Rental Cash Flow Projection

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					Chapter 20


The Student Handbook to
THE APPRAISAL OF REAL ESTATE


The Income Capitalization
Approach


                               1
    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
    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
    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
 Table 20.1 Reconstructed Operating Statement


Potential gross income (PGI)      25,000   @    $9.00       =        $225,000
Vacancy & collection loss          5%      of   PGI         =         -$11,250
Effective gross income (EGI)                                         $213,750

Estimated Annual Expenses
 Property taxes                                 $ 33,000        Fixed expenses
 Property insurance                             $   4,500
 Repairs                                        $ 30,000
 Management                      5.848%         $ 12,500        Variable expenses
 Utilities                                      $ 22,000
 Reserves for new roof            1/20          $   1,250       Reserves for replacement
 Reserves for parking lot         1/15          $     800
Total expenses                                  $ 104,050           -$104,050
Net operating income (I     O)                                       $109,700




Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20                                                                                 5
    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
    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
    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
    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
 Table 20.2 Capitalization Rate Extraction
 Worksheet
                                    Subject        Sale 1           Sale 2        Sale 3
Reported sale price                              $1,985,000      $1,458,000     $3,258,000

PGI for next year                   $510,000      $369,000        $253,680       $601,000
Vacancy & collection loss             -$25,500       -$25,830        -$15,221       -$48,080
EGI for ne xt year                  $484,500      $343,170        $238,459       $552,920
O perating expense next ye ar
T axes                               $56,000       $44,258         $26,000        $72,000
Insurance                            $10,600        $9,600          $4,500        $14,500
Management                  $0.05    $24,225       $17,159         $11,923        $27,646
Maintenance - building               $22,050       $16,055         $10,700        $26,500
Maintenance - grounds                $11,000        $8,000          $4,900        $13,800
Utilities                            $67,000       $55,000         $34,000        $76,800
Reserve fund - roof covering          $5,000        $4,200          $2,600         $4,200
Reserve - parking lot                 $4,500        $3,900          $2,500         $7,500
Reserve fund - HVAC                   $3,200        $2,500          $2,900         $6,200
Reserve fund - elevator               $1,500        $1,200          $1,800         $3,600
T enant improvements                  $5,500        $4,400          $3,500        $12,600
Total expe nses                     $210,575      $166,272        $105,323       $265,346

Net operating income                $273,925      $176,899        $133,136       $287,574

Extracted capitalization rates                           8.91%         9.13%            8.83%


                                     $273,925        /                  $0.09       =           $3,043,611.11


Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20                                                                                                      10
    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
 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
   Potential gross income        $260,725        $260,924       $278,724       $290,724      $290,724      $293,502
   Vacancy and collection (4%)    -$10,429        -$10,437       -$11,149       -$11,629      -$11,629      -$11,740
   Effective gross income        $250,296        $250,487       $267,575       $279,095      $279,095      $281,762
   All expenses                   $55,000         $56,650         $58,350        $60,100      $61,903       $63,760
   Net operating income          $195,296        $193,837       $209,225       $218,995      $217,192      $218,002
   Reversion (10%)                        Last year's income divided by the cap. rate      $2,158,366
   Cash flow                     $195,295        $193,837       $209,225       $218,995    $2,375,558
   Discounted at (9%)              0.9174          0.8417         0.7722         0.7084         0.6499
   Present values                $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
    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
    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
    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
 Problems


    Suggested solutions begin on page 365.




Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20                                         16
 Problem 7


 Purchase price                                    $1,235,000
 Mortgage amount @ 75%                              -$926,250
 Down payment @ 25% of sale price                    $308,750



 Net operating income =                               $96,000
 Annual debt service                                 -$78,558
 Income to the equity                                 $17,442

 Income to the equity/equity investment                 5.65%

Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20                                                      17
 Problems 8 and 10
                               Problem 8
Base rent             $      5,000    X      12    =   $   60,000
Sales % rent          $ 850,000
Less base             $ 600,000
Overage income        $ 250,000       X      3% =      $    7,500
                                                       $   67,500
      Problem    10
Tenant             PGI
1                   60,000
2                   75,000
3                   65,000
4                   75,000
PGI               275,000
V& C               -13,750
EGI               261,250
Expenses         -100,000
NOI               161,250
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20                                                          18

				
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