Income capitalisation

Approach

Presented by:
Abhijeev Pal Singh
Shivpreet Singh Sandhu

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 The Capitalization Method of
Valuation
• The traditional method of analyzing and valuing
investment properties is the capitalization
method (also known as the Income Approach)

• The basic concept is that the capital value of an

income producing property is simply the sum of
the present values of all the anticipated future
income and capital flows from the property
discounted at some appropriate interest rate
(also known as the Capitalization Rate)

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 The Capitalization Method of
Valuation
• Sales of investment properties can be
analyzed to find the capitalization rate
and this rate can then be utilized in the
valuation of comparable properties
• Historically, in periods of zero or steady
growth in rental values and for
properties with simple leases the
capitalization method was used
exclusively
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 The Capitalization Method of
Valuation
• The modern world of valuation and
investment analysis now has to cope with
fluctuating growth rates, multi-tenanted
properties, complex leasing arrangements
and the impact of taxation that do cause
problems when attempting to implement the
capitalization method
• When faced with the foregoing complexities
most analyst prefer to utilize the more
explicit and flexible approach contained in
the Discounted Cash Flow Method of
valuation that is dealt with later
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 The Capitalization Method of
Valuation
• NOTE: Regretfully most authors of valuation
text books have not caught up with the
invention of financial calculators and still stay
with the lack of technology available in the
1960’s. In the past valuers used sets of
financial tables that contain factors for the PV
of one dollar for various interest rates and
years, and other factors including FV of one
dollar, FV of one dollar per annum (annuity
table), PV of one dollar per annum, etc.

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 The Capitalization Method of
Valuation
• In order that these “history books” may be
understood to modern valuers we set out,
where appropriate, the old fashioned way and
provide a modern translation
• It is essential that all valuation practitioners
understand the Capitalization Method and
understand its strengths and weaknesses.
Presented here is a brief overview of the
Historical Capitalization Method and the
Current Capitalization Method

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 The Capitalization Method of
Valuation

• At the most basic level of valuation

there are three main interest in
property that need to be analyzed
and valued (the full rented or rack
rented freehold, the reversionary
freehold and the leasehold)

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 The Historical Capitalization
Method
• The Historical Capitalization Method
can be traced back over one hundred
years and is still, regretfully in daily
use in some parts of the world. The
approach is best understood by using
some very simple examples:
• Fully Rented Freehold Interest
• Term and Reversion
• Leasehold
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 Fully Rented Freehold Interest
• A property that is fully-let at open market value
is known as a rack rented freehold or a fully-let
freehold
• Freeholds are assumed to be perpetual interests
and can therefore be analyzed and valued using
the perpetuity formula
• Capital Value = Income/interest rate
• NOTE: The capitalization formula is also often
expressed as:
• Capital Value = Income x Years Purchase (YP)
• Where for a perpetuity YP = 1/interest rate
• Or
• Capital Value = Income x Income Multiplier
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 Example - Analysis
• Properties A, B, and C are comparable except for
size. They are rack rented at $10,000; $12,000; and
$13,000 per annum respectively. Property A sold
recently for $125,000 and property C for $162,500.
What is the market value of property B?
• Analysis
• Capital Value = Income /interest rate
• For property A: $125,000 = $10,000/I
• I = 10,000/125,000 = 8%
• For Property C: $162,500 = $13,000/I
• I=$13,000/$162,500 = 8%
• The analysis shows that investors require a return of
8% for this type of property

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 Example - Valuation
• Valuation
• Capital Value = Income/interest rate
• For property B:
• Capital Value = $12,000/0.08
• Capital Value = $150,000
• Traditional Layout
• Rental Income $12,000
• YP in perpetuity at 8% 12.5
• Valuation $150,000

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 Reversionary Freehold Interests
• A reversionary freehold interest is one where the
rent passing is currently less than the full open
market rental value. When the lease with this
lower rent expires it is assumed that the rent will
revert to its full value.
• Example
• Property D is comparable to the properties in
Example above but is currently let at $7,000 per
annum with three years left to run on the lease.
Its current open market rental value is $12,000
per annum
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 Leasehold Interests
• The tenant in Example used previously above has an
interest in property being the present value of the
profit rent. A tenant’s profit rent is defined as the
difference between the open market rental value and
the rent actually being paid under the lease. This
leasehold interest may be valued as follows:
• Traditional Layout
• Open Market Rent $12,000
• Less Current or Actual Rent $ 7,000
• Profit Rent $ 5,000
• YP 3 years at 8% 2.5771
• Leasehold Interest Valued $12,886

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 IMPORTANT NOTE
• Using these valuation methods the value of the Reversionary
Freehold Interest when added to the leasehold interest equals the
value of the Rack Rented Freehold Interest
• The sum of the parts equals the whole
• Today the validity of such simplistic techniques and the implied
assumptions have been questioned
• One valid criticism is that it is inappropriate to value different
interests using the same interest rate. Surely the leasehold interest
above, which is of such short duration and difficult to dispose of in
the market place should be valued using an interest rate derived
from the sale similar leasehold interests.
• It can also be argued that the rent currently being paid under the
lease in the Reversionary Freehold interest is more secure than the
reversion to the full open market rental value and should therefore
be valued at a different (lower?) interest rate.
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 INCOME CAPITALISATION
APPROACH
• Income-producing real estate is typically
purchased as an investment
• This approach consist of methods,
techniques, and mathematical procedures
that a valuer uses to analyse a property’s
capacity to generate benefits and to convert
these into an indication of present value.

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Rental Income

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INTERESTS TO BE VALUED
• Appraisers don’t value real estate, they value
property interests in real estate
• Various rights include fee simple (freehold),
leasehold and leased fee
• Rights may be subject to special situations
– Minority shareholder or partnership interests
– Equity interests subject to various levels of debt
– Participation mortgages for lenders
– Master leasehold, sandwich leasehold, sub-
leasehold estates

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 INTERESTS TO BE VALUED
• Business Enterprise / Going-concerns
– are properties with non-realty components
– include hotels, restaurants and hospitals
– Business enterprise value is a value
enhancement that results from items of intangible
personal property .
– Going-concern value is the value created by a
proven property operation with income sufficient
to pay a fair return to all the agents of
productions.
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 RELATIONSHIP TO VALUE
INFLUENCES AND
APPRAISAL PRINCIPLES
• Anticipation and change
• Supply and demand
• Substitution
• Balance
• Externalties
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 MARKET VALUE &
INVESTMENT VALUE
• Market value
– value based on the typical market participant
– objective, impersonal and detached
• Investment value
– value of a certain property use to a particular
investor
– based on subjective, personal parameters.

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 YIELD RATES
• A yield rate is a rate of return on
capital and is usually expressed as a
compound annual percentage rate.
• Considers ALL expected property
benefits including the proceeds from
a sale at the termination (end) of the
investment
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 YIELD RATES con’t
• Interest rates usually refers to the yield rate
for debt capital (loans), not equity capital
• A Discount Rate is a yield rate used to
convert anticipated future payments or
receipts into present value
• Internal Rate of Return (IRR) refers to the
yield rate that is earned for a given capital
investment over a period of ownership

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 RATES OF RETURN
• Valuers assume that the investor’s
objective is a total return that exceeds the
amount invested.
• Therefore, investor’s expected return
consist of
– 1) full recovery of amount invested (return of
capital)
– 2) profit or reward (return on capital)

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 RETURN ON &
RETURN OF CAPITAL
• Return of capital refers to the
recovery of invested capital
• Return on capital refers to the
additional amount received as
compensation for use of the investor’s
capital until it is recaptured.
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 INCOME RATES
• Income rates express the relationship between
one year’s income and the corresponding
capital value of a property.
– Overall Capitalisation Rate (RO)
– Equity Capitalisation Rate (RE)
• Cap Rates are NOT rates of return or a full
measure of investment performance

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 RATE ESTIMATION
• Income and yield rates should represent the
annual rate of return necessary to attract
investment capital.
• These rates are influenced by many factors
– Degree of apparent Risk
– Market attitudes towards future inflation
– Prospective rates of return for alternative
investments

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 RATE ESTIMATION
• Influenced by many factors
continued..
– Rates of return earned on
comparable properties in the past
– Supply and demand for mortgage
funds
– Availability of tax shelters
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 RATE ESTIMATION
• As the rates of return used in the income
approach represent PROSPECTIVE rates, not
historical rates, the market’s perspective of risk
and changes in purchasing power are
particularly important.
• Generally, higher capitalisation overall rates
are associated with less desirable properties
and lower cap rates with more desirable
properties

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 RATE ESTIMATION
• Risk - anticipation of receiving future
benefits creates value, but the possibility of
losing future benefits detracts from value.
• Expected Inflation & Deflation - the
expected amounts of these affect the
forecast of future benefits and the
estimation of an appropriate income or
yield rate.

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 RATE ESTIMATION
• Need to distinguish between Inflation and
Appreciation
• Inflation - an increase in the volume of
money and credit, a rise in the general level
of prices, and the consequently erosion of
purchasing power
• Appreciation - the real value results from an
excess of demand over supply which
increases property values.
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 Valuation Process
• To value using the Income Approach
the appraiser’s first step is to estimate
the income.
– Potential Gross Income (PGI)
total income if 100% occupied at full
rental income

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 Potential Gross Income

Rental Units 4
Monthly Rental Rate 500

Potential Monthly Income 2,000

Annualize (x 12 months) 12
Potential Gross Income $24,000

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 Effective Gross Income
– Effective Gross Income (EGI)
PGI less vacancy and credit loss
(sometimes referred to as Net Revenue)

Potential Gross Income $24,000

Less: Vacancy and Credit Loss 2,400
(10%)
Effective Gross Income 21,600

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 Valuation Process
– Net Operating Income (NOI)
Effective Gross Income (EGI) less
operating expenses

Potential Gross Income $24,000

Less: Vacancy and Credit Loss 2,400
(10%)
Effective Gross Income 21,600
Less: Operating Expenses 10,000
Net Operating Income $11,600
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 Direct Capitalization

• Direct Capitalization
– Property Value = Net operating income /
overall capitalisation rate
•V=I/R
•R=I/V
•I=RxV

RE 205 Real Estate Finance and 35

Investment Analysis-2007
 Direct Capitalization
• Extract Capitalization Rates from Other
comparable sales

Sale 1 Sale 2 Sale 3 Sale 4

Price 122,200 133,300 127,800 105,500

NOI 11,000 12,000 11,500 9,500

Rate 9.0% 9.0% 9.0% 9.0%

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 Direct Capitalization
• To arrive at subject value
– Use extracted capitalization rate
– Apply to subject’s NOI

V=I/R
– 12,000 / .09 = 133,333,
rounded to say $133,500

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 Multipliers
• Multipliers don’t consider expenses and are a relationship
between income and price only

Sale 1 Sale 2 Sale 3 Sale 4

Price 122,200 133,300 127,800 105,500

PGI 22,000 24,000 23,000 19,000

PGIM 5.55 5.55 5.55 5.55

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 Gross Income Multipliers
• To arrive at a value
– Take the extracted multiplier
– Apply to subject’s gross income
– 5.55 x 24,000 = $133,200

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 Gross Rent Multipliers
• Gross rent multipliers
• Same as GIM, except based on
monthly income (versus annual
income for GIM)
• Effectively 12 times GIM
• Used for small residential rental
properties
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