Income Capitalization Approach to Value

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					Income Capitalization Approach to Value
         Based on anticipated future benefits of ownership; income and
          appreciation/depreciation in value.
         Fluctuations in demand and supply may cause market rents to exceed or
          fall short of current contract rents [Leased fee versus Fee Simple]. We use
          the market rent, occupancy and capitalization rates as the basis for

 Step 1: Estimate Income
   +Gross Potential Rental Income
          Direct rent
          Expense reimbursements
   +Gross Potential Non-rental Income
   =Gross Potential Income
   - Vacancy and Credit Loss
   -      Vacancy
   -      Credit
   =Effective Gross Income
   -Operating Expenses
          Replacement Allowance
   =Net Operating Income
          Compared to GAAP metrics - Net Income before income taxes,
          depreciation, interest and amortization [EBITDA] [p.493 text]
   -Capital Expenses [Yield capitalization only]
   =Cash Flow
Step 2 Estimate a Rate of Return to convert Income into
       Return on our invested capital = yield for risk that we undertake [equivalent to
       bond yield]
       Return of our invested capital = allowance for recapture of original investment
       either through annual income or through appreciation in value at the end of a
       holding period

       Direct Capitalization uses an Overall Capitalization Rate [OAR] to convert a
       single year’s estimate of income into value; e.g., $10,000 divided by 8% =
       $120,000. The OAR allows for both the return on and return of the original
       investment in the rate

       Yield Capitalization uses a Discount Rate [p.461] that converts a multi-period
       estimate of cash flows over a specified holding period into a current estimate of


Table 20.1 Rates, Ratios and Relationships

       Value = Income / Capitalization Rate

Table 20.2 Terminology

Market Value versus Investment Value - p. 450 - see above – how we use market data to
establish value versus how we use market data to make investment decisions

Leases and Expenses p. 451

Market rent p. 453 - definition – related to how we use market data to estimate value

       Rent Comparable analysis – Handbook pages 308-309
       Current leases
       History of the property
Operating Expenses

       Fixed expenses – expenses that do not vary directly with occupancy [RE Taxes
       and Insurance]
       Variable expenses – expenses that tend to vary directly with occupancy [utilities,
       payroll, cleaning and janitorial, maintenance and repair

       Does not include federal & state income taxes, interest, depreciation and
       amortization; does not include capital as opposed to operating expenses, does not
       include expenses related to divisions of ownership [partnership fees, etc.].

       Expenses are estimated at the level that reflects prudent management – this
       excludes insider or sweet heart deals, below or above market contracts,
       extraordinary conditions versus sustainable levels of expenses.

Reserve for Replacement Calculations

       Definition - p. 491 - normally does not include tenant improvements and
       leasing commissions but this can vary depending on purpose and local custom


              Stabilized constant Annual expense allowance – Direct Capitalization
              and Yield Capitalization [$/SF, % of revenue, $ amount]

              Non-stabilized, irregular, periodic or non-periodic expenses as forecasted
              to be incurred during holding period – Yield Capitalization [$ amounts]

Derivation of Capitalization Rates [pp. 502 – 503] – Market Extracted Rates

       Preferred method

       Look at Table 22.2 – see how capitalization rates are extracted from Sales
       Look at example on p. 503 – se how Reserve for Replacement calculations
       influence the Capitalization Rate extraction process

       Note: there are areas where Reserves are not used such as the market for single-
       tenant, net leased real estate. Most properties are assumed to have similar
       replacement issues either due to leases or physical age and characteristics of

Derivation of Capitalization Rates – Mortgage Equity – Band of Investment

       Very similar to another financial concept – weighted average cost of capital
       [WACC]. Assumption is that a property is composed of Debt [Mortgage] and
       Equity. The overall rate of return for the property [OAR] is assumed to be a
       weighted average of the return to mortgage holding and equity investor.
       See discussion, formulas on page 506 in Text.

       Assumed mortgage financing for a property is available for 75% loan to value;
       25% equity required. Assumed equity return is 10% and mortgage terms are
       8.5% with 25 year amortization requirement.

Component             Weight                 Return                 Weighted average
Equity                25%                    10.00%                 2.50%
Debt                  75%                    8.48%                  6.36%
Total Property        100%                                          8.86%
Debt Coverage Formula

       DCR = [or DSC debt service coverage] = Debt coverage ratio = NOI/ Annual
       Debt Service payment [NOI/ I m]

       DSC = NOI/I m

       OAR = DSC x Rm x M
       Example: 1.40 x 8.48 x .75 = 8.904%

SELF Study: Residual methods [see problem 8 in Handbook for Chapter 22]
            Gross Income Multiplier and Gross Rent Multiplier [see Text pp. 516-17]