the Company will be primarily business-to-business and avoid entanglements with consumers. This policy of partnering rather than lending and excluding consumer-based efforts avoids substantial risks and regulations associated with providing loans and lending to consumers. The costs of compliance with those regulations and measures to mitigate those risks would drive up our expenses and significantly dilute our financial returns.
The Whole Story
The policies and approaches described in this section do not stand alone. The Company maintains many other policies, standards, and procedures designed to mitigate risks and deliver optimal returns.
References
Appraisal Institute. (2013). The Appraisal of Real Estate (14th ed.). Appraisal Institute.
Betts, R. M., & Ely, M. S. (2013). Basic Real Estate Appraisal (9th ed.). Cengage Learning.
Brueggeman, W. B., & Fisher, J. D. (2011). Real Estate Finance and Investments (14th ed.). McGraw-Hill/Irwin.
Clapp, J. M. (2004). Automated Valuation Models: What Do They Measure and How Do They Work? The Appraisal Journal, 72(4), 47–56.
Geltner, D., Miller, N. G., Clayton, J., & Eichholtz, P. (2007). Commercial Real Estate Analysis and Investments (2nd ed.). Cengage Learning.
