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

2. 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.

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

4. 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

5. 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

6. 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

7. 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)

8. 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

9. 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

10. 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: % %

11. 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

12. 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

13. 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

14. 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

15. Development of Capitalization Rates
Interest Rate or Discount Rate

16. Development of Capitalization Rates
Land Capitalization Rate (RL) and Building Capitalization Rate (RB)

17. Development of Capitalization Rates
Equity Capitalization Rate (RE)

18. 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%

19. Development of Capitalization Rates
Leased Fee Capitalization Rate (RLF)

20. 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.

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

22. 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

23. 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

24. 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

25. 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

26. So That’s Capitalization Rate Development
Are there any Questions?
Wayne Foss, MBA, MAI, CRE, Fullerton, CA USA