Chapter 8:
Income Capitalization
Approach
The Income Approach to
Valuation
 Value determined as present value of future
benefits
 Perspective of typical investor
Income Capitalization
Methods
 Direct Capitalization
 Converts a single year’s income into an indication of value
using an income rate or income multiplier.
 Advantage is that cap rates and income multipliers come
directly from market indications.
 Disadvantage is that expected changes in income will be
similar for the comparable properties and the subject property.
 Yield Capitalization
 Converts expected future cash flows into an indication of
value using discounted cash flow analysis.
 Advantage is that the income each year is explicitly identified.
Application of the Income
Approach
 Office buildings
 Expense passthrough
 Consumer price index (CPI)
 Consumer price index (CPI)
 Leased fee interest
 Retail shopping centers
 Minimum Rent
 Overage Rent
 Percentage Rent
Application of the Income
Approach
 Multifamily residential properties
 Industrial properties
 Hotels and Motels
 Nonrealty
 Business Value
 Development Projects
 Special-Use Properties
Value Estimation Using
Direct Capitalization
 Appropriate when:
 First-year cash flows are representative of an
average or normal year’s earnings
 The income multiplier or capitalization rate is derived
from comparable sales with the same potential for
future income.
Potential Gross Income
Multiplier
 First, the PGIM is obtained by extracting PGIMs from recent
sales of similar properties in the area and calculating the
average PGIM:
 PGIM=Value/PGI
 Then, use that PGIM to calculate the value of your subject
property using the following equation:
 Value of subject=PGI of subject x PGIM
Effective Gross Income
Multiplier
 More appropriate to use when long-term differences in vacancy
between subject and comparable occur.
 First, the EGIM is obtained by extracting EGIMs from recent sales of
similar properties in the area and calculating the average EGIM:
 EGIM=Value/EGI
 Then, use that EGIM to calculate the value of your subject property
using the following equation:
 Value of subject=EGI of subject x EGIM
Net Income Multiplier
 More appropriate to use when long-term differences in
expense ratios between subject and comparable occur.
 First, the NIM is obtained by extracting NIMs from recent sales of
similar properties in the area and calculating the average NIM:
 NIM=Value/NOI
 Then, use that NIM to calculate the value of your subject
property using the following equation:
 Value of subject=NOI of subject x NIM
Capitalization Rate
 We can also use Net Income as a tool for estimating valuation
with a capitalization rate.
 First, the cap rate is obtained by extracting cap rates from
recent sales of similar properties in the area and calculating the
average cape rate:
 Cap Rate=NOI/Value
 Then, use that Cap Rate to calculate the value of your subject
property using the following equation:
 Value of subject=NOI of subject/Cap Rate
Residual Techniques Using
Direct Capitalization:
Building Residual
 Assuming the value of land is known but value of building is not, the
value of components can be broken and total value estimated as
follows: Land Value
450,000
Land cap rate
Building cap rate
NOI
Less return to land (450,000x.095)
Building cash flow
0.095
0.1
200,000
42,750
157,250
Building cash flow/building cap rate=Building value
(157,250/.10)=1,572,500
Building value
Plus land value
Property value
1,572,500
450,000
2,022,500
Residual Techniques Using
Direct Capitalization: Land
Residual
 Assuming the value of the building is known but value of the land is not,
the value of components can be broken and total value estimated as
follows:
Building Value
1,400,000
Land cap rate
Building cap rate
NOI
Less return to building (1,400,000x.1)
Land cash flow
0.095
0.1
200,000
140,000
60,000
Land cash flow/land cap rate=Land value
(60,000/.095)=631,579
Building value
Plus land value
Property value
1,400,000
631,579
2,031,579
Residual Techniques Using
Direct Capitalization: Land
Residual
 The land residual technique was originally developed as a way to
analyze highest and best use. The appraiser would create an
estimate of land residual value for each development alternative. The
alternative that yields the highest land residual value is considered the
highest and best use.
 This approach, however, requires separate cap rate estimates for the
land and building. This is difficult in practice, so an alternative is to use
an overall cap rate calculation.
NOI/Overall cap rate=Property
Value
200,000/.10=2,000,000
Property value
Less building value
Land value
2,000,000
1,400,000
600,000
Value Estimation Using Yield
Capitalization: Fixed Income
and Resale Price
 Yield capitalization involves discounting unlevered cash flows at the
property discount rate (target property yield for a given investor).
1
PGI
Less vacancy and credit loss
EGI
Less operating expense
NOI
2
3
4
300,000 300,000 300,000 300,000
18,000
18,000
282,000 282,000 282,000 282,000
282,000
82,000
18,000
300,000
18,000
82,000
18,000
5
82,000
82,000
82,000
200,000 200,000 200,000 200,000
200,000
Net resale proceeds
If I=12%, solving for NPV gives a value estimate of $2,026,037
2,300,000
Value Estimation Using Yield
Capitalization: Variable
Income and Fixed Resale
Price
1
2
3
4
5
PGI
Less vacancy and credit
loss
300,000
312,000
324,480
337,459
350,958
18,000
18,720
19,469
20,248
21,057
EGI
282,000
293,280
305,011
317,211
329,901
82,000
85,024
88,138
94,580
98,021
200,000
208,256
216,873
222,631
231,880
Less operating expense
NOI
Net resale proceeds
 If I=12%, solving for NPV gives a value estimate of $2,077,068
2,300,000
Value Estimation Using Yield
Capitalization: Variable
Income and Resale Price
Based on Terminal Cap Rate
 Chapter 6 mentioned the topic of terminal cap rates, and this is
where that concept gets used.
 The terminal cap rate can be applied to an estimate of income
for the next owner to estimate the resale price.
 This income depends upon how market rates are expected to
change over the first owner’s holding period and whether any
of the original leases are still in effect.
Value Estimation Using Yield
Capitalization: Variable
Income and Resale Price
Based on Terminal Cap Rate
 If Estimated NOI in year 6=$241,480 and the Terminal cap
rate=10%
 Resale value=Estimated NOI in year 6/Terminal cap rate
 Resale value = $241,480/.10 = $2,414,800
Value Estimation Using Yield
Capitalization: Variable
Income and Resale Price
Based on Terminal Cap Rate
1
2
3
4
5
6
PGI
Less vacancy and
credit loss
300,000
312,000
324,480
337,459
350,958
364,996
18,000
18,720
19,469
20,248
21,057
21,900
EGI
Less operating
expense
282,000
293,280
305,011
317,211
329,901
343,096
82,000
85,024
88,138
94,580
98,021
101,616
NOI
200,000
208,256
216,873
222,631
231,880
241,480
Net resale proceeds
2,414,800
 Assuming a 5 year holding period, if I=12%, solving for NPV gives a
value estimate of $2,142,209