Appraisers' Free Forum

At AI's new class in yield capitalization (General Appraiser Income Approach, Part 2), there was an example problem given in which the first three cash flows were negative, and the last two positive. The project yield rate was given at 11.5% (or something like that), and we were to solve for value. The instructor applied the 11.5% yield rate to all five cash flows and the reversion. I was OK with applying it to the reversion, because it sometimes works out that way.

But applying the project yield rate to the negative cash flows gave me a rash. The effect of doing that is to reduce the amount expended by 1/1.115^t, and I don't think that's right. The negative cash flows represent money expended to get the project going. It should (in an ideal world) be budgeted and fully funded. If that is true, IMO it should be drawing interest (and be discounted) at the safe rate, not the project yield rate. The instructor, a veteran of 20+ years' experience, said "No!" Being the perpetual iconoclast, I think he's wrong. What do you guys think?

I agree with the instructor for academic discussion purposes and with you in real life matters.

Negative cash flows are still cash flows and with given a project yield rate, you have to account for those. What I think might be confusing is the calculation of the rate (safe rate vs project yield). In this case, the rate was a given. I guess it's a question of accounting versus economics. Accounting considers cash expenditures only and economics considers opportunity costs.

What's shackling my reasoning is my lack of experience with this sort of thing coupled with my lack of association with people who do. If I were doing a project, I'd calculate my cost and project my finished value using the safe rate to discount projected expenditures, and the project yield rate for incoming cash. But real-life entrepreneurs may not do it that way.

My local redneck investors commonly use a GIM, and wouldn't know a cap rate from Chapter 7. Yield cap makes their eyes glaze over and causes a copious flow of fertilizer from them.

Investors in my market behave the same way, Jim. GIM and Direct Cap. About all it takes to appraise a limited service motel in these parts is knowing how to multiply by 3.

I don't compound or confuse the situation by trying to make something more mathematically precise than it is. We read and report the market. If it's simple, I keep it simple. If it's complex, I'll confuse the excrement out of them. If you can't dazzle them with brilliance, baffle them with bull.

Got a chuckle out of one war story the instructor told. Seems he reviewed a report in which the appraiser had gone to great lengths to establish his direct cap rate. He then used up a couple more pages deriving a GIM from the same numbers. Claimed his opinion of value by direct cap was supported by its determination by GIM. Doofus didn't realize they were reciprocals of each other. (But his client did. That's why he got reviewed.)