Chapter 20
The Student Handbook to
THE APPRAISAL OF REAL ESTATE
The Income Capitalization Approach
1
The Income Capitalization Approach
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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.
Relationship to appraisal principles
 Anticipation and change
 Supply and demand
Applicability and limitations
Interests to be valued
 Leased fee
 Leasehold
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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Leases
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Types of leases
 Flat rental lease
 Variable rate lease
 Step-up or step-down lease
 Lease with annual increase
 Revaluation lease
 Percentage lease
Expenses in leases
 Gross lease
 Net lease
 Triple net lease
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
3
Rent
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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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Future Benefits
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Potential gross income (PGI)
 Starting point
 As if full and w/o collection losses
Effective gross income (EGI)
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PGI less vacancy and collection losses
Net operating income (NOI or IO)
 EGI less fixed expenses and variable expenses
 Less reserves for replacement (sometimes)
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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Future Benefits, continued
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Equity dividend – 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
 Sometimes it is nothing.
 Sometimes it is a meaningful amount.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
6
Reconstructed Operating Statement
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
7
Operating Expenses
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Necessary to maintain the property
Debt service not included
Fixed expenses – do not vary with occupancy
Variable expenses – do vary with occupancy
Replacement allowance – included if expense is
included in capitalization rates of comparable properties
but not if expense is not
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
8
Rates of Return
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Return on and return of capital
 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
 Overall capitalization rate (RO) – ratio of a single year’s
income (periodic) to the sale price or value (lump sum)
 Net income multiplier – reciprocal of overall
capitalization rate
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
9
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
10
Rates of Return, continued
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Discount rates
 Internal rate of return – rate of return on the
investment considering the price paid for the
investment, the periodic cash flows, and the reversion
 Overall yield rate – rate of return including debt and
equity
 Equity yield rate – rate of return from the perspective
of the equity investor, i.e., the rate of return on the
amount paid as a down payment from periodic income
after debt service and including the reversion after the
debt has been paid off
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
11
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
Last year's income divided by the cap. rate
$2,158,366
Effective gross income
All expenses
Net operating income
Reversion (10%)
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
12
Estimating Rates
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Risk
 A big factor because risk is a primary component of
the yield rate
 A risky investment requires a higher return than a less
risky investment.
 Investment-specific
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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Estimating Rates, continued
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Inflation
 Also a factor in the 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
14
Capitalization Procedures
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Direct capitalization
 Uses a single year’s income
 Based on the ratio of property income to sale price
Yield capitalization
 Uses multiple years’ income
 Based on the assumption that all investments are the
present value of future cash flows.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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Capitalization Procedures, continued
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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.
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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Problems
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Suggested solutions begin on page 428.
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
17
Problem 7
Purchase price
Mortgage 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
Base rent
Sales % rent
Less base
Overage income
Problem 8
5,000
X
$
$ 850,000
$ 600,000
$ 250,000
X
12
=
3% =
$ 60,000
$
7,500
$
67,500
Problem 10
Tenant
PGI
1
60,000
2
75,000
3
65,000
4
75,000
PGI
275,000
V&C
-13,750
EGI
261,250
Expenses
-100,000
NOI
161,250
Student Handbook to THE APPRAISAL OF REAL ESTATE
Chapter 20
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