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Welcome toWelcome to Integra Realty ResourcesIntegra Realty Resources

One Company - Infinite SolutionsOne Company - Infinite Solutions

22

Edward K. Wadsworth, MAI, CREEdward K. Wadsworth, MAI, CREDavid L. Cary, MAIDavid L. Cary, MAI

INTEGRA REALTY RESOURCESINTEGRA REALTY RESOURCESBostonBoston

INCOME CAPITALIZATIONPRIMER

Why Use the Income Approach?Why Use the Income Approach?

Earning power is the critical element Earning power is the critical element affecting value for investment affecting value for investment propertyproperty

Best used when valuing Leased Fee Best used when valuing Leased Fee estates, or when valuing Fee Simple estates, or when valuing Fee Simple estate for comparative purposes.estate for comparative purposes.

Best reflects buyer and seller pricing Best reflects buyer and seller pricing decisions for investment property.decisions for investment property.

What is Fair Cash Value according What is Fair Cash Value according to the ATB?to the ATB?

““Fair cash value” means the same as “fair market Fair cash value” means the same as “fair market value” expressed as the price which someone will value” expressed as the price which someone will pay for it on the open market.pay for it on the open market.11

““Fair cash value” means the price that an owner Fair cash value” means the price that an owner willing but not compelled to sell ought to receive willing but not compelled to sell ought to receive from one willing but not compelled to buy.from one willing but not compelled to buy.22

““Fair cash value” means the same as “fair market Fair cash value” means the same as “fair market value” expressed as the price which someone will value” expressed as the price which someone will pay for it on thepay for it on the open market. open market.33

11Donovan v. City of Haverhill, 247 Mass. 69 at 71Donovan v. City of Haverhill, 247 Mass. 69 at 7122Assessors of Quincy v. Boston Consolidated Gas Company, 309 Mass. 60Assessors of Quincy v. Boston Consolidated Gas Company, 309 Mass. 6033Massachusetts Supreme Court Decision, Epstein v. Boston Housing Massachusetts Supreme Court Decision, Epstein v. Boston Housing Authority, 317 Mass. 279 at 299Authority, 317 Mass. 279 at 299

Income Approach to ValueIncome Approach to ValueCritical ElementsCritical Elements

NetIncom

e

InterestRates ExpensesLeases

GrossIncome

RiskVacancy

MarketRents

Cap Rate

Steps to FollowSteps to Follow

Examine Economic Profile of PropertyExamine Economic Profile of Property Estimate Gross Potential IncomeEstimate Gross Potential Income Estimate an allowance for vacancy and credit lossEstimate an allowance for vacancy and credit loss Estimate operating expensesEstimate operating expenses Calculate net operating income before real estate tax Calculate net operating income before real estate tax

(NIBT)(NIBT) Estimate a capitalization rateEstimate a capitalization rate Divide NIBT by Cap Rate to estimate valueDivide NIBT by Cap Rate to estimate value

Overall Rate (ROverall Rate (Roo) plus Effective Tax Rate (ETR) ) plus Effective Tax Rate (ETR) expressed as NIBT/(Rexpressed as NIBT/(Roo + ETR) + ETR)

Adjust for capital improvements needed and/or Adjust for capital improvements needed and/or stabilization costs.stabilization costs.

CASE STUDY – Office BuildingCASE STUDY – Office Building

Objective is to estimate market Objective is to estimate market value of leased fee estate and fee value of leased fee estate and fee simple estatesimple estate

Multi-tenant office building Multi-tenant office building Built in 1978Built in 1978 Building size is 19,436 square feetBuilding size is 19,436 square feet 5,000 s.f. vacant (6-mths to lease)5,000 s.f. vacant (6-mths to lease) $10/s.f. TI allowance for new tenant$10/s.f. TI allowance for new tenant Good Suburban LocationGood Suburban Location

Economic Profile of PropertyEconomic Profile of Property

Unit Tenant Lease Type Lease Expr. Sq. Ft. Rent/Sq.Ft. Rent

109 & 101 Home Mortgage Network Gross May-08 1,715 $16.49 $28,276212 ZoPonski RE Gross Aug-09 350 $10.29 $3,600210 Computer Services Gross Sep-09 1,125 $15.57 $17,520102 ABC Hospital Gross Jan-10 1,905 $25.11 $47,831200 ABC Hospital Gross Nov-10 4,831 $24.57 $118,677213 & 214 XYZ Law Firm Gross Jan-10 641 $18.61 $11,928108 Dr. Owner Gross Feb-09 2,815 $23.88 $67,222205 Vacant Vacant Vacant 5,000 $0217 Hometown Psych. Gross Aug-10 1,054 $21.44 $22,600Gross Scheduled Income (Occupied Space)1 14,436 $22.00 $317,654

1 Also equal to Base Rental Income

Summary of Scheduled Contract Rents

Market Rent EstimateMarket Rent Estimate

Rental Bldg. Age Size SFType of Space % Occupied Rent/SF

386 N. York St. Medical OfficeYour Town, MA 95%1220 Hobson Medical OfficeYour Town, MA 99%242 N. York Street Medical OfficeYour Town, MA 95%533 W. North Ave. Medical OfficeYour Town, MA 93%2803 Butterfield Rd. General OfficeYour Town, MA 85%2001 Midwest Rd. General OfficeYour Town, MA 95%

1980 Varies $21.00

1980 Varies $22.00

1980 500 to 3,000 $25.75

1984 500 to 2,500 $22.50

1990 1,000 to 5,000 $28.00

1990's 1,500 to 5,000 $25.00

Summary of Competitive Rental Data

Gross Potential IncomeGross Potential Income

Unit Tenant Lease Type Lease Expr. Sq. Ft. Rent/Sq.Ft. Rent

109 & 101 Home Mortgage Network Gross May-08 1,715 $16.49 $28,276212 ZoPonski RE Gross Aug-09 350 $10.29 $3,600210 Computer Services Gross Sep-09 1,125 $15.57 $17,520102 ABC Hospital Gross Jan-10 1,905 $25.11 $47,831200 ABC Hospital Gross Nov-10 4,831 $24.57 $118,677213 & 214 XYZ Law Firm Gross Jan-10 641 $18.61 $11,928108 Dr. Owner Gross Feb-09 2,815 $25.00 $70,375205 Vacant Gross Vacant 5,000 $25.00 $125,000217 Hometown Psych. Gross Aug-10 1,054 $21.44 $22,600Base Rental Income (Gross Potential Income) 19,436 $22.94 $445,807

Gross Potential Income

Stabilized Net Income Statement Before RE Stabilized Net Income Statement Before RE TaxesTaxes

Actual Actual2005 2006 2007 Per S.F.

Gross Potential Income $445,807 $22.94Vacancy and Collection Allowance @ 5% $22,290 $1.15

Effective Gross Income $476,589 $420,500 $423,517 $21.79

Less Operating Expenses Before RE Tax Insurance $1,822 $1,987 $2,500 $0.13 Maintenance and Repairs $18,356 $68,356 $20,000 $1.03 Janitorial Services $16,382 $17,296 $18,000 $0.93 Depreciation $57,123 $57,123 $0 $0.00 Mortgage Interest $119,756 $115,239 $0 $0.00 Utilities $28,378 $30,190 $31,000 $1.59 Management By Owner By Owner $21,176 $1.09 Professional Fees $2,893 $297 $750 $0.04 Reserves $0 $0 $2,900 $0.15Total Expenses $244,710 $290,488 $96,326 $4.96Stabilized NOI Before RE Tax $231,879 $130,012 $327,191 $16.83

NRA = 19,436 SFVacancy and Collection Loss = 5%Management = 5%

Stabilized FiguresHistorical Operations and Stabilized Forecast (Reconstructed)

CAPITALIZATIONCAPITALIZATION Capitalization is the process of converting Capitalization is the process of converting

income into valueincome into value One of the main forms of capitalization is One of the main forms of capitalization is

Direct CapitalizationDirect Capitalization Direct Capitalization is the process of Direct Capitalization is the process of

estimating current value by dividing a estimating current value by dividing a single year’s income by a capitalization ratesingle year’s income by a capitalization rate

Capitalization rate as a basis for taxation Capitalization rate as a basis for taxation combines an investment rate with the combines an investment rate with the effective tax rateeffective tax rate

How are Investment Cap. How are Investment Cap. Rates Estimated?Rates Estimated?

Capitalization rates are derived from Capitalization rates are derived from comparable sales, investor surveys, or comparable sales, investor surveys, or estimated using financial formulasestimated using financial formulas

For most property types, capitalization For most property types, capitalization rates are applied to income that has been rates are applied to income that has been adjusted for vacancy and collection loss, adjusted for vacancy and collection loss, management fees and a reserve allowance management fees and a reserve allowance to cover future capital improvements.to cover future capital improvements.

Extraction of Capitalization Rate Extraction of Capitalization Rate from Sale Comparablefrom Sale Comparable

Commercial Building Broker Information Appraiser Adjustment

Gross Income at 100% Occupancy $438,000 $438,000Vacancy and Collection Loss Allowance $0 $21,900 5%

Effective Gross Income (EGI) $438,000 $416,100Less Operating Expenses CAM, Insurance, Repairs, Maintenance $135,000 $135,000 Management $0 $24,966 6% Reserves $0 $2,500 Subtotal $135,000 $162,466Net Income $303,000 $253,634

Sale Price $3,100,000 $3,100,000Cost of New Roof Needed $0 $50,000Total Investment in Property $3,100,000 $3,150,000Indicated Investment Capitalization Rate (Rt) 9.8% 8.1%

Extraction of Equity Return (Dividend Rate) from Extraction of Equity Return (Dividend Rate) from Sale Comparable (RSale Comparable (REE))

Comparable Office Bldg. Sale Broker Information Appraiser Adjustment

Sale Price $3,100,000 $3,100,000Stabilized NOI w/RE Tax Included $256,500 $207,134

Annual Debt Service: 75% LTV, 5.5% Interest, $171,330 $171,330 25-year loan, Monthly Payments

Cash Flow $85,170 $35,804

Initial Equity (Down Payment) $775,000 $825,000 *

Cash on Cash Return (RE ) 11.0% 4.34%

Mortgage Equity Formula – Mortgage Equity Formula – Investment RateInvestment Rate

Combines the requirements of a current Combines the requirements of a current mortgage typical for the subject class of mortgage typical for the subject class of property, together with the equity return property, together with the equity return requirements of an investor. requirements of an investor.

• Based on 75% LTV, 6.00% Interest, 25 Year amortization Based on 75% LTV, 6.00% Interest, 25 Year amortization and 5% cash on cash return, the following capitalization and 5% cash on cash return, the following capitalization rate is indicated.rate is indicated.

Cap Rate = (LTV x RCap Rate = (LTV x RM M ) + (% Equity x R) + (% Equity x REE))Cap Rate = (75% x 7.73%) + (25% x 5%)Cap Rate = (75% x 7.73%) + (25% x 5%)Cap Rate = 7.1%Cap Rate = 7.1%

(Next)(Next)

OrOr

Structures Portion RateWeighted

Rate

Mtg Loan 75% 7.73% = 5.80%Equity (Down Payment) 25% 5.00% = 1.30%

100% 7.10%

Debt Coverage Ratio FormulaDebt Coverage Ratio Formula

Capitalization rate may be derived using typical Capitalization rate may be derived using typical financing criteria available in the marketplace.financing criteria available in the marketplace.

• These criteria include typical debt coverage ratio*, These criteria include typical debt coverage ratio*, mortgage constant and LTV ratio required by lendersmortgage constant and LTV ratio required by lenders

Cap. Rate = DCR x LTV x RCap. Rate = DCR x LTV x RMM Cap Rate = 1.20 x 75% x 7.73%Cap Rate = 1.20 x 75% x 7.73%Cap Rate = 7.0%Cap Rate = 7.0%

**The ratio of net operating income to the amount required for debt service The ratio of net operating income to the amount required for debt service (principal + interest)(principal + interest)

Capitalization Rate SurveysCapitalization Rate Surveys

IRR-ViewpointYear End 2007

NationalCBDOffice

IRR-ViewpointYear End 2007

NationalSuburban

Office

Korpacz4Q-2007

National CBDOffice

Korpacz4Q-2007National

Suburban Office

ACLI3Q-2007National

OfficeRange 5.0%-11.5% 5.5%-9.0% 4.0%-9.0% 5.0%-10.5% NAAverage 7.46% 7.42% 6.64% 7.20% 6.10%

CAPITALIZATION RATE SURVEYS – OFFICE PROPERTIES

Source: IRR-Viewpoint 2008; Korpacz Real Estate Investor Survey; American Council of Life Insurers Investment Bulletin.

Range of Investment Range of Investment Capitalization RatesCapitalization Rates

Extraction from Comparable SaleExtraction from Comparable Sale 8.1% 8.1%

Band of Investment MethodBand of Investment Method 7.1% 7.1%

Debt Coverage Ratio MethodDebt Coverage Ratio Method 7.0% 7.0%

Cap. Rate Surveys 7.0%Cap. Rate Surveys 7.0%

FACTORS THAT IMPACT CAP FACTORS THAT IMPACT CAP RATESRATES

Quality of TenancyQuality of Tenancy Duration of LeasesDuration of Leases Terms of LeaseTerms of Lease Market ConditionsMarket Conditions

EFFECTIVE TAX RATEEFFECTIVE TAX RATE

Tax Rate per $1,000 of assessed Tax Rate per $1,000 of assessed value ÷ 1,000value ÷ 1,000

Assume CIP Tax Rate = Assume CIP Tax Rate = $15.00/$1,000 of assessed value$15.00/$1,000 of assessed valueThen $15.00/1,000 = 1.5%Then $15.00/1,000 = 1.5%

Capitalization of IncomeCapitalization of Income

Stabilization CostsStabilization Costs- $1.50/s.f. Leasing Fee$1.50/s.f. Leasing Fee- 3 months to lease 5K s.f.3 months to lease 5K s.f.- $10/s.f. TI Allowance$10/s.f. TI Allowance

CapitalizationCapitalization

Leasing Fees $7,500Rent Loss During Absorption $25,000 *Tenant Improvements $50,000Stabilization Costs $82,500

* Gross Rent = $25

Less Exp. = $5

Net Rent Loss = $20

5,000SF x $20/SF x .25 = $25,000

Stabilization Costs

Stabilized NOI Before RE Tax $327,191Capitalization Rate** 8.5%Fair Cash Value As Stabilized $3,849,306Less: Stabilization Costs $82,500Total $3,766,806Fair Cash Value "As Is" $3,770,000

(rounded)** Investment Rate + Effective Tax Rate

7% = 1.5% = 8.5%

Direct Capitalization of Income

ReconciliationReconciliation Income approach is most applicable for Income approach is most applicable for

income producing properties.income producing properties. Income approach may not provide a Income approach may not provide a

good estimate of value for properties good estimate of value for properties suitable for owner-users.suitable for owner-users.

There may be a large disparity between There may be a large disparity between the results of the income approach and the results of the income approach and sales approach for owner-user sales approach for owner-user properties under current market properties under current market conditions. conditions.

Case Study Two - ApartmentCase Study Two - Apartment

4-story, elevator apartment building4-story, elevator apartment building 63 units63 units Built in 1930Built in 1930 95% rented95% rented Proposed is refurbishing of 34 units Proposed is refurbishing of 34 units

costing $225,000costing $225,000 Current Scheduled Income is $556,400. Current Scheduled Income is $556,400.

Economic Status of PropertyEconomic Status of Property

Contract RentsOne

BedroomStudios Total

Total Contract Income $23,805 $22,565 $46,370

Total # of Units 27 36 63

Office/Janitor Apts. 0 0 0

# Eligible for Rent 27 36 63

# Vacant 1 2 3

# Rented 26 34 60

% Rented 96% 94% 95%

Average Contract Rental $916 $664 $773

Rental Range $715-$995 $595-$715 $595-$995

Average Size 641 360 481Avg. Contract Rent/SF $1.43 $1.84 $1.61

536 W. Main Street, Anytown, MASummary of Current Status as of January 1, 2007

Competitive Rent SurveyCompetitive Rent Survey

Comp. Rental Location

TypeMonthly Rents

Rent/SF

520 W. Beldon One Bedroom - 550 SF $960 $1.74Anytown, MA Studios - 425 SF $680 $1.60

Comments:

440 Fullerton One Bedroom - 550 SF $1,000 $1.18Anytown, MA Studios - 450 SF $800 $1.78

Comments:

1936 N. Clark St. One Bedroom - 550 SF $1,100 $1.69Anytown, MA Studios - 450 SF $800 $2.00

Comments:

Competitive Apartment Rents

1920's vintage, 5-story, elevator apartment building. Heat is included in the rent. Fitness center. No on-site parking. Units in average condition.

1920's vintage, 5-story, elevator apartment building. Heat is included in the rent. No amenities. No on-site parking. Units have been renovated.

1920's vintage, mid-rise, elevator apartment building. Heat is included in the rent. Fitness center, sun deck. No on-site parking. Units have been renovated.

Analysis of Competitive RentsAnalysis of Competitive Rents

Complex 1 2 3

Rent: 1Bdrs $960 $1,000 $1,100Rent: Studios $680 $800 $800

Rent PSF 1Bdrs $1.74 $1.81 $1.69Rent PSF Studios $1.60 $1.78 $2.00

Adjustments to PSFLocation 0.0% 0.0% -10.0%Age/Updating 10.0% 0.0% 0.0%Utilities -5.0% -5.0% -5.0%Amenities -2.5% 2.5% -2.5%Parking 0.0% 0.0% 0.0%

Net Adjustment 2.5% -2.5% -17.5%Adjusted PSF Rents

Rent PSF: 1Bdrs $1.78 $1.76 $1.39Rent PSF: Studios $1.64 $1.74 $1.65

Rent Comparison Grid

Market Rent EstimateMarket Rent Estimate

Market Rent for One-bedroom units are Market Rent for One-bedroom units are estimated to average $1,000 or $1.56/s.f.estimated to average $1,000 or $1.56/s.f.

Market Rent for studios are estimated to Market Rent for studios are estimated to average $700 or $1.94 per square foot.average $700 or $1.94 per square foot.

Total potential market rent is calculated Total potential market rent is calculated belowbelow

27, 1-bedroom @ $1,000/month x 12 months = $324,00036, studios @ $700/month x 12 months = $302,400Stabilized Gross Potential Apartment I ncome $626,400

Stabilized Income StatementStabilized Income Statement

Year Actual 2005Stabilized 2006

Gross Rents $626,400Laundry Income $9,500

Total Gross Potential Income $635,900

Less Vacancy and Collection Loss @ 5% $31,795

Effective Gross Income $567,235 $604,105

Less: Operating Expenses Before RE TaxAdvertising $1,500 $2,000Insurance $16,000 $16,000Janitor $16,000 $16,000Legal and Professional $3,500 $2,000Maintenance and Repairs $2,450 $15,000Management and Office $0 $31,795Other Expenses $500 $500Painting and Decorating $5,000 $15,000Scavenger $3,000 $3,000Supplies $3,000 $3,000Utilities $13,580 $14,000Reserves $0 $15,750 *

Total Expenses Before RE Tax $64,530 $134,045

Net Operating Income Before RE Tax $502,705 $470,060

* $250/Unit

Comparative Analysis of ExpensesComparative Analysis of Expenses

Apartment Complex Subject LaSalle Kenmore WolcottYear of Expenses 2006 2006 2006 2006Number of Units 63 41 59 46% Total Expenses 44% 37% 44% 39%% Taxes 22% 16% 16% 13%% Other Expenses 22% 21% 28% 25%

Expenses Per Unit $4,191 $6,098 $2,747 $3,045Expenses w/o Taxes $2,128 $3,434 $1,730 $2,001

Expenses Per SF $8.71 $7.52 $6.48 $5.83Expenses PSF w/o Taxes $4.42 $4.23 $4.08 $3.83

Comparative Analysis of Expenses

Extraction of Investment Cap. Rates Extraction of Investment Cap. Rates From SalesFrom Sales

Sale Subject Property 1 2 3Address 536 W. Main Street 1824 N. Lincoln Pk 532 Belmont 550-560 W. Adeline

Anytown, MA Anytown, MA Anytown, MA Anytown, MADate of Sale NA Jun-05 Apr-06 May-06Gross Sale Price NA $3,810,000 $5,700,000 $4,550,000# Units 63 37 45 38Apts. Mix 27-1's & 36-0's 24-0's, 12-1's, 1-2's 60-0's, 27-1's, 12-2's 32-1's, & 6-2's#Bldgs/#Stories One/Four One/Five One/Three One/ThreeRooms 162 82 155 139Age 1930 1920's 1925 VintageStyle Elevator Elevator Walk-up Walk-upParking Spaces None 33 None NoneAmenities Laundry Laundry Laundry LaundryCondition Good good Average AverageHeat Paid By Tenant By Landlord By Landlord By Landlord

Gross Income (GI) $635,900 $375,000 $560,000 $432,000Vacancy Allowance $31,795 $18,750 $28,000 $21,600Effective Gross Income $604,105 $356,250 $532,000 $410,400Expenses $134,045 $151,750 $212,000 $150,400Net Income (NOI) $470,060 $204,500 $320,000 $260,000

Capitalization Rate NA $0 $0 $0GIM NA 10.16 10.17857143 10.53240741Expense Ratio 22.2% 42.6% 39.8% 36.6%

NOI Per Unit $7,461 $5,527 $7,111 $6,842Sale Price Per Unit NA $102,973 $126,667 $119,737

NOI Per Room $2,902 $2,494 $2,065 $1,871Sale Price Per Room NA $46,463 $36,774 $32,734

Range of Investment Cap. RatesRange of Investment Cap. Rates

Extraction From Comparable Sales = Extraction From Comparable Sales = 5.6%5.6%

Band of Investment methodBand of Investment method (75% LVR, 30yr loan w/monthly pmts., 6% interest (75% LVR, 30yr loan w/monthly pmts., 6% interest rate, Rrate, REE))

(.75 x .0719) + (.25 x .06) = 6.9%(.75 x .0719) + (.25 x .06) = 6.9%

Debt Coverage RatioDebt Coverage RatioLVR x DCR x RLVR x DCR x RMM = .75 x 1.2 x .0719 = 6.5% = .75 x 1.2 x .0719 = 6.5%

Investor Surveys = 6% (see next page)Investor Surveys = 6% (see next page)

Investor SurveysInvestor Surveys

IRR-ViewpointYear End 2006

NationalUrban

Multifamily

IRR-ViewpointYear End 2006

NationalSuburban

Multifamily

Korpacz1Q-2007National

Apartment

ACLI4Q-2006National

Apartment

Range 4.0%-10.0% 4.0%-8.4% 3.5%-8.00% NA

Average 6.70% 6.44% 5.89% 6.10%

CAPITALIZATION RATE SURVEYS – MULTIFAMILY PROPERTIES

Source: IRR-Viewpoint 2007; Korpacz Real Estate Investor Survey; American Council of Life Insurers Investment Bulletin.

Effective Tax RateEffective Tax Rate

$15.00/$1,000 AV = $15 / 1,000 = $15.00/$1,000 AV = $15 / 1,000 = 1.5%1.5%

Capitalization Rate of Tax PurposesCapitalization Rate of Tax Purposes

6% + 1.5% = 7.5%6% + 1.5% = 7.5%

Stabilization CostsStabilization Costs

Proposed for construction of 34 units costing $225,000Proposed for construction of 34 units costing $225,000 Six months to complete construction and to achieve stabilization of Six months to complete construction and to achieve stabilization of

income.income. The income lag represents 50% (6 months) of Gross Rent for 34 The income lag represents 50% (6 months) of Gross Rent for 34

units. units. Leasing Fees are based on one month’s rent for 34 units.Leasing Fees are based on one month’s rent for 34 units. Profit incentive is estimated to be $150,000. Profit incentive is estimated to be $150,000.

Less: Hard Costs for Improvement CostsLess: Hard Costs for Improvement Costs $ 225,000$ 225,000Less: 6-months Income Lag Less: 6-months Income Lag $ 169,028$ 169,028Less: Leasing Fees for 34 unitsLess: Leasing Fees for 34 units $ 28,500$ 28,500Less: Profit IncentiveLess: Profit Incentive $ 150,000$ 150,000Total Stabilization CostsTotal Stabilization Costs $ 572,528$ 572,528

Capitalization of IncomeCapitalization of Income

Stabilized NOI Before RE Tax $470,060

Capitalization Rate for Tax Purposes 7.5%

Stabilized Market Value $6,267,467

Less: Stabilization Costs $572,528

Total $5,694,939

Fair Cash Value For Tax Purposes "As Is" $5,700,000

Direct Capitalization of Income Before RE Tax

Integra Realty Resources – Integra Realty Resources – BostonBoston

Edward K. Wadsworth, MAI, CREEdward K. Wadsworth, MAI, CRE

David L. Cary, MAIDavid L. Cary, MAI