Effects of Capitalization on Real Estate Valuation

Instructor: Eileen Cappelloni

Eileen worked for the Orange County Asssociation of Realtors for 31 years. She has written real estate courses and exams for other publishing companies

What is the income approach in the appraisal process? When is it generally used? This lesson will explain and give examples of how capitalization affects valuation using the income approach. You will also learn about multipliers, equity rates, yield capitalization, and discover how to calculate the net operating income of a property.

Income Approach to Appraisal

Rashida is an experienced appraiser. She has been asked by a willing but nervous investor client, Alan, to help him purchase property for less than $2 million with little risk. Rashida does her research, investigates an attractive apartment building, and sits down with Alan to discuss the reasons why she is proposing this particular investment.

The income approach is primarily used to determine the approximate value that a property's net earnings ability will support. In other words, how much money can Alan reasonably hope to make with this property?

This approach is mostly used for commercial income properties. When a property is purchased to generate income from rents or leases, or it is being valued as a business, the income method of appraisal is the most widely used.

Capitalization Rate

There are a few different ways to calculate the value of a property's net earnings. One is called direct capitalization, or finding the capitalization rate. The capitalization rate consists of a mathematical formula where projected income is determined and converted to a future value. There are several steps:

  1. Approximate Potential Gross Income (PGI). This consists of contract rent, which is the long-term leased rental amounts, and market rent, which is the rental amount estimated for owner-occupied or vacant space, and space occupied by short-term tenants. In this case, Rashida's calculations conservatively estimate potential gross income to be $360,000.

  2. Find the Vacancy and Collection Losses (V&C). Generally calculated as a percentage of the PGI, V&C represents rent that the owner will not be receiving. Rashida's estimation is higher than she actually anticipates because of her client's evident nervousness. She comes up with $36,000 in vacancy and loss collections, allowing for the cost of two units becoming vacant, even though the building is currently fully occupied.

  3. Subtract the V&C from the PGI. The remaining income is called the Effective Gross Income (EGI), and in this case, is estimated to be 360,000 - 36,000 = $324,000.

  4. Estimate all operating expenses (OE); including fixed expenses, which do not change with occupancy levels, variable expenses, which change with occupancy rates, and reserves for replacement (R), which must be put aside annually to replace those items that wear and need to be replaced. Here Rashida already knows that the current operating expenses are $122,000. She then allows for another $5,000 for higher than anticipated fixed expenses.

  5. Subtract all three types of operating expenses from the effective gross income to come up with the Net Operating Income (NOI).
    EGI - OE = NOI
    So, 324,000 - (122,000 + 5,000) = $197,000

  6. Rashida chooses a capitalization rate that is enough to provide Alan with a sufficient return on his investment over the ownership period. She determines the rate by comparing sales of comparable properties in the same market area, and finds it to be approximately 10%.

  7. She then estimated the value of the property by dividing the NOI by the overall capitalization rate.
    Net operating income / capitalization rate = Value
    $196,000 / 0.10 = $1,960,000
    Alan should have a sufficient return on his investment if he pays the estimated value or less.

The IRV Formula

Another way Rashida can derive capitalization rates is to use the IRV formula - a simple formula that uses the estimated value of property and the estimated net operating income requested from an investment.

  • I = net operating income
  • R = rate of capitalization
  • V = estimated value

If any two of the three values are known, the unknown value is easily calculated:

I = R * V
V = I / R
R = I / V

Another method of calculation is using a gross multiplier. This method uses the gross rentals of a property rather than the net operating income. But because of the Alan's preferred conservative approach, using the net operating income is the more favorable method.

Other Important Terms

Band of investment is an appraisal method used for determining the amount an investor would have to pay for a property so that it equals its operating income. It is calculated by multiplying the operating income by an approximate capitalization rate, which can only be estimated. In Alan's case, the estimated capitalization rate falls within the acceptable rate for the property he would like to purchase.

Market extraction is an appraisal process that attempts to predict functional and external obsolescence. It is not always easily predicted due to a number of outside factors. In Alan's case, where a neighborhood is continuing to grow, and the buildings are relatively new, it is unlikely that there will be functional or external obsolescence occurring in the predictable future.

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