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The Student Handbook toTHE APPRAISAL OF REAL ESTATE

Chapter 20

The Income Capitalization Approach

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Relationships to Value Influences and Appraisal Principles Supply and Demand

Application and Limitations Interests to Be Valued

Leased fee Leasehold

Leases Gross lease Net lease Triple net leases

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Future Benefits Periodic cash flows Reversion or resale of the investment

Common Lease Structures Flat rental lease Variable rate lease Step-up or step-down lease Lease with annual increase Revaluation lease Percentage lease

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Common Rent Types Market rent Contract rent Effective rent Excess rent Deficit rent Percentage rent Overage rent

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Table 20.1 Reconstructed Operating Statement

Potential gross income (PGI) 25,000 @ $9.00 = $225,000Vacancy & collection loss 5% of PGI = -$11,250Effective gross income (EGI) $213,750

Estimated Annual Expenses Property taxes 33,000$ Fixed expenses Property insurance 4,500$ Repairs 30,000$ Management 5.848% 12,500$ Variable expenses Utilities 22,000$ Reserves for new roof 1/20 1,250$ Reserves for replacement Reserves for parking lot 1/15 800$ Total expenses 104,050$ -$104,050Net operating income (IO) $109,700

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Potential Gross Income Starting point As if full and w/o collection losses

Vacancy and Collection Losses Effective Gross Income Less Fixed Expenses Less Variable Expenses Less Reserves for Replacement (Sometimes) Net Operating Income (NOI or IO)

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Equity Dividend Rate Also called cash on cash Equity income (IE) divided by equity input (VE –

down payment) The ratio of the income to the equity to the

equity input (down payment) Ignores the value of the reversion

Reversion Return of the investment

Sometimes it is nothing. Sometimes it is a meaningful amount.

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Operating Expenses Necessary to maintain the property Debt service not included Fixed expenses – do not vary with occupancy Variable expenses – do vary with occupancy Replacement reserves should be included if

they are included in capitalization rates of comparable properties but not if they are not.

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Rates of Return Return on and Return of Capital

Return on an investment is like the interest on a mortgage.

Return of an investment is like the principal payments on a mortgage.

Income Rates Overall capitalization rates (RO) The ratio of a single year’s income (periodic) to

the sale price or value (lump sum) Net income multiplier is the reciprocal of the

overall capitalization rate.

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Table 20.2 Capitalization Rate Extraction Worksheet

Subject Sale 1 Sale 2 Sale 3Reported sale price $1,985,000 $1,458,000 $3,258,000

PGI for next year $510,000 $369,000 $253,680 $601,000Vacancy & collection loss -$25,500 -$25,830 -$15,221 -$48,080EGI for next year $484,500 $343,170 $238,459 $552,920

Taxes $56,000 $44,258 $26,000 $72,000Insurance $10,600 $9,600 $4,500 $14,500Management $0.05 $24,225 $17,159 $11,923 $27,646Maintenance - building $22,050 $16,055 $10,700 $26,500Maintenance - grounds $11,000 $8,000 $4,900 $13,800Utilities $67,000 $55,000 $34,000 $76,800Reserve fund - roof covering $5,000 $4,200 $2,600 $4,200Reserve - parking lot $4,500 $3,900 $2,500 $7,500Reserve fund - HVAC $3,200 $2,500 $2,900 $6,200Reserve fund - elevator $1,500 $1,200 $1,800 $3,600Tenant improvements $5,500 $4,400 $3,500 $12,600Total expenses $210,575 $166,272 $105,323 $265,346

Net operating income $273,925 $176,899 $133,136 $287,574

Extracted capitalization rates 8.91% 9.13% 8.83%

$273,925 / $0.09 = $3,043,611.11

Operating expense next year

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Discount rates, yield rates, interest rates, and internal rates of return all have similar definitions.

The present value of a property can be considered to be the present value of the future benefits, which are the cash flows and the resale value of the property.

The discounted cash flow model essentially says, “How much do I get and when do I get it?”

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Table 20.3 Cash Flow Projection

For reversion value only

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

$72,000 $72,000 $72,000 $84,000 $84,000 $84,000

$66,144 $66,144 $66,144 $66,144 $66,144 $66,144

$51,600 $53,000 $60,000 $60,000 $60,000 $60,000

$14,400 $18,000 $19,200 $19,200 $19,200 $19,200

$27,780 $27,780 $27,780 $27,780 $27,780 $30,558

$28,800 $24,000 $33,600 $33,600 $33,600 $33,600

$260,725 $260,924 $278,724 $290,724 $290,724 $293,502

-$10,429 -$10,437 -$11,149 -$11,629 -$11,629 -$11,740$250,296 $250,487 $267,575 $279,095 $279,095 $281,762

$55,000 $56,650 $58,350 $60,100 $61,903 $63,760

$195,296 $193,837 $209,225 $218,995 $217,192 $218,002

$2,158,366

$195,295 $193,837 $209,225 $218,995 $2,375,558

0.9174 0.8417 0.7722 0.7084 0.6499 $179,164 $163,153 $161,564 $155,136 $1,543,875 $2,202,891

Last year's income divided by the cap. rate 

Tenant 1

Tenant 2

Tenant 3

Tenant 4

Tenant 5

Tenant 6

Vacancy and collection (4%)

Potential gross income

Effective gross income

All expenses

Present values

Net operating income

Reversion (10%)

Cash flow

Discounted at (9%)

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Yield Rates—Rates of Return on the Investment Internal rate of return is the rate of return on the

investment considering the price paid for the investment, the periodic cash flows, and the reversion.

Overall yield rate is the rate of return including debt and equity.

Equity yield rate is the rate of return from the perspective of the equity investor. It is the rate of return on the amount paid as down payment from periodic income after debt services and including the reversion after the debt has been paid off.

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Estimating Rates Risk is a big factor since risk is a primary

component of the yield rate. If the investment is risky, it deserves more return than if it were not a risky investment. This is investment-specific.

Inflation is also a factor in a yield rate. The change in the buying power of the currency will affect the investment criteria. Unfortunately, almost all competing investments suffer under the same inflation rate; therefore, competition will not allow the investor to adjust for this factor. Investors may want higher yields during high inflation periods but the alternatives may not allow it.

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Income Capitalization Approach Methods Direct capitalization of a single year’s income. This

is a technique based on the ratio of property income to sale price.

Yield capitalization of multiple years’ income. This method is based on the assumption that all investments are the present value of future cash flows.

Direct capitalization, yield capitalization, and discounting compared. If income is level and the data is good, direct capitalization is easy and accurate. If income is irregular or data is hard to obtain, discounted cash flow analysis will work better.

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Problems

Suggested solutions begin on page 365.

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Problem 7

Purchase price $1,235,000Mortgage amount @ 75% -$926,250Down payment @ 25% of sale price $308,750

Net operating income = $96,000Annual debt service -$78,558Income to the equity $17,442

Income to the equity/equity investment 5.65%

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Problems 8 and 10

Base rent 5,000$ X 12 = 60,000$ Sales % rent 850,000$ Less base 600,000$ Overage income 250,000$ X 3% = 7,500$

67,500$

Problem 8

Tenant PGI1 60,0002 75,0003 65,0004 75,000PGI 275,000V & C -13,750EGI 261,250Expenses -100,000NOI 161,250

Problem 10