1. The Student Handbook to T HE A PPRAISAL OF R EAL E STATE 1 Chapter 20 The Income Capitalization Approach

2. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 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

3. Student Handbook to T HE A PPRAISAL OF R EAL E STATE 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

4. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 20 4 Rent Common rent types  Market rent  Contract rent  Effective rent  Excess rent  Deficit rent  Percentage rent  Overage rent

5. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 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 I O )  EGI less fixed expenses and variable expenses  Less reserves for replacement (sometimes)

6. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Future Benefits, continued Equity dividend – also called cash on cash  Equity income (I E ) divided by equity input (V E – 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

7. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 20 7 Reconstructed Operating Statement

8. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 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

9. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 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 (R O ) – ratio of a single year’s income (periodic) to the sale price or value (lump sum)  Net income multiplier – reciprocal of overall capitalization rate

10. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 20 10 Capitalization Rate Extraction Worksheet

11. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 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

12. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 20 12 Cash Flow Projection For reversion value only

13. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 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

14. Student Handbook to T HE A PPRAISAL OF R EAL E STATE 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

15. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 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.

16. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 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?”

17. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 20 17 Problems Suggested solutions begin on page 428.

18. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 20 18 Problem 7

19. Student Handbook to T HE A PPRAISAL OF R EAL E STATE Chapter 20 19 Problems 8 and 10