1. Chapter 8: Income Capitalization Approach

2. The Income Approach to Valuation
Value determined as present value of future benefits
Perspective of typical investor

3. 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.

4. Application of the Income Approach
Office buildings
Expense passthrough
Consumer price index (CPI)
Leased fee interest
Retail shopping centers
Minimum Rent
Overage Rent
Percentage Rent

5. Application of the Income Approach
Multifamily residential properties
Industrial properties
Hotels and Motels
Nonrealty
Business Value
Development Projects
Special-Use Properties

6. 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.

7. 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

8. 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

9. 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

10. 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

11. 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
0.095
Building cap rate
0.1
NOI
200,000
Less return to land (450,000x.095)
42,750
Building cash flow
157,250
Building cash flow/building cap rate=Building value
(157,250/.10)=1,572,500
Building value
1,572,500
Plus land value
Property value
2,022,500

12. 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
0.095
Building cap rate
0.1
NOI
200,000
Less return to building (1,400,000x.1)
140,000
Land cash flow
60,000
Land cash flow/land cap rate=Land value
(60,000/.095)=631,579
Building value
Plus land value
631,579
Property value
2,031,579

13. 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
2,000,000
Less building value
1,400,000
Land value
600,000

14. 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 2 3 4 5
PGI
300,000
Less vacancy and credit loss
18,000
EGI
282,000
Less operating expense
82,000
NOI
200,000
Net resale proceeds
2,300,000
If I=12%, solving for NPV gives a value estimate of $2,026,037

15. Value Estimation Using Yield Capitalization: Variable Income and Fixed Resale Price1 2 3 4 5
PGI
300,000
312,000
324,480
337,459
350,958
Less vacancy and credit loss
18,000
18,720
19,469
20,248
21,057
EGI
282,000
293,280
305,011
317,211
329,901
Less operating expense
82,000
85,024
88,138
94,580
98,021
NOI
200,000
208,256
216,873
222,631
231,880
Net resale proceeds
2,300,000
If I=12%, solving for NPV gives a value estimate of $2,077,068

16. 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.

17. 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

18. Value Estimation Using Yield Capitalization: Variable Income and Resale Price Based on Terminal Cap Rate 1 2 3 4 5 6
PGI
300,000
312,000
324,480
337,459
350,958
364,996
Less vacancy and credit loss
18,000
18,720
19,469
20,248
21,057
21,900
EGI
282,000
293,280
305,011
317,211
329,901
343,096
Less operating expense
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