Chapter 16: Income-capitalization Methods

Capitalization of Site Income

u   Straight capitalization--assumes site value remains constant during the holding period.

u   Recapture adjusted capitalization--assumes site value increases or decreases during the holding period.

Capitalization of Site Income: Strait-line Example

u   Strait-line capitalization: Assume a parking lot has an annual income of $5,000 annually. Assume also that the appropriate capitalization rate is 10%.

u   VLand = ILand RLand = $5,000 .10 = $50,000

Capitalization of Site Income: Recapture Adjusted Example

u   Sinking fund capitalization: Assume a parking lot has an annual income of $5,000 annually. The property is expected to increase in value by 10% over the ten year holding period. Assume also that the appropriate capitalization rate is 10%.

u       VLand = ILand RLand

u       RLand = yLand - overall * an

u   VLand =$5,000 (.10-.1* .062745) = $53,347

Capitalization of Building Income

u   Strait-line capitalization--assumes the decline in the income produced by the building is a constant percentage over its useful life. (usually not realistic.)

u   Annuity capitalization-- assumes the income produced by the building is relatively constant over its useful life. RBuilding = an

u       Sinking fund capitalization-- assumes the slower decline than strait-line in the income produced by the building over its useful life. (still not very realistic.) RBuilding > an

Capitalization of Building Income Strait-line Example

u   Assume a building has an annual income of $25,000. The building is expected to have a useful life of 25 years. Assume also that the appropriate discount rate is 10%.

u   A building that looses 100% of its value in 25 years, looses 1 25 or 4% per year.

u   Therefore the RBuilding = 10% + 4% =14%

u   VBuilding = IBuilding RBuilding = $25,000 14% = $178,500

Capitalization of Building Income Annuity Example

u   Assume a building has an annual income of $25,000. The building is expected to have a useful life of 25 years. Assume also that the appropriate discount rate is 10%.

u   RBuilding = yLand - overall * an

u   Therefore the RBuilding = 10% -(-1) * .010168 =

u   VBuilding = IBuilding RBuilding = $25,000 .110168 = $226,926

Direct capitalization

u   Capitalizes the value of the building and land at the same time.

u       Should only be used if the appraiser has ample evidence for the calculation of Roverall

u       VOverall = IOverall ROverall

u   Assume a property has an annual income of $30,000 and the appropriate discount rate is 10.5%.

u   VOverall = $30,000 .105 = $285,714

Residual techniques

u   Site residual technique

u   Building residual technique

u   Property residual technique

n   Basic Relationships

u      VOverall = VLand + VBuilding

u      IOverall = ILand + IBuilding

u      ILand = VLand * RLand

u      IBuilding = VBuilding * RBuilding

u      VLand = ILand RLand

u      VBuilding = IBuilding RBuilding

u      RLand = Return on Investment

u   RBuilding = RLand + 1 (Useful life of building)

Land Residual Problem

u   Given the following for a proposed property:

u   Return on Land Investment (RL) = 10%

u   Useful life of building = 25 years

u   Building Cost = $300,000

u   Expected NOI = $65,000, What is the Value?

u   RBuilding = RLand + 1 (Useful life of building)
= 10% + 1
25 = 10% + 4% = 14%

u       IBuilding =VBuilding * RBuilding = 300,000*14%= 42,000

u    ILand = IOverall - IBuilding = 65,000 - 42,000 = 23,000

u    VLand = ILand RLand = $23,000 10% = $230,000

u    VOverall =VLand+VBuilding =230,000 +300,000 = $530,000

Building Residual Problem

u   Given the following for a proposed property:

u   Return on Land Investment (RL) = 10%

u   Useful life of building = 40 years

u   Land Cost = $100,000

u   Expected NOI = $35,000, What is the Value?

u   RBuilding = RLand + 1 (Useful life of building)
= 10% + 1
40 = 10% + 2.5% = 12.5%

u       ILand =VLand * RLand = 100,000*10%= 10,000

u    IBuilding = IOverall - ILand = 35,000 - 10,000 = 25,000

u    VBuilding = IBuilding RBuilding = $25,00012.5% = $200,000

u    VOverall =VLand+VBuilding =100,000 +200,000 = $300,000

Property Residual Technique

u   The value of an income producing property is the present value of the income stream plus the present value of the sales price at end useful life.

u       VOverall =VIncome during useful life+VReversion

u   Research indicates that a property is expected to generate $20,000 per year income during its 25 year useful life, that the property should sell for $90,000 at the end of that life, and that the appropriate capitalization rate is 10%.

u   VOverall = PVA ($20,000, 10%, 25years)
+ PVLump Sum ($90,000, 25 years, 10%)

u   VOverall = $181,541 + $8,307 = $189,848

Mortgage-equity Capitalization

u   Divides the property income into two streams: Income to the mortgage and Income to the owner.

u       IOverall = IMortgage+ IOwner

u       VOverall =VMortgage+VEquity

u   VMortgage may be determined by the DSCR

u  DSCR = NOI Annual Debt Service

u  Therefore ADS = NOI DSCR

u  Knowing ADS and market financing terms, the appraiser can solve for VMortgage : Known--P/YR, I/YR, Number of years; Compute PV

u       VEquity = IEquity REquity

Mortgage-equity Capitalization Example

u   Assume a DSCR of 1.39, market financing of 9% for 20 years paid monthly, an annual property income of $5,000, and an equity capitalization rate of 12%.

u   ADS = NOI DSCR = $5,000 1.39 = $3,597 (MDS=3597 12 = 299.75)

u   VMortgage = PVA (299.75, 9%, 20 years) = $33,315.70

u   IEquity = $5,000 - $3,597 = $1403

u   VEquity= IEquity REquity = $1,403 .12 = $11,692

u   VOverall =VMortgage+ VEquity= $33,316 + $11,692 = $45,008

Capitalization of Cash Flows

u   Also called the Discounted Cash Flow Technique
n

u   VOverall = BFCFt + PRn .
t =1 (1+yo)t (1+yo)n

u  where: BFCFt is the NOI + Reserves in year t

u  PRn= proverty reversion (sales price) in year n

u  yo = appropriate discount rate
n

u   Vequity = BTCFt + ERn .
t =1 (1+ye)t (1+ye)n

u  where: BTCFt is the BFCF - ADS in year t

u  ERn= equity reversion (PR - Mtg. Bal) in year n

u  ye = equity yield rate