Chapter 14
Income Capitalization:
Rates and Techniques
Basic Real Estate Appraisal: Principles & Procedures – 9th Edition
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STUDENT LEARNING OUTCOMES
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• Define Income Capitalization
• List the Three Key Characteristics of a
Future Stream of Income
• List the Two Methods used to Derive or
Calculate Overall Capitalization Rates
• Define and Illustrate Direct Capitalization
• Define Discounted Cash Flow and Describe
its Use in Appraisals
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14.1 PURPOSE AND THEORY OF
CAPITALIZATION
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Capitalization…
…the process of converting the projected
future income of a property into an estimate
of value, as of a specific date
• Reflects the Present Worth of Future
Benefits
• Recognizes the Time Value of Money
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CAPITALIZATION (Con’t.)
Key Characteristics of Future Income Streams:
• Quantity ($ Amount)
• Quality (Relative Risk)
• Timing (Durability & Frequency)
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CAPITALIZATION RATE DEFINED
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• Any Rate used to Convert Income into Value
• It Directly or Indirectly Provides for…
• A Return on the Investment (Interest or Yield)
• A Return of the Investment (Capital Recovery)
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TYPES OF CAPITALIZATION RATES
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The type of rate is dependent on which of
two Capitalization Techniques is used…
• Direct Capitalization (Ratio Capitalization)
• What the Market believes about future cash
flows is hidden in the Capitalization Rate
• Yield Capitalization
• In Yield Capitalization the pattern and duration
of the future income stream is explicit
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COMPARING INVESTMENT PROPERTY
The Choice of a Capitalization Technique and Rate
Considers the following Investment Criteria…
• Burden of Property Taxes
• Safety
• Shelter from Income Taxes
• Yield
• Liquidity
• Size or Denomination
• Freedom from
• Hypothecation
Management
(Security for a Loan)
• Prospects for
• Leverage
Appreciation
(Positive or Negative)
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CURRENT AND FUTURE RETURNS
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• Income Stream – the initial return or profit
received Monthly or Annually
• Reversion – the deferred return from the
Future Resale Proceeds (or Refinancing)
• If a Property is encumbered by a Loan:
• Income Stream or Cash Flow after loan
payments is Equity Dividend or Return to Equity
• Reversion will be affected by Equity Buildup due
to principle reduction (loan amortization)
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YIELD VERSUS RECAPTURE
• Yield = Return on Investment Capital
• Recapture = Return of Investment Capital
• Both the Yield and the Recapture can be
provided through a combination of the
periodic income stream and capital
recovery (reversion)
• From a Lender’s perspective – principle
and interest payments provide both in an
amortized loan (a lender’s investment)
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RELATING TO ECONOMIC PRINCIPLES
ECONOMIC PRINCIPLE
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INCOME PROCEDURE
Anticipation
(Present Worth of Future Benefits)
Capitalization of Future Income
Agents of Production
Subtracting Operating Expenses
Contribution
Residual Capitalization
Highest and Best Use
Highest Residual Land Value
(Return to the Land)
Consideration of these Principles can influence the choice of
Capitalization Techniques and the Selection of Capitalization Rates
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14.2 SELECTION OF THE
CAPITALIZATION RATE
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Four Types of Rates
• Interest Rate
• Return on Capital; Yield or Discount Rate: Internal Rate
of Return; Period Rate
• Overall Capitalization Rate
• OAR; Ro; Cap Rate; Ratio between Income & Value
• Recapture Rate
• Return of Capital; typically Annually; Amortization
• Composite Capitalization Rate
• Composed of an Interest and a Recapture Rate
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RELATIONSHIP BETWEEN YIELD AND
OVERALL RATES
• If Income and Value remain stable over
time, then Yield (Yo) = OAR (Ro)
• If Value is expected to increase, then the
OAR (Ro) is less than the Yield Rate (Yo)
• If Value is expected to decrease, then the
OAR (Ro) is greater than the Yield Rate (Yo)
• The foregoing relationship reflects the
expected future change in value (Δ or Delta)
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ESTIMATING OVERALL RATES
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Direct Comparison
Band of Investment
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ESTIMATING INTEREST RATES
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ESTIMATING INTEREST RATES (Con’t.)
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ESTIMATING INTEREST RATES (Con’t.)
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Summation Method of Estimating Interest Rates
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ADJUSTING OVERALL RATES
The Analysis of Overall Rates Derived from
Comparable Sales, and Rate Selection,
should consider…
• Property Location
• Age, Quality and Condition of Improvements
• Remaining Economic Life of the Improvements
• Ratio of Building Value to the Total Value
• Expenses that occur as a Percentage of Value
(e.g. Property Taxes)
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CAPITAL RECOVERY METHODS
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Straight-Line Method
• Assumes equal annual recapture from net income
• Used in several capitalization methods
Sinking Fund Method
• Assumes “safe rate” earnings
• Rarely used in appraisals
Annuity (Inwood) Method
• Provides capital recovery in same way as loan
amortization
• Assumes recapture amounts earn interest
• An older form of yield capitalization
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14.3 DIRECT AND RESIDUAL
CAPITALIZATION TECHNIQUES
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• Direct Capitalization technique
• Equity Residual technique
• Building Residual technique
• Land Residual technique
Detailed on slides that follow
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DIRECT CAPITALIZATION TECHNIQUE
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• Simplest and Most Reliable
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EQUITY RESIDUAL TECHNIQUE
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BUILDING RESIDUAL TECHNIQUE
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LAND RESIDUAL TECHNIQUE
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14.4 ESTIMATING, MEASURING AND
DISCOUNTING CASH FLOWS
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• Yield Capitalization is nearly always used
to value future income streams
• Yield Capitalization requires estimates of:
• Future Cash Flows (or their pattern)
• The Time Period (projected holding period)
• The Yield Rate (interest rate, discount rate, or
internal rate of return)
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USE OF CASH FLOWS IN APPRAISALS
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Estimating Cash Flows
• Measuring Cash Flow from Periodic Income
• Even Cash Flow (Level Income Stream)
• Uneven Cash Flow (Increases or Declines)
• Income Projections
• Consider historical trends as well as market
expectations over the projected holding period
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CASH FLOWS IN APPRAISALS (Con’t.)
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Measuring Sale Proceeds Cash Flows
• Estimating the Future Sales Price
• Estimate the Net Operating Income at the end
of the Holding Period, and Capitalize it using a
Going-Out OAR to indicate Future Resale Price
or
• Project the Future Value by applying an Annual
Percent value change to a Current Value
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DISCOUNTING CASH FLOWS
• Discounted Cash Flow (DCF)
• Theory of “Discount” Math
• Future $’s are Worth less than Current $’s
• Discount or Present Value Factors
• Six Functions of a Dollar ($)
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DISCOUNTING CASH FLOWS (Con’t.)
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Discount Formula for a Single Future Payment
Summary of Discounted Cash Flows
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CHAPTER SUMMARY
Income capitalization is the process of
converting future income into a value
estimate as of the date of value. By
selecting capitalization rates that reflect
the types and amounts of return sought
in the real estate investment market, the
appraiser completes the link between
income and value.
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CHAPTER SUMMARY (Con’t.)
The market value of amounts to be
received in the future must always be
reduced or discounted to their present
values in some way to recognize the
time value of money (i.e. Present Worth
of Future Benefits). Direct Capitalization
and Yield Capitalization are the basic
techniques by which to convert income
into an estimate of value.
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IMPORTANT TERMS & CONCEPTS
Band of Investment Method
Discounted Cash Flow (DCF)
Building Residual Technique
Equity Dividend Rate
Capital Recovery
Equity Residual Technique
Capitalization Rate
Equity Yield Rate
Cash Flow
Going-In OAR
Composite Capitalization Rate
Going-Out OAR
Debt Service
Hypothecation
Delta (Value Change)
Income Stream
Direct Capitalization Technique
Interest Rate
Direct Comparison Method
Internal Rate of Return
Discount Rate
Investment Value
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IMPORTANT TERMS & CONCEPTS
Land Residual Technique
Reversion
Leverage
Safe Rate
Mortgage Constant
Summation Method
Overall Capitalization Rate (OAR)
Time Value of Money
Periodic Rate
Yield Capitalization
Ratio Capitalization
Yield Rate
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Recapture Rate
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