The Student Handbook toTHE APPRAISAL OF REAL ESTATE

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Chapter 20

The Income Capitalization Approach

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 2

The Income Capitalization Approach

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.

Relationship to appraisal principles Anticipation and change Supply and demand

Applicability and limitations Interests to be valued

Leased fee Leasehold

Student Handbook to THE APPRAISAL OF REAL ESTATE

Leases

Types of leases Flat rental lease Variable rate lease Step-up or step-down lease Lease with annual increase Revaluation lease Percentage lease

Expenses in leases Gross lease Net lease Triple net lease

Chapter 20 3

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 4

Rent

Common rent types Market rent Contract rent Effective rent Excess rent Deficit rent Percentage rent Overage rent

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 5

Future Benefits

Potential gross income (PGI) Starting point As if full and w/o collection losses

Effective gross income (EGI) PGI less vacancy and collection losses

Net operating income (NOI or IO) EGI less fixed expenses and variable expenses Less reserves for replacement (sometimes)

Student Handbook to THE APPRAISAL OF REAL ESTATE

Future Benefits, continued

Equity dividend – 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.

Chapter 20 6

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 7

Reconstructed Operating Statement

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 8

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 allowance – included if expense is

included in capitalization rates of comparable properties but not if expense is not

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 9

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 rate (RO) – ratio of a single year’s income (periodic) to the sale price or value (lump sum)

Net income multiplier – reciprocal of overall capitalization rate

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 10

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

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 11

Rates of Return, continued

Discount rates Internal rate of return – rate of return on the

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

Overall yield rate – rate of return including debt and equity

Equity yield rate – rate of return from the perspective of the equity investor, i.e., the rate of return on the amount paid as a down payment from periodic income after debt service and including the reversion after the debt has been paid off

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 12

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%)

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 13

Estimating Rates

Risk A big factor because risk is a primary

component of the yield rate A risky investment requires a higher return

than a less risky investment. Investment-specific

Student Handbook to THE APPRAISAL OF REAL ESTATE

Estimating Rates, continued

Inflation Also a factor in the 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.

Chapter 20 14

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 15

Capitalization Procedures

Direct capitalization Uses a single year’s income Based on the ratio of property income to sale

price Yield capitalization

Uses multiple years’ income Based on the assumption that all investments

are the present value of future cash flows.

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 16

Capitalization Procedures, continued

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. The discounted cash flow model essentially says,

“How much do I get and when do I get it?”

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 17

Problems

Suggested solutions begin on page 428.

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 18

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%

Student Handbook to THE APPRAISAL OF REAL ESTATEChapter 20 19

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