Module 3: Introduction to Income Capitilization

Question 1

Capitilization

Answer 1

the conversion of income into value

Question 2

income capitalization approach

Answer 2

measures the present value of the future benefits derived from property ownership. It is based on the conversion of the income producing capability of a property into value through the capitalization process.

Question 3

Two Methods of Capitalizaton

Answer 3

Direct Capitalization

Yield Capitalization

Question 4

Direct Capitalization

Answer 4

used when there is one income from one time period (e.q., one month, one year, etc.)

Question 5

Yield Capitalization

Answer 5

used when there are a series of incomes to be derived in the future over more than one time period (e.g., 2 years, 36 months, 10 years) that need to be discounted to present value

Question 6

Gross Rent Multiplier (GRM)

Answer 6

The GRM is the relationship between income and value, and can then be used to solve for value.

Question 7

GRM

Answer 7

Sale price /gross rent per month

Question 8

Direct Capitalization method for value

Answer 8

Gross rent per month * GRM

Question 9

commercial properties

Answer 9

always analyzed on the basis of annual income not monthly income

Question 10

commercial properties

Answer 10

commercial properties are generally analyzed and valued on the basis of Net operating income, which includes deductions for vacancy and operating expenses, rather than gross income (before deduction of vacancy and operating expenses) as in the case with 1-4 family properties.

Question 11

Direct capitiliazation for residential

Answer 11

• derive gross rent multiplier (GRM) for comps
  
  • sale price /total monthly rent for property
• analyze the comps based on other comparable elements
• use the GRM of the comp that is most similar to the subject to derive value for the subject

Question 12

VIF formula

Answer 12

Value or sale price / monthly rent = GRM

Question 13

Direct capitiliazation process

Answer 13

Gross rent per month * Gross rent multiplier (GRM) = value

Question 14

Direct capitilization commercial

Answer 14

NOI / sale price = cap rate

NOI * cap rate = value

Question 15

Yield capitilization

Answer 15

Discounted cash flow analysis

Question 16

Direct capitiliazation

Answer 16

Only analyzes one year

Question 17

Yield capitiliazation

Answer 17

More than one year is analyzed

Question 18

Commercial Properties

Answer 18

Always analyzed and valued on the basis of annual income not monthly income as with 1-4 family properties

Question 19

NOI

Answer 19

Commercial properties are analyzed and valued on the basis of Net operating income, which includes deductions for vacancy and operating expenses rather than gross income as in the case of 1-4 family properties

Question 20

Direct Capitalization for Commercial

Answer 20

• Derive the overall capitalization rate
• research market data, look for sales of comparable commercial properties
• Using the data gathered about the comps calculate the capitalization rates for the comps
• NOI of comps * Sale price of Comp= Cap rate of comp.
• Use the overall cap rate of all comps to derive value of subject
• NOI of subject / overall cap rate = Value

Question 21

Yield Capitalization

Answer 21

In yield capitalization, the income from each period over time including the reversion at the end is discounted back to present value using a discount rate

Question 22

Yield Capitalization

Answer 22

• analyze the subjects income stream
• conduct research to discover discount rate
• calculate present value of income stream based on annual compounding using discount rate found from research
• analyze the reversion or lump sum benefit to an investor of the property.
• Research to indicate what the value would be at the end of the holding period.
• calculate the present value of the future lump sum using the same discount rate
• Add the FV of the lump sum and the income stream to obtain the yield capitalization value

Question 23

6 concepts and principles are influential to the income capitalization approach

Answer 23

1. Highest and best use
2. Anticipation and change
3. Supply and demand
4. Substitution
5. Balance
6. Externalities

Question 24

When to use the income approach

Answer 24

The income capitalization approach is suitable for properties that are bought and sold on the basis of the income they do or can produce, including hotels, office and apartment buildings, shopping centers, etc.

When information on rental data or required rates of return is lacking, this approach has little or no applicability (as is the case of most single-family residential markets or nuclear power plants).

Question 25

Terms related to income capitalization

Answer 25

``` Potential Gross Income Effective Gross Income Net Operation Income Pre-Tax Cash Flow After-Tax Cash Flow Reversion ```

Question 26

Reversion

Answer 26

A reversion is defined as a lump-sum benefit that an investor receives or expects to receive at the termination of an investment.

Question 27

Rate of Return

Answer 27

The ratio of income or yield to the original investment; the ratio of the current annual net income generated from the operation of an enterprise to the capital investment, the net yield over the duration of the investment.

Question 28

Rate of return

Answer 28

the rate is a function of the future benefits to the original investment. It can be based either on a single-year performance or measured over an entire projection period (5 or more years). Typical investors seek recovery of the amount invested (i.e., the return OF capital) plus a profit (i.e., return ON capital).

Question 29

Rate of Return

Answer 29

For example, if a property generated $50,000 of annual net operating income, and the original investment was $500,000, a 10% annual rate of return would be calculated as follows: Annual income from investment :$50,000 Original investment: $500,000 $50,000 / $500,000 = 10% Annual Rate of Return

Question 30

Equity Capitalization Rate

Answer 30

An equity capitalization rate (RE) is an income rate that reflects the relationship between a single year’s pre-tax cash flow expectancy and the equity investment used to convert pre-tax cash flow (equity dividend) into an equity value indication, also called the cash-on-cash rate, cash flow rate, or equity dividend rate. All that the equity capitalization rate is looking at is the amount of down payment and its corresponding rate.

Question 31

mortgage capitalization rate

Answer 31

This is the capitalization rate for debt or the ratio of the annual debt service to the principal amount of the mortgage loan. In other words, it is the ratio of income to mortgage amount. A mortgage capitalization rate may be calculated based on the initial mortgage amount or the outstanding mortgage amount; also called annual constant or mortgage constant.

Question 32

Other types of Rates used

Answer 32

mortgage capitalization rate equity capitalization rate these rates are used for a specific property interest as opposed to the overall capitalization rate. mortgage cap rate could be used to anticipate annual debt service, and equity cap rate can be used to anticipate equity received from a property

Question 33

Terms for Yield rates

Answer 33

interest rate - the return or yield rate on debt capital, usually express as the nominal annual percentage of the amount loaned or invested. discount rate - an interest rate used to convert future payments or receipts into present value

Question 34

Return on and Return of Capital

Answer 34

Return "On" - refers to the additional amount received for use of the investors capital until it is recaptured Return "Of" - refers to the recovery of the invested capital

Question 35

Return "On" and Return "Of"

Answer 35

Different treatments depend on the capitalization method employed. Direct Cap - no separate mathematical distinction is made between return on and return of - its all the same rate. Yield Cap - the distinction between return of and return on capital is always definite and precise for each years cash flow and reversion.

Question 36

Direct Capitalization

Answer 36

based on the anticipated income for the year following the purchase date or the effective date specified in the appraisal. It is the simple division of net operating income by a capitalization rate (hence, the name direct capitalization).

Question 37

Yield Capitalization

Answer 37

more complicated in that projection of many years of net operating income (return ON) together with reversion (return OF) must be made. These are then converted into value using a discounting process.

Question 38

Fundamental Considerations of Selecting a Discount Rate

Answer 38

- judgement based on market evidence of the rate of return needed to attract mutual investment capital - Consider risk - consider market attitudes towards expected inflation and deflation - prospective rates of return for alternate investment opportunities - historical rates of return - supply and demand of mortgage funds - availability of tax shelters

Question 39

Overall Cap Rate - Direct Cap

Answer 39

used to evaluate income from a single one-year period not a stream of income over a number of years

Question 40

Cap Rate - Yield Cap

Answer 40

used to evaluate income from a stream of income over a number of years.

Question 41

Discount Rate

Answer 41

an interest rate used to convert future payments or receipts into present value

Question 42

Interest Rate

Answer 42

the rate of return or yield rate on debt capital, usually expressed as the nominal annual percentage change of the amount loaned of invested.

Question 43

The principle of ____________ is the basis of the income capitalization approach. A) Modification B) Substitution C) Anticipation D) Change

Answer 43

C) Anticipation Feedback: The principle of anticipation is the basis of the income capitalization approach. Feedback: Link: Page 8

Question 44

What does GRM refer to in the appraiser's analysis of a residential income property? A) General Rent Multiplier B) General Rental Market C) Gross Rent Multiplier D) Gross Rent Monthly

Answer 44

C) Gross Rent Multiplier Feedback: GRM is a factor derived from the market and is multiplied by the gross rent to provide a value indicator for the appraised property.

Question 45

Which of the following is true of an equity capitalization rate? A) Is also referred to as the annual constant B) It is the ratio of mortgage debt service to the original amount of equity C) An income rate that reflects the relationship between a single years pre-tax cash flow expectancy and the equity investment D) It is the ratio of pre-tax mortgage debt service and the principal amount of the mortgage

Answer 45

C) An income rate that reflects the relationship between a single years pre-tax cash flow expectancy and the equity investment Feedback: Link: Page 13

Question 46

Which of the following is effective gross income less operating expenses and reserves (if applicable)? A) Net operating income B) Pretax cash flow C) After-tax cash flow D) Potential gross income

Answer 46

A) Net operating income Feedback: Net operating income is the income remaining after operating expenses are deducted from effective gross income, but before debt service is deducted. Feedback: Link: Page 11

Question 47

What characteristics are identifiable in an income producing property based on investment value? A) The value based on construction costs B) Objective, impersonal, and reflects what typical investors in the market might do C) The value that favors the clients cause D) The value to a particular investor and has personal, subjective parameters

Answer 47

D) The value to a particular investor and has personal, subjective parameters Feedback: Link: Page 10

Question 48

The principle of anticipation affirms that value is based on: A) Location and condition B) Properties offering similar utility C) Future benefits D) Cash flow

Answer 48

C) Future benefits Feedback: The principle of anticipation affirms that a property's present value is based on the anticipation of receiving benefits (income) in the future. Feedback: Link: Page 8

Question 49

The appraiser has derived an overall capitalization rate from the market specific to the appraised property. What type of income would the appraiser use in this instance to derive a value indication for the property? A) Gross annual rent B) Gross operating income over a one-year period C) Net operating income over a one-year period D) Monthly net income

Answer 49

C) Net operating income over a one-year period | Feedback: Net operating income is capitalized with an overall rate in the direct capitalization process.

Question 50

What characteristics are identifiable in an income producing property based on market value? A) The value to a particular investor and has personal, subjective parameters B) Objective, impersonal, and reflects what typical investors in the market might do C) The value that favors the clients cause D) The value based on construction costs

Answer 50

B) Objective, impersonal, and reflects what typical investors in the market might do Feedback: Link: Page 10

Question 51

Which of the following is another term for yield capitalization? A) Direct capitalization B) Discounted cash flow analysis C) Equity capitalization D) Compounding

Answer 51

B) Discounted cash flow analysis Feedback: The cash flows take place over a period of time that is greater than one year and discounted to present value.

Question 52

A discount rate is used to do what? A) To convert future payments or receipts into present value B) To convert present payments or receipts into future value C) To convert future payments or receipts into future value D) To obtain a discount on wholesale purchases

Answer 52

A) To convert future payments or receipts into present value Feedback: Link: Page 15