PROCEDURE Capitalization

After completing this lesson, you will be able to: describe the process of direct capitalization. describe the process of yield capitalization. explain the methods for estimating capitalization rates. discuss some residual techniques for deriving opinions of value. distinguish between return of investment and return on investment.

After completing this lesson, you will be able to: describe the process of direct capitalization. describe the process of yield capitalization. explain the methods for estimating capitalization rates. discuss some residual techniques for deriving opinions of value. distinguish between return of investment and return on investment.

capitalization

As you learned earlier, the income approach to valuation uses the following formula to derive an opinion of value of the property: Net Operating Income ÷ Cap Rate = Value In previous lessons, you learned about some of the factors that go into estimating net operating income. In this lesson, you will learn about some issues related to the cap rate (also known as the capitalization rate). The income approach makes use of a process known as capitalization. Capitalization refers to converting income into value. A capitalization rate (or cap rate) is the rate of return used in this process of converting income into value.

Band of Investment** Example

Band of Investment Example The overall capitalization rate is estimated by calculating a weighted average of the mortgage constant (.105) and the equity dividend rate (.095). The weight given to the two factors--mortgage constant and equity dividend rate--depends on the amount of the investment that is made up of the mortgage loan and the amount that is made up of the equity (down payment). If the loan amounts to 80% of the value of the property and the down payment is 20% of the value, the overall capitalization rate is calculated as shown below: Mortgage .105 x .80 = .0840 + Equity .095 x .20 = .0190 Overall Rate .1030 or 10.3%

Band of Investment Example*

Band of Investment Example To create an overall capitalization rate, the following information is needed: Mortgage Constant--The mortgage constant is the ratio of the annual loan payments to the loan amount. The mortgage constant is based on the interest rate and the term of the loan. Equity Dividend Rate (or Equity Cash on Cash Rate)--The equity dividend rate is the ratio of the "pre-tax cash flow" to the amount of the equity investment (down payment). The "pre-tax cash flow" is amount of net operating income remaining after loan payments have been deducted. For our example, assume the mortgage constant is .105. (In other words, the annual loan payments are 10.5% of the loan amount.) Also, assume that the equity dividend rate is .095. (That is, the purchaser demands a 9.5% cash on cash return on the down payment.)

If income attributable to a building is $50,000, and the total income for the property is $90,000, what is the estimated income attributable the land using the land residual technique? $140,000 $50,000 $40,000 $55,000

Bldg Income 50,000 Total Property Income 90,000 Land income = 40,000

Built-Up

Built-Up The built-up method begins with a base rate or "safe" rate. This rate is the return on an investment that is risk free. Next, additions are made to the base rate for the factors mentioned previously (risk, liquidity, and management) as they apply to the particular investment being analyzed. An example is shown below: 7% Safe rate + 2% Risk + 1% Liquidity (or lack of liquidity) + 1% Burden of management 11% Indicated rate Because it may be difficult to estimate the safe rate, along with the risk, liquidity, and management factors, this method for estimating a rate can be difficult to use.

Cap Rates**** Let's look at one important feature of cap rates:

Cap Rates Let's look at one important feature of cap rates: As the cap rate increases, the value of the property decreases. As the cap rate decreases, the value of the property increases. Let's look at an example of this.

Cap Rates Examples

Cap Rates Property #1 and Property #2 each generate annual net operating income amounting to $12,000. The appropriate cap rate for Property #1 is 12%, whereas the appropriate cap rate for Property #2 is 8%. Let's convert this information into opinions of value for the properties. The formula we use to calculate an opinion of value is: Net Operating Income ÷ Cap Rate = Value The indicated values for the properties are: Property #1 Property #2 $12,000 $12,000 Net operating income ÷ .12 ÷ .08 Cap rate $100,000 $150,000 Opinion of value of property

Comparable Sales

Comparable Sales Using the cap rate developed from comparable sales, the appraiser can now calculate an opinion of the value of the subject property. For example, if the subject property generates a net operating income of $19,000, the opinion of value of the property would be calculated using the IRV formula: Net Operating Income ÷ Cap Rate = Value Thus, the indicated value of the subject property would be: $19,000 ÷ .095 = $200,000 The comparable sales method of estimating cap rates is typically the preferred method when sufficient data on comparable properties exist. When such data do not exist, another method must be used. Let's move on to other methods of estimating cap rates.

Deriving an Opinion of Value

Deriving an Opinion of Value In many situations, you will use a single overall capitalization rate to derive an opinion of the total value of a property. However, capitalization rates can also be used to calculate separate values for different elements of a property. For example, the value of a property can be separated into building value and land value by determining the amount of income that is attributable to each component. The techniques for calculating the income and value attributable to separate components of a property are referred to as residual techniques.

Deriving an Opinion of Value Residual Techniques Building Residual

Deriving an Opinion of Value Residual Techniques Building Residual The building residual technique is used to calculate the value of a building when the land value is already known or can be determined. To use this technique, the following information must be available: net operating income value of land land capitalization rate building capitalization rate Take a look at the example that appears on the next screen. Residual Techniques Building Residual Assume the following: Net operating income (NOI) for the entire property is $80,000. Value of the land is $200,000. The land capitalization rate is 8%. The building capitalization rate is 10%.

Deriving an Opinion of Value Residual Techniques Building Residual Example

Deriving an Opinion of Value Residual Techniques Building Residual Using the income attributable to the building and the building capitalization rate, we can now calculate the value of the building using the following formula: Income ÷ Capitalization Rate = Value In our example, the income from the building is $64,000 and the building capitalization rate (identified earlier) is 10%. Thus: $64,000 ÷ .10 = $640,000 The value attributable to the building is $640,000. Adding the value of the building to the value of the land, an opinion of the total property value is derived: $640,000 + $200,000 = $840,000

Deriving an Opinion of Value Residual Techniques We will examine the following two types of residual techniques: building residual land residual

Deriving an Opinion of Value Residual Techniques We will examine the following two types of residual techniques: building residual land residual

Estimating Cap Rates

Estimating Cap Rates At this point, you might be wondering how an appropriate cap rate can be determined and used to arrive at an opinion of the value of an income-producing property. There are several methods for estimating a capitalization rate for a particular property. These methods include: comparable sales band of investment built-up Let's take a look at each of these methods.

Estimating Cap Rates Band of Investment

Estimating Cap Rates Band of Investment With the band of investment method, an overall capitalization rate is estimated by calculating separate capitalization rates for different components of the property and combining these rates into an overall capitalization rate. For example, many investment properties are purchased with a mortgage loan and the buyer's down payment (equity). Separate capitalization rates can be determined for the mortgage loan component and the buyer's equity component. From these separate rates, a weighted average is calculated to arrive at an overall capitalization rate. An example of this method appears on the next several screens.

Estimating Cap Rates Built-Up

Estimating Cap Rates Built-Up The last method for estimating a capitalization rate that we will look at is the built-up method. With the built-up method, the separate factors that go into creating a capitalization rate are estimated and added together to get an overall rate. These factors include: risk liquidity management

Estimating Cap Rates Comparable Sales

Estimating Cap Rates Comparable Sales Comp 1 Comp 2 Comp 3 Comp 4 NOI $18,400 $13,800 $19,600 $17,100 Sales Price $200,000 $150,000 $200,000 $180,000 Cap Rate 9.2% 9.2% 9.8% 9.5% In this situation, the appraiser may estimate the appropriate cap rate to be 9.5%. NOTE: If the comparable properties differ from the subject property, adjustments will be needed. Adjustments are part of the sales comparison approach and will not be covered here.

Estimating Cap Rates Comparable Sales

Estimating Cap Rates Comparable Sales As with many other elements of appraisal, cap rates may be determined by analyzing comparable properties that have recently sold in the market. An appraiser locates properties that are similar to the subject property being appraised, e.g., a 4-unit apartment building. The appraiser then collects data on these properties, including income and sales prices. Using such data, cap rates can be calculated using the following formula: Income ÷ Sales Price = Cap Rate Take a look at the example on the following screen.

If the income attributable to a building is $60,000 and the building cap rate is 5%, what is the indicated value of the building using the building residual technique? $600,000 $1,200,000 $300,000 $120,000

IRV 60,000 bdlg income/5% cap rate = Value of bldg 1.2M

If income attributable to land is $40,000, and the total income for the property is $100,000, what is the estimated income attributable the building using the building residual technique? $60,000 $140,000 $30,000 $40,000

Land Income 40,000 Total Income Property 100,000 Building income using residual technique? 60,000

If the income attributable to land is $40,000 and the land cap rate is 10%, what is the indicated value of the land using the land residual technique? $4,000,000 $40,000 $400,000 $250,000

Land Income = 40,000 Land Cap Rate = 10% Land value = 40,000/.10 = 400,000

Methods There are two methods of capitalization: direct capitalization yield capitalization

Methods There are two methods of capitalization: direct capitalization yield capitalization

Direct Capitalization

One method of capitalization is called "direct" capitalization. With direct capitalization, income from a single year is converted to current value by dividing by the appropriate capitalization rate, or cap rate. Direct capitalization is represented by the IRV formula, which you learned about earlier: Income ÷ Rate = Value In this formula: I = Income for 1 year R = Appropriate Cap Rate V = Value of the Property

Using this information, the next step is to determine the amount of income attributable to the BUILDING. This calculation is shown below: $80,000 NOI for the entire property - $16,000 Income attributable to land $64,000 Income attributable to building

Residual Techniques Building Residual On the previous screen, the income attributable to the LAND was calculated to be $16,000. Using this information, the next step is to determine the amount of income attributable to the BUILDING. This calculation is shown below: $80,000 NOI for the entire property - $16,000 Income attributable to land $64,000 Income attributable to building

Residual Techniques Building Residual The first step is to determine how much of the NOI is attributable to the LAND.

Residual Techniques Building Residual The first step is to determine how much of the NOI is attributable to the LAND. The formula used to calculate income is: Capitalization Rate x Value = Income Thus, if the land capitalization rate is 8% and the value of the land is $200,000, then income attributable to the land is: .08 x $200,000 = $16,000

Residual Techniques Land Residual Assume the following:1

Residual Techniques Land Residual Assume the following: Net operating income (NOI) for the entire property is $80,000. Value of the building is $640,000. The land capitalization rate is 8%. The building capitalization rate is 10%.

Residual Techniques Land Residual Assume the following: 3

Residual Techniques Land Residual On the previous screen, the income attributable to the BUILDING was calculated to be $64,000. Using this information, the next step is to determine the amount of income attributable to the LAND. This calculation is shown below: $80,000 NOI for the entire property - $64,000 Income attributable to building $16,000 Income attributable to land

Residual Techniques Land Residual Assume the following: 2

Residual Techniques Land Residual The first step is to determine how much of the net operating income (NOI) is attributable to the BUILDING. The formula used to calculate income is: Capitalization Rate x Value = Income Thus, if the building capitalization rate is 10% and the value of the building is $640,000, then income attributable to the building is: .10 x $640,000 = $64,000

Deriving an Opinion of Value Residual Techniques Land Residual

Residual Techniques Land Residual The land residual technique is the opposite of the building residual technique. The land residual technique is used to calculate the value of land when the value of improvements on the land (building) is already known or can be determined. Let's return to the example used for the building residual technique, but this time we will assume that the value of the building is known and the land value is unknown.

Residual Techniques Land Residual Assume the following: 4

Residual Techniques Land Residual Using the income attributable to the land and the land capitalization rate, we can now calculate the value of the land using the following formula: Income ÷ Capitalization Rate = Value In our example, the income from the land is $16,000 and the land capitalization rate (identified earlier) is 8%. Thus: $16,000 ÷ .08 = $200,000 The value attributable to the land is $200,000. Residual Techniques Land Residual Adding the value of the land to the value of the building, an opinion of the total property value is derived: $200,000 + $640,000 = $840,000

Return of Investment vs. Return on Investment The last issue we will address in this lesson is return OF investment vs. return ON investment. Return OF investment refers to the return or recapture of the investor's original investment. Return ON investment refers to compensation or profit received in exchange for the use of the investor's capital. It is the cash flow to the investor that the investment generates.

Return of Investment vs. Return on Investment The last issue we will address in this lesson is return OF investment vs. return ON investment. Return OF investment refers to the return or recapture of the investor's original investment. Return ON investment refers to compensation or profit received in exchange for the use of the investor's capital. It is the cash flow to the investor that the investment generates.

Yield Capitalization

Yield Capitalization Another type of capitalization that you should be familiar with is "yield" capitalization. With yield capitalization, all expected income (or cash flow) is converted into present value. Because yield capitalization involves all expected income, estimates must be made for future income and expenses, across the entire holding period, not just a single year (as with direct capitalization). The holding period refers to the period of time the investment will be owned. With yield capitalization, the future income must be "discounted" to its present value. Discounting is based on the concept of the time value of money. According to this concept, a dollar today is worth more than a dollar received tomorrow because today's dollar has the capability of earning interest. Discounting refers to converting future income into a present value. (Due to the concept of the time value of money, income received in the future is worth less than if the same amount of income were received today.)

Direct capitalization involves converting _____ into an opinion of value. all expected income a single year of income

a single year of income

Yield capitalization involves converting _____ into present value. a single year of income all expected income

all expected income

An appraiser determines separate capitalization rates for the mortgage loan component and the buyer's equity component of a property. From these separate rates, the appraiser calculates a weighted average to arrive at an overall capitalization rate. In this situation, the appraiser has used the _____ method for estimating a capitalization rate. band of investment comparable sales built-up residual

band of investment

The method for estimating a capitalization rate by determining a "safe" rate and adding risk, liquidity, and management factors is called the _____ method. comparable sales residual band of investment built-up

built-up

An appraiser arrives at a capitalization rate for a particular property by calculating the capitalization rates for similar properties that have recently sold. In this situation, the appraiser has used the _____ method for estimating a capitalization rate. comparable sales band of investment built-up residual

comparable sales

The conversion of an estimate of a single year of income into an opinion of value is called _____. direct capitalization yield capitalization internal capitalization indirect capitalization

direct capitalization

The return of the original amount of the investment is referred to as the _____. return on investment return off investment return of investment return over investment

return of investment

The additional amount received by an investor as compensation for the use of the investor's capital is called _____. return on investment return of investment return off investment return over investment

roi

Future income must be "discounted" to its present value according to the process of _____. **** yield capitalization direct capitalization

yield capitalization

The conversion of all expected income into present value is called _____. equity capitalization direct capitalization revenue capitalization yield capitalization

yield capitalization