Capitalization Rate Development

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Capitalization Rate Development

• Income Streams, Rates and Factors for Direct
  Capitalization

Wayne Foss, MBA, MAI, CRE, Fullerton, CA USA
Email waynefoss_at_usa.net
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Terms and Definitions
Income Rate The ratio of one years income
to the value of the property. Examples are RO, RE
and RM
Discount Rate An interest rate used to
convert future payments or receipts into present
value. Examples are IRR and YO
Yield Rate A rate of return on capital for
a specific time period. Usually expressed as a
compound annual percentage rate.
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Terms and Definitions
Interest Rates Effective Interest Rate
(i) interest per dollar per period the nominal
annual interest rate divided by the number of
conversion periods per year. Nominal
Interest Rate (I) A stated or contract rate an
interest rate, usually annual
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Direct Capitalization

• A Method used to convert an estimate of a single
  years income expectancy into an indication of
  value.
• A capitalization technique that employs
  capitalization rates and multipliers extracted
  from sales

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Basic Formulas

• I R x V

R I / V
V I / R

• V I x F

I V / F
F V / I
Where I Income R Capitalization Rate V
Value F Factor
I
R
V
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Income Streams

• Potential Gross Income
• Effective Gross Income
• Net Operating Income
• Equity Income
• Mortgage Income
• Land Income
• Building Income
• Income to the Landlords leased fee interest
• Income to the tenants leasehold interest

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Income Capitalization Rates

• Overall (property) capitalization rate, fee
  simple (RO)
• Mortgage Capitalization Rate (RM)
• Equity Capitalization, or equity dividend rate
  (RE)
• Land Capitalization Rate (RL)
• Building Capitalization Rate (RB)
• Capitalization Rate for the leased fee position
  (RLF)
• Capitalization Rate for the leasehold position
  (RLH)

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Income Factors

• Potential Gross Income Multiplier (PGIM)
• Can be expressed as a monthly or annual
  multiplier
• Gross Rent Multiplier (GRM)
• Generally expressed as a monthly multiplier
• Effective Gross Income Multiplier

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Derivation of the Overall (Property)
Capitalization Rate (RO)

• From Comparable Sales
• When Net Income is known
• RO Net Operating Income / Sales Price

• When Net Operating Income is unknown but the
  Effective Gross Income Multiplier is Known
• RO Net Income Ratio / EGIM

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Overall Capitalization Rate (RO)a Weighted Rate

• Example if Net Operating Income and Sales
  Price are known,
  then Overall Capitalization Rate (RO) is
  calculated as
• Net Operating Income / Sales Price RO
• 100,000 ? 1,000,000 10.0

• RO is a weighted rate, between land and
  buildings
• Land 25 x 8.5 2.1
• Improvements 75 x 10.5 7.9
• Total 100 10.0

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Model for the Direct Capitalization Technique
Net Operating Income xxx,xxx.xx Capitalizati
on of Income Income to Property divided by
RO Overall Property Value Indicated Value per
Direct Capitalization Technique xxx,xxx.xx App
lication 100,000.00 10.0
1,000,000.00
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Rates Used in the Residual Techniques

• Building Capitalization Rate
• Interest Rate (return on investment)
• Recapture Rate (return of investment)
• Land Capitalization Rate
• Interest Rate (return on investment)
• For Assessment purposes the effective tax rate is
  added to each capitalization rate

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Components of the Building Capitalization Rate
(RB)

• Return on Investment (interest rate)
• Return of Investment (recapture rate)
• Straight Line 1 / remaining economic life
• I.e. 1 20 5.0
• Can be calculated with other recapture
  assumptions
• For assessment purposes add the effective tax
  rate
• Calculated as the nominal tax rate times the
  assessment ratio
• I.e. Assessment Ratio 50.0, nominal tax rate
  4.0
• Effective tax rate 50 x 4.0 2.0
• RB Int. Rate Recap. Rate or
• RB Int. Rate Recap. Rate Eff. Tax Rate

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Components of the Land Capitalization Rate (RL)

• Return on Investment (interest rate)
• For assessment purposes add the effective tax
  rate
• Calculated as the nominal tax rate times the
  assessment ratio
• I.e. Assessment Ratio 50.0, nominal tax rate
  4.0
• Effective tax rate 50 x 4.0 2.0
• RL Int Rate or
• RL Int Rate Eff Tax Rate

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Development of Capitalization Rates
Interest Rate or Discount Rate
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Development of Capitalization Rates
Land Capitalization Rate (RL) and Building
Capitalization Rate (RB)
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Development of Capitalization Rates
Equity Capitalization Rate (RE)
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Development of Capitalization Rates
Mortgage Capitalization Rate (RM) By
definition, the Mortgage Capitalization Rate is
the relationship between annual debt service and
the balance of the loan. At the beginning of
the loan term, the Mortgage Capitalization Rate
is equal to the annual mortgage constant.
For Example Loan 650,000.00 Term 30
years Interest Rate 7.0 Amortization Type
Monthly Amortization Factor
.006653 Annual Payment 51,893.40 RM
51,893.40 650,000.00 7.98
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Development of Capitalization Rates
Leased Fee Capitalization Rate (RLF)
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Development of Capitalization Rates
Leasehold Capitalization Rate (RLH)
If Net Operating Income is Equal to or Greater
Than Market Net Operating Income, there is no
value to the leasehold position.
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The Residual Techniques
The Building Residual Technique What is Known
1. Net Operating Income 2. Land
Value What is Unknown Improvement Value
The Land Residual Technique What is Known
1. Net Operating Income 2. Depreciated
Value of the Improvements What is Unknown Land
Value
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Model for the Building Residual Technique
Net Operating Income xxx,xxx.xx Less Income
Available to the Land Land Value times RL
- xx,xxx.xx Income Available to
the Improvements xxx,xxx.xx Capitalization
of Income Income to Improvements divided by
RB Building Value Plus Land Value
xxx,xxx.xx Indicated Value per Building Residual
Technique xxx,xxx.xx
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Example for the Building Residual Technique
Net Operating Income 100,000.00 Less Income
Available to the Land 250,000.00 x 8.5
- 21,250.00 Income Available to
the Improvements 78,750.00 Capitalization
of Income 78,750.00 10.5
750,000.00 Plus Land Value
250,000.00 Indicated Value per Building Residual
Technique 1,000,000.00
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Model for the Land Residual Technique
Net Operating Income xxx,xxx.xx Less Income
Available to the Improvements Improvements
Value times RB - xx,xxx.xx Income
Available to the Land xxx,xxx.xx Capitaliza
tion of Income Income to Land divided by RL
Land Value Plus Improvements Value
xxx,xxx.xx Indicated Value per Land Residual
Technique xxx,xxx.xx
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Example for the Land Residual Technique
Net Operating Income 100,000.00 Less Income
Available to the Improvements 750,000.00
x 10.5 - 78,750.00 Income
Available to the Land 21,250.00 Capitaliz
ation of Income 21,250.00 8.5
250,000.00 Plus Improvements Value
750,000.00 Indicated Value per Land Residual
Technique 1,000,000.00
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So Thats Capitalization Rate Development
Are there any Questions?
Wayne Foss, MBA, MAI, CRE, Fullerton, CA USA
Email waynefoss_at_usa.net