The Income Capitalization Approach

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The Income Capitalization Approach
Chapter 20
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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

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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

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Rent

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

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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)

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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.

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Reconstructed Operating Statement
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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

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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 years income (periodic) to the sale price
  or value (lump sum)
• Net income multiplier reciprocal of overall
  capitalization rate

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Capitalization Rate Extraction Worksheet
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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

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Cash Flow Projection
For reversion value only
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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

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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.

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Capitalization Procedures

• Direct capitalization
• Uses a single years 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.

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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?

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Problems

• Suggested solutions begin on page 428.

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Problem 7
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Problems 8 and 10