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The Income Capitalization Approach

Chapter 20. The Income Capitalization Approach. Relationships to Value Influences and Appraisal Principles Supply and Demand Application and Limitations Interests to Be Valued Leased fee Leasehold Leases Gross lease Net lease Triple net leases. Future Benefits Periodic cash flows

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The Income Capitalization Approach

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  1. Chapter 20 The Income Capitalization Approach

  2. Relationships to Value Influences and Appraisal Principles • Supply and Demand • Application and Limitations • Interests to Be Valued • Leased fee • Leasehold • Leases • Gross lease • Net lease • Triple net leases Chapter 20

  3. Future Benefits • Periodic cash flows • Reversion or resale of the investment • Common Lease Structures • Flat rental lease • Variable rate lease • Step-up or step-down lease • Lease with annual increase • Revaluation lease • Percentage lease Chapter 20

  4. Common Rent Types • Market rent • Contract rent • Effective rent • Excess rent • Deficit rent • Percentage rent • Overage rent Chapter 20

  5. Table 20.1 Reconstructed Operating Statement Chapter 20

  6. Potential Gross Income • Starting point • As if full and w/o collection losses • Vacancy and Collection Losses • Effective Gross Income • Less Fixed Expenses • Less Variable Expenses • Less Reserves for Replacement (Sometimes) • Net Operating Income (NOI or IO) Chapter 20

  7. Equity Dividend Rate • Also called cash on cash • Equity income (IE) divided by equity input (VE – down payment) • The ratio of the income to the equity to the equity input (down payment) • Ignores the value of the reversion • Reversion • Return of the investment • Sometimes it is nothing. • Sometimes it is a meaningful amount. Chapter 20

  8. Operating Expenses • Necessary to maintain the property • Debt service not included • Fixed expenses – do not vary with occupancy • Variable expenses – do vary with occupancy • Replacement reserves should be included if they are included in capitalization rates of comparable properties but not if they are not. Chapter 20

  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 rates (RO) • The ratio of a single year’s income (periodic) to the sale price or value (lump sum) • Net income multiplier is the reciprocal of the overall capitalization rate. Chapter 20

  10. Table 20.2 Capitalization Rate Extraction Worksheet Chapter 20

  11. Discount rates, yield rates, interest rates, and internal rates of return all have similar definitions. • The present value of a property can be considered to be the present value of the future benefits, which are the cash flows and the resale value of the property. • The discounted cash flow model essentially says, “How much do I get and when do I get it?” Chapter 20

  12. Table 20.3 Cash Flow Projection For reversion value only Chapter 20

  13. Yield Rates—Rates of Return on the Investment • Internal rate of return is the rate of return on the investment considering the price paid for the investment, the periodic cash flows, and the reversion. • Overall yield rate is the rate of return including debt and equity. • Equity yield rate is the rate of return from the perspective of the equity investor. It is the rate of return on the amount paid as down payment from periodic income after debt services and including the reversion after the debt has been paid off. Chapter 20

  14. Estimating Rates • Risk is a big factor since risk is a primary component of the yield rate. If the investment is risky, it deserves more return than if it were not a risky investment. This is investment-specific. • Inflation is also a factor in a 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. Chapter 20

  15. Income Capitalization Approach Methods • Direct capitalization of a single year’s income. This is a technique based on the ratio of property income to sale price. • Yield capitalization of multiple years’ income. This method is based on the assumption that all investments are the present value of future cash flows. • 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, discounted cash flow analysis will work better. Chapter 20

  16. Problems • Suggested solutions begin on page 365. Chapter 20

  17. Problem 7 Chapter 20

  18. Problems 8 and 10 Chapter 20

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