Real Estate Appraisal: Income Approach and Site Valuation

Capitalization Rate

  • The capitalization rate is the rate of return an investor (a potential purchaser) desires to receive on the money invested in a property (the purchase price).

  • It's a crucial component in valuing income-producing properties.

  • Formula: The investor can determine how much they can pay for a property by dividing the net operating income by the desired rate of return.

    • Purchase Price=Net Operating IncomeDesired Rate of Return\text{Purchase Price} = \frac{\text{Net Operating Income}}{\text{Desired Rate of Return}}

  • Example:

    • Annual Net Operating Income: $160,000\$160,000

    • Investor's Desired Return: 9.5%9.5\%

    • Value=$160,0000.095=$1,684,211\text{Value} = \frac{\$160,000}{0.095} = \$1,684,211

    • This means the investor can pay up to $1,684,211\$1,684,211 for a property earning $160,000\$160,000 in Net Operating Income and still achieve their desired yield of 9.5%9.5\%.

Recapture

  • A capitalization rate generally considers two components:

    1. Return on Investment (Interest/Profit): This is the investor's profit on the amount of money invested in the property's purchase.

    2. Return of Investment (Recapture): This refers to the investor's ability to recoup the purchase price of the property by the end of their term of ownership.

  • Land vs. Improvements:

    • Land: The portion of the purchase price attributable to land typically does not need to be recaptured, as land is considered indestructible and its value can be recovered upon the property's sale.

    • Improvements: These are assets that will wear out (depreciate). Since the purchase price of improvements may not be fully recovered when the property is sold, most investors require a recapture provision in their capitalization rate.

  • A recapture provision anticipates future depreciation of improvements.

  • An overall rate is a capitalization rate that provides for both interest (return on investment) and recapture (return of investment).

  • Example (Ted's Apartment Building):

    • Purchase Price: $1,250,000\$1,250,000

    • Land Value: $500,000\$500,000

    • Building Value: $750,000\$750,000

    • Building's Remaining Economic Life: 3030 years

    • Ted's Desired Return on Investment: 10%10\%

    • Recapture Calculation:

      • Annual Recapture for Building: $750,00030 years=$25,000 per year\frac{\$750,000}{30 \text{ years}} = \$25,000 \text{ per year}

      • Recapture Rate as a Percentage of Purchase Price: $25,000$1,250,000=0.02 or 2%\frac{\$25,000}{\$1,250,000} = 0.02 \text{ or } 2\%

    • Overall Rate:

      • Overall Rate=Return on Investment Rate+Recapture Rate\text{Overall Rate} = \text{Return on Investment Rate} + \text{Recapture Rate}

      • Overall Rate=10%+2%=12%\text{Overall Rate} = 10\% + 2\% = 12\%

Selecting a Capitalization Rate

  • An appraiser may be provided with a capitalization rate by the buyer/investor.

  • Otherwise, the appraiser must select a rate that reflects returns generally demanded for similar properties.

  • Methods for Determining an Appropriate Capitalization Rate:

    1. Direct Comparison Method:

      • Appraiser analyzes recent sales of comparable income properties.

      • Assumes the subject property will have a capitalization rate similar to these comparables.

    2. Band of Investment Method:

      • Takes into account the prevailing mortgage interest rates for the investor's loan.

      • Also considers the required rate of return on the investor's equity investment.

    3. Summation Method:

      • Starts with the interest rate paid by a safe investment (e.g., bonds).

      • Adds figures to cover three real estate-specific factors:

        • Additional risk posed by real estate.

        • Lack of liquidity of real estate investments.

        • Management costs associated with the property.

  • Important Considerations for Capitalization Rate Selection:

    • Quality of Income: Refers to the reliability of tenants.

    • Durability of Income: Refers to how long the income can be expected to last.

    • These factors influence the risk:

      • Greater risk   ⟹  \implies Higher capitalization rate   ⟹  \implies Lower property value.

      • Smaller risk   ⟹  \implies Lower capitalization rate   ⟹  \implies Higher property value.

Capitalization Methods (Income Approach)

  • After calculating net income and selecting a capitalization rate, the final step in the income approach is capitalizing the income to estimate value.

  • Basic Capitalization Procedure:

    • Value=Net IncomeCapitalization Rate\text{Value} = \frac{\text{Net Income}}{\text{Capitalization Rate}}

  • Residual Techniques: These methods value the land and building separately, capitalizing a