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To an investor, the future cash flows dictate what the present value
should be and what he/she is willing to pay for the property.
Income capitalization converts anticipated cash flows into
present value by
"capitalizing" net operating income by
a market derived "capitalization rate".
Essentially, a
capitalization rate is a rate of return on investment much like a dividend
earned on a stock. It is used by real
estate investors as a benchmark for determining how much they should pay
for a property. In appraisal practice, capitalization rates are extracted
from "sales" of similar investment properties and applied to the net
income of a subject property to determine it's value.
There are several ways to estimate value
using "capitalization". These include
direct
capitalization and
yield capitalization.
The method used depends upon several factors such as the timing and
regularity of the cash flows, period of time the investment is held,
whether or not long term leases are involved, and so forth.
Direct capitalization
is the most widely used and simplest approach to apply. It is used
when income is not expected to vary significantly over time.
For example,
direct capitalization would be used to value a 14 unit apartment building that produces a consistent annual operating
income and has generally short term leases that keep pace with the market.
Direct Capitalization vs.
Yield Capitalization
Direct
capitalization typically involves the
analysis of a single years net income (or average of several years income).
The resultant "NOI" is capitalized by an overall capitalization rate to
derive value.
Direct capitalization simulates investor motivation when reliable
estimates of income and market derived cap rates are readily available in
the market and reveal a consistent pattern. Use of direct capitalization
does not require explicit projections of income and assumes that
expectations for future income are similar for the subject and
comparables.
Yield
capitalization, on the other hand, requires explicit projects of income,
holding period, and property reversion and generally considers the income streams
for several years.
Yield capitalization does not necessarily rely on
comparable sales but does require selection of an appropriate
discount
rate and considers the timing of recapture. Conceptually, yield
capitalization involves the conversion of future benefits into present
value by applying an appropriate yield rate to the various cash flows. These future
benefits include any series of periodic incomes with or without a
reversion (resale) of the property. In the determination of
market value, typical investor’s yields are applied.
Other Techniques For Estimating Capitalization Rates
Mortgage equity (band of investment)
technique - considers the blended position of the cost of borrowed
capital with the equity position to deriving a capitalization rate.
Debt service coverage ratio
(DSCR ratio) - derives an overall capitalization rate by blending the typical market debt coverage requirements
of lending institutions with the return of the borrowed capital.
Discounted Cash Flow Analysis
When long term leases
(leased fee interest) exist or when income is expected to vary over
a projected
holding period, a
discounted cash flow analysis is usually considered. This
is a more complex type of analysis that derives value by "discounting"
the projected annual pre-tax income flows and the anticipated reversion
over the holding period into a present value estimate.
More to come...
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| Potential Gross
Income |
|
|
| 14 units @ $900 per month x
12 months |
$151,200 |
| |
Less: |
Vacancy/Collection Loss
- 5% |
(7,560) |
| |
|
|
| Effective Gross
Income |
|
$143,640 |
| |
Less Operating
Expenses |
|
| |
|
Property Taxes |
(13,500) |
|
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|
Lawn Care |
(3,500) |
|
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|
Supplies/Maintenance |
(8,500) |
|
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|
Remodeling (3 Units
annually @ $2400) |
(7,200) |
|
| |
|
Common Lighting |
(1,400) |
|
| |
|
Water & Sewer |
(4,600) |
|
| |
|
Hazard Insurance |
(7,100) |
|
| |
|
Mngmt - 10%
of EGI |
(14,364) |
|
| |
|
Reserves |
(3,500) |
|
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|
|
|
|
(63,664) |
|
Net
Operating Income |
|
$79,976 |
| |
"Capitalized" @
10 % = Indicated Value |
|
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($79,976 / .10)
= |
$799,760 |
| |
|
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|
R |
$799,800 |
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How Direct Capitalization Is
Applied
To estimate an offering price
for a property that has no predetermined holding period and for which
rents are not expected to vary greatly over time, an investor will usually
apply direct capitalization. This involves projecting
what rents can be expected over the next year and then deducting expenses. The "net" cash
flow that remains will provide a "return" to the investor and it is this
return expectation that will guide the investor as to how much to pay for
the property.
The above example
shows how the projected annual cash flow and investor required rate of
return can be used to estimate value. First,
potential gross income
is "forecasted" based upon an analysis of competitive rentals of
similar property type. Since all rental properties experience some
vacancy and collection losses, forecasted (proforma) rents are adjusted
downward. The net result is referred to as
effective
gross income. (Effective income is more commonly referred to as
"collected" or "actual" revenue when reported).
Operating expenses are estimated based on
comparative properties in the same market. These include normal expense
items typically paid by the landlord such as real property taxes,
insurance, major maintenance, and property management. Total operating
expenses are then deducted from
effective
gross income
to derive
net
operating income. |
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Extraction of Cap Rates From the Market |
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|
Sale 1 |
Sale 2 |
Sale 3 |
| |
Sale Price |
$125,000 |
$375,000 |
$260,000 |
|
| |
Net Operating Income |
$12,500 |
$
36,000 |
$ 26,520 |
|
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Implied Cap Rate |
.10 |
.096 |
.102 |
|
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Cap Rate |
10% |
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If the annual net
operating income of a property you were considering buying was say, $15,000,
and other similar properties (that sold) were producing cap rates in
the range of 10%, then you might expect to pay about $150,000 for the
property.
Capitalization rates can vary according to interest rates,
specific investor return requirements, financial/managerial risk, degree
of liquidity, management burden, and other factors – all affect the rate
of return acceptable to a given investor.
Risk is commensurate with return therefore,
when an investor is considering to purchase real estate, he/she will also consider the degree
of risk in alternate investments such as bank rate
securities, government, industrial, or municipal bonds, stocks, and other selected enterprises
- all of which are in competition. |
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Income Capitalization
Terms
- Capitalization
A process of converting
income to value. (See also direct capitalization and yield
capitalization).
-
Direct
Capitalization
[1] A valuation method
used to convert a single year's income expectancy (or an annual average
of several year's income expectancies) into a value estimate. [2]
A capitalization technique that utilizes capitalization (cap) rates and
multipliers extracted from sales to provide a value estimate. Yield and
value change are implied but not identified.
- Discount
Rate
The term used to explain the compound interest rate
used in the in approach to value to convert expected future cash flows
into a present value.
-
Discounted Cash Flow Analysis
A valuation technique that specifies [1]
the quantity, variability, timing, duration of periodic income, and [2]
the quantity/timing of the reversion (sale of property) then discounts
these cash flows at a specified yield rate to derive a present value
estimate.
- Effective Gross
Income
Anticipated income from
operation of the real estate after deduction for vacancy and collection
loss.
The leased fee interest, as distinguished from
the leasehold estate (tenant rights to occupancy), is defined as
the ownership interest held by a landlord with the right of occupancy and
use conveyed to others. Theoretically, the combined estates would make up
the fee simple estate which is the unencumbered interest
traditionally valued. When a lease encumbers a property, the partitioned
interests must be analyzed. The rights of the leased fee owner (the
lessor) and the leasehold (the lessee) are specified by contract terms
contained within the lease. Regardless of the interest appraised, all
estates are subject to the limitations imposed by the governmental powers
of taxation, eminent domain, police power, and escheat.
-
Net
Operating Income (NOI)
The net income left
remaining after deduction of all operating expenses from effective
gross income but before payment of debt service and deduction of book
depreciation.
-
Potential
Gross Income
The total income a
property is capable of generating at full occupancy but before
deduction of vacancy and operating expenses.
- Reversion
[1]
the value of property at the
expiration of a certain time period.
[2] the right of a lessor to possess leased property upon the
termination of a lease. [3] REVERSIONARY INTEREST -
the interest a person has in property upon the termination of the
preceding estate.
- Yield
Capitalization
A capitalization
method that derives a present value estimate by discounting each future
benefit at an appropriate yield rate or by developing and overall rate
that explicitly reflects the investment's income pattern, value change,
and yield rate. A valuation method that converts projected income into
value and considers the equity return on investment. |
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