Valuation Models – Direct Capitalization

 

 

 

 

 

 

 

 

Direct Capitalization

 

Considerations

 

ü      One year’s income expectancy

ü      Convert income into value via rate or factor

ü      The rate or factor implicitly considers assumptions regarding holding period, return on/return of, and assumptions regarding appreciation/decline in value.

ü      Factors/rates may be extracted relatively easily from market indicators.

 

Development of the Income/Expense Statement

 

 

Considerations

 

 

ü      Accurate development essential to credible income approach results

ü      Shows a stabilized, i.e., “typical,” year of operations

ü      Assumes annual year end accounting of income and expenses

ü      Principle of Anticipation applies

ü      Contract vs. Market Rent

ü      Who pays what, and when?

ü      Leases: Gross, modified gross, triple net, and other

 

 

 

Requirements

 

ü      Historical income/expense: 1-5 years

ü      Interview management/ownership

ü      Proforma statement, if available

ü      Management Reports, if available

ü      Listing of capital improvements/major repairs over past 5 years

ü      Vacancy/occupancy reports, depending on property

ü      Leases, or lease abstracts

ü      Comparable Expense Data:

o       Competing properties

o       Appraiser Files

o       Surveys (IREM, BOMA, ULI)

o       Secondary Data Sources

o       Direct Sources such as managers, brokers, insurance agents, etc.

INCOME

 

Potential Gross Income (Income @ 100% Occupancy)               PGI

 

LESS Vacancy and Collection Loss                                                          - Vac/Colls)

 

Other Income (may appear before or after Vacancy & Collection Loss

 

Effective Gross Income                                                                                  EGI

 

EXPENSES

NOTE: The classifications are for general understanding and depend on the property, its location, and local practices: any fixed expense item may become a variable expense.

 

Expenses can be developed as a lump sum, per square foot, per unit, % of EGI (or PGI), etc.

 

Reimbursements: Depend upon local practice and lease terms.

 

FIXED (Expenses that don’t vary with occupancy):

            RE Taxes

            Insurance

 

VARIABLE (Expenses that vary with occupancy)

            Utilities

            Management (Often as % of EGI)

            Maintenance

            Leasing

            Acctg/Legal

            Other (Property Specific Items)

 

REPLACEMENT RESERVES (Account to provide for replacement of short-lived items, such as roof, boiler, carpeting, appliances, parking lot, etc.). Can be calculated as % of income, straight line basis, lump sum, or sinking fund.

___________

TOTAL EXPENSES

           

NET OPERATING INCOME (EGI – Total Expenses)                               NOI

           

OPERATING EXPENSE RATIO:      EXPS/EGI = OER     

 

LESS ANNUAL DEBT SERVICE (ADS)                                                       - ADS

 

BEFORE TAX CASH FLOW              (Cash flow to Equity)                                   BTCF

 

LESS Tax Consequences                                                                           - Income Tax

 

AFTER TAX CASH FLOW                                                                             ATCF

 

 

DIRECT CAPITALIZATION RELATIONSHIPS

 

 

 

 

PGI                              *                       PGIM                          =          Value

 

 

EGI                              *                       EGIM                          =          Value

 

 

NOI                             *                       NIM                             =          Value

 

 

 

 

TOTAL EXPENSES  /                       EGI                              =          OER

 

 

NOI                             /                       EGI                              =          NIR

 

 

 

 

 

NOI                             /                       SP                               =          Overall Rate (Ro)



 

-                      ADS           /                       Mortgage Amount     =          Loan Constant (Rm)

(ANNUAL DEBT SERVICE)

 

 

BTCF                          /                       Equity                         =          Equity Rate (Re)

(BEFORE TAX CASH FLOW)           (SP or Value – Loan Amount)

 

           


 

                                                                                                         

 

                             Income Property Appraisal Basics –

Direct Capitalization and Yield Capitalization

 

 

I.                   Direct Capitalization

 

Cash flow Based

 

Return on and Return off are Implicit

 

“Snapshot” look at property

 

Band of Investment is an appropriate technique

 

Various types of income multipliers (Effective/Potential)

 

Rates and Indicators are easily extractable from sales data

 

Widely used, widely understood.

 

 

Basic Relationships

 

          “IRV”

 

                   Income (I) / Rate ( R ) = Value ( V )

 

                   Income (I) x Factor ( F ) = Value (V )

 

                   And variations

 

Cash flow based: thus, equity dividend, equity cash flow becomes important in order to measure investor expectations.

 

 

 

II. Yield Capitalization

 

          Tends to make explicit return on, return of

 

          Considers overall return to the investor through cash flows and reversion

 

          Holding period becomes important consideration

 

          Tends to be difficult to extract from sales data

 

          Often confused with direct capitalization

 

 

Basic Relationships

 

Overall Rate - Yield Capitalization

 

Ro = Yo  -     CHG (Delta Sign)

 

          add to rate if declining

          subtract if increasing

               = change in property value

 

Interest rate consists of:

 

1. Return of Capital (Investment)

2. Return of Capital (Profit/Interest earned)

 

Present Value Formula

 

          Present Value = Future Value

                                      (1 + i)n

 

Discounted Cash Flow Model

 

          PW CF1 + CFn                          + PW Reversion

 

Relationship of various Positions

 

                             Ym < Y0 < Ye

 

The mortgage yield is less than the overall property yield, which is less than the equity yield.  On the other hand, the mortgage position represents less risk compared to the equity position.

 

1. Return of Capital (Investment)

2. Return of Capital (Profit/Interest earned)

 

Present Value Formula

 

          Present Value = Future Value

                                      (1 + i)n

 

Discounted Cash Flow Model

 

          PW CF1 + CFn                          + PW Reversion

 

Relationship of various Positions

 

                             Ym < Y0 < Ye

 

The mortgage yield is less than the overall property yield, which is less than the equity yield.  On the other hand, the mortgage position represents less risk compared to the equity position.