Real Estate Valuation)

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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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• 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 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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• 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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• 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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• 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)


Less: Vacancy and Credit Loss (10%)

2,400

Effective Gross Income 21,600

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Valuation Process–Net Operating Income (NOI)

Effective Gross Income (EGI) less operating expenses


Less: Vacancy and Credit Loss (10%)

2,400

Effective Gross Income 21,600

Less: Operating Expenses 10,000

Net Operating Income $11,600

RE 205 Real Estate Finance and Investment Analysis-2007

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Direct Capitalization

• Direct Capitalization

– Property Value = Net operating income / overall capitalisation rate

• V = I / R

• R = I / V

• I = R x V

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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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