Fine Tuned Income Approach in Real Estate Valuation in Emerging Europe: The Case of Bulgaria

Abstract

The Chamber of Independent Appraisers in Bulgaria adopted the International Valuations Standards of IVSC. The income approach is one of the three approaches for valuation adopted by International Valuation Standards Council (IVS, 2011). It prescribes three methods of the approach: (1) capitalization; (2) discounted cash flows (DCF), and (3) various option valuation models. The DCF application in real estate valuation is illustrated in TIP 1 Discounted Cash Flows of IVS. One of the key input variables in the DCF method is the discount rate. IVS in paragraph 21 in TP 1 presents the capital asset pricing model as a method for estimation of the cost of equity. The CAPM could be adjusted for country risk and other specific firm risks. The focus of our study is on the main considerations behind the appropriate determination of the discount rate when performing real estate valuations throughout the Income Approach. We propose a model, which is a modification of the Salomon Smith Barney model for cost of capital determination. The model reflects the following characteristics: (1) the degree of diversification of the particular investor (imperfectly diversified); (2) country risk; (3) firm specific risks; and (4) time varying risk nature. The first assumption of the model is that the Bulgarian financial market is partially integrated into the Global market. Our second assumption is that the purchase parity holds in the long run. The lack of size effect is the third assumption. The inputs of the model have as a source only publicly available data. The systematic country risk indicator is the Index of Economic Freedom of the Heritage Foundation. The Global equity risk premium is obtained from the Credit Suisse Global Investment Returns Yearbook. The equity risk premium is adjusted with the ratio between the unconditional long run standard deviation of the company and the unconditional long run standard deviation of the global portfolio. The unconditional long run standard deviation is a square root of the unconditional long run variance, which is derived from the AR(1)-GARCH (1,1) model with non-normal distributed residuals. The econometric model incorporates the non-synchronous effect and time varying risk. An illustration of the proposed model is the case of U.S. investor who considers an investment in a couple of Bulgarian REITs.