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
valuation.

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
Fixed
Variable
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
Value
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
value.

NOTES

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

Methods:

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
buildings.

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
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]

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