Welcome to

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Welcome to

• Integra Realty Resources
• One Company - Infinite Solutions

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Edward K. Wadsworth, MAI, CREDavid L. Cary,
MAIINTEGRA REALTY RESOURCESBoston

INCOME CAPITALIZATION PRIMER
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Why Use the Income Approach?

• Earning power is the critical element affecting
  value for investment property
• Best used when valuing Leased Fee estates, or
  when valuing Fee Simple estate for comparative
  purposes.
• Best reflects buyer and seller pricing decisions
  for investment property.

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What is Fair Cash Value according to the ATB?

• Fair cash value means the same as fair market
  value expressed as the price which someone will
  pay for it on the open market.1
• Fair cash value means the price that an owner
  willing but not compelled to sell ought to
  receive from one willing but not compelled to
  buy.2
• Fair cash value means the same as fair market
  value expressed as the price which someone will
  pay for it on the open market.3
• 1Donovan v. City of Haverhill, 247 Mass. 69 at
  71
• 2Assessors of Quincy v. Boston Consolidated Gas
  Company, 309 Mass. 60
• 3Massachusetts Supreme Court Decision, Epstein
  v. Boston Housing
• Authority, 317 Mass. 279 at 299

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Income Approach to ValueCritical Elements
Vacancy
Market Rents
Risk
Interest Rates
Expenses
Leases
Gross Income
Cap Rate
Net Income
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Steps to Follow

• Examine Economic Profile of Property
• Estimate Gross Potential Income
• Estimate an allowance for vacancy and credit loss
• Estimate operating expenses
• Calculate net operating income before real estate
  tax (NIBT)
• Estimate a capitalization rate
• Divide NIBT by Cap Rate to estimate value
• Overall Rate (Ro) plus Effective Tax Rate (ETR)
  expressed as NIBT/(Ro ETR)
• Adjust for capital improvements needed and/or
  stabilization costs.

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CASE STUDY Office Building

• Objective is to estimate market value of leased
  fee estate and fee simple estate
• Multi-tenant office building
• Built in 1978
• Building size is 19,436 square feet
• 5,000 s.f. vacant (6-mths to lease)
• 10/s.f. TI allowance for new tenant
• Good Suburban Location

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Economic Profile of Property
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Market Rent Estimate
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Gross Potential Income
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Stabilized Net Income Statement Before RE Taxes
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CAPITALIZATION

• Capitalization is the process of converting
  income into value
• One of the main forms of capitalization is Direct
  Capitalization
• Direct Capitalization is the process of
  estimating current value by dividing a single
  years income by a capitalization rate
• Capitalization rate as a basis for taxation
  combines an investment rate with the effective
  tax rate

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How are Investment Cap. Rates Estimated?

• Capitalization rates are derived from comparable
  sales, investor surveys, or estimated using
  financial formulas
• For most property types, capitalization rates are
  applied to income that has been adjusted for
  vacancy and collection loss, management fees and
  a reserve allowance to cover future capital
  improvements.

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Extraction of Capitalization Rate from Sale
Comparable
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Extraction of Equity Return (Dividend Rate) from
Sale Comparable (RE)
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Mortgage Equity Formula Investment Rate

• Combines the requirements of a current mortgage
  typical for the subject class of property,
  together with the equity return requirements of
  an investor.
• Based on 75 LTV, 6.00 Interest, 25 Year
  amortization and 5 cash on cash return, the
  following capitalization rate is indicated.
• Cap Rate (LTV x RM ) ( Equity x RE)
• Cap Rate (75 x 7.73) (25 x 5)
• Cap Rate 7.1
• (Next)

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Or
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Debt Coverage Ratio Formula

• Capitalization rate may be derived using typical
  financing criteria available in the marketplace.
• These criteria include typical debt coverage
  ratio, mortgage constant and LTV ratio required
  by lenders
• Cap. Rate DCR x LTV x RM
• Cap Rate 1.20 x 75 x 7.73
• Cap Rate 7.0
• The ratio of net operating income to the amount
  required for debt service (principal interest)

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Capitalization Rate Surveys
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Range of Investment Capitalization Rates

• Extraction from Comparable Sale 8.1
• Band of Investment Method 7.1
• Debt Coverage Ratio Method 7.0
• Cap. Rate Surveys
  7.0

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FACTORS THAT IMPACT CAP RATES

• Quality of Tenancy
• Duration of Leases
• Terms of Lease
• Market Conditions

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EFFECTIVE TAX RATE

• Tax Rate per 1,000 of assessed value 1,000
• Assume CIP Tax Rate 15.00/1,000 of assessed
  value
• Then 15.00/1,000 1.5

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Capitalization of Income

• Stabilization Costs
• 1.50/s.f. Leasing Fee
• 3 months to lease 5K s.f.
• 10/s.f. TI Allowance

• Capitalization

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Reconciliation

• Income approach is most applicable for income
  producing properties.
• Income approach may not provide a good estimate
  of value for properties suitable for owner-users.
• There may be a large disparity between the
  results of the income approach and sales approach
  for owner-user properties under current market
  conditions.

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Case Study Two - Apartment

• 4-story, elevator apartment building
• 63 units
• Built in 1930
• 95 rented
• Proposed is refurbishing of 34 units costing
  225,000
• Current Scheduled Income is 556,400.

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Economic Status of Property
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Competitive Rent Survey
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Analysis of Competitive Rents
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Market Rent Estimate

• Market Rent for One-bedroom units are estimated
  to average 1,000 or 1.56/s.f.
• Market Rent for studios are estimated to average
  700 or 1.94 per square foot.
• Total potential market rent is calculated below

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Stabilized Income Statement
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Comparative Analysis of Expenses
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Extraction of Investment Cap. Rates From Sales
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Range of Investment Cap. Rates

• Extraction From Comparable Sales 5.6
• Band of Investment method
• (75 LVR, 30yr loan w/monthly pmts., 6
  interest rate, RE)
• (.75 x .0719) (.25 x .06) 6.9
• Debt Coverage Ratio
• LVR x DCR x RM .75 x 1.2 x .0719 6.5
• Investor Surveys 6 (see next page)

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Investor Surveys
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Effective Tax Rate

• 15.00/1,000 AV 15 / 1,000 1.5
• Capitalization Rate of Tax Purposes
• 6 1.5 7.5

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Stabilization Costs

• Proposed for construction of 34 units costing
  225,000
• Six months to complete construction and to
  achieve stabilization of income.
• The income lag represents 50 (6 months) of Gross
  Rent for 34 units.
• Leasing Fees are based on one months rent for 34
  units.
• Profit incentive is estimated to be 150,000.
• Less Hard Costs for Improvement Costs
  225,000
• Less 6-months Income Lag 169,028
• Less Leasing Fees for 34 units 28,500
• Less Profit Incentive 150,000
• Total Stabilization Costs 572,528

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Capitalization of Income
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Integra Realty Resources Boston
Edward K. Wadsworth, MAI, CRE David L. Cary, MAI