Income Capitalization Terms

Capitalization

A process of converting income to value. (See also direct capitalization and yield capitalization).

Direct Capitalization

[1] A valuation method used to convert a single year's income expectancy (or an annual average of several year's income expectancies) into a value estimate. [2] A capitalization technique that utilizes capitalization (cap) rates and multipliers extracted from sales to provide a value estimate. Yield and value change are implied but not identified.

Discount Rate

The term used to explain the compound interest rate used in the in approach to value to convert expected future cash flows into a present value.

Discounted Cash Flow Analysis

A valuation technique that specifies [1] the quantity, variability, timing, duration of periodic income, and [2] the quantity/timing of the reversion (sale of property) then discounts these cash flows at a specified yield rate to derive a present value estimate.

Effective Gross Income

Anticipated income from operation of the real estate after deduction for vacancy and collection loss.

Leased Fee Interest

The leased fee interest, as distinguished from the leasehold estate (tenant rights to occupancy), is defined as the ownership interest held by a landlord with the right of occupancy and use conveyed to others. Theoretically, the combined estates would make up the fee simple estate which is the unencumbered interest traditionally valued. When a lease encumbers a property, the partitioned interests must be analyzed. The rights of the leased fee owner (the lessor) and the leasehold (the lessee) are specified by contract terms contained within the lease. Regardless of the interest appraised, all estates are subject to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.

Net Operating Income (NOI)

The net income left remaining after deduction of all operating expenses from effective gross income but before payment of debt service and deduction of book depreciation.

Potential Gross Income

The total income a property is capable of generating at full occupancy but before deduction of vacancy and operating expenses.

Reversion

[1] the value of property at the expiration of a certain time period. [2] the right of a lessor to possess leased property upon the termination of a lease. [3] REVERSIONARY INTEREST - the interest a person has in property upon the termination of the preceding estate.

Yield Capitalization

A capitalization method that derives a present value estimate by discounting each future benefit at an appropriate yield rate or by developing and overall rate that explicitly reflects the investment's income pattern, value change, and yield rate. A valuation method that converts projected income into value and considers the equity return on investment.

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Income approach

From Wikipedia, the free encyclopedia

The Income Approach is one of three major groups of methodologies, called valuation approaches, used by appraisers. It is particularly common in commercial real estate appraisal and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or business valuation.

While there are quite a few acceptable methods under the rubric of the income approach, most of these methods fall into three categories: direct capitalization, discounted cash flow, and gross income multiplier.

Direct Capitalization

This is simply the product of dividing the annual net operating income (NOI) by the appropriate capitalization rate (CAP rate). For income producing real estate, the NOI is the net income of the real estate (but not the business interest) plus any interest expense and non-cash items (e.g. -- depreciation) minus a reserve for replacement. The CAP rate may be determined in one of several ways, including market extraction, band-of-investments, or a built-up method. When appraising complex property, or property which has a risk-adjustment due to unusual factors (i.e. -- contamination), a risk-adjusted cap rate is appropriate.^[1] An implicit assumption in direct capitalization is that the cash flow is a perpetuity and the cap rate is a constant. If either cash flows or risk levels are expected to change, then direct capitalization fails and a discounted cash flow method must be used.

In UK practice, Net Income is capitalised by use of market-derived yields. If the property is rack-rented then the All Risks Yield will be used. However, if the passing rent differs from the Estimated Rental Value (ERV), then either the Term & Reversion, Layer or Equivalent Yield methods will be employed. In essence, these entail discounting the different income streams - that of the current or passing rent and that of the reversion to the full rental value - at different adjusted yields.

Discounted Cash Flow

THe DCF model is analogous to a net present value estimation in finance. However, appraisers often mistakenly use a market-derived cap rate and NOI as substitutes for the discount rate and/or the annual cash flow. The Cap rate equals the discount rate plus-or-minus a factor for anticipated growth. The NOI may be used if market value is the goal, but if investment value is the goal, then some other measure of cash flow is appropriate^[2].

Gross Rent Multipler

The GRM is simply the ratio of the selling price divided into monthly (or annual) rent. If several similar properties have sold in the market recently, then the GRM can be computed for those and applied to the anticipated monthly rent for the subject property. GRM is useful for rental houses, duplexes, and simple commercial properties when used as a supplement to other more well developed methods.

Short-cut DCF

The Short-cut DCF method is based on a model developed by Professor Neil Crosby of the University of Reading (and ultimately based on earlier work by Wood and Greaves). The RICS have encouraged use of the method in appropriate circumstances.^[3] The Short-cut DCF is an adaptation to property valuation of the DCF method, which is widely used in finance.

In the Short-cut DCF, the passing rent, which is constant (in nominal or real terms) for the duration of the rent period, is discounted at an appropriate rate of return (possibly derived by reference to the risk-free rate of return obtained on government bonds, to which is added an allowance for risk and an allowance for the illiquidity of property assets). The reversion is discounted at the market-derived All Risks Yield (ARY), which correctly implies growth in the reversionary income stream. The reversionary income is the current Estimated Rental Value (ERV) inflated by an appropriate annual growth factor (or CAGR - Compound Annual Growth Rate). The crux of the Crosby-Wood model, and that which sets it apart from the customary DCF, is that the growth factor is derived by means of formula, as a function of the rate of return and the All Risks Yield. For example, if the rate of return is 10% per annum, the ARY is 8% per annum and rent is reviewed annually, then the growth factor will be 2%. (This simple subtraction only works when rent is reviewed annually - in all other situations the growth factor is derived by use of the Crosby formula.) Thus the Short-cut DCF produces a mathematically consistent valuation.

Further Reading

• Baum, A. and Mackmin, D. (1989) The Income Approach to Property Valuation (Third Edition), Routledge, London.
• Baum, A. and Crosby, N. (1988) Property Investment Appraisal (Second Edition), Routledge, London.
• Havard, T. (2004) Investment Property Valuation Today, Estates Gazette, London.
• The Appraisal of Real Estate (12th Edition), The Appraisal Institute, Chicago.

References

1. ^ Bill Mundy, The Impact of Hazardous Material on Value, The Appraisal Journal, 1992.
2. ^ John A. Kilpatrick, Market Value(s), presentation to the Appraisal Institute, 2000, http://www.greenfieldadvisors.com/publications/marketvalues.pdf,
3. ^ See RICS (1997) Commercial Investment Property: Valuation Methods - An Information Paper.

The Cost Approach

The Cost Approach is based on the principle of substitution which asserts that no prudent buyer or investor will pay more for a property than that amount for which the site could be acquired and which improvements that have equal desirability and utility can be constructed without undue delay. It is a method of appraising property based on the depreciated reproduction or replacement cost (new) of improvements, plus the market value of the site.

This approach has the most validity/reliability when improvements are new or near-new. For older/aged structures, the cost approach may not be relevant due to the greater subjectivity involved in estimating accrued depreciation.

The cost approach begins with the determination of site value. Sales of vacant land with similar zoning, utility, and acquired for the same or similar use as the subject property being appraised, are analyzed. In markets where site sales are limited, other site sales of varying property type may be considered as long as they have core similarities in legally acceptable use.

Once site value has been determined, reproduction or replacement costs of the improvements are estimated as if the improvements were new. The estimate is then further adjusted for all elements of accrued depreciation including physical depreciation, functional and/or external obsolescence.

The following breakdown method shows how the cost approach is used to value a commercial building.



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Sales comparison approach

From Wikipedia, the free encyclopedia

The sales comparison approach (SCA) is one of the three major groupings of valuation methods, called the three approaches to value, commonly used in real estate appraisal. This approach compares a subject property's characteristics with those of comparable properties which have recently sold in similar transactions. The process uses one of several techniques to adjust the prices of the comparable transactions according to the presence, absence, or degree of characteristics which influence value. As such, all sales comparison approach methods are variations on hedonic-type measurements, which determine the value of something as the sum of the value of the various components which contribute utility.

Units of Comparison

The SCA relies on the assumption that a matrix of attributes or significant features of a property drive its value. For examples, in the case of a single family residence, such attributes might be floor area, views, distance to amenities, number of bathrooms, lot size, age of the property and condition of property.

Economic Basis

The sales comparison approach is based upon the principles of supply and demand, as well as upon the principle of substitution. Supply and demand indicates value through typical market behavior of both buyers and sellers. Substitution indicates that a purchaser would not purchase an improved property for any value higher than it could be replaced for on a site with equivocal utility, assuming no undue delays in construction.

Examples of Methods

In practice, the most common SCA method used by estate agents and real estate appraisers is the sales adjustment grid. It uses a small number of recently sold properties in the immediate vicinity of the subject property to estimates the value of its attributes. Adjustments to the comparables may be determined by trend analysis, matched-pairs analysis, or simple surveys of the market.

More advanced researchers and appraisers commonly employ statistical techniques based on multiple regression methods which generally compare a larger number of more geographically dispersed property transactions to determine the significance and magnitude of the impact of different attributes on property value. Research has shown that the sales adjustment grid and the multiple regression model are theoretically the same, with the former applying more heuristic methods and the latter using statistical techniques^[1].

Spatial auto regression plagues these statistical techniques, since high priced properties tend to cluster together and therefore one property price is not independent of its neighbor. Given property inflation and price cycles, both comparison techniques can become unreliable if the time interval between transactions sampled is excessive. The other factor undermining a simplistic use of the SCA is the evolving nature of city neighborhoods, though in reality urban evolution occurs gradually enough to minimize its' impact on this approach to value.

In more complex situations, such as litigation or contaminated property appraisal, appraisers develop SCA adjustments using widely accepted advanced techniques, such as repeat sales models (to measure house price appreciation over time), survey research (e.g. -- contingent valuation), case studies (to develop adjustments in complex situations) or other statistically-based techniques.

Further reading

• The Appraisal of Real Estate, 12th Edition, by the Appraisal Institute is an industry-recognized textbook.
• The Uniform Standards of Professional Appraisal Practice, by The Appraisal Foundation, updated and published annually through the 2006 edition; henceforth, updated editions are to appear biannually.

References

1. ^ see, for example, Lentz and Wang, Journal of Real Estate Research, 1997