income capitalization: rates and techniques

INCOME CAPITALIZATION: RATES AND TECHNIQUES

Chapter 14

Annuity recapture method

Band of investment method

Building residual technique

Capital recovery

Capitalization rate

Cash flow

Composite capitalization rate

Debt service

Delta (value change)

Direct capitalization technique

Direct comparison method

Discount rate

Discounted cash flow (DCF)

Equity dividend rate

Equity residual technique

Equity yield rate

Going-in OAR

Going-out OAR

Hypothecation

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CHAPTER TERMS AND CONCEPTS

Income stream

Interest rate

Internal rate of return

Investment value

Land residual technique

Leverage

Mortgage constant

Overall capitalization rate

(OAR)

Periodic rate

Ratio capitalization

Recapture rate

Reversion

Safe rate

Straight-line recapture method

Summation method

Time value of money

Yield capitalization

Yield rate

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CHAPTER TERMS AND CONCEPTS

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.

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INCOME CAPITALIZATION

Definition Income Capitalization Translates Income into its

Capital Equivalent

Income Characteristics Quality Quantity Duration

Three Aspects of Future Income

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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

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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?

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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

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INCOME IS PRODUCTION

Relating Income Capitalization to Economic Principles

• Principle of Anticipation• Principle of Agents of Production• Principle of Contribution• Principle of Highest and Best Use

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SELECTION OF CAPITALIZATION RATE

Types of Rates Interest Rate

o Return ON capitolo Yield rateo Discount rate

Overall Rate (OAR)o Ratio between income and value

Recapture Rateo Return OF capitalo Recaptureo Amortization

Composite Capitalization Rate

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METHODS OF ESTIMATING RATES

Methods of Estimating RatesDirect comparisonBand of InvestmentSummation

oCapitalization

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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

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CAPITALIZATION CHART

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THE BUILDING RESIDUAL TECHNIQUE

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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

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Discount Formula

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SUMMARY

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Income capitalization is the process of translating income into value. By selecting capitalization rates that reflect the types andamounts 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.