Description of Mortgage-Equity Appraisal Software

The Mortgage-Equity Appraisal Software estimates the value of commercial real estate using a Mortgage-Equity Appraisal Model which allows for either a 5-year or 10-year holding period. The projected property cash flows are allocated to the mortgage and equity components based on current lending terms and market rates of returns to each component. The value of the property equals the sum of the mortgage component plus the equity component.

The process of estimating the value of the mortgage and equity components is summarized in the following seven steps:

1. The terms of typical financing are set forth including: interest rate, amortization term, loan-to-value ratio, the debt coverage ratio, and the debt yield.

2. A before-tax equity yield and terminal capitalization rate are established. The equity yield takes into account the benefits of ownership; it is typical for buyers to base their equity yield on a five or ten-year holding period. The yield explicitly includes annual cash flow distributions and the equity residual. The equity yield implicitly includes refinancing distributions that return any property appreciation and mortgage amortization, income tax benefits, and non-financial considerations such as status and prestige.

3. The terminal capitalization rate is established as that rate appropriate for the property to be sold at the end of the assumed 5-year or a 10-year holding period.

4. The value of the equity component is calculated by first deducting the yearly debt service from the forecasted Net Income, leaving the net income to equity for each forecast year. The Net Income forecast for the year following the end of the holding period is capitalized into a reversionary value. From this figure, the mortgage balance is deducted at of the end of the holding period along with normal selling expenses; the resulting equity residual is discounted back to the date of value at the equity yield rate. The net income to equity for each of the ten projection years also undergoes a similar discounting process. The sum of these discounted values equates to the value of the equity component. Adding the equity component to the initial mortgage balance yields the overall property value.

5. The mortgage amount, the annual debt service, and the remaining mortgage balance all depend on the value to be calculated. Thus, the preceding calculation must be solved through an algebraic equation that computes the total property value. This software uses the algebraic solution developed by Suzanne Mellen in “Simultaneous Valuation: A New Technique” Appraisal Journal, April 1983.

6. In addition to estimating value using a specified loan-to-value ratio, the software also estimates value using a debt coverage ratio and a debt yield. Lenders are increasingly using a debt coverage ratio or a debt yield to size their loans and are placing less emphasis on the loan-to-value ratio.

7. The proof of value is performed by allocating the total property value between mortgage and equity components and verifying that the rates of returns set forth in Steps #1 and #2 can be precisely met from the forecasted net income.