The Income Capitalization Approach

The Income Capitalization Approach The PV of a property can be considered to be the PV of the future benefits, which are the cash flows and the resale value of the property. Relation to appraisal principles Anticipation and change Supply and demand Applicability and limitations Interests to be valued Leased fee Leasehold Chapter 21

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 21

Rent Common rent types Market rent Contract rent Effective rent Excess rent Deficit rent Percentage rent Overage rent Chapter 21

Future Benefits Potential gross income (PGI) Starting point As if full and without collection losses Effective gross income (EGI) PGI less vacancy and collection losses Net operating income (IO or NOI) EGI less fixed expenses and variable expenses Less reserves for replacement (sometimes) Chapter 21

Future Benefits, continued Equity income – also called equity dividend, equity cash flow rate, or cash-on-cash return rate Income to the equity after debt service (IE) divided by equity holder’s investment (VE) Ignores the value of the reversion Reversion – return of the investment Sometimes it is nothing Sometimes it is a meaningful amount Chapter 21

Reconstructed Operating Statement Chapter 21

Operating Expenses Necessary to maintain the property Debt service not included Fixed expenses – do not vary with occupancy Variable expenses – vary with occupancy Replacement allowance – included if expense is included in capitalization rates of comparable properties but not included if expense is not Chapter 21

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 Chapter 21

Capitalization Rate Extraction Worksheet Chapter 21

Rates of Return, continued Discount rates IRR – 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 Chapter 21

Cash Flow Projection For reversion value only Chapter 21

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 Chapter 21

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 21

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 Chapter 21

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, DCF analysis will work better. The discounted cash flow model essentially says, “How much do I get and when do I get it?” Chapter 21

Review Exercise 10. Suggested Solution Chapter 21