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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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2 Terms and Definitions Income Rate: The ratio of one year’s income to the value of the property. Examples are R O, R E and R M Discount Rate: An interest rate used to convert future payments or receipts into present value. Examples are IRR and Y O 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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3 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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4 Direct Capitalization zA Method used to convert an estimate of a single year’s income expectancy into an indication of value. zA capitalization technique that employs capitalization rates and multipliers extracted from sales

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5 Basic Formulas zI = R x V R = I / VV = I / R z V = I x FI = V / FF = V / I Where: I = Income R = Capitalization Rate V = Value F = Factor I RV

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6 Income Streams zPotential Gross Income zEffective Gross Income zNet Operating Income zEquity Income zMortgage Income zLand Income zBuilding Income zIncome to the Landlord’s leased fee interest zIncome to the tenant’s leasehold interest

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7 Income Capitalization Rates zOverall (property) capitalization rate, fee simple (R O ) zMortgage Capitalization Rate (R M ) zEquity Capitalization, or equity dividend rate (R E ) zLand Capitalization Rate (R L ) zBuilding Capitalization Rate (R B ) zCapitalization Rate for the leased fee position (R LF ) zCapitalization Rate for the leasehold position (R LH )

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8 Income Factors zPotential Gross Income Multiplier (PGIM) yCan be expressed as a monthly or annual multiplier zGross Rent Multiplier (GRM) yGenerally expressed as a monthly multiplier zEffective Gross Income Multiplier

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9 Derivation of the Overall (Property) Capitalization Rate (R O) z From Comparable Sales When Net Income is known: R O = Net Operating Income / Sales Price When Net Operating Income is unknown but the Effective Gross Income Multiplier is Known: R O = Net Income Ratio / EGIM

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10 Overall Capitalization Rate (R O ) a Weighted Rate z Example: if Net Operating Income and Sales Price are known, then Overall Capitalization Rate (R O ) is calculated as: Net Operating Income / Sales Price = R O $100,000 $1,000,000 = 10.0% z R O is a weighted rate, between land and buildings Land: 25% x 8.5% = 2.1% Improvements:75% x 10.5% = 7.9% Total: 100% 10.0%

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11 Model for the Direct Capitalization Technique Net Operating Income $xxx,xxx.xx Capitalization of Income: Income to Property divided by R O = Overall Property Value Indicated Value per Direct Capitalization Technique $xxx,xxx.xx Application: $100, $1,000,000.00

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12 Rates Used in the Residual Techniques zBuilding Capitalization Rate: yInterest Rate (return on investment) yRecapture Rate (return of investment) zLand Capitalization Rate: yInterest Rate (return on investment) zFor Assessment purposes the effective tax rate is added to each capitalization rate

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13 Components of the Building Capitalization Rate (R B ) zReturn on Investment (interest rate) zReturn of Investment (recapture rate) yStraight Line: 1 / remaining economic life I.e.: 1 20 = 5.0% yCan be calculated with other recapture assumptions zFor assessment purposes add the effective tax rate yCalculated as the nominal tax rate times the assessment ratio xI.e.: Assessment Ratio 50.0%, nominal tax rate 4.0% xEffective tax rate = 50% x 4.0% = 2.0% zR B = Int. Rate + Recap. Rate or zR B = Int. Rate + Recap. Rate + Eff. Tax Rate

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14 Components of the Land Capitalization Rate ( R L ) zReturn on Investment (interest rate) zFor assessment purposes add the effective tax rate yCalculated as the nominal tax rate times the assessment ratio xI.e.: Assessment Ratio 50.0%, nominal tax rate 4.0% xEffective tax rate = 50% x 4.0% = 2.0% zR L = Int Rate or zR L = Int Rate + Eff Tax Rate

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15 Development of Capitalization Rates Interest Rate or Discount Rate

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16 Development of Capitalization Rates Land Capitalization Rate (R L ) and Building Capitalization Rate (R B )

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17 Development of Capitalization Rates Equity Capitalization Rate (R E )

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18 Development of Capitalization Rates Mortgage Capitalization Rate (R M ) 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 = $650,000.00Term = 30 years Interest Rate = 7.0%Amortization Type = Monthly Amortization Factor = Annual Payment = $51, R M = $51, $650, = 7.98%

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19 Development of Capitalization Rates Leased Fee Capitalization Rate (R LF )

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20 Development of Capitalization Rates Leasehold Capitalization Rate (R LH ) 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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21 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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22 Model for the Building Residual Technique Net Operating Income $xxx,xxx.xx Less Income Available to the Land: Land Value times R L : -$ xx,xxx.xx Income Available to the Improvements: $xxx,xxx.xx Capitalization of Income: Income to Improvements divided by R B = Building Value Plus Land Value $xxx,xxx.xx Indicated Value per Building Residual Technique $xxx,xxx.xx

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

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24 Model for the Land Residual Technique Net Operating Income $xxx,xxx.xx Less Income Available to the Improvements: Improvements Value times R B : -$ xx,xxx.xx Income Available to the Land: $xxx,xxx.xx Capitalization of Income: Income to Land divided by R L = Land Value Plus Improvements Value $xxx,xxx.xx Indicated Value per Land Residual Technique $xxx,xxx.xx

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

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26 So That’s Capitalization Rate Development Wayne Foss, MBA, MAI, CRE, Fullerton, CA USA

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