VALUATION BY INCOME
CAPITALIZATION
LEARNING OBJECTIVES
• Explain the difference between appraisal and
investment analysis.
• Estimate the NOI in a reconstructed
operating statement.
• Identify the two main components of
capitalization rates.
VALUATION BY INCOME
CAPITALIZATION
LEARNING OBJECTIVES
• Calculate overall capitalization rates by the
general formula, market extraction, and
mortgage-equity analysis
• Estimate a property’s market value by direct
capitalization, using an overall rate.
• Estimate the market value of a leased fee
estate, using DCF analysis.
VALUATION MODELS IN
THE INCOME
APPROACH
• Discounted Cash Flow Analysis
• value estimated as: the present value of the
expected cash flows
• Investment value uses the expected cash flows
and discount rate of a particular investor.
• Market value uses the expected cash flows and
discount rate of the typical market participant.
• Direct Capitalization
• value estimated as: V = NOI / R
DCF: Expected Cash
Flows (NOIs) from
Operations
Item
Year 1
Year 2
Year 3
Year 4
Year 5
PGI $180,000 $185,400 $190,962 $196,691 $202,592
- V&C
18,000 18,540
19,096
19,669
20,259
= EGI
162,000 166,860 171,866 177,022 182,333
- OE
72,900 75,087
77,340
79,660
82,050
= NOI
89,100 91,773
94,526
97,362 100,283
DCF: Expected Net
Proceeds from Sale
Item
Expected Sales Price
- Selling Expenses
= Net Sale Proceeds
Symbol
(SP)
(SE)
(NSP)
Year 5
$1,026,000
51,300
$ 974,700
Present Value of
Expected Cash Flows
(before debt)
Yr
NOI
NSP
PV@10.5%
1
89,100
80,633
2
91,773
75,161
3
94,526
70,059
4
97,362
65,304
5
100,283
974,700
652,515
PV =
$ 943,672
DCF using Expected BeforeTax Cash Flows
• Assume the following loan terms available to a
particular investor:
• loan-to-value ratio = 80%,
• thus, loan amount = $944,000 x 0.80 = $755,200
• interest rate is 9.5%, amortized over 30 years, paid
monthly
• thus, annual debt service = $6,350 x 12 = $76,202
• Assume the return required of the investor is 18
percent
DCF: Expected
BTCFs from
Operations
Item
Year 1
Year 2
Year 3
Year 4
Year 5
PGI $180,000 $185,400 $190,962 $196,691 $202,592
- V&C
18,000 18,540
19,096
19,669
20,259
= EGI
162,000 166,860 171,866 177,022 182,333
- OE
72,900 75,087
77,340
79,660
82,050
= NOI
89,100 91,773
94,526
97,362 100,283
- DS
76,202 76,202
76,202
76,202
76,202
=BTCF $ 12,898 $ 15,571 $ 18,324 $ 21,160 $ 24,081
DCF: Expected BTER
from Sale
Item
Symbol
Expected Sales Price
(SP)
- Selling Expenses
(SE)
= Net Sale Proceeds
(NSP)
Remaining Mtg. Bal.
(RMB)
= Before-Tax Equity Rev. (NSP)
Year 5
$1,026,000
51,300
$ 974,700
661,875
$ 312,825
Present Value of
Expected Cash Flows
(BTCFs)
Yr
BTCFs
BTER
PV@18%
1
12,898
10,931
2
15,571
11,183
3
18,324
11,153
4
21,160
10,914
5
24,081
312,825
147,265
PV =
$ 191,446
Vo = Ve + Vd
= $ 191,446 + $ 755,200 = $ 946,646
DIRECT CAPITALIZATION
• The Income Capitalization Equation is:
V = I / R,
where V = value,
I = income, and
R = capitalization rate.
• Often used to estimate R, when V and I are
known.
R=I/V
The Reconstructed
Operating Statement
• Potential Gross Income
• Vacancy and Collection Losses
• Expenses
• fixed
• variable
• reserves and other nonrecurring expenses
• expense exclusions
• Net Operating Income
The Reconstructed
Operating Statement
Item
Potential Gross Income
less: Vacancy and Collection Losses
Effective Gross Income
less: Operating Expenses
Fixed
Variable
Reserves for Replacement
Net Operating Expenses
Amount
$ 180,000
18,000
162,000
27,900
45,000
2,500
$ 86,600
Direct Capitalization
Estimate
• The Income Capitalization Equation is:
V = I / R,
where V = value,
I = income, and
R = capitalization rate.
• Assume capitalization rate is estimated to be
9.2%
• Indicated value using the direct income capitalization
approach: V = $ 86,600 / .092 = $ 934,783
rounded to $ 934,800
Capitalization Rates and
Yield Rates
• The overall capitalization rate can be explained
as:
RO = yO - g,
where RO = the overall capitalization rate
yO = the discount rate (or yield rate), and
g = the expected annual compounded
rate
of growth.
Capitalization Rates
Symbol Type
Income
Value
RO
Overall Capitalization Rate
=
NOI

VO
RE
Equity Capitalization Rate
=
BTCF

Ve
Rm
Mortgage Capitalization Rate
=
ADS

Vm
RB
Building Capitalization Rate
=
IB

VB
RL
Land Capitalization Rate
=
IL

VL
Direct Market
Extraction of RO
Office
Forecast
RO
Building
NOI
Price
(NOI/Price)
A
$40,000 $512,800
0.078
B
57,000 647,700
0.088
C
36,000 395,600
0.091
D
45,000 562,500
0.080
SUBJECT
$ 86,600
mean =
0.084
VO = NOI / RO = 86,600 / 0.084 = 1,030,952
Simple Mortgage-Equity
Analysis
RO = [mRm + (1-m)Re],
where RO = the overall capitalization rate,
m = loan-to-loan ratio,
Rm = mortgage capitalization rate, and
Re = equity capitalization rate.
Mortgage-Equity Analysis
Example
Comparable
Ve
BTCF
Re
A
$225,118
$ 9,500 0.0422
B
190,244
7,800 0.0410
C
185,393
8,250 0.0445
Assume m = 0.75, Rm = 0.1048
RO = 0.75(0.104844) + 0.25(0.04257) = 0.08928