week 4 - income cap

Question 1

explain the theory of income approach

Answer 1

Based on the theory that the current value (market value/investment value) of a property (investment grade) is the present worth of the future income which this property is capable of producing.

The principle of ‘anticipation’ is fundamental
Value is a function of the anticipated benefits to be derived from the property
Current Value = current value of future income derived

Question 2

applications of income capitalisation approach

Answer 2

Applies to income-producing (investment grade) property, as well as properties that can be easily compared to income-producing properties

Offices
Retail properties
Some industrial properties
Rental residential properties etc.

Question 3

define income producing property

Answer 3

A property that has been purchased with the sole intention of earning a return on the investment either through

Regular rent
Capital gain

Question 4

income capatalisation approach can be split into

Answer 4

Direct cap method - profit method

DCF (yeild capatalisation)

Question 5

explain the theory of direct capatalization approach

Answer 5

Based on the theory that the value (usually market value) of a property is based on the net operating income (NOI) produced by the property.
Is used to convert an estimate of a single year’s NOI expectancy into an indication of value by dividing the NOI by an appropriate capitalization rate
The principle of ‘anticipation’ is fundamental
Value is a function of the anticipated benefits to be derived from the property

Question 6

explain the direct capatalization approach process

Answer 6

net operating income
capatalization rate
capatalized value
capital adjustments
= market value of property

Question 7

how to calacuate Net operatin income

Answer 7

Potential Gross Income 
-  Vacancy and collection loss allowance 
\+ Miscellaneous income 
-  Property outgoings
   Net operating income

Question 8

what is potential gross income

Answer 8

The total of all rental income (annual) derived directly from the property assuming that there is no vacancy
Lettable Area X rent per m2 per annum= Potential gross income (PGS)

Where Lettable Area could be:

• Net Lettable Area (NLA): sum of its whole floor lettable areas, office buildings and business parks. Areas excluded: stairs, fire stairs, access ways, lift shafts, smoke lobbies etc.
• Gross lettable area retail (GLAR):retail tenancy areas in shopping centres, free-standing shops, strip shops, terrace style or semi-detached shops in suburban streets.
• Gross floor area (GLA):tenancy areas in industrial property, warehouses, showrooms, and freestanding supermarkets.

Question 9

define net lettable area

Answer 9

• Net Lettable Area (NLA): sum of its whole floor lettable areas, office buildings and business parks. Areas excluded: stairs, fire stairs, access ways, lift shafts, smoke lobbies etc

Question 10

define gross lettable area retail

Answer 10

Gross lettable area retail (GLAR):retail tenancy areas in shopping centres, free-standing shops, strip shops, terrace style or semi-detached shops in suburban streets.

Question 11

define gross floor area

Answer 11

tenancy areas in industrial property, warehouses, showrooms, and freestanding supermarkets.

Question 12

define gross rent

Answer 12

Gross rent (rent in Gross Leases) – The tenant pays a flat rental amount, and the landlord pays for all property outgoings.

Question 13

define net rent

Answer 13

Net rent (rent in Net Leases)- The tenant pays a portion or all of property outgoings in addition to rent.

Question 14

define passing rent

Answer 14

Passing rent (Face rent): The quoted rent in the lease before taking into account any ‘Incentives’. Lease incentives: a bonus or discount offered to a tenant in consideration for their entry into a lease with a particular landlord

Question 15

define effective rent

Answer 15

Effective rent: Face rent – lease incentives

Question 16

define current market rents

Answer 16

Current market rents: Determined by comparison with recent new lettings of similar premises

Question 17

what is vaccancy and collection allowance

Answer 17

Estimated income loss due to tenants vacating the property and/or tenants defaulting (not paying) their rent

Is expressed as a % of potential gross income
Consider:
Market conditions
Historical vacancies
Type of the space

Question 18

what is miscellaneous income

Answer 18

Any income other than the rental income

Examples
Naming rights
Satellite dish space 
Communication towers
Subsidy from government

Question 19

explain property outgoings

Answer 19

Outgoings are defined as those expenses, statutory charges, fixed and variable that are paid to keep the property in a good state so as to maintain the maximum market rental capacity. Includes:
Statutory charges: land tax, municipal or shire council rates, water rates for sewerage and drainage
Operating expenses: insurance, utilities, and replacement allowance etc.
Replacement allowance- Provides for the periodic replacement of short life items.

Excludes: Financing costs, Landlord‘s and tenants’ income tax and corporation operating costs, Non-cash items (e.g. depreciation)
Outgoings recoveries (Recoverable)
- Under a net rent lease, the tenant pays the outgoings whereas under a gross rent lease the landlord is responsible for the outgoings.
- The net rent lease allows for the landlord to pay the outgoings directly (usually not directly billed to the tenant) and recover them from the tenant. This is known as recovery of outgoings (Recoverable).

Question 20

what is the capatlization rate

Answer 20

A measure of the ratio between the net operating income (NOI) in the first year and the property’s current sale price (value)
Can be calculated by: Cap rate = NOI/ Sale price(Value)
The capitalization rate reflects the rental income-producing capacity of the property.
Used in direct cap method to calculate the value: Value= NOI/Cap rate

Question 21

explain market extracted method for cap rate

Answer 21

Direct extraction method is preferred, and it needs three or more comparable with good information
Similar properties should have similar cap rate.The capitalization rate of subject property are calculated using comparable sale evidence
Comparable Cap Rate = NOI of comparable/ SP of comparable
Reconciliation made by weighting:
Average (weighted) of all comparable cap rates= market cap rate (cap rate of the subject property)

Question 22

define capatalization

Answer 22

Capitalization is the process of converting income into value

Question 23

define direct capatalization

Answer 23

Direct Capitalization is the process of estimating current value by dividing a single year’s NOI by a capitalization rate

Question 24

Capitalized Value formula =

Answer 24

Net operating income / Capitalization rate (MV = NOI / Cap Rate)

Question 25

what are capital adjustments

Answer 25

One-off” adjustments to the value after the capitalised value has been established
Cost items that need improvements or maintenance to ensure lettability
Specific maintenance, repairs or an essential upgrade cost, or other requirement of a local authority to meet statutory regulations
Other costs related to the reletting of the space
Agents’ leasing fees, a fitout or incentive amount, and other costs to lease the space
Capital costs of re-leasing

market value = capitalised value - capital adjustments

Question 26

strengths of direct capatalisation method

Answer 26

: A simplified approach that arrives at an easily determined value; Does not rely on projections, only the cash flows for the upcoming 12 months; Most useful for businesses with stable, predictable cash flows and earnings; More appropriate for stable market places

Question 27

weaknesses of direct capitalisation method

Answer 27

Change of future market condition is ignored; Fails to reflect changes in the annual cash flows; Capital Growth is ignored; Inadequate data on comparable sales due to: Above or below market leases and Differing length of leases

Question 28

explain the profit method

Answer 28

Applied to properties whose value is derived from the profitability of the businesses.
Suitable for:
those kinds of premises with a degree of monopoly because of licensing
those which are not of a kind normally let or sold separately from the business in which they are employed
Commercial properties for which the landlord is the owner of business

Example : Hotels, Cinemas, theatres , Casinos and clubs etc.

Question 29

explain the valuation process for the profit method

Answer 29

gross earnings
- cost of purchases (direct costs)
- working expeneses (inidrect costs)
- return on businesses owner’s capital invested divisable balance
- expected profit from business operation
money left to be paid as rent *annual rental income

market value property rental income / cap rate

Question 30

exmaples of direct costs

Answer 30

Total cost of purchase of goods related to the main business (direct costs related to the business)
Example: For hotel properties purchases for hotel rooms, purchase costs of food and beverages etc

Question 31

exmaples of working expenses

Answer 31

Salaries, wages 
Costs incurred in connection with:
Utilities 
Printing and postage
Telecommunications
Advertising
Repairs and maintenance etc
Taxes
Insurance
Rates
Any other costs

Question 32

explain divisable balance

Answer 32

The Divisible Balance is the sum available to be shared between the business operation and the property.
Expected profit from business operation –a return on any capital employed and a reward to the business reflecting the extent of the risk and the need for profit.
Divisible balance-Expected profit from business operation= Rental income for the property

Question 33

difference between profit and direct cap methods

Answer 33

Direct cap method– properties on leases with rents (e.g. gross leases and net leases).
The business is NOT to be considered.
If a building is leased to an operator to run the building as a business, the direct cap method looks purely at the rent.

Profits approach – properties owned by the business owner , direct and indivisible link between the property and the business
The business is to be considered.
Starts with the gross earnings of the business conducted at the premises that is valued.