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Chapter 20
The Student Handbook to
THE APPRAISAL OF REAL ESTATE
The Income Capitalization
Approach
1
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Relationships to Value Influences and Appraisal
Principles
 Supply and Demand
Application and Limitations
 Interests to Be Valued
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Leased fee
Leasehold
Leases
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Gross lease
Net lease
Triple net leases
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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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
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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Common Rent Types
 Market rent
 Contract rent
 Effective rent
 Excess rent
 Deficit rent
 Percentage rent
 Overage rent
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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Table 20.1 Reconstructed Operating Statement
Potential gross income (PGI)
Vacancy & collection loss
Effective gross income (EGI)
25,000
5%
@
of
$9.00
PGI
=
=
$225,000
-$11,250
$213,750
Estimated Annual Expenses
Property taxes
Property insurance
Repairs
Management
Utilities
Reserves for new roof
Reserves for parking lot
Total expenses
Net operating income (I
5.848%
1/20
1/15
$ 33,000
$
4,500
$ 30,000
$ 12,500
$ 22,000
$
1,250
$
800
$ 104,050
O)
Fixed expenses
Variable expenses
Reserves for replacement
-$104,050
$109,700
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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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)
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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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
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Sometimes it is nothing.
Sometimes it is a meaningful amount.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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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.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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Rates of Return
 Return on and Return of Capital
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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
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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.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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Table 20.2 Capitalization Rate Extraction
Worksheet
Subject
Sale 1
$1,985,000
Sale 2
$1,458,000
Sale 3
$3,258,000
$510,000
$369,000
$253,680
$601,000
Reported sale price
PGI for next year
Vacancy & collection loss
EGI for next year
Operating expense next year
Taxes
Insurance
Management
$0.05
Maintenance - building
Maintenance - grounds
Utilities
Reserve fund - roof covering
Reserve - parking lot
Reserve fund - HVAC
Reserve fund - elevator
Tenant improvements
Total expenses
Net operating income
-$25,500
-$25,830
-$15,221
-$48,080
$484,500
$343,170
$238,459
$552,920
$56,000
$10,600
$24,225
$22,050
$11,000
$67,000
$5,000
$4,500
$3,200
$1,500
$5,500
$210,575
$44,258
$9,600
$17,159
$16,055
$8,000
$55,000
$4,200
$3,900
$2,500
$1,200
$4,400
$166,272
$26,000
$4,500
$11,923
$10,700
$4,900
$34,000
$2,600
$2,500
$2,900
$1,800
$3,500
$105,323
$72,000
$14,500
$27,646
$26,500
$13,800
$76,800
$4,200
$7,500
$6,200
$3,600
$12,600
$265,346
$273,925
$176,899
$133,136
$287,574
Extracted capitalization rates
8.91%
$273,925
/
9.13%
$0.09
8.83%
=
$3,043,611.11
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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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?”
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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Table 20.3 Cash Flow Projection
For reversion value only
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Tenant 1
$72,000
$72,000
$72,000
$84,000
$84,000
$84,000
Tenant 2
$66,144
$66,144
$66,144
$66,144
$66,144
$66,144
Tenant 3
$51,600
$53,000
$60,000
$60,000
$60,000
$60,000
Tenant 4
$14,400
$18,000
$19,200
$19,200
$19,200
$19,200
Tenant 5
$27,780
$27,780
$27,780
$27,780
$27,780
$30,558
Tenant 6
$28,800
$24,000
$33,600
$33,600
$33,600
$33,600
Potential gross income
$260,725
$260,924
$278,724
$290,724
$290,724
$293,502
Vacancy and collection (4%)
-$10,429
$250,296
-$10,437
$250,487
-$11,149
$267,575
-$11,629
$279,095
-$11,629
$279,095
-$11,740
$281,762
$55,000
$56,650
$58,350
$60,100
$61,903
$63,760
$195,296
$193,837
$209,225
$218,995
$217,192
$218,002
Effective gross income
All expenses
Net operating income
Reversion (10%)
Last year's income divided by the cap. rate
$2,158,366
Cash flow
$195,295
$193,837
$209,225
$218,995
$2,375,558
Discounted at (9%)
Present values
0.9174
$179,164
0.8417
$163,153
0.7722
$161,564
0.7084
$155,136
0.6499
$1,543,875
$2,202,891
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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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.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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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.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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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.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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Problems
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Suggested solutions begin on page 365.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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Problem 7
Purchase price
M ortgage amount @ 75%
Down payment @ 25% of sale price
Net operating income =
Annual debt service
Income to the equity
Income to the equity/equity investment
$1,235,000
-$926,250
$308,750
$96,000
-$78,558
$17,442
5.65%
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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Problems 8 and 10
Problem 8
5,000
X
$
$ 850,000
$ 600,000
$ 250,000
Base rent
Sales % rent
Less base
Overage income
X
=
$
60,000
3% =
$
7,500
$
67,500
12
Problem 10
Tenant
1
2
3
4
PGI
V&C
EGI
Expenses
NOI
PGI
60,000
75,000
65,000
75,000
275,000
-13,750
261,250
-100,000
161,250
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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