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The Income Capitalization Approach
Income Capitalization is a valuation method appraisers and real estate investors use to estimate the value of income producing real estate. It is based upon the premise of anticipation i.e., the expectation of future benefits. This method of valuation relates value to two things: [1] the "market rent" that a property can be expected to earn and, [2] the "reversion" (resale) when a property is sold. 

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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...

 
     
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)  
    Lawn Care (3,500)  
    Supplies/Maintenance (8,500)  
    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)  
       

 

(63,664)
Net Operating Income

 

$79,976
  "Capitalized" @ 10 %  =  Indicated Value  
   ($79,976 / .10)  =              $799,760
        R $799,800
           
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.  
           
Extraction of Cap Rates From the Market
    Sale 1 Sale 2 Sale 3
  Sale Price $125,000 $375,000 $260,000  
  Net Operating Income $12,500 $ 36,000 $ 26,520  
  Implied Cap Rate .10 .096 .102  
  Cap Rate

10%

     
 
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.
 

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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