Estimating the Value of Apartment Buildings

By Frew, James; Jud, G. Donald | The Journal of Real Estate Research, January-March 2003 | Go to article overview

Estimating the Value of Apartment Buildings


Frew, James, Jud, G. Donald, The Journal of Real Estate Research


Abstract This article is the winner of the Apartments manuscript prize (sponsored by the National Multi Housing Council) presented at the 2002 American Real Estate Society Annual Meeting.

This article applies hedonic modeling techniques to estimate the value of a sample of apartment properties sold in the greater Portland, Oregon area. An equation for value as a function of location, amenities and capitalization rate is derived. This model explains about 95% of the variation in apartment property prices. Property values decline with increasing distance from the city center. Moreover, values are shown to rise less than proportionally to increases in project size and numbers of units and decline with project age, but the marginal effect of project aging is small.

Introduction

Valuation of apartment projects is important to appraisers, investors, tax assessors and other real estate market participants. This study applies hedonic modeling techniques to estimate the value of a sample of apartment properties sold during 1996-99 in the greater Portland, Oregon area. The results provide a model of the application of hedonic modeling to apartment valuation.

Literature Review

A number of studies have sought to explain the rent paid in the market for rental units using hedonic price theory. This hedonic approach is developed in the work of Lancaster (1971), Rosen (1974) and others. This literature has been reviewed by Jud, Benjamin and Sirmans (1996). A recent study of the relationship between rents and distance is available in Soderberg and Janssen (2001). In addition, Frew and Wilson (2000) examine the rent-distance relationship in the Portland area.

Property rents and values are related through the capitalization (cap) rate. The cap rate as used in the real estate literature refers to the ratio of net operating income (NOI) to property value. This rate has a particularly important role in property valuation, because the income capitalization method converts the expected NOI stream from commercial property into an estimate of asset value by dividing the net NOI stream by the capitalization rate (Brueggeman and Fisher, 1993: 438). Because NOI is the difference between effective rents and operating expenses, property value is fundamentally related to rents and the cap rate, if expenses are a constant fraction of rents.

The cap rate bears a close relation to the weighted average cost of capital (WACC) as defined in the corporate finance literature (Copeland and Weston, 1988). The WACC is the rate of discount that reflects the average costs of debt and equity capital employed by a firm. Discounting the cash flows from corporate assets at the WACC reveals the value of the firm. The relation between the WACC and firm valuation has extensive theoretical underpinnings extending from the firm valuation work of Modigliani and Miller (1958). Sharpe's (1964) development of the capital asset pricing model (CAPM) revolutionized stock portfolio theory and provided a widely accepted method to empirically estimate the cost of equity, which as this paper shows, is an embedded component in the cap rate.

Empirical work in the real estate literature seeks to explain the cap rate relative to other rates and macroeconomic factors (Froland, 1987; and Evans, 1990). Ambrose and Nourse (1993) develop an investment approach based on the WACC; however, they do not incorporate the CAPM in their model. Instead, they rely on the intuitive argument that debt rates on mortgages should be related to government debt rates and that the cap rate should be related to the earnings-price ratio.

Jud and Winkler (1995) draw on the theoretical underpinnings of the WACC and the CAPM models in the corporate finance and investment literature to develop a theoretic model of the capitalization rate for real estate properties. Recognizing the imperfect market conditions inherent with real estate transactions, they use a lag component process for market variables as suggested by Evans (1990). …

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