Income Capitalization: Rates and Techniques Basic Real Estate Appraisal: Principles & Procedures – 9 th Edition © 2015 OnCourse Learning Chapter 14

STUDENT LEARNING OUTCOMES Define Income Capitalization List the Three Key Characteristics of a Future Stream of Income List the Two Methods used to Derive or Calculate Overall Capitalization Rates Define and Illustrate Direct Capitalization Define Discounted Cash Flow and Describe its Use in Appraisals 2 Page 448 © 2015 OnCourse Learning

14.1 PURPOSE AND THEORY OF CAPITALIZATION Capitalization… … the process of converting the projected future income of a property into an estimate of value, as of a specific date Reflects the Present Worth of Future Benefits Recognizes the Time Value of Money 3 Page 449 © 2015 OnCourse Learning

CAPITALIZATION (Con’t.) Key Characteristics of Future Income Streams: Quantity ($ Amount) Quality (Relative Risk) Timing (Durability & Frequency) 4 Page 450 © 2015 OnCourse Learning

CAPITALIZATION RATE DEFINED Any Rate used to Convert Income into Value It Directly or Indirectly Provides for… A Return on the Investment (Interest or Yield) A Return of the Investment (Capital Recovery) 5 Page 450 © 2015 OnCourse Learning

TYPES OF CAPITALIZATION RATES The type of rate is dependent on which of two Capitalization Techniques is used… Direct Capitalization (Ratio Capitalization) What the Market believes about future cash flows is hidden in the Capitalization Rate Yield Capitalization In Yield Capitalization the pattern and duration of the future income stream is explicit 6 Page 451 © 2015 OnCourse Learning

COMPARING INVESTMENT PROPERTY The Choice of a Capitalization Technique and Rate Considers the following Investment Criteria… 7 Page 451 © 2015 OnCourse Learning Safety Yield Liquidity Freedom from Management Prospects for Appreciation Burden of Property Taxes Shelter from Income Taxes Size or Denomination Hypothecation (Security for a Loan) Leverage (Positive or Negative)

CURRENT AND FUTURE RETURNS Income Stream – the initial return or profit received Monthly or Annually Reversion – the deferred return from the Future Resale Proceeds (or Refinancing) If a Property is encumbered by a Loan: Income Stream or Cash Flow after loan payments is Equity Dividend or Return to Equity Reversion will be affected by Equity Buildup due to principle reduction (loan amortization) 8 Page 454 © 2015 OnCourse Learning

YIELD VERSUS RECAPTURE Yield = Return on Investment Capital Recapture = Return of Investment Capital Both the Yield and the Recapture can be provided through a combination of the periodic income stream and capital recovery (reversion) From a Lender’s perspective – principle and interest payments provide both in an amortized loan (a lender’s investment) 9 Page 456 © 2015 OnCourse Learning

RELATING TO ECONOMIC PRINCIPLES 10 Page 459 © 2015 OnCourse Learning ECONOMIC PRINCIPLEINCOME PROCEDURE Anticipation (Present Worth of Future Benefits) Capitalization of Future Income Agents of ProductionSubtracting Operating Expenses ContributionResidual Capitalization Highest and Best Use Highest Residual Land Value (Return to the Land) Consideration of these Principles can influence the choice of Capitalization Techniques and the Selection of Capitalization Rates

14.2 SELECTION OF THE CAPITALIZATION RATE Four Types of Rates Interest Rate Return on Capital; Yield or Discount Rate: Internal Rate of Return; Period Rate Overall Capitalization Rate OAR; R o ; Cap Rate; Ratio between Income & Value Recapture Rate Return of Capital; typically Annually; Amortization Composite Capitalization Rate Composed of an Interest and a Recapture Rate 11 Page 460 © 2015 OnCourse Learning

RELATIONSHIP BETWEEN YIELD AND OVERALL RATES If Income and Value remain stable over time, then Yield (Y o ) = OAR (R o ) If Value is expected to increase, then the OAR (R o ) is less than the Yield Rate (Y o ) If Value is expected to decrease, then the OAR (R o ) is greater than the Yield Rate (Y o ) The foregoing relationship reflects the expected future change in value (Δ or Delta) 12 Page 461 © 2015 OnCourse Learning

ESTIMATING OVERALL RATES Direct Comparison Band of Investment 13 Page 463 © 2015 OnCourse Learning

ESTIMATING INTEREST RATES 14 Page 465 © 2015 OnCourse Learning

ESTIMATING INTEREST RATES (Con’t.) 15 Page 466 © 2015 OnCourse Learning

ESTIMATING INTEREST RATES (Con’t.) 16 Page 467 © 2015 OnCourse Learning Summation Method of Estimating Interest Rates

ADJUSTING OVERALL RATES The Analysis of Overall Rates Derived from Comparable Sales, and Rate Selection, should consider… Property Location Age, Quality and Condition of Improvements Remaining Economic Life of the Improvements Ratio of Building Value to the Total Value Expenses that occur as a Percentage of Value (e.g. Property Taxes) 17 Page 468 © 2015 OnCourse Learning

CAPITAL RECOVERY METHODS Straight-Line Method Assumes equal annual recapture from net income Used in several capitalization methods Sinking Fund Method Assumes “safe rate” earnings Rarely used in appraisals Annuity (Inwood) Method Provides capital recovery in same way as loan amortization Assumes recapture amounts earn interest An older form of yield capitalization 18 Page 469 © 2015 OnCourse Learning

14.3 DIRECT AND RESIDUAL CAPITALIZATION TECHNIQUES Direct Capitalization technique Equity Residual technique Building Residual technique Land Residual technique Detailed on slides that follow 19 Page 472 © 2015 OnCourse Learning

DIRECT CAPITALIZATION TECHNIQUE Simplest and Most Reliable 20 Page 472 © 2015 OnCourse Learning

EQUITY RESIDUAL TECHNIQUE 21 Page 473 © 2015 OnCourse Learning

BUILDING RESIDUAL TECHNIQUE 22 Page 474 © 2015 OnCourse Learning

LAND RESIDUAL TECHNIQUE 23 Page 475 © 2015 OnCourse Learning

14.4 ESTIMATING, MEASURING AND DISCOUNTING CASH FLOWS Yield Capitalization is nearly always used to value future income streams Yield Capitalization requires estimates of: Future Cash Flows (or their pattern) The Time Period (projected holding period) The Yield Rate (interest rate, discount rate, or internal rate of return) 24 Page 478 © 2015 OnCourse Learning

USE OF CASH FLOWS IN APPRAISALS Estimating Cash Flows Measuring Cash Flow from Periodic Income Even Cash Flow (Level Income Stream) Uneven Cash Flow (Increases or Declines) Income Projections Consider historical trends as well as market expectations over the projected holding period 25 Page 479 © 2015 OnCourse Learning

CASH FLOWS IN APPRAISALS (Con’t.) Measuring Sale Proceeds Cash Flows Estimating the Future Sales Price Estimate the Net Operating Income at the end of the Holding Period, and Capitalize it using a Going-Out OAR to indicate Future Resale Price or Project the Future Value by applying an Annual Percent value change to a Current Value 26 Page 482 © 2015 OnCourse Learning

DISCOUNTING CASH FLOWS Discounted Cash Flow (DCF) Theory of “Discount” Math Future $’s are Worth less than Current $’s Discount or Present Value Factors Six Functions of a Dollar ($) 27 Page 482 © 2015 OnCourse Learning

DISCOUNTING CASH FLOWS (Con’t.) 28 Page 485 © 2015 OnCourse Learning Discount Formula for a Single Future Payment Summary of Discounted Cash Flows

CHAPTER SUMMARY Income capitalization is the process of converting future income into a value estimate as of the date of value. By selecting capitalization rates that reflect the types and amounts of return sought in the real estate investment market, the appraiser completes the link between income and value. 29 Page 487 © 2015 OnCourse Learning

CHAPTER SUMMARY (Con’t.) The market value of amounts to be received in the future must always be reduced or discounted to their present values in some way to recognize the time value of money (i.e. Present Worth of Future Benefits). Direct Capitalization and Yield Capitalization are the basic techniques by which to convert income into an estimate of value. 30 Page 487 © 2015 OnCourse Learning

IMPORTANT TERMS & CONCEPTS Band of Investment MethodDiscounted Cash Flow (DCF) Building Residual TechniqueEquity Dividend Rate Capital RecoveryEquity Residual Technique Capitalization RateEquity Yield Rate Cash FlowGoing-In OAR Composite Capitalization RateGoing-Out OAR Debt ServiceHypothecation Delta (Value Change)Income Stream Direct Capitalization TechniqueInterest Rate Direct Comparison MethodInternal Rate of Return Discount RateInvestment Value 31 Page 489 © 2015 OnCourse Learning

IMPORTANT TERMS & CONCEPTS Land Residual TechniqueReversion LeverageSafe Rate Mortgage ConstantSummation Method Overall Capitalization Rate (OAR)Time Value of Money Periodic RateYield Capitalization Ratio CapitalizationYield Rate Recapture Rate 32 Page 489 © 2015 OnCourse Learning