1. The Income Capitalization Approach

2. The Income Capitalization Approach
The PV of a property can be considered to be the PV of the future benefits, which are the cash flows and the resale value of the property.
Relation to appraisal principles
Anticipation and change
Supply and demand
Applicability and limitations
Interests to be valued
Leased fee
Leasehold
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3. Leases Types of leases Flat rental lease Variable rate lease
Step-up or step-down lease
Lease with annual increase
Revaluation lease
Percentage lease
Expenses in leases
Gross lease
Net lease
Triple net lease
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4. Rent Common rent types Market rent Contract rent Effective rent
Excess rent
Deficit rent
Percentage rent
Overage rent
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5. Future Benefits Potential gross income (PGI) Starting point
As if full and without collection losses
Effective gross income (EGI)
PGI less vacancy and collection losses
Net operating income (IO or NOI)
EGI less fixed expenses and variable expenses
Less reserves for replacement (sometimes)
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6. Future Benefits, continued
Equity income – also called equity dividend, equity cash flow rate, or cash-on-cash return rate
Income to the equity after debt service (IE) divided by equity holder’s investment (VE)
Ignores the value of the reversion
Reversion – return of the investment
Sometimes it is nothing
Sometimes it is a meaningful amount
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7. Reconstructed Operating Statement
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8. Operating Expenses Necessary to maintain the property
Debt service not included
Fixed expenses – do not vary with occupancy
Variable expenses – vary with occupancy
Replacement allowance – included if expense is included in capitalization rates of comparable properties but not included if expense is not
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9. Rates of Return Return on and return of capital
Return on an investment is like the interest on a mortgage.
Return of an investment is like the principal payments on a mortgage.
Income rates
Overall capitalization rate (RO) – ratio of a single year’s income (periodic) to the sale price or value (lump sum)
Net income multiplier – reciprocal of overall capitalization rate
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10. Capitalization Rate Extraction Worksheet
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11. Rates of Return, continued
Discount rates
IRR – rate of return on the investment considering the price paid for the investment, the periodic cash flows, and the reversion
Overall yield rate – rate of return including debt and equity
Equity yield rate – rate of return from the perspective of the equity investor, i.e., the rate of return on the amount paid as a down payment from periodic income after debt service and including the reversion after the debt has been paid off
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12. Cash Flow Projection
For reversion value only
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13. Estimating Rates
Risk
A big factor because risk is a primary component of the yield rate
A risky investment requires a higher return than a less risky investment
Investment-specific
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14. Estimating Rates, continued
Inflation
Also a factor in the yield rate
The change in the buying power of the currency will affect the investment criteria.
Unfortunately, almost all competing investments suffer under the same inflation rate. Therefore, competition will not allow the investor to adjust for this factor.
Investors may want higher yields during high inflation periods, but the alternatives may not allow it.
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15. Capitalization Procedures
Direct capitalization
Uses a single year’s income
Based on the ratio of property income to sale price
Yield capitalization
Uses multiple years’ income
Based on the assumption that all investments are the present value of future cash flows
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16. Capitalization Procedures, continued
Direct capitalization, yield capitalization, and discounting compared
If income is level and the data is good, direct capitalization is easy and accurate.
If income is irregular or data is hard to obtain, DCF analysis will work better.
The discounted cash flow model essentially says, “How much do I get and when do I get it?”
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17. Review Exercise 10. Suggested Solution
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