Chapter 14
INCOME CAPITALIZATION: RATES AND TECHNIQUES
CHAPTER TERMS AND CONCEPTS
Annuity recapture method
Direct capitalization technique
Band of investment method
Direct comparison method
Building residual technique
Discount rate
Capital recovery
Discounted cash flow (DCF)
Capitalization rate
Equity dividend rate
Cash flow
Equity residual technique
Composite capitalization rate
Equity yield rate
Debt service
Going-in OAR
Delta (value change)
Going-out OAR
Hypothecation
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CHAPTER TERMS AND CONCEPTS
Income stream
Periodic rate
Interest rate
Ratio capitalization
Internal rate of return
Recapture rate
Investment value
Reversion
Land residual technique
Safe rate
Leverage
Straight-line recapture method
Mortgage constant
Summation method
Overall capitalization rate
Time value of money
(OAR)
Yield capitalization
Yield rate
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LEARNING OUTCOMES
1. Define income capitalization.
2. List the three key characteristics of a future
stream of income.
3. List the three methods used to derive or
calculate interest and/or capitalization
rates.
4. Define and illustrate direct capitalization.
5. Define discounted cash flow and describe
its use in appraisals.
INCOME CAPITALIZATION
Definition
 Income Capitalization Translates Income into its
Capital Equivalent
Income Characteristics
 Quality
 Quantity
 Duration
Three Aspects of Future Income
INCOME CAPITALIZATION
Capitalization
 Recognizes the Time Value of Money
 Estimates the Present Worth of Future Benefits
A Capitalization Rate Provides
 A Return on Investment
 A Return of Investment
o
Directly or indirectly
COMPARING INVESTMENT PROPERTY
Investment Criteria
 Safety
– Burden of Taxes
 Yield
– Shelter from Taxes
 Liquidity
– Denomination
 Management – Hypothecation
 Appreciation – Leverage
Current and Future Return
 Income stream
 Cash flow
 Reversion
Yield – vs. – Recapture
 Yield = Return on investment capital
 Recapture = Return of investment capital
Which Property Is the Safer Investment?
RELATING ECONOMIC PRINCIPLES
Income Procedure
Economic Principle
Project income for the
property
Anticipation
Subtract operating
expenses
Agents of Production
Allocate net income to land
and buildings
Agents of Production;
Contribution
Value land by the residual
income attributed to land
Highest and best use;
Contribution
INCOME IS PRODUCTION
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Relating Income Capitalization to Economic Principles
•
•
•
•
Principle of Anticipation
Principle of Agents of Production
Principle of Contribution
Principle of Highest and Best Use
SELECTION OF CAPITALIZATION RATE
Types of Rates
 Interest Rate
o
o
o
Return ON capitol
Yield rate
Discount rate
 Overall Rate (OAR)
o
Ratio between income and value
 Recapture Rate
o
o
o
Return OF capital
Recapture
Amortization
 Composite Capitalization Rate
METHODS OF ESTIMATING RATES
Methods of Estimating Rates
 Direct comparison
 Band of Investment
 Summation
o Capitalization
PROVIDING CAPITAL RECOVERY
Straight-Line Method
 Assumes equal annual recapture from net income
 Used in several capitalization methods
Sinking Fund Method
 Assumes “safe rate” earnings
 Not commonly used in appraisals
Annuity (Inwood) Method
 Provides capital recovery in same way as loan
amortization
 Assumes recapture amounts earn interest
 Is referred to as yield capitalization
CAPITALIZATION CHART
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THE BUILDING RESIDUAL TECHNIQUE
THE EQUITY RESIDUAL TECHNIQUE
ESTIMATING, MEASURING, & DISCOUNTING CASH FLOWS
• The Use of Cash Flows in Appraisals
• Estimating Cash Flows
•
•
•
•
Measuring Cash Flow from Periodic Income
Even Cash Flow
Uneven Cash Flow
Income Projections
• Measuring Cash Flow from Sale
Proceeds
•
Estimating the Future Sale Price
• Discounting Cash Flows
Discount Formula
SUMMARY
Income capitalization is the process of
translating income into 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.
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.