# INCOME CAPITALISATION APPROACH

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```					  Discounted Cash Flow
Method of Valuation – Part B

• RE 205 Real Estate Finance and
Investment Analysis
• Lecturer: Paula Raqeukai
• Week 13

RE 205 Real Estate Finance and   1
Investment Analysis-2007
Estimating Value Through a
Discounted Cash Flow
• What is Discounted Cash Flow?
• A Capital Budgeting decision-making
criteria that are based on the time
value of money

RE 205 Real Estate Finance and   2
Investment Analysis-2007
Three Discounted Cash Flow
Capital-Budgeting Techniques
• 1. What is Net Present Value (NPV)?
• A capital-budgeting concept defined as the
present value of the project’s annual net
cash flows less the project’s initial outlay.
• Whenever the project’s NPV is greater
than zero, the project will be accepted;
and whenever there is a negative value
associated with the acceptance of a
project, it will be rejected.
RE 205 Real Estate Finance and   3
Investment Analysis-2007
Three Discounted Cash Flow
Capital-Budgeting Techniques
• If the project’s net present value is
zero, then it returns the required rate
of return and should be accepted.
• This accept-reject criterion is
illustrated below:
• NPV > or = 0 Accept
• NPV < 0      Reject
RE 205 Real Estate Finance and   4
Investment Analysis-2007
Three Discounted Cash Flow
Capital-Budgeting Techniques
• Example: The firm is considering new
machinery, for which the cash flows are shown
in the table below. If the firm has a 12% required
rate of return, the present value of the cash flow
is \$47,678 as calculated.
• Furthermore, the net present value of the new
machinery is \$7,678. Because this value is
greater then zero, the net present value criterion
indicates that the project should be accepted.

RE 205 Real Estate Finance and        5
Investment Analysis-2007
Three Discounted Cash Flow
Capital-Budgeting Techniques
CALCULATION OF NPV FOR INVESTMENT IN NEW MACHNIERY - EXAMPLE

NO. OF YEAR OR
PRESENT VALUE
LIFE OF THE       CASH FLOW                                    PRESENT VALUE
FACTOR AT 12%
PROJECT

Inflow year 1      \$     15,000             0.893           \$              13,395
Inflow year 2      \$     14,000             0.797           \$              11,158
Inflow year 3      \$     13,000             0.712           \$                   9,256
Inflow year 4      \$     12,000             0.636           \$                   7,632
Inflow year 5      \$     11,000             0.567           \$                   6,237

Present Value of
\$                  47,678
Cash inflows

Investment Initial
(\$40,000)
Outlay

RE 205 Real Estate Finance and                                   6
Investment Analysis-2007
Three Discounted Cash Flow
Capital-Budgeting Techniques
• CALCULATOR SOLUTION
• DATA INPUT: 40,000 FUNCTION KEY +/-
• CFi
• 15,000 CFi; 14,000 CFi; 13,000 CFi;
12,000 CFi; 11,000 CFi; 12 = i
• FUNCTION KEY: NPV ANSWER 7,675

RE 205 Real Estate Finance and   7
Investment Analysis-2007
Three Discounted Cash Flow
Capital-Budgeting Techniques
• 2. What is Internal Rate of Return
(IRR)?
• A capital-budgeting technique that reflects the
rate of return a project earns. Mathematically
it is the discount rate that equates the present
value of the inflows with the present value of
the outflows.

RE 205 Real Estate Finance and      8
Investment Analysis-2007
Three Discounted Cash Flow
Capital-Budgeting Techniques
• 3. What is Profitability index (PI)?
• A capital-budgeting criterion defined
as the ratio of the present value of the
future net cash flows to the initial
outlay.

RE 205 Real Estate Finance and   9
Investment Analysis-2007
Three Discounted Cash Flow
Capital-Budgeting Techniques
• What is Capital Budgeting?
• The decision–making process with
respect to investment in fixed assets
such as land & buildings or real estate.
Specifically it involves measuring the
incremental cash flows associated with
investment proposals and evaluating the
worth of these cash flows.
RE 205 Real Estate Finance and   10
Investment Analysis-2007
MEASURING A PROJECT’S
BENEFITS AND COSTS
• In measuring cash flows, we will be interested
only in the incremental or differential cash flows
that can be attributed to the proposal being
evaluated.
• The project’s cash flows will fall into one of three
categories below:
• (i) the initial outlay (initial cost of project);
• (ii) the differential flows over the project’s life;
• (iii) the terminal cash flow
RE 205 Real Estate Finance and    11
Investment Analysis-2007
COMPONENTS FOR CASH FLOWS

1. Investment Life (length of cash flow) – No
particular time is “the right one” don’t use the
always five or always ten yea rule; Depend
upon the circumstances eg. Site with 4 year
lease based on interim use then reverts to
development site – use until lease ends and
property would be sold for re-development;
Property with 2 year rent holiday then revert to
market;

RE 205 Real Estate Finance and       12
Investment Analysis-2007
COMPONENTS FOR CASH FLOWS
2. Current income (probably the first cash flow)
- be based on lease terms and market
situations;
- Must be realistic in terms of market expectations
- Carefully establish what the net income is to owner
- Period will vary depending upon number and type of
tenant. For multi-tenanted with complex lease
arrangements monthly may be better
- Vacancies need to be included

RE 205 Real Estate Finance and     13
Investment Analysis-2007
COMPONENTS FOR CASH FLOWS
3. Income growth or changes (reflected by changes in annual
income over time)
•     - Must be based on market expectations of growth for that
type of property
•     - Don’t use the CPI unless you can prove that growth mirrors
the CPI
•     - Considers economic issues
•     e.g. – population changes
•          - supply & demand figures – building completions
•            & building starts
•          - other relevant economic indicators

RE 205 Real Estate Finance and                 14
Investment Analysis-2007
COMPONENTS FOR CASH FLOWS
4. Any special one off payments or
returns which are expected (e.g. capital
improvements)

RE 205 Real Estate Finance and   15
Investment Analysis-2007
COMPONENTS FOR CASH FLOWS
5. Capital growth or reversionary value
(value of the property at the end of the
cash flow)

RE 205 Real Estate Finance and   16
Investment Analysis-2007
COMPONENTS FOR CASH FLOWS
• 6. Residual Value
• Can be used on income or other methods – particularly
if interim use
• Most common method is to apply capitalization rate
(initial yield) to expected income in the year following the
sale
• Can take a “ballpark figure” at the beginning and inflate
at a capital growth rate
• For investment Analysis may include cost sale but not
normally for market valuation. For valuation purposes
you must be consistent. What even assumptions are
built into the sales analysis must be included in the
application.

RE 205 Real Estate Finance and          17
Investment Analysis-2007
FOUR MAIN SOURCES OF CASH
FLOWS
1. Gross Income – PGI (Potential Gross
Income) is the maximum income that
can be obtained from the property. The
effective gross income (EGI) provides
a more realistic rental situation of
property. Gross income multipliers
should be applied to the EGI rather than
to the PGI

RE 205 Real Estate Finance and   18
Investment Analysis-2007
FOUR MAIN SOURCES OF CASH
FLOWS
2. Net Operating Income (NOI) – Is the
most important level of analysis for the
valuer. It is obtained by deducting the
operating expenses from the effective
gross income. The income capitalization
approaches and the income discounting
approaches are applied at this level to
provide the full value of the asset.

RE 205 Real Estate Finance and   19
Investment Analysis-2007
FOUR MAIN SOURCES OF CASH
FLOWS
3. Before-Tax Cash Flows (BTCF) – are
the before-tax reward to the equity owner
after servicing the debt (after the Bank…).
The discounted cash flow approaches
should start at this level. The present
value of the equity must be added to the
present value of the debt to derive the full
value of the asset in a no-tax world

RE 205 Real Estate Finance and   20
Investment Analysis-2007
FOUR MAIN SOURCES OF CASH
FLOWS
4. After-Tax cash Flows (ATCF) – are the
residual reward to the equity owner. It is
an “after-debt and after-tax” level (after the
Bank, after the Queen…). The present
value of the after-tax equity must be added
to the present value of the debt to derive
the full value of the assets in a taxed
world.

RE 205 Real Estate Finance and   21
Investment Analysis-2007
INITIAL YIELD - ASSUMPTIONS
• All cash flows occur at one time
• Productivity is defined as the annual net operating
income from property before debt service & income
taxes
• The projection period is for the full useful life of the
improvements, with no consideration of the ownership
life cycle
• Capital is recaptured from income, except for land,
which is assumed to be constant. No explicit
consideration is given to resale price changes or
transaction cost

RE 205 Real Estate Finance and        22
Investment Analysis-2007
YIELD CALCULATIONS
• Each of the situations above can be calculated
as a discounted cash flow using the necessary
assumptions
• Term and reversion (equivalent yield) and initial
yield can also be calculated more simply.
• Term and reversion as an annuity of the term as
a Deferred Perpetuity for the Reversion
• Initial yield as a Perpetuity

RE 205 Real Estate Finance and   23
Investment Analysis-2007
APPLICATION OF INCOME METHODS
• The valuer needs to consider which assumptions to
make explicit and which to be zero or implicit. The
circumstances of the property to be valued and the
market place will normally determined this
• If there are a significant number of rack rented (market
rented) properties suitable as sales evidence and if
expectations of investment life, capital and rental growth
etc are all about the same
• THEN simple capitalization using initial yield would be
suitable
• Typically this could occur with condominium block,
industrial estates or shop-house blocks

RE 205 Real Estate Finance and        24
Investment Analysis-2007
APPLICATION OF INCOME METHODS
• If there a number of sale properties which are no rack
rented then at least the equivalent yield must be
calculated to allow for the term and reversion
• Similarly if the property to be valued is a freehold
interest where some rental is not at market value, then
at least the term and reversion approach must be
adopted to allow for the non-market situation of the
rental
• These situations can occur with all types of income
properties at any time but are most likely
• - if the market is in boom or bust situation
• - if the current use is interim – reversion value may not
be based on current income
• - if rentals are off-set with incentives
RE 205 Real Estate Finance and        25
Investment Analysis-2007
APPLICATION OF INCOME METHODS
• In complex income valuation situations all assumptions
may need to be made explicit. When different properties
have different expectations of growth, vacancies, costs,
investment life etc then it becomes necessary to use
analysis where all cash flows are considered separately
(can not use annuities and perpetuities) and a
Discounted Cash Flow approach must therefore be used.
• This will typically occur with more complex investment
properties such as shopping centres and office buildings
but may also be appropriate for other properties as well
• In these situation Sales Analysis should be used if
possible to establish a discount rate.
RE 205 Real Estate Finance and       26
Investment Analysis-2007
DCF EXAMPLE
DCF - EXAMPLE

CALCULATE NPV FOR THE SUBJECT (Using 17% rate)

NET CASH
YEAR   INCOME      OUTGOINGS      RESIDUAL                    PV FACTOR       PV OF NCF
FLOW

1      \$22,000    \$       900                  \$ 21,100        0.8547    \$           18,034

2      \$23,800    \$       950                  \$ 22,850        0.7305    \$           16,692

3      \$27,000    \$      5,000                 \$ 22,000        0.6244    \$           13,736

4      \$29,000    \$      1,100                 \$ 27,900        0.5337    \$           14,889

5      \$31,100    \$      1,200    \$ 330,000    \$ 359,900       0.4561    \$          164,154

NPV@17% = \$227,505

RE 205 Real Estate Finance and                                27
Investment Analysis-2007
The Basics of Valuing
Development Sites
• As with all valuation Keep it Simple – if you can solve the
problem simply then do so..
• In many cases development properties can be assessed
on a simple per square metre or other unit comparison
e.g. per lot created or per unit built or per acre basis.
result is a small range of unit prices this may be
sufficient to estimate value. Even if the range is large it
should provide an estimate for you to work around.
• In some cases the result needs finer tuning. This is when
the some form of residual method may be used.

RE 205 Real Estate Finance and          28
Investment Analysis-2007
HYPOTHETICAL DEVELOPMENT
METHOD
• The hypothetical development method (HDM) or land residual
method is used where the property is capable of development,
but existing methods are unsatisfactory to achieve a sensible
conclusion. The property will generally not be used at the highest
and best legal use. The value of land suitable for development is
related to the profit potential.
• This method involves the valuer in a process similar to a
developer feasibility study. The process in short is:
• - subtract the amount that a developer might typically require as
a
return
• - subtract all the other costs involved
• - this leaves you with the amount that can be paid for the land

RE 205 Real Estate Finance and             29
Investment Analysis-2007
BASIS FOR HDM
• The basis for the HDM is the simple formula
• Profit = VFP – LC – DC
•   Where:
•   VFP = Value of Finished Product
•   LC = Land Costs
•   DC = Development Costs
****The END – Refer to Lab for applications*****

RE 205 Real Estate Finance and   30
Investment Analysis-2007

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