Income Capitalization

• Under income approach, the value of real estate is the present value of all future cash inflows
• The market value of property equals net operating income (NOI) divided by an appropriate market capitalization rate (R), V = NOI/R
• NOI (Net Operating Income) = potential gross income – vacancy and collection losses – operating expenses
• R (Market capitalization rate) is the percentage rate by which the future income stream is divided to arrive at a single figure that represents present value.

The concept of net operating income

• NOI is defined as the balance of cash remaining after deducting the operating expenses of a property from the gross income generated by the property. In determination of NOI, debt service on any existing or projected mortgages is ignored. Historic accounting depreciation deductions are ignored.
• Gross Rental receipts reflects the appraiser’s estimate of what rental income would be if the property were 100% occupied for 12-month period. In deriving GRR, the appraiser relies on three major sources: (1) records of the subject property (2) comparables, and (3) trends in the market place.
• After getting GRR, analyst must ascertain any additional income earned from sources other than rent. Examples are (1) automatic washers and dryers in the laundry room, (2) vending machines, (3) parking fees, (4) swimming pools, and (5) other amenity fees. GRR + other income represent potential gross income
• Effective gross income is derived by subtracting vacancy and collection loss from PGI. The vacancy and collection loss is calculated as a % of GRR (range between 5-15% of GRR). It reflects the experience of the subject property or of comparable properties in the area and also projected trend in the market.
• Operating expenses are directly related to the operation and maintenance of the property. Typical operating expenses include the following items: real estate taxes, payroll, maintenance and repair, fire and hazard insurance premiums, utility costs, security expenses, management fees, supplies, replacement allowances, etc. After operating expenses are deducted from effective gross income, the resulting figure is NOI.

Factors affecting the capitalization rate

• Types of property (e.g. apartment building, office building, etc)
• Location (in the main business district, a few feet may make one location better than another)
• Age ( the older the building, the less future income can be derived from it in its present state)
• Quality of the tenancies (e.g. holding tenant quality constant, a long-term lease usually means more secure NOI than a short-term lease)

From a theoretical standpoint, the capitalization rate has four separate elements:

• Real return
• The real return required by investors can be estimated by looking at the traditional relationship between the rate on government securities that are risk free and the rate of inflation. Over the past 2 decades, researchers have put the real return at 2-3% annually.

• Inflation premium
• When an analyst is constructing a capitalization rate, a judgment must be made as to the expected rate of inflation during the holding period of the asset that is being valued.
• One guideline in estimating the combined real return and inflation premium expected by investors is the current rate on Treasury bonds having a maturity equal to the projected holding period of the subject property.

• Risk premium
• How large the risk premium should be is the subject of endless professional and academic debate. The riskier the project, the higher the risk premium and consequently the higher the capitalization rate.

• Recapture premium
• If an investment were to produce income in perpetuity, the three elements already mentioned would be sufficient to make up the capitalization rate. However, the project has a finite life and therefore investor demands a return of invested capital.
• The recapture premium can be calculated by using either the straight-line or sinking fund method. For example, the projects were expected to last 50 years, the straight-line recapture premium would be a 2% a year.
• A sinking fund concept introduces the element of interest that will be earned on the capital. Thus the investor can receive less than 2% each year and still recover the entire investment over the 50-year period.
• The major distinction between the straight-line and sinking fund methods is that reinvestment is not assumed. In the sinking fund method, reinvestment of the recaptured capital is assumed to produce a return.