Direct Capitalization Proper Development in the Income Approach

Direct Capitalization: Proper Development in the Income Approach to Valuation Kenneth L. Joyner, RES, AAS

Presentation Goals ü ü What is the Direct Capitalization Method When the Direct Capitalization Method would be the most reliable method of valuing income producing properties A Basic Understanding of the 3 Components of the Direct Capitalization Method How Market Value is Computed When Valuing Property Using the Direct Capitalization Method

Direct Capitalization Defined ü A method used to convert an estimate of a single year’s income expectancy into an indication of value in one direct step (i. ) i. The Dictionary of Real Estate Appraisal, Fourth Edition, Appraisal Institute

Direct Capitalization ü When to use Direct Capitalization ü It is most reliable when you have comparable sales with income stream with the same characteristics of risk, timing, stability, financing, and income projections as your subject

Basic Components of the Direct Capitalization Method Net Operating Income ü Capitalization Rate ü Market Value ü ü Formula Ø Net Operating Income / Capitalization Rate =Market Value

Income Estimation ü Net Operating Income ü How Do We Get There ü Reconstruct the Income Statement ü Go ü ü ü to the Market (Looking for the TYPICAL) Market Rent Market Vacancy/Collection Levels Market Expense Levels (Average One Year Expense Level)

Income(s) Estimation ü Different Levels of Income ü ü ü Potential Gross Income=(Market Rent X Total Leaseable Area) Effective Gross Income=PGI-Vacancy & Collection Loss + Miscellaneous Income Net Operating Income=EGI-Operating Expenses & Replacement Reserves

Steps to Income Estimation 1. Potential Gross Income - Vacancy and Collection Loss + Miscellaneous Income Effective Gross Income - Operating Expenses Net Operating Income

Basic Components of the Direct Capitalization Method Net Operating Income ü Capitalization Rate ü Market Value ü ü Formula Ø Net Operating Income / Capitalization Rate =Market Value

Capitalization Rate Definition ü Ø Ø Any rate used to convert an estimate of income to an estimate of market value (ii. ) Reflects the ratio of income to value Ø Example n A 10% cap rate means that net operating income is equal to 10% of the market value of the property ii. Property Appraisal and Assessment Administration, IAAO, 1997.

Capitalization Rates ü The capitalization rate (this typical relationship between income and value) is based on market information/data Includes typical buyer/seller expectations and requirements from the market Ø When computing for ad valorem purposes it should include a component for property taxes (effective tax rate) Ø

Capitalization Rates ü Effective Tax Rate Ø In North Carolina since the level of assessment is 100% of market value, effective tax rate and the approved tax rates in each jurisdiction are the SAME Ø Included as a part of the capitalization rate only when determining value for ad valorem purposes

Capitalization Rates ü Effective Tax Rate (Cont. ) To deduct the property taxes paid as an expense in determining the NOI would presuppose correctness in the value that the bill is based on Ø We include the ETR as a part of the overall capitalization rate to avoid bias in the final estimate of value for property taxes Ø

Basic Components of the Direct Capitalization Method Net Operating Income ü Capitalization Rate ü Market Value ü ü Formula Ø Net Operating Income / Capitalization Rate =Market Value

Definition of Market Value ü The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress (iii. ) iii. The Dictionary of Real Estate Appraisal, Fourth Edition, Appraisal Institute

Definition of Market Value ü NCGS 105 -283 defines market value as “the price estimated in terms of money at which the property would change hands between a willing and financially able buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of all the uses to which the property is adapted and for which it is capable of being used”

Basic Components of the Direct Capitalization Method Net Operating Income ü Capitalization Rate ü Market Value ü ü Formula Ø Net Operating Income / Capitalization Rate =Market Value

Computing Value ü How to apply Ø Formula v NOI/Cap ü Rate=Market Value Ex. $100, 000/. 1=$1, 000

Computing Value

Computing Value ü (cont. )

Presentation Goals ü ü What is the Direct Capitalization Method When the Direct Capitalization Method would be the most reliable method of valuing income producing properties A Basic Understanding of the 3 Components of the Direct Capitalization Method How Market Value is Computed When Valuing Property Using the Direct Capitalization Method