Module 3: Introduction to Income Capitilization Flashcards
Capitilization
the conversion of income into value
income capitalization approach
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.
Two Methods of Capitalizaton
Direct Capitalization
Yield Capitalization
Direct Capitalization
used when there is one income from one time period (e.q., one month, one year, etc.)
Yield Capitalization
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
Gross Rent Multiplier (GRM)
The GRM is the relationship between income and value, and can then be used to solve for value.
GRM
Sale price /gross rent per month
Direct Capitalization method for value
Gross rent per month * GRM
commercial properties
always analyzed on the basis of annual income not monthly income
commercial properties
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.
Direct capitiliazation for residential
- 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
VIF formula
Value or sale price / monthly rent = GRM
Direct capitiliazation process
Gross rent per month * Gross rent multiplier (GRM) = value
Direct capitilization commercial
NOI / sale price = cap rate
NOI * cap rate = value
Yield capitilization
Discounted cash flow analysis
Direct capitiliazation
Only analyzes one year
Yield capitiliazation
More than one year is analyzed
Commercial Properties
Always analyzed and valued on the basis of annual income not monthly income as with 1-4 family properties
NOI
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
Direct Capitalization for Commercial
- 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
Yield Capitalization
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
Yield Capitalization
- 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
6 concepts and principles are influential to the income capitalization approach
- Highest and best use
- Anticipation and change
- Supply and demand
- Substitution
- Balance
- Externalities
When to use the income approach
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).
Terms related to income capitalization
Potential Gross Income Effective Gross Income Net Operation Income Pre-Tax Cash Flow After-Tax Cash Flow Reversion
Reversion
A reversion is defined as a lump-sum benefit that an investor receives or expects to receive at the termination of an investment.
Rate of Return
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.
Rate of return
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).
Rate of Return
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
Equity Capitalization Rate
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.
mortgage capitalization rate
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.
Other types of Rates used
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
Terms for Yield rates
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
Return on and Return of Capital
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
Return “On” and Return “Of”
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.
Direct Capitalization
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).
Yield Capitalization
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.
Fundamental Considerations of Selecting a Discount Rate
- 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
Overall Cap Rate - Direct Cap
used to evaluate income from a single one-year period not a stream of income over a number of years
Cap Rate - Yield Cap
used to evaluate income from a stream of income over a number of years.
Discount Rate
an interest rate used to convert future payments or receipts into present value
Interest Rate
the rate of return or yield rate on debt capital, usually expressed as the nominal annual percentage change of the amount loaned of invested.
The principle of ____________ is the basis of the income capitalization approach.
A) Modification
B) Substitution
C) Anticipation
D) Change
C) Anticipation
Feedback: The principle of anticipation is the basis of the income capitalization approach.
Feedback: Link: Page 8
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
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.
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
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
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
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
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
D) The value to a particular investor and has personal, subjective parameters
Feedback: Link: Page 10
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
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
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
C) Net operating income over a one-year period
Feedback: Net operating income is capitalized with an overall rate in the direct capitalization process.
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
B) Objective, impersonal, and reflects what typical investors in the market might do
Feedback: Link: Page 10
Which of the following is another term for yield capitalization?
A) Direct capitalization
B) Discounted cash flow analysis
C) Equity capitalization
D) Compounding
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.
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
A) To convert future payments or receipts into present value
Feedback: Link: Page 15
