1. 1 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin CHAPTER 13 VALUATION MODELS IN THE INCOME APPROACH Discounted Cash Flow Analysis –value estimated as: the present value of the expected cash flows Investment value uses the expected cash flows and discount rate of a particular investor. Market value uses the expected cash flows and discount rate of the typical market participant. Direct Capitalization –value estimated as: V = NOI / R

2. 2 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin DCF: Expected Cash Flows (NOIs) from Operations

3. 3 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin DCF: Expected Net Proceeds from Sale

4. 4 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Present Value of Expected Cash Flows (before debt)

5. 5 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin DCF using Expected Before-Tax Cash Flows Assume the following loan terms available to a particular investor: –loan-to-value ratio = 80%, thus, loan amount = $944,000 x 0.80 = $755,200 –interest rate is 9.5%, amortized over 30 years, paid monthly thus, annual debt service = $6,350 x 12 = $76,202 Assume the return required of the investor is 18 percent

6. 6 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin DCF: Expected BTCFs from Operations

7. 7 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin DCF: Expected BTER from Sale

8. 8 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Present Value of Expected Cash Flows (BTCFs)

9. 9 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin DIRECT CAPITALIZATION The Income Capitalization Equation is: V = I / R, whereV = value, I = income, and R = capitalization rate. Often used to estimate R, when V and I are known. R = I / V

10. 10 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Reconstructed Operating Statement Potential Gross Income Vacancy and Collection Losses Expenses –fixed –variable –reserves and other nonrecurring expenses –expense exclusions Net Operating Income

11. 11 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Reconstructed Operating Statement

12. 12 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Direct Capitalization Estimate The Income Capitalization Equation is: V = I / R, whereV = value, I = income, and R = capitalization rate. Assume capitalization rate is estimated to be 9.2% –Indicated value using the direct income capitalization approach: V = $ 86,600 /.092 = $ 934,783 rounded to $ 934,800

13. 13 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Capitalization Rates and Yield Rates The overall capitalization rate can be explained as: R O = y O - g, where R O = the overall capitalization rate y O = the discount rate (or yield rate), and g = the expected annual compounded rate of growth.

14. 14 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Capitalization Rates

15. 15 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Direct Market Extraction of R O

16. 16 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Simple Mortgage-Equity Analysis R O = [mR m + (1-m)R e ], where R O = the overall capitalization rate, m = loan-to-loan ratio, R m = mortgage capitalization rate, and R e = equity capitalization rate.

17. 17 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Mortgage-Equity Analysis Example