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**Capitalization Rate Development**

Income Streams, Rates and Factors for Direct Capitalization Wayne Foss, MBA, MAI, CRE, Fullerton, CA USA

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**Terms and Definitions Income Rate:**

The ratio of one year’s income to the value of the property. Examples are RO, RE and RM Discount Rate: An interest rate used to convert future payments or receipts into present value. Examples are IRR and YO Yield Rate: A rate of return on capital for a specific time period. Usually expressed as a compound annual percentage rate.

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**Terms and Definitions Interest Rates: Effective Interest Rate (i)**

interest per dollar per period; the nominal annual interest rate divided by the number of conversion periods per year. Nominal Interest Rate (I) A stated or contract rate; an interest rate, usually annual

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**Direct Capitalization**

A Method used to convert an estimate of a single year’s income expectancy into an indication of value. A capitalization technique that employs capitalization rates and multipliers extracted from sales

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**Basic Formulas I = R x V R = I / V V = I / R V = I x F I = V / F**

F = V / I Where: I = Income R = Capitalization Rate V = Value F = Factor I R V

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**Income Streams Potential Gross Income Effective Gross Income**

Net Operating Income Equity Income Mortgage Income Land Income Building Income Income to the Landlord’s leased fee interest Income to the tenant’s leasehold interest

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**Income Capitalization Rates**

Overall (property) capitalization rate, fee simple (RO) Mortgage Capitalization Rate (RM) Equity Capitalization, or equity dividend rate (RE) Land Capitalization Rate (RL) Building Capitalization Rate (RB) Capitalization Rate for the leased fee position (RLF) Capitalization Rate for the leasehold position (RLH)

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**Income Factors Potential Gross Income Multiplier (PGIM)**

Can be expressed as a monthly or annual multiplier Gross Rent Multiplier (GRM) Generally expressed as a monthly multiplier Effective Gross Income Multiplier

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**Derivation of the Overall (Property) Capitalization Rate (RO)**

From Comparable Sales When Net Income is known: RO = Net Operating Income / Sales Price When Net Operating Income is unknown but the Effective Gross Income Multiplier is Known: RO = Net Income Ratio / EGIM

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**Overall Capitalization Rate (RO) a Weighted Rate**

Example: if Net Operating Income and Sales Price are known, then Overall Capitalization Rate (RO) is calculated as: Net Operating Income / Sales Price = RO $100,000 $1,000,000 = 10.0% RO is a weighted rate, between land and buildings Land: 25% x % = 2.1% Improvements: 75% x 10.5% = 7.9% Total: % %

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**Model for the Direct Capitalization Technique**

Net Operating Income $xxx,xxx.xx Capitalization of Income: Income to Property divided by RO = Overall Property Value Indicated Value per Direct Capitalization Technique $xxx,xxx.xx Application: $100, ¸ % = $1,000,000.00

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**Rates Used in the Residual Techniques**

Building Capitalization Rate: Interest Rate (return on investment) Recapture Rate (return of investment) Land Capitalization Rate: For Assessment purposes the effective tax rate is added to each capitalization rate

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**Components of the Building Capitalization Rate (RB)**

Return on Investment (interest rate) Return of Investment (recapture rate) Straight Line: 1 / remaining economic life I.e.: 1 ¸ 20 = 5.0% Can be calculated with other recapture assumptions For assessment purposes add the effective tax rate Calculated as the nominal tax rate times the assessment ratio I.e.: Assessment Ratio 50.0%, nominal tax rate 4.0% Effective tax rate = 50% x 4.0% = 2.0% RB = Int. Rate + Recap. Rate or RB = Int. Rate + Recap. Rate + Eff. Tax Rate

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**Components of the Land Capitalization Rate (RL)**

Return on Investment (interest rate) For assessment purposes add the effective tax rate Calculated as the nominal tax rate times the assessment ratio I.e.: Assessment Ratio 50.0%, nominal tax rate 4.0% Effective tax rate = 50% x 4.0% = 2.0% RL = Int Rate or RL = Int Rate + Eff Tax Rate

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**Development of Capitalization Rates**

Interest Rate or Discount Rate

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**Development of Capitalization Rates**

Land Capitalization Rate (RL) and Building Capitalization Rate (RB)

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**Development of Capitalization Rates**

Equity Capitalization Rate (RE)

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**Development of Capitalization Rates**

Mortgage Capitalization Rate (RM) By definition, the Mortgage Capitalization Rate is the relationship between annual debt service and the balance of the loan. At the beginning of the loan term, the Mortgage Capitalization Rate is equal to the annual mortgage constant. For Example: Loan = $650, Term = 30 years Interest Rate = 7.0% Amortization Type = Monthly Amortization Factor = Annual Payment = $51,893.40 RM = $51, ¸ $650, = 7.98%

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**Development of Capitalization Rates**

Leased Fee Capitalization Rate (RLF)

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**Development of Capitalization Rates**

Leasehold Capitalization Rate (RLH) If Net Operating Income is Equal to or Greater Than Market Net Operating Income, there is no value to the leasehold position.

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**The Residual Techniques**

The Building Residual Technique What is Known: 1. Net Operating Income 2. Land Value What is Unknown: Improvement Value The Land Residual Technique What is Known: 1. Net Operating Income 2. Depreciated Value of the Improvements What is Unknown: Land Value

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**Model for the Building Residual Technique**

Net Operating Income $xxx,xxx.xx Less Income Available to the Land: Land Value times RL : $ xx,xxx.xx Income Available to the Improvements: $xxx,xxx.xx Capitalization of Income: Income to Improvements divided by RB = Building Value Plus Land Value $xxx,xxx.xx Indicated Value per Building Residual Technique $xxx,xxx.xx

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**Example for the Building Residual Technique**

Net Operating Income $100,000.00 Less Income Available to the Land: $250, x 8.5% : $ 21,250.00 Income Available to the Improvements: $ 78,750.00 Capitalization of Income: $78, ¸ 10.5% = $750,000.00 Plus Land Value $250,000.00 Indicated Value per Building Residual Technique $1,000,000.00

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**Model for the Land Residual Technique**

Net Operating Income $xxx,xxx.xx Less Income Available to the Improvements: Improvements Value times RB : $ xx,xxx.xx Income Available to the Land: $xxx,xxx.xx Capitalization of Income: Income to Land divided by RL = Land Value Plus Improvements Value $xxx,xxx.xx Indicated Value per Land Residual Technique $xxx,xxx.xx

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**Example for the Land Residual Technique**

Net Operating Income $100,000.00 Less Income Available to the Improvements: $750, x 10.5% : $ 78,750.00 Income Available to the Land: $ 21,250.00 Capitalization of Income: $21, ¸ 8.5% = $250,000.00 Plus Improvements Value $750,000.00 Indicated Value per Land Residual Technique $1,000,000.00

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**So That’s Capitalization Rate Development**

Are there any Questions? Wayne Foss, MBA, MAI, CRE, Fullerton, CA USA

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