Chapter 20 The Student Handbook to THE APPRAISAL OF REAL ESTATE The Income Capitalization Approach.
Download ReportTranscript Chapter 20 The Student Handbook to THE APPRAISAL OF REAL ESTATE The Income Capitalization Approach.
Slide 1
Chapter 20
The Student Handbook to
THE APPRAISAL OF REAL ESTATE
The Income Capitalization
Approach
1
Slide 2
Relationships to Value Influences and Appraisal
Principles
Supply and Demand
Application and Limitations
Interests to Be Valued
Leased fee
Leasehold
Leases
Gross lease
Net lease
Triple net leases
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
2
Slide 3
Future Benefits
Periodic cash flows
Reversion or resale of the investment
Common Lease Structures
Flat rental lease
Variable rate lease
Step-up or step-down lease
Lease with annual increase
Revaluation lease
Percentage lease
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
3
Slide 4
Common Rent Types
Market rent
Contract rent
Effective rent
Excess rent
Deficit rent
Percentage rent
Overage rent
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
4
Slide 5
Table 20.1 Reconstructed Operating Statement
Potential gross income (PGI)
Vacancy & collection loss
Effective gross income (EGI)
25,000
5%
@
of
$9.00
=
=
PGI
$225,000
-$11,250
$213,750
Estimated Annual Expenses
Property taxes
Property insurance
Repairs
Management
5.848%
Utilities
Reserves for new roof
1/20
Reserves for parking lot
1/15
Total expenses
Net operating income (I
$
$
$
$
$
$
$
33,000
4,500
30,000
12,500
22,000
1,250
800
$ 104,050
O)
Fixed expenses
Variable expenses
Reserves for replacement
-$104,050
$109,700
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
5
Slide 6
Potential Gross Income
Starting point
As if full and w/o collection losses
Vacancy and Collection Losses
Effective Gross Income
Less Fixed Expenses
Less Variable Expenses
Less Reserves for Replacement (Sometimes)
Net Operating Income (NOI or IO)
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
6
Slide 7
Equity Dividend Rate
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.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
7
Slide 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 reserves should be included if they are
included in capitalization rates of comparable
properties but not if they are not.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
8
Slide 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 rates (RO)
The ratio of a single year’s income (periodic) to the sale
price or value (lump sum)
Net income multiplier is the reciprocal of the overall
capitalization rate.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
9
Slide 10
Table 20.2 Capitalization Rate Extraction
Worksheet
Subject
Reported sale price
PGI for next year
Vacancy & collection loss
EGI for next year
Operating expense next year
Taxes
Insurance
Management
Maintenance - building
Maintenance - grounds
Utilities
Reserve fund - roof covering
Reserve - parking lot
Reserve fund - HVAC
Reserve fund - elevator
Tenant improvements
Total expenses
Net operating income
$510,000
-$25,500
$0.05
Sale 1
$1,985,000
$369,000
-$25,830
Sale 2
$1,458,000
$253,680
-$15,221
Sale 3
$3,258,000
$601,000
-$48,080
$484,500
$343,170
$238,459
$552,920
$56,000
$10,600
$24,225
$22,050
$11,000
$67,000
$5,000
$4,500
$3,200
$1,500
$5,500
$210,575
$44,258
$9,600
$17,159
$16,055
$8,000
$55,000
$4,200
$3,900
$2,500
$1,200
$4,400
$166,272
$26,000
$4,500
$11,923
$10,700
$4,900
$34,000
$2,600
$2,500
$2,900
$1,800
$3,500
$105,323
$72,000
$14,500
$27,646
$26,500
$13,800
$76,800
$4,200
$7,500
$6,200
$3,600
$12,600
$265,346
$273,925
$176,899
$133,136
$287,574
Extracted capitalization rates
8.91%
$273,925
/
9.13%
$0.09
8.83%
=
$3,043,611.11
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
10
Slide 11
Discount rates, yield rates, interest rates, and internal
rates of return all have similar definitions.
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.
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 ESTATE
Chapter 20
11
Slide 12
Table 20.3 Cash Flow Projection
For reversion value only
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Tenant 1
$72,000
$72,000
$72,000
$84,000
$84,000
$84,000
Tenant 2
$66,144
$66,144
$66,144
$66,144
$66,144
$66,144
Tenant 3
$51,600
$53,000
$60,000
$60,000
$60,000
$60,000
Tenant 4
$14,400
$18,000
$19,200
$19,200
$19,200
$19,200
Tenant 5
$27,780
$27,780
$27,780
$27,780
$27,780
$30,558
Tenant 6
$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
Potential gross income
Vacancy and collection (4%)
Effective gross income
All expenses
Net operating income
Reversion (10%)
Cash flow
Discounted at (9%)
Present values
Last year's income divided by the cap. rate
$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
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
12
Slide 13
Yield Rates—Rates of Return on the Investment
Internal rate of return is the rate of return on the
investment considering the price paid for the
investment, the periodic cash flows, and the reversion.
Overall yield rate is the rate of return including debt
and equity.
Equity yield rate is the rate of return from the
perspective of the equity investor. It is the rate of
return on the amount paid as down payment from
periodic income after debt services and including the
reversion after the debt has been paid off.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
13
Slide 14
Estimating Rates
Risk is a big factor since risk is a primary component
of the yield rate. If the investment is risky, it deserves
more return than if it were not a risky investment. This
is investment-specific.
Inflation is also a factor in a 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.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
14
Slide 15
Income Capitalization Approach Methods
Direct capitalization of a single year’s income. This is
a technique based on the ratio of property income to
sale price.
Yield capitalization of multiple years’ income. This
method is based on the assumption that all
investments are the present value of future cash flows.
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.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
15
Slide 16
Problems
Suggested solutions begin on page 365.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
16
Slide 17
Problem 7
Purchase price
M ortgage amount @ 75%
Down payment @ 25% of sale price
Net operating income =
Annual debt service
Income to the equity
Income to the equity/equity investment
$1,235,000
-$926,250
$308,750
$96,000
-$78,558
$17,442
5.65%
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
17
Slide 18
Problems 8 and 10
Problem 8
Base rent
Sales % rent
Less base
Overage income
$
5,000
$ 850,000
$ 600,000
$ 250,000
X
12
=
$
60,000
X
3%
=
$
7,500
$
67,500
Problem 10
Tenant
1
2
3
4
PGI
V&C
EGI
Expenses
NOI
PGI
60,000
75,000
65,000
75,000
275,000
-13,750
261,250
-100,000
161,250
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
18
Chapter 20
The Student Handbook to
THE APPRAISAL OF REAL ESTATE
The Income Capitalization
Approach
1
Slide 2
Relationships to Value Influences and Appraisal
Principles
Supply and Demand
Application and Limitations
Interests to Be Valued
Leased fee
Leasehold
Leases
Gross lease
Net lease
Triple net leases
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
2
Slide 3
Future Benefits
Periodic cash flows
Reversion or resale of the investment
Common Lease Structures
Flat rental lease
Variable rate lease
Step-up or step-down lease
Lease with annual increase
Revaluation lease
Percentage lease
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
3
Slide 4
Common Rent Types
Market rent
Contract rent
Effective rent
Excess rent
Deficit rent
Percentage rent
Overage rent
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
4
Slide 5
Table 20.1 Reconstructed Operating Statement
Potential gross income (PGI)
Vacancy & collection loss
Effective gross income (EGI)
25,000
5%
@
of
$9.00
=
=
PGI
$225,000
-$11,250
$213,750
Estimated Annual Expenses
Property taxes
Property insurance
Repairs
Management
5.848%
Utilities
Reserves for new roof
1/20
Reserves for parking lot
1/15
Total expenses
Net operating income (I
$
$
$
$
$
$
$
33,000
4,500
30,000
12,500
22,000
1,250
800
$ 104,050
O)
Fixed expenses
Variable expenses
Reserves for replacement
-$104,050
$109,700
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
5
Slide 6
Potential Gross Income
Starting point
As if full and w/o collection losses
Vacancy and Collection Losses
Effective Gross Income
Less Fixed Expenses
Less Variable Expenses
Less Reserves for Replacement (Sometimes)
Net Operating Income (NOI or IO)
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
6
Slide 7
Equity Dividend Rate
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.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
7
Slide 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 reserves should be included if they are
included in capitalization rates of comparable
properties but not if they are not.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
8
Slide 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 rates (RO)
The ratio of a single year’s income (periodic) to the sale
price or value (lump sum)
Net income multiplier is the reciprocal of the overall
capitalization rate.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
9
Slide 10
Table 20.2 Capitalization Rate Extraction
Worksheet
Subject
Reported sale price
PGI for next year
Vacancy & collection loss
EGI for next year
Operating expense next year
Taxes
Insurance
Management
Maintenance - building
Maintenance - grounds
Utilities
Reserve fund - roof covering
Reserve - parking lot
Reserve fund - HVAC
Reserve fund - elevator
Tenant improvements
Total expenses
Net operating income
$510,000
-$25,500
$0.05
Sale 1
$1,985,000
$369,000
-$25,830
Sale 2
$1,458,000
$253,680
-$15,221
Sale 3
$3,258,000
$601,000
-$48,080
$484,500
$343,170
$238,459
$552,920
$56,000
$10,600
$24,225
$22,050
$11,000
$67,000
$5,000
$4,500
$3,200
$1,500
$5,500
$210,575
$44,258
$9,600
$17,159
$16,055
$8,000
$55,000
$4,200
$3,900
$2,500
$1,200
$4,400
$166,272
$26,000
$4,500
$11,923
$10,700
$4,900
$34,000
$2,600
$2,500
$2,900
$1,800
$3,500
$105,323
$72,000
$14,500
$27,646
$26,500
$13,800
$76,800
$4,200
$7,500
$6,200
$3,600
$12,600
$265,346
$273,925
$176,899
$133,136
$287,574
Extracted capitalization rates
8.91%
$273,925
/
9.13%
$0.09
8.83%
=
$3,043,611.11
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
10
Slide 11
Discount rates, yield rates, interest rates, and internal
rates of return all have similar definitions.
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.
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 ESTATE
Chapter 20
11
Slide 12
Table 20.3 Cash Flow Projection
For reversion value only
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Tenant 1
$72,000
$72,000
$72,000
$84,000
$84,000
$84,000
Tenant 2
$66,144
$66,144
$66,144
$66,144
$66,144
$66,144
Tenant 3
$51,600
$53,000
$60,000
$60,000
$60,000
$60,000
Tenant 4
$14,400
$18,000
$19,200
$19,200
$19,200
$19,200
Tenant 5
$27,780
$27,780
$27,780
$27,780
$27,780
$30,558
Tenant 6
$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
Potential gross income
Vacancy and collection (4%)
Effective gross income
All expenses
Net operating income
Reversion (10%)
Cash flow
Discounted at (9%)
Present values
Last year's income divided by the cap. rate
$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
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
12
Slide 13
Yield Rates—Rates of Return on the Investment
Internal rate of return is the rate of return on the
investment considering the price paid for the
investment, the periodic cash flows, and the reversion.
Overall yield rate is the rate of return including debt
and equity.
Equity yield rate is the rate of return from the
perspective of the equity investor. It is the rate of
return on the amount paid as down payment from
periodic income after debt services and including the
reversion after the debt has been paid off.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
13
Slide 14
Estimating Rates
Risk is a big factor since risk is a primary component
of the yield rate. If the investment is risky, it deserves
more return than if it were not a risky investment. This
is investment-specific.
Inflation is also a factor in a 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.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
14
Slide 15
Income Capitalization Approach Methods
Direct capitalization of a single year’s income. This is
a technique based on the ratio of property income to
sale price.
Yield capitalization of multiple years’ income. This
method is based on the assumption that all
investments are the present value of future cash flows.
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.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
15
Slide 16
Problems
Suggested solutions begin on page 365.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
16
Slide 17
Problem 7
Purchase price
M ortgage amount @ 75%
Down payment @ 25% of sale price
Net operating income =
Annual debt service
Income to the equity
Income to the equity/equity investment
$1,235,000
-$926,250
$308,750
$96,000
-$78,558
$17,442
5.65%
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
17
Slide 18
Problems 8 and 10
Problem 8
Base rent
Sales % rent
Less base
Overage income
$
5,000
$ 850,000
$ 600,000
$ 250,000
X
12
=
$
60,000
X
3%
=
$
7,500
$
67,500
Problem 10
Tenant
1
2
3
4
PGI
V&C
EGI
Expenses
NOI
PGI
60,000
75,000
65,000
75,000
275,000
-13,750
261,250
-100,000
161,250
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
18