Lesson 5 Flashcards
Capitalization
Process of converting a future stream of income flows into a single present value
Process of converting income from a property into an expression of capital value
Mathematical relationship between income and capital value
Derivation of the Overall Capitalization Rate
Market analysis, summation method, weighted average method
Techniques used in capitalization process: direct methods
Gross Income Multiplier, Equity Capitalization Rate, Mortgage Capitalization Rate, Overall Capitalization Rate
Do not differentiate between return on and return of capital
Techniques used in capitalization process: annuity methods
Inwood using a factor, provides for return on and return of capital
Hoskold method, provides for return on capital at appropriate discount rate and return of capital using sinking fund factor
May be grouped into three main categories: variable, level, and increasing or decreasing annuities
Techniques used in capitalization process: yield methods
Interest rate, Internal Rate of Return, Equity Yield Rate
Direct capitalization vs yield method
Direct Capitalization is based on 1 year’s income, while yield method is based on a discounting process of future benefits over a finite investment period
Gross Income Multiplier (GIM)
Sale Price / EGI
Adjusted GIM
NOI ratio of subject / NOI ratio of comparable x comparable unadjusted GIM
Accounts for variations in profitability between different properties
NOI Ratio
NOI / EGI. Sum of NOI ratio + expense ratio = 1
Mortgage Capitalization Rate (Mortgage Constant)
Annual debt service / principal amount of mortgage
Expresses the relationship between the annual debt service and the principal amount of the mortgage at the date of sale. Percentage representing the portion of the loan amount that must be paid each year to repay the principal and interest owing on a loan. The annual payment that is required to repay the principal and interest on a loan of $1 within the amortization period.
Equity Capitalization Rate
NOI - annual debt service / sale price - mortgage (cash flow / equity)
Ratio between forecasted before-tax cash flow and equity capital of purchase price.
Derivation of overall capitalization rate: market-derived capitalization rate
To analyze several recent sales of similar properties to determine the overall capitalization rate implicit in the transactions
Derivation of overall capitalization rate: summation method
Overall capitalization rate is built up through a rough decomposition of the elements of a discount rate. The analyst starts with the expected rate of return on a risk-free asset, then adds some risk premium to account for additional risks borne the subject property such as illiquidity, high transaction costs, cyclicity, locational constraints, and quality of management
Derivation of overall capitalization rate: weighted average approach
Using a weighted average of the costs of borrowed capital and the cost of equity capital to determine the overall capitalization rate
Equity Dividend Rate
The annual before-tax return on equity. In other words, the before-tax cash flows divided by the equity (BTCF/E).
Overall Capitalization Rate (OCR)
OCR = NOI ÷ Value
Value = NOI ÷ OCR
NOI = Value x OCR
Valuation of income-producing properties
Most commonly appraised using income-based valuation techniques. Market value estimate represents present value of expected future net benefits. Primarily impacted by principles of anticipation, change, supply and demand. Main problems facing appraiser are how to estimate income stream and how to discount these to present day.
Fee Simple Interest
Most complete interest in real estate where the title is only encumbered by the four powers of government: taxation, land-use controls (police power), eminent domain, and escheat (reversion of title to government when an owner dies intestate).
Leased Fee Estate
Ownership interest held by the lessor (landlord), which includes the right to receive the rent specified in the lease, plus the reversionary right when the lease expires
Leasehold Estate
Right held by the lessee to use and occupy real estate for a stated term and under the conditions specified in the lease. Leasehold estate is the complement of the leased fee estate in that the value of the fee simple interest in the property would consist of the sum of the value of the leased fee interest plus the value of the leasehold interest.
Value of leasehold estate
Difference in the present value between market rent and contract (i.e. excess rent, assuming market rent exceeds contract rent) for the remainder of the term, including the value of all rent incentives provided by the landlord
Value of subleasehold or sublessee’s interest
Present value of the difference between market rent and contract rent for the unexpired term of the sublease
What creates leasehold value
- Change in market conditions
2. Capital investment by the lesee
Net Effective Rent
Actual cash inflow resulting from a lease agreement
