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Chapter 8: Income Capitalization Approach The Income Approach to Valuation Value determined as present value of future benefits Perspective of typical investor Income Capitalization Methods Direct Capitalization Converts a single year’s income into an indication of value using an income rate or income multiplier. Advantage is that cap rates and income multipliers come directly from market indications. Disadvantage is that expected changes in income will be similar for the comparable properties and the subject property. Yield Capitalization Converts expected future cash flows into an indication of value using discounted cash flow analysis. Advantage is that the income each year is explicitly identified. Application of the Income Approach Office buildings Expense passthrough Consumer price index (CPI) Consumer price index (CPI) Leased fee interest Retail shopping centers Minimum Rent Overage Rent Percentage Rent Application of the Income Approach Multifamily residential properties Industrial properties Hotels and Motels Nonrealty Business Value Development Projects Special-Use Properties Value Estimation Using Direct Capitalization Appropriate when: First-year cash flows are representative of an average or normal year’s earnings The income multiplier or capitalization rate is derived from comparable sales with the same potential for future income. Potential Gross Income Multiplier First, the PGIM is obtained by extracting PGIMs from recent sales of similar properties in the area and calculating the average PGIM: PGIM=Value/PGI Then, use that PGIM to calculate the value of your subject property using the following equation: Value of subject=PGI of subject x PGIM Effective Gross Income Multiplier More appropriate to use when long-term differences in vacancy between subject and comparable occur. First, the EGIM is obtained by extracting EGIMs from recent sales of similar properties in the area and calculating the average EGIM: EGIM=Value/EGI Then, use that EGIM to calculate the value of your subject property using the following equation: Value of subject=EGI of subject x EGIM Net Income Multiplier More appropriate to use when long-term differences in expense ratios between subject and comparable occur. First, the NIM is obtained by extracting NIMs from recent sales of similar properties in the area and calculating the average NIM: NIM=Value/NOI Then, use that NIM to calculate the value of your subject property using the following equation: Value of subject=NOI of subject x NIM Capitalization Rate We can also use Net Income as a tool for estimating valuation with a capitalization rate. First, the cap rate is obtained by extracting cap rates from recent sales of similar properties in the area and calculating the average cape rate: Cap Rate=NOI/Value Then, use that Cap Rate to calculate the value of your subject property using the following equation: Value of subject=NOI of subject/Cap Rate Residual Techniques Using Direct Capitalization: Building Residual Assuming the value of land is known but value of building is not, the value of components can be broken and total value estimated as follows: Land Value 450,000 Land cap rate Building cap rate NOI Less return to land (450,000x.095) Building cash flow 0.095 0.1 200,000 42,750 157,250 Building cash flow/building cap rate=Building value (157,250/.10)=1,572,500 Building value Plus land value Property value 1,572,500 450,000 2,022,500 Residual Techniques Using Direct Capitalization: Land Residual Assuming the value of the building is known but value of the land is not, the value of components can be broken and total value estimated as follows: Building Value 1,400,000 Land cap rate Building cap rate NOI Less return to building (1,400,000x.1) Land cash flow 0.095 0.1 200,000 140,000 60,000 Land cash flow/land cap rate=Land value (60,000/.095)=631,579 Building value Plus land value Property value 1,400,000 631,579 2,031,579 Residual Techniques Using Direct Capitalization: Land Residual The land residual technique was originally developed as a way to analyze highest and best use. The appraiser would create an estimate of land residual value for each development alternative. The alternative that yields the highest land residual value is considered the highest and best use. This approach, however, requires separate cap rate estimates for the land and building. This is difficult in practice, so an alternative is to use an overall cap rate calculation. NOI/Overall cap rate=Property Value 200,000/.10=2,000,000 Property value Less building value Land value 2,000,000 1,400,000 600,000 Value Estimation Using Yield Capitalization: Fixed Income and Resale Price Yield capitalization involves discounting unlevered cash flows at the property discount rate (target property yield for a given investor). 1 PGI Less vacancy and credit loss EGI Less operating expense NOI 2 3 4 300,000 300,000 300,000 300,000 18,000 18,000 282,000 282,000 282,000 282,000 282,000 82,000 18,000 300,000 18,000 82,000 18,000 5 82,000 82,000 82,000 200,000 200,000 200,000 200,000 200,000 Net resale proceeds If I=12%, solving for NPV gives a value estimate of $2,026,037 2,300,000 Value Estimation Using Yield Capitalization: Variable Income and Fixed Resale Price 1 2 3 4 5 PGI Less vacancy and credit loss 300,000 312,000 324,480 337,459 350,958 18,000 18,720 19,469 20,248 21,057 EGI 282,000 293,280 305,011 317,211 329,901 82,000 85,024 88,138 94,580 98,021 200,000 208,256 216,873 222,631 231,880 Less operating expense NOI Net resale proceeds If I=12%, solving for NPV gives a value estimate of $2,077,068 2,300,000 Value Estimation Using Yield Capitalization: Variable Income and Resale Price Based on Terminal Cap Rate Chapter 6 mentioned the topic of terminal cap rates, and this is where that concept gets used. The terminal cap rate can be applied to an estimate of income for the next owner to estimate the resale price. This income depends upon how market rates are expected to change over the first owner’s holding period and whether any of the original leases are still in effect. Value Estimation Using Yield Capitalization: Variable Income and Resale Price Based on Terminal Cap Rate If Estimated NOI in year 6=$241,480 and the Terminal cap rate=10% Resale value=Estimated NOI in year 6/Terminal cap rate Resale value = $241,480/.10 = $2,414,800 Value Estimation Using Yield Capitalization: Variable Income and Resale Price Based on Terminal Cap Rate 1 2 3 4 5 6 PGI Less vacancy and credit loss 300,000 312,000 324,480 337,459 350,958 364,996 18,000 18,720 19,469 20,248 21,057 21,900 EGI Less operating expense 282,000 293,280 305,011 317,211 329,901 343,096 82,000 85,024 88,138 94,580 98,021 101,616 NOI 200,000 208,256 216,873 222,631 231,880 241,480 Net resale proceeds 2,414,800 Assuming a 5 year holding period, if I=12%, solving for NPV gives a value estimate of $2,142,209