10/10(new)

Direct Capitalization & Cap Rates

Income Approach

  • often called “income capitalization”

    • capitalize: the process of converting future income into a present value

  • Real estate development (ground-up construction) has slightly different considerations

  • How much income does the subject generate

buyers perspective

  • Will the subject supply the magnitude of income I need, at the time I need it, with the appropriate risk?

underlying assumptions

  • The value of a real estate can be estimated from the present value of its future anticipated income

two methods

  • Direct capitalization - is a real estate valuation method that estimates a propertys market value by dividing a single year's net operating income (NOI) by a market-derived capitalization rate (cap rate)

    • Property value = net operating income/ capitalization rate

  • discounted cash flows (DCF)- is a valuation method that estimates the value of an investment today based on its projected future cash flows

    • present value= cash flow/ (1+discount rate)^time

  • how do DCF and Direct Cap Differ?

    • both models require a calculation of the Net Operating Income (NOI) which is the “cash flow” to the owner?

    • direct capitalization requires:

      • first year (NOI)

      • selection of an applicable cap rate

    • DCF valuation requires:

      • estimate of holding period

      • estimates of annual CF (NOI) over the holding period

      • estimate of the reversion (expected sale of the property)

      • selection of discount rate (based on OCC or IRR)

  • Potential Gross Income (PGI)

    • rental income assuming 100% occupancy

    • sometimes referred to as potential gross revenue (PGR)

  • vacancy and collection loss

    • we must transition our income forecast from “potential” to “effective”

    • one difference is the amount of income effectively reaalization

    • vacancy and collection (VC) loss is based on:

      • historical experience of subject property

      • competing properties in the market

      • “natural vacancy” rate: vacancy rate that is expected in a stable or equilibruim marker

  • other income

    • income other than rents

    • does not include expense reimbursements ( we treat those separately)

    • other/ misc. income

      • garage rentals and parking fees

      • laundry and vending machines

      • clubhouse rentals

  • operating expenses (OPEX)

    • ordinary, recuring expenditures necessary to keep a property functioning competitvely. required to generate EGI

      • fixed: DOES NOT vary with occupancy ( at least in the short-run)

        • insurance

        • real estate tax

      • variable: DOES vary with occupancy

        • CAM (common area maintenance)

        • management

        • utilities

        • janitorial

      • DOES NOT include:

        • mortgage payments

        • tax depreciation

        • capital expenditures

  • capital expenditures (CAPEX)

    • non-recurring expenditues that increase value of structure and prolong its useful life:

      • roof replacement

      • additions

      • HVAC replacement

      • resuracing of parking area

    • capital (rather than expense payments) are being put into the property

    • for our purposes, we are primarily focused on the “bottom" line” (NOI/net cash flows)

    • however, there are tax motivations for classifying expenditures as operating expenses vs. capital expenditures

  • different treatments of CapEX