State Tax Commission. Basic Income. MAAO Prerequisite Course. Published July 2014

Transcription

1 State Tax Commission Basic Income MAAO Prerequisite Course Published July 2014 All rights reserved. This material may not be published, broadcast, rewritten or redistributed in whole or part without the express written permission of the State Tax Commission 1

2 BASIC INCOME APPROACH The State Tax Commission gratefully acknowledges the assistance provided by the following reference sources: The Appraisal of Real Estate, 14th edition, published by the Appraisal Institute, 2013 Capitalization Theory and Techniques, 2nd edition, published by the Appraisal Institute and Charles B. Akerson, 2000 Property Assessment Valuation, 2nd edition, published by the International Association of Assessing Officers, 1996 All definitions in text from: The Dictionary of Real Estate Appraisal, 5th edition, published by the Appraisal Institute,

3 Table of Contents Chapter 1: Introduction to the Income Approach... 4 Chapter 2: Economic Principles Underlying the Income Approach Chapter 3: Real Estate Finance Basics Chapter 4: Types of Mortgages Chapter 5: Sources of Real Estate Capital Chapter 6: Compound Interest Tables Chapter 7: Leases: Types and Terminology Chapter 8: Potential Gross Income Chapter 9: Vacancy and Collection Loss Chapter 10: Miscellaneous Income & Effective Gross Income Chapter 11: Operating Expense Analysis Chapter 12: Net Operating Income, Debt Service and Equity Dividend Chapter 13: The Capitalization Process Chapter 14: Deriving Capitalization Rates Chapter 15: Residual Capitalization Techniques Chapter 16: Income Streams and Selection of Capitalization Methods Chapter 17: Putting it all Together

4 Chapter 1: Introduction to the Income Approach The income approach is based upon the premise that there is a definite relationship between the amount of income a property will earn and its value. When buying income producing properties, the expectation of monetary gain is the primary motivation of the typical purchaser. The income approach to value is the process that measures and estimates the extent to which these future benefits might reasonably be expected, and then translates these benefits into a lump sum value. income capitalization approach - A set of procedures through which an appraiser derives a value indication for an income-producing property by converting its anticipated benefits (cash flows and reversion) into property value. This conversion can be accomplished in two ways. One year s income expectancy can be capitalized at a market-derived capitalization rate or at a capitalization rate that reflects a specified income pattern, return on investment, and change in the value of the investment. Alternatively, the annual cash flows for the holding period and the reversion can be discounted at a specified yield rate. Procedurally, this process consists of estimating either the annual net or gross income the subject is capable of producing, deducting the amount of necessary annual expenses, selecting a capitalization technique and rate, and finally capitalizing the net income into value by the use of the appropriate technique. The process of converting the anticipated benefits (cash flows and reversion) into property value is termed capitalization. Direct capitalization is based on a single year s income expectancy that is converted into value in one step. In yield capitalization, the cash flows for the holding period and the reversion can be discounted separately at a specified yield rate or modeled to reflect the anticipated income pattern in order to derive an indication of market value. This course will focus on direct capitalization methods. direct capitalization - A method used to convert an estimate of a single year s income expectancy into an indication of value in one direct step, either by dividing the net income estimate by an appropriate capitalization rate or by multiplying the income estimate by an appropriate factor. Direct capitalization employs capitalization rates and multipliers extracted or developed from market data. Only a single year s income is used. Yield and value changes are implied but not identified. yield capitalization - A method used to convert future benefits into present value by 1) discounting each future benefit at an appropriate yield rate, or 2) developing an overall rate that explicitly reflects the investment s income pattern, holding period, value change, and yield rate. 4

5 As stated in the definition, the income approach is a valuation method in which the anticipated future benefits are discounted to a present value estimate through the capitalization process. We can dissect this definition into four distinct areas: Anticipated future benefits: An investor in income producing properties is trading a sum of present dollars (purchase price) for the right to receive a sum of future dollars during the ownership period. These future benefits may include annual cash flows from the operation of the property, appreciation in value over the holding period and potential income tax advantages. Discounting: The conversion of future benefits to a present value using a specified rate is called discounting. Because a dollar today is worth more than a dollar received in the future, these future dollars are discounted to the present. We will discuss these discounting concepts in more detail later in this course. Present worth: The current value in money of the right to collect future payments. The present worth is simply the discounted value of future payments. Capitalization: The process which converts an income stream into an indication of value. We will discuss capitalization theory in more detail later in this course. Income-producing properties are generally purchased for the income they will produce; the greater the earning power, the higher the value. The income approach is grounded in the premise that the income generated by a property has a direct correlation to the property's value. Direct Capitalization Methods The basic formula for calculating property value is sometimes called the IRV formula because it uses I = Income, R = Rate, and V = Value. The Income is the income that is generated by the property. The Rate is the capitalization rate. The Value represents the property value. 5

6 Capitalization Rate Method There are methods to determine I Income and R rates to arrive at V value. As you will see later in the course, the I Income can represent income to the property (NOI), income to the land (I L ), income to the building (I B ), and even income to the mortgage (I M ), and equity (I E ), positions. capitalization rate (R) - Any rate used to convert income into value The formula is displayed below: In the IRV formula, Income divided by Rate equals Value (I / R = V). If the unknown factor is covered, the relative position of the two remaining factors reveals the proper relationship. 6

7 Example 1-1 A property has a net operating income of $270,000 and the property overall capitalization rate is 10.20%. What is the indicated value? Income / Rate = Value or $270,000 /.1020 = $2,647,059. Income $270,000 Rate.1020 Value $2,647,059 Example 1-2 A property has a value of $1,000,000 and net operating income of $105,000. What is the overall capitalization rate? Income / Value = Rate or $105,000 / $1,000,000 = Income $105,000 Rate.1050 Value $1,000,000 7

8 Example 1-3 A property has a value of $475,000 and the overall rate is 9.50%. What is the net operating income? Rate x Value = Income or.095 x $475,000 = $45,125. Income $45,125 Rate.0950 Value $475,000 Multiplier Method A factor or multiplier may be used to convert income into value. multiplier -A figure that is multiplied by income to produce an estimate of value; called a gross income multiplier when gross income is used, a gross rent multiplier when gross rent is used, and a net income multiplier when net income is used; may be monthly or annual. When a factor is used instead of a rate to compute value, the following formula is used Value = Income x Factor or V = I x F. In the VIF formula, if the unknown factor is covered, the relative position of the two remaining factors reveals the proper relationship. 8

9 Example 1-4 A property has potential gross income of $570,000 and the potential gross income multiplier is What is the indicated value? I x F = V or $570,000 x 4.25 = $2,422,500. Value $2,422,500 Income $570,000 Factor 4.25 Example 1-5 A property has a value of $1,000,000 and an effective gross income of $200,000. What is the effective gross income multiplier? V / I = F or $1,000,000 / $200,000 =

10 Value $1,000,000 Income $200,000 Factor 5.00 Example 1-6 A property has a value of $480,000 and the net operating income multiplier is What is the net operating income? V / F = I or $480,000 / = $45,000. Value $480,000 Income $45,000 Factor As you can see, there are different types of income that may be used to determine value. In our examples we used potential gross income, effective gross income and net operating income. The factors applied therefore reflect potential gross income multipliers, effective gross income multipliers and net operating income multipliers. It is extremely important that the multipliers be applied in the same manner they are extracted. For example, PGI multipliers should be applied to PGI and not EGI. 10

11 Outline of Income Approach In the IRV formula, the I income typically reflects the net operating income of a property. The exhibit on the next page outlines the basic steps of income approach including the steps necessary to arrive at net operating income. Outline of the Income Approach Potential Gross Income (PGI) Less Vacancy and Collection Loss Plus Miscellaneous/ Other Income Equals Effective Gross Income (EGI) Less Operating Expenses Equals Net Operating Income (NOI) Less Annual Debt Service (ADS) Equals Cash Flow (CF) The proper income amount is then treated by the capitalization process for conversion into a value estimate. 11

12 Chapter 1 Quiz: Introduction to the Income Approach 1.) What is the term for a method used to convert an estimate of a single year s income expectancy into an indication of value in one direct step, either by dividing the net income estimate by an appropriate capitalization rate or by multiplying the income estimate by an appropriate factor? a.) capitalization rate b.) direct capitalization c.) yield capitalization d.) multiplier or factor 2.) What is the term for a figure that is multiplied by income to produce an estimate of value? a.) capitalization rate b.) direct capitalization c.) yield capitalization d.) multiplier or factor 3.) What is the term for any rate used to convert income into value? a.) capitalization rate b.) direct capitalization c.) yield capitalization d.) mortgage rate 4.) If a property has a net operating income of $150,000 and the appropriate capitalization rate is 10%, what is the value of the property? a.) $150,000 b.) $15,000 c.) $15,000,000 d.) $1,500,000 5.) If a property has potential gross annual income of $30,000 and a value of $180,000, what is the potential gross income multiplier? a.).1667 b.) 6.0 c.) $5,400,000,000 d.)

13 6.) Which of the following relationships is false? a.) I / R = V b.) I x R = V c.) V = I / R d.) R x V = I 7.) Which of the following relationships is true? a.) F x V = I b.) V x I = F c.) V / F = I d.) I x V = F 8.) If a property has a net operating income of $10,000 and a value of $160,000 what is the capitalization rate? a.) 6.25% b.) 16% c.) 625 d.) ) If a property has an effective gross income of $230,000 and an effective gross income multiplier of What is the value of the property? a.) $680,000 b.) $1,196,000 c.) $44,230 d.) $230, ) A 20 unit apartment community has annual net operating income of $36,750. The proper overall capitalization rate is 10.5%. What is the value per apartment unit? a.) $77,160 b.) $3,858 c.) $17,500 d.) $350,000 13

14 Chapter 2: Economic Principles Underlying the Income Approach The economic principles you learned in earlier courses are interrelated and interact within the marketplace. Several principles relate to the income approach with the principle of anticipation being most applicable. The principles of change and supply and demand also strongly relate to this approach. These principles plus several others will be highlighted as to their application within the framework of the income approach. Anticipation: Value is created by the expectation of benefits to be received in the future, i.e. the present worth of the right to receive future benefits. These benefits can be in the form of an income stream or amenities as anticipated by the market participants. anticipation - The perception that value is created by the expectation of benefits to be derived in the future. Anticipation is fundamental to the income approach. All income capitalization methods, techniques and procedures attempt to consider anticipated future benefits. Investors are anticipating the future income stream from property in their buying decisions. Examples include: Anticipated increases or decreases in future value, rents or expenses Expectations of future rates of return requirements and inflation Scheduled changes to contract rents Capitalizing income estimates into a value indication Relationship between contract rents and market rents Change: The law of cause and effect at work. Change is inevitable though, at times, it may be difficult to identify. The expectations of investors concerning changes in income, expense levels and property values must be considered by the appraiser. change - The result of the cause and effect relationship among the forces that influence real property value. The principle of change is related to the principle of anticipation and can affect the prediction of future benefits. Change is inevitable and may be gradual or rapid. 14

15 Examples include: Abrupt changes closing of plant or military base Price of construction materials with hurricane Oil and commodity price fluctuations Tax law revisions Changes to income (rents) and expenses (operating costs) Supply and Demand: The interaction of supply and demand (buyers and sellers; tenants and landlords) constitute the market. The related concept of competition is important for forecasting future benefits and rates of return. Both income and rates of return are determined in the market. supply and demand - In economic theory, the principle that states that the price of a commodity, good, or service varies directly, but not necessarily proportionately, with demand, and inversely, but not necessarily proportionately, with supply. In a real estate appraisal context, the principle of supply and demand states that the price of real property varies directly, but not necessarily proportionately, with demand and inversely, but not necessarily proportionately, with supply. Examples include: Increase in supply of property type (new development) Profitable hotel may face new competition Downtown retail properties compete with suburban mall Existing homes compete with new construction Balance: Value is created and sustained when the appropriate mix of land uses are developed. Value is enhanced by a reasonable balance of types and locations of income producing properties. When applied to an individual property, the principle states that the maximum market value is reached when the four agents of production (land, labor, capital and management) are in a state of equilibrium. Balance means the highest market value will be realized when the size and type of improvements are proportional to each other and as well as to the land. balance - The principle that real property value is created and sustained when contrasting, opposing or interacting elements are in a state of equilibrium. The principle of balance interrelates with other economic principles such as contribution, increasing or decreasing returns and conformity. 15

16 Examples include: Land to building ratios Amount and type of amenities with building Parking ratios Contribution: This principle states that a value of a component of property depends upon its contribution to the whole. A component does not necessarily add a dollar for dollar to its value to the entire property. contribution - The concept that the value of a particular component is measured in terms of the amount it adds to the value of the whole property or as the amount that its absence would detract from the value of the whole. With income producing properties, the value of a component can be measured by the amount it contributes to the net operating income. The principle of contribution is related to the principles of balance and increasing or decreasing returns. Examples include: Swimming pool could add, make no change, or be a detriment to value Addition of air conditioning and the impact on rent Contribution of existing use to site Interim use (temporary less than optimal use) Externalities: The principle of externalities states that factors external to a property can have positive or negative impact on its value. Because real estate is immobile, it is affected by external influences more strongly than other goods. externalities - The principle that economies outside a property have a positive effect on its value while diseconomies outside a property have a negative effect on its value. 2. In appraisal, off-site conditions that affect a property s value. Exposure to street noise or proximity to a blighted property may exemplify negative externalities, whereas proximity to attractive and well-maintained properties or easy access to mass transit may exemplify positive externalities. Examples include: Uses and conditions of neighboring properties Foreign capital/currency exchange rates National fiscal policy and tax laws Local laws and ordinances Capitalization rates 16

17 Substitution: The value of a property in the market tends to be limited by the cost of acquiring an equally desirable substitute property with a similar income stream and level of risk and assuming no unreasonable delay. substitution - The appraisal principle that states that when several similar or commensurate commodities, goods, or services are available, the one with the lowest price will attract the greatest demand and widest distribution. This is the primary principle upon which the cost and sales comparison approaches are based. Examples include: Market rents Prices of competitive properties Selection of desirable substitutes Capitalization rates 17

18 Chapter 2 Quiz: Economic Principles Underlying the Income Approach 1.) The principle that economies outside a property have a positive effect on its value while diseconomies outside a property have a negative effect on its value. a.) Anticipation b.) Change c.) Substitution d.) Externalities 2.) The perception that value is created by the expectation of benefits to be derived in the future. This is the underlying premise of the income approach. a.) Anticipation b.) Change c.) Substitution d.) Externalities 3.) The appraisal principle that states that when several similar or commensurate commodities, goods, or services are available, the one with the lowest price will attract the greatest demand and widest distribution. a.) Anticipation b.) Change c.) Substitution d.) Externalities 4.) The impact on value of an apartment property that contains a swimming pool in an area where properties with swimming pools command rents far in excess of the cost to construct pools. This concept reflects what economic principle. a.) Anticipation b.) Contribution c.) Substitution d.) Externalities 5.) Which principle indicates that the price of real property varies directly, but not necessarily proportionately, with demand and inversely, but not necessarily proportionately with supply? a.) Anticipation b.) Change c.) Substitution d.) Supply and Demand 18

19 6.) This principle is the result of the cause and effect relationship among the forces that influence real property value. a.) Anticipation b.) Change c.) Substitution d.) Contribution 7.) In a situation where landlords lower their rents to attract tenants from their competition reflects which economic principle? a.) Anticipation b.) Supply and Demand c.) Change d.) Externalities 8.) The appropriate amount of land to building ratios and parking ratios describe which principle? a.) Anticipation b.) Change c.) Balance d.) Externalities 9.) An investor s expectation of increases or decreases in future value, rents or expenses reflects which economic principle? a.) Anticipation b.) Contribution c.) Substitution d.) Externalities 10.) An increase in construction of new retail properties in a market reflects which economic principle? a.) Supply and Demand b.) Change c.) Substitution d.) Balance 19

20 Chapter 3: Real Estate Finance Basics Because of the dollar amounts of many real estate transactions, most purchasers of income producing real estate do not pay the entire purchase price with cash. Consequently, most real estate transactions are financed through a combination of cash and mortgage financing. A mortgage is a legal document which creates a security interest in the real estate for a sum of money loaned to a borrower. As a condition of this loan, the borrower conveys an interest in the real estate to guarantee satisfaction of the mortgage terms. The terms and conditions of a mortgage vary widely and can be as individual as the parties who negotiate the document. The financial strength of the borrower, general economic conditions and desires of the lender and borrower are all ingredients which come together in determining the terms of the mortgage. Mortgage Terminology We will begin with some definitions of common mortgage related terms. mortgage - A pledge of a described property interest as collateral or security for the repayment of a loan under certain terms and conditions. Remember, a mortgage is a legal document which creates a security interest in the real estate but it is not the loan document. mortgagee - A party who advances funds for a mortgage loan and in whose favor the property is mortgaged; the lender mortgagor - One who gives a mortgage as security for a loan; the borrower. interest rate - The rate of return, or yield, on debt capital. This is the annual rate for use of the borrowed money. It is the rate paid for the right to use capital. amortization - The process of retiring a debt or recovering a capital investment, typically through scheduled, systematic repayment of the principal; a program of periodic contributions to a sinking fund or debt retirement fund. See also negative amortization. 20

21 amortization schedule - A schedule of debt repayment specifying the timing and amount of payments; a program of retiring debt through the scheduled, systematic repayment of principal. On the next page is a sample amortization schedule for a $100,000 loan with a 6% interest rate and a 10 year mortgage repayment term. As you can see in the schedule, the annual payment (end of year in this example) is $13,587. This first payment can be further divided into the amount needed to pay the 6% interest on the outstanding balance (.06 x $100,000 or $6,000) with the remainder of the payment $7,587 ($13,587 -$6,000 = $7,587) used to reduce the outstanding loan balance. The outstanding balance at the end of the first year is $92,413 ($100,000 - $7,857 = $92,413). A review of each year on the schedule shows that while the amount of the payments remain constant, the amount of interest and principle repayment change. For example in the second year, the 6% interest is applied to the outstanding balance of $92,413 resulting in annual interest of $5,545. The resulting amount applied to principle reduction is $8,042 ($13,587 -$5,545 = $8,042). At the end of the tenth year the final payment covers the annual interest on the remaining balance of $769 and the remaining principal amount of $12,818 to fully extinguish the loan. AMORTIZATION SCHEDULE Fully Amortizing 6.0% Period Amount Payment Interest Principal Balance 1 $100,000 $13,587 $6,000 $7,587 $92,413 2 $92,413 $13,587 $5,545 $8,042 $84,371 3 $84,371 $13,587 $5,062 $8,525 $75,847 4 $75,847 $13,587 $4,551 $9,036 $66,811 5 $66,811 $13,587 $4,009 $9,578 $57,233 6 $57,233 $13,587 $3,434 $10,153 $47,080 7 $47,080 $13,587 $2,825 $10,762 $36,318 8 $36,318 $13,587 $2,179 $11,408 $24,910 9 $24,910 $13,587 $1,495 $12,092 $12, $12,818 $13,587 $769 $12,818 $0 partially amortizing mortgage loan - A loan that is not fully amortized at maturity; the outstanding principal must be repaid in one lump sum; often created by writing a loan for one maturity and calculating debt service payments based on a longer amortization period. See also balloon mortgage. 21

22 The following is a sample partially amortizing amortization schedule for a $100,000 loan with a 6% interest rate and a 10 year mortgage repayment term. While similar to our first example, in this instance the annual payment is only $10,000 and not the $13,587 that would be needed to bring the loan balance to zero at the end of ten years. This first payment can be further divided into the amount needed to pay the 6% interest on the outstanding balance (.06 x $100,000 or $6,000) with the remainder of the payment $4,000 ($10,000 -$6,000 = $4,000) used to reduce the outstanding loan balance. The outstanding balance at the end of the first year is $96,000 ($100,000 - $4,000 = $96,000). A review of each year on the schedule shows that while the amount of the payments remain constant the amount of interest and principle repayment change. At the end of the tenth year the final payment covers the annual interest on the balance of $3,242 and $6,758 toward the outstanding principal. The loan is not paid in full. At the end of ten years there is an outstanding balance of $47,277 still owed by the mortgagor/borrower. AMORTIZATION SCHEDULE Partially Amortizing 6.0% Period Amount Payment Interest Principal Balance 1 $100,000 $10,000 $6,000 $4,000 $96,000 2 $96,000 $10,000 $5,760 $4,240 $91,760 3 $91,760 $10,000 $5,506 $4,494 $87,266 4 $87,266 $10,000 $5,236 $4,764 $82,502 5 $82,502 $10,000 $4,950 $5,050 $77,452 6 $77,452 $10,000 $4,647 $5,353 $72,099 7 $72,099 $10,000 $4,326 $5,674 $66,425 8 $66,425 $10,000 $3,985 $6,015 $60,410 9 $60,410 $10,000 $3,625 $6,375 $54, $54,035 $10,000 $3,242 $6,758 $47,277 balloon payment - The outstanding balance due at the maturity of a balloon mortgage. A balloon payment is a lump sum principal amount or a portion that remains of a mortgage loan at the end of the term or at some specified date. In the example above, the balloon payment amount is $47,

23 loan term or mortgage term - The amount of time, specified in the loan documents, between the loan closing and the date the loan is to be paid off. The loan term (or mortgage term) may differ from the amortization period. For example, a loan may be amortized over 25 years but be due in 5 years. principal - A capital sum invested; a payment that represents partial or full repayment of the capital loaned or invested, as distinguished from the payment of interest; the unrecovered capital remaining in a loan or investment. loan-to-value ratio - The ratio between a mortgage loan and the value of the property pledged as security, usually expressed as a percentage; also called loan ratio. For example a property sells for $1,000,000. The purchaser pays a $300,000 down payment and finances the remaining $700,000 with a mortgage loan. In this example the loan to value ratio is 70% ($700,000 loan / $1,000,000 value) mortgage constant - The periodic mortgage payment expressed as a proportion of the original loan amount; also called the loan constant. It may be easier to view the Mortgage Constant as the ratio of total annual debt service (principal and interest payments) to the principal amount of the mortgage loan. In our fully amortizing loan example, the mortgage constant is % ($13,587 payment / $100,000 loan amount = or %). A dynamic feature of the mortgage constant is that every loan with a 6% interest rate, annual payments and a10 year amortization will have the same exact mortgage constant of To ensure that you understand this concept, fill in the blanks in the following table for loans with a 6% interest rate, annual payments and a10 year amortization. Loan Amount Annual Payment Mortgage Constant $100,000 $13, $500 $67.94 $250, $679, The frequency or the interval over which mortgage payments are scheduled for payment can be monthly, quarterly, semiannual, or annually and the frequency of payment impacts the mortgage constant. 23

24 For example, we know that a loan with a 6% interest rate, annual payments and 10 year amortization has a mortgage constant of However, a loan with a 6% interest rate, monthly payments and 10 year amortization has a mortgage constant of As a check, the monthly payments to amortize a $100,000 loan are $1, Multiplying the monthly payment by the 12 months in a year results in an annual payment of $13,322. Dividing the annual debt service payments of $13,322 by the loan amount of $100,000 results in a mortgage constant of The slightly lower mortgage constant is logical because each monthly payment is paying down some of the principal thus reducing the amount subject interest. Other things being equal, the more frequent the payments, the lower that mortgage constant. debt coverage ratio (DCR) - The ratio of net operating income to annual debt service (DCR = NOI/IM), which measures the relative ability of a property to meet its debt service out of net operating income; also called debt service coverage ratio (DSCR). A larger DCR indicates a greater ability for a property to withstand a downturn in revenue, providing an improved safety margin for a lender. The purpose of the Debt Coverage Ratio or the ratio of net operating income to annual debt service is to give the lender a cushion to ensure the property can generate enough net operating income to be able to support its debt service (mortgage payments). For this reason, debt coverage ratios will always be greater than 1.0. For example, in our fully amortizing loan example the mortgage payment (debt service) for our $100,000 loan with a 6% interest rate, annual payments, and 10 year repayment term was $13,587. As the lender, we would want to ensure that this property generates at least $13,587 in net operating income (NOI) to repay the debt (loan). If our property generated NOI of $19,022 what would be the indicated debt coverage ratio. Net Operating Income (NOI) $19,022 = 1.40 Mortgage Debt Service (DS) $13,587 In this example the property generates NOI 1.40 times that needed to support the mortgage payments. Later in this course we will learn a method that uses this debt coverage ratio concept to derive an overall capitalization rate. 24

25 Chapter 3 Quiz: Real Estate Finance Basics 1.) The ratio of net operating income to annual debt service, which measures the relative ability of a property to meet its debt service out of net operating income is called? a.) b.) c.) d.) Loan to value ratio Debt coverage ratio Amortization schedule Balloon payment 2.) A party who advances funds for a mortgage loan and in whose favor the property is mortgaged; the lender is called? a.) b.) c.) d.) Mortgage Mortgagee Interest Rate Mortgagor 3.) What is the mortgage constant for a $200,000 loan with annual payments of $17,000? a.) b.) 8.5% c.) 11.76% d.) ) A loan that is not fully amortized at maturity with outstanding principal that must be repaid in one lump sum is called? a.) b.) c.) d.) Loan to value ratio Partially amortizing mortgage loan Fully amortization mortgage loan Balloon Payment 5.) The periodic mortgage payment expressed as a proportion of the original loan amount; also the annual debt service divided by loan amount. a.) b.) c.) d.) Mortgage constant Amortization schedule Debt coverage ratio Balloon Payment 25

26 6.) One who gives a mortgage as security for a loan; the borrower. a.) b.) c.) d.) Mortgage Mortgagee Interest Rate Mortgagor 7.) Which loan would have the highest mortgage constant? a.) b.) c.) d.) Partially amortizing loan Interest only loan Fully amortizing loan Partially amortizing loan with balloon payment 8.) A property with a loan of $2,900,000 generates net operating income of $340,000. The annual mortgage payments for this property are $272,000. What is the debt coverage ratio? a.) 9.38% b.) 80% c.) 11.72% d.) ) The outstanding balance due at the maturity of a partially amortizing loan is called? a.) b.) c.) d.) Loan residual ratio Debt coverage ratio Amortization schedule Balloon payment 10.) A property just sold for $2,000,000. The purchaser supplied a down payment of $600,000 and financed the remainder with a mortgage loan. What is the loan to value ratio for this transaction? a.) 30% b.) 70% c.) 20% d.) 80% 26

27 Chapter 4: Types of Mortgages Mortgage loans supply most of the capital involved in real estate investments. Traditional mortgages loans are made for long terms of years and carry fixed interest rates. A level payment mortgage requiring the same dollar amount payment each period for the entire loan term is the most popular. Some of the more common types of mortgages include: fixed-rate mortgage (FRM) - A conventional mortgage with an interest rate that does not vary over the life of the loan. In a fixed rate mortgage each payment includes a portion of the principal balance and interest on the unpaid balance. Payments are periodic (generally monthly) and equal. interest-only mortgage - A non amortizing loan in which the lender receives interest only during the term of the loan and recovers the principal in a lump sum at the time of maturity. In an interest only mortgage the payment is just that, the amount of interest that accrued on the unpaid balance between payment periods. adjustable-rate mortgage (ARM) or variable-rate mortgage (VRM) - A debt secured by real estate with an interest rate that may move up or down following a specified schedule or in accordance with the movements of a standard or index to which the interest rate is tied. These are mortgages where the interest rate may fluctuate. Changes in the rate are triggered by movements in some independent standard or index. Common indices to which the interest rates are tied include federal banking cost of funds, the one-year Treasury interest rates, the prime rate, or LIBOR. graduated-payment mortgage (GPM) - A debt secured by real estate in which mortgage payments are matched to projected increases in the borrower s income. The periodic payments start out low and gradually increase. A graduated-payment mortgage provides for lower debt service payments during the early years of the mortgage with regular periodic increases over the life of the loan. equity participation mortgage - A mortgage in which the lender receives a share of the income and sometimes a share of the reversion from a property on which the lender has made a loan; also called participation mortgage. 27

28 Equity participation mortgages provides for the lender to receive a portion of the net operating income and perhaps part of the proceeds from the sale of the property. Lenders may opt for this type of arrangement either as a hedge against inflation or as a means of increasing their total yield on the loan. wraparound mortgage - A mortgage that is subordinate to, but inclusive of, any existing mortgage or mortgages on a property. Usually a third-party lender refinances the property, assuming the existing mortgage and its debt service and wrapping around a new, junior mortgage. The wraparound lender gives the borrower the difference between the outstanding balance of the existing mortgage or mortgages and the face amount of the new mortgage To execute a wraparound mortgage the original loan must be assumable. A wraparound lender gives the borrower the difference between the outstanding balance on the existing mortgage and the face amount of the new mortgage. Wraparound mortgages became widespread in periods of high mortgage rates and appreciating property values, but they have generally fallen into disuse with declining mortgage rates. reverse mortgage - A type of mortgage whereby senior homeowners systematically borrow against the equity in their home, receiving regular (usually monthly) payments from the lender. Borrowed funds and accrued interest come due when the last surviving borrower dies or permanently vacates the premises. Also called a reverse-annuity mortgage or home equity conversion mortgage. Seller Financing purchase-money mortgage (PMM) - A mortgage that is given by a purchaser to a seller in lieu of cash as partial payment for the purchase of real property; if the purchaser defaults on a payment, the seller may foreclose. A PMM is an alternative to an institutional loan. Title to the property is provided at closing. The lender/seller may also attach additional collateral to the loan beyond the property being sold. land contract - A contract in which a purchaser of real estate agrees to pay a portion of the purchase price when the contract is signed and additional sums, at intervals and in amounts specified in the contract, until the total purchase price is paid and the seller delivers the deed; used primarily to protect the seller s interest in the unpaid balance because reversion to clear title can be accomplished more quickly than it could be under a mortgage; also called contract for deed or installment (sale) contract. 28

29 A seller finances the sale of a property by permitting the buyer to pay for it over a period of time, but the title is delivered only after all payments are made. In the event of default, the buyer normally forfeits all payments made and the seller may also elect to hold the buyer to the contract. 29

30 Chapter 4 Quiz: Types of Mortgages 1.) A mortgage that provides for lower debt service payments during the early years of the mortgage with regular periodic increases over the life of the loan is called? a.) b.) c.) d.) Purchase money mortgage Fixed rate mortgage Land contract Graduated payment mortgage 2.) A mortgage in which the lender receives a share of the income and sometimes a share of the reversion from a property on which the lender has made a loan is called? a.) b.) c.) d.) Reverse mortgage Fixed rate mortgage Wraparound mortgage Equity participation mortgage 3.) A seller finances the sale of a property by permitting the buyer to pay for it over ten years. After all payments are made the seller gives the buyer title to the property. What type of financing does this transaction represent? a.) b.) c.) d.) Purchase money mortgage Fixed rate mortgage Land contract Graduated mortgage 4.) A type of mortgage where each level payment includes a portion of the principal balance and interest on the unpaid balance is called? a.) b.) c.) d.) Interest only mortgage Fixed rate mortgage Land contract Graduated mortgage 5.) A type of mortgage whereby senior homeowners systematically borrow against the equity in their home, receiving regular (usually monthly) payments from the lender. Borrowed funds and accrued interest come due when the last surviving borrower dies or permanently vacates the premises is called? a.) b.) c.) d.) Reverse mortgage Fixed rate mortgage Land contract Graduated mortgage 30

31 6.) A non-amortizing loan in which the lender receives payments of interest on the outstanding balance and then recovers the principal in a lump sum at the time of maturity is called? a.) b.) c.) d.) Purchase money mortgage Fixed rate mortgage Interest only mortgage Graduated mortgage 7.) What type of loan could have an interest rate that is based on being 3% above the LIBOR rate and reset every year? a.) b.) c.) d.) Fixed rate mortgage Interest only mortgage Adjustable rate mortgage Partially amortizing mortgage with balloon payment 8.) A loan is originated for $1,000,000. The terms of the loan call for annual interest only payments at a 4% interest rate for a loan term of ten years. What are the annual interest payments and what is the amount due at the end of the loan term? a.) b.) c.) d.) $4,000 payments and $1,000,000 due at end of term $40,000 payments and $600,000 due at end of term $400,000 payments and $600,000 due at end of term $40,000 payments and $1,000,000 due at end of term 9.) A mortgage that is given by a purchaser to a seller in lieu of cash as partial payment for the purchase of real property is called? a.) b.) c.) d.) Fixed rate mortgage Purchase money mortgage Adjustable rate mortgage Partially amortizing mortgage with balloon payment 10.) A mortgage that is subordinate to, but inclusive of, any existing mortgage or mortgages on a property. Usually a third-party lender refinances the property, assuming the existing mortgage and its debt service and wrapping around a new, junior mortgage. The lender gives the borrower the difference between the outstanding balance of the existing mortgage or mortgages and the face amount of the new mortgage is called? a.) b.) c.) d.) Fixed rate mortgage Interest only mortgage Adjustable rate mortgage Wraparound mortgage 31

32 Chapter 5: Sources of Real Estate Capital Real estate requires capital for both equity and debt positions. The financial goals and motivations of both positions are quite different. The equity position is willing to assume a level of risk. The debt position is generally conservative, passive and less willing to assume risk. The difference between equity and debt investors is shown through their market actions. An equity investor is more willing to assume risk. Equity investors realize their earnings are subordinate to a project's operating expenses and debt service requirements. As we will see later in the course, equity investors earnings are termed dividends. These equity dividends, however, are just part of the total return anticipated by the investor. Investors may also expect the value of their original investment to appreciate, remain stable or decline during their holding period. The debt investor participates in bonds or mortgages, usually pursuing conservative investments in search of certain and predictable income and the repayment of their principal. This type of investor expects a priority claim on investment earnings and often looks for security in the form of a lien on the assets involved. Equity - An ownership claim on property. Property value minus total debt equals total equity value, which has a residual claim to property income subordinate to operating expenses and the claims of creditors. Therefore, equity investors assume greater risk than creditors (e.g., mortgagees). Equity investment is compensated with dividends (periodic cash flow) and uncertain but possible appreciation in the value of the investment. Equity sources of capital include: Partnerships A partnership is a common vehicle for pooling real estate equity funds where two or more persons jointly own a business and share in its profits and losses. Partnership - An association of two or more persons who carry on as co-owners of a business for profit A general partnership is an ownership arrangement in which all partners share in investment gains and losses and each is fully responsible for all liabilities. A partner has complete liability for the acts of the other partners and is responsible for the debts incurred. 32

33 A limited partnership is an ownership arrangement consisting of general and limited partners. General partners manage the business and assume full liability for partnership debt, while limited partners are passive and liable only to the extent of their own capital contributions. Syndications A syndication is a private or public partnership that pools funds for the acquisition and development of real estate projects. Private syndications are limited to small groups of investors and are relatively free from government regulation. Public syndications involve large groups of investors and generally operate in more than one state, so they are subject to Security Exchange Commission (SEC) registration regulations. Real Estate Investment Trusts (REITS) Real estate investment trusts (REIT's) pool investment funds of small investors to acquire real estate investment positions that could not be handled by these investors individually by buying shares of REIT stock. REITs tend to purchase properties in superior locations in superior markets or certain property types. Joint Ventures A joint venture is a combination of two or more entities that join to undertake a specific project. Although a joint venture often takes the form of a general or limited partnership, it differs from a partnership in that it is intended to be temporary and project-specific. Pension Funds Private and government-operated pension funds are a huge and rapidly growing source of investment capital. Usually the pension contributions are placed with a trustee who invests the money prudently. The real property holdings of a pension fund may be in the form of equity or debt investments. Life Insurance Funds Life insurance companies invest heavily in real estate as both mortgage lending (debt) and property ownership (equity). Life insurance companies usually acquire real estate positions that are long-term in nature. International Equity Funds Foreign investors supply needed equity capital to realty ventures in this country. This international investment capital comes from a variety of sources, such as foreign individuals, countries, financial institutions, and pension funds. 33

34 Sources of debt capital include commercial banks, savings and loan associations, life insurance companies, mutual savings banks, junior mortgage companies and secondary mortgage market. Debt - One of two characteristic types of capital, the other being equity. The debt investor expects a priority claim on investment earnings and looks for security in the form of a lien on the assets involved and usually the promise to repay. Debt investors may participate in bonds or mortgages and receive fixed or variable interest on the investment with repayment of the principal upon maturity. Sources of debt capital Commercial Banks Commercial Banks offer a variety of financial services to businesses and individuals. In keeping with their role as short-term lenders, commercial banks have traditionally supplied construction and development loans for commercial and industrial properties. Savings and Loan Associations Savings and loan associations (S&Ls) are financial intermediaries. They receive savings deposits, lend them at interest, and distribute dividends to depositors after paying operating expenses and establishing appropriate reserves. The failure of many S&Ls in the 1980 s has had a profound effect on real estate market and lending and appraiser regulation. Life Insurance Companies The mortgage investments of life insurance companies cover the full range of realty types such as residential, apartments, offices, shopping malls, hotels, and industrial properties. Because many companies have great financial resources, they have been important in financing larger high dollar properties such as hotels, office buildings and shopping malls. Mutual Savings Banks Mutual savings banks are owned by their members and have broader investment powers than savings and loan associations and while they concentrate on mortgages, they also invest in other types of equity investments. 34

35 Junior/Second Mortgage Originators Junior mortgages or second mortgages are used to raise additional mortgage funds. These second mortgages are used for creating additional leverage and facilitating sales of properties with first mortgages that cannot be refinanced. Junior mortgages involve greater risk than senior liens do and therefore command higher interest rates. Banks, savings and loan associations, and life insurance companies are usually precluded from making large junior mortgage loans. Other private lenders and financing companies are not supervised to the same extent and provide this secondary financing. Secondary Mortgage Market In the secondary mortgage market, mortgagees sell packages of their mortgages at prices consistent with current rates. Selling these mortgages frees up their capital permitting them to lend when they might otherwise lack funds. Securities are investment instruments that convey stock or bonds by dividing a pool of property mortgages into partnerships, corporations or trust entities. By pooling a large numbers of mortgages the risk inherent to an individual property can be mitigated. The secondary mortgage market also contains CMO s and CMBS. collateralized mortgage obligations (CMOs) - Securities issued and sold in capital markets on debt collateralized by pools of Ginnie Mae, Fannie Mae, Freddie Mac, and conventional institutional mortgages. Collateralized mortgage obligations are an important source of liquidity for the mortgage industry. commercial mortgage-backed securities (CMBS) - A bond or other investment instrument backed by loans secured with commercial rather than residential property. 35

36 Chapter 5 Quiz: Sources of Real Estate Capital 1) A loan from a commercial bank falls within this category of real estate capital? a.) b.) c.) d.) debt capital equity capital secondary market both debt capital and equity capital 2) A market where mortgagees sell packages of their mortgages thus freeing up capital so they may continue to lend when they might otherwise lack funds is called? a.) b.) c.) d.) general partnership market equity capital market secondary market commercial loan market 3) Life insurance companies deal within this category of real estate capital? a.) b.) c.) d.) debt capital equity capital secondary market both debt capital and equity capital 4) A general partnership is a form of this type of real estate capital? a.) b.) c.) d.) debt capital equity capital secondary market both debt capital and equity capital 5) This type of investor s claim to property income is subordinate to operating expenses and the claims of creditors and therefore assumes greater risk? a.) b.) c.) d.) debt investor equity investor secondary market both debt capital and equity capital 36

37 6) What type of mortgage involves greater risk than senior liens and therefore commands higher interest rates? a.) b.) c.) d.) Junior mortgage Conventional mortgage Savings and loan mortgage Guaranteed mortgage 7) This investor expects a priority claim on investment earnings and looks for security in the form of a lien on the assets involved and usually the promise to repay. They may participate in bonds or mortgages and receive fixed or variable interest on the investment with repayment of the principal upon maturity? a.) b.) debt investor equity investor 8) This type of institution offers a variety of financial services to businesses and are typically short-term lenders that supply construction and development loans? a.) b.) c.) d.) Life insurance company Commercial bank Pension fund Real estate investment trust 9) This type of equity investor pools investment funds of small investors to acquire real estate investment positions. They tend to purchase properties in superior locations or invest in certain property types? a.) b.) c.) d.) Life insurance company Real estate investment trusts Pension fund Commercial bank 10) This type of investor participates in bonds or mortgages, usually pursuing conservative investments in search of certain and predictable income and the repayment of their principal? a.) b.) debt investor equity investor 37

38 Chapter 6: Compound Interest Tables The Income Approach to value is designed to compute the present worth of future benefits. One method of determining present worth is by the use of Compound Interest Tables. These tables are summaries of various compound interest factors using different interest rates, time periods, and payment schedules. The tables can be found in textbooks (e.g., Property Assessment Valuation) or the factors can be calculated with financial calculators such as the HP-12C or within Microsoft Excel. A sample table based on 6% annual interest will be used in our examples and is presented on the next page. The Compound Interest Tables are most commonly presented in a format with 6 columns in specific order. There are various names for the functions, but they are typically arrayed as follows: Column 1: Amount of 1 Amount of 1 Future Worth of $1 at Compound Interest Future Value of $1 Future Worth of $1 (FW $1) amount of one (Sn) - The compound interest factor that indicates the amount to which $1 (or other unit of currency) will grow with compound interest at a specified rate for a specified number of periods. The amount of one is one of the six functions of one found in standard financial tables; also called future value of one. This series of factors shows the amount to which $1 will grow at a given interest rate in a given number of years. The column is constructed by adding compound interest to a onetime deposit at the beginning of the first year. 38

39 39

40 Amount of 1 Example 6-1 What is the value 5 years from now of a $1,000 deposit in your savings account if the interest rate is 6% compounded annually? Answer: Look to the 6% Annual Table, Column 1 (Amount of 1) for 5 years shows a factor of Thus, a one-time deposit made today of $1,000 will grow to $1, in five years: $1,000 x = $1, in 5 years at 6% interest when compounded annually We can also calculate the amount $1 will grow by using a financial calculator such as the HP-12C. The HP-12C keystrokes necessary to solve or example are provided below. (HP Keystrokes: 1000 CHS PV, 6 i, 5 n, FV ) display 1, The formula used to derive the Amount of 1 (compounded annually) factor is: FW $1 = (1 + i) n Where FW $1 is the Amount of 1, i is the interest rate expressed as a decimal, and n is the number of years in the compounding period. In the above example, the Amount of 1 Factor can be calculated as follows: FW $1= (1 +.06) 5 FW $1 = (1.06) x (1.06) x (1.06) x (1.06) x (1.06) FW $1 = (Try it on your calculator.) Column 2: Amount of 1 per Period Amount of 1 Per Period Future Worth of $1 Per Period w/interest Future Worth of $1 Per Period (FW $1/P) amount of one per period (Sn ) - The compound interest factor that indicates the amount to which $1 (or other unit of currency) per period will grow with compound interest at a specified rate for a specified number of periods. The amount of one per period is one of the six functions of one found in standard financial tables; also called sinking fund accumulation factor or future value of one per period. This series of factors shows the amount to which $1 deposited each year (at the end of the year) will grow at a given rate of interest in a given number of years. 40

41 Amount of 1 per Period Example 6-2 What is the value 5 years from now of a $1,000 deposit in your savings account each year (at the end of the year) if the interest rate is 6% compounded annually? Answer: Looking to the 6% Annual Table, Column 2 (Amount of 1 Per Period) for 5 years shows a factor of Thus, a deposit of $1,000 each year (at the end of the year) for 5 years will grow to $5, $1,000 x = $5, (HP Keystrokes: 1000 CHS PMT, 6 i, 5 n, FV ) display 5, The formula used to derive the Amount of 1 Per Period Factor is: FW $1/P = ( 1+ i ) n 1 i Where FW $1/P is the Amount of 1 Per Period, i is the interest rate expressed as a decimal, and n is the number of years in the compounding period. In the above example, the Amount of 1 Per Period Factor can be calculated as follows: ( ) FW $1/P = = (.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) This one is a little trickier to try on your calculator but it is simplified as: FW $1/P = or =

42 Column 3: Sinking Fund Factor Sinking-Fund Factor (SFF) Accumulation to $1 Periodic Payment to Grow to $1 sinking fund factor (1/Sn ) - The compound interest factor that indicates the amount per period that will grow, with compound interest, to $1 (or other unit of currency). The sinking fund factor is one of the six functions of one found in standard financial tables. This series of factors shows the annual deposit required to accumulate $1 at a given rate of interest in a given number of years. Sinking-Fund Factor Example 6-3 An investor wants the sum of $1,000 to be available in 5 years. The interest rate is 6% compounded annually. What amount must he deposit (at the end of the year) annually to reach the goal? Answer: Looking to the 6% Annual Table, Column 3 (Sinking-Fund Factor) for 5 years shows a factor of Thus, in order to accumulate $1,000 at the end of 5 years, a deposit at the end of each year in the amount of $ is made. $1,000 x = $ (HP Keystrokes: 1000 FV, 6 i, 5 n, PMT ) display Note: When you solve for PMT, the answer is negative indicating that it is money paid out at the end of each year. The formula used to derive the Sinking-Fund Factor is: SFF = ( 1 i ) 1 i + n Where SFF is the Sinking-Fund Factor, i is the interest rate expressed as a decimal, and n is the number of years in the compounding period. 42

43 In the example on the previous page, the Sinking-Fund Factor can be calculated as follows:. 06 SFF = ( 1.06) = = = Column 4: Present Worth of 1: Present Worth of 1 Present Value of $1 Present Worth of $1 (PW $1) Reversion Factor present value of one (1/Sn) - A compound interest factor that indicates how much $1 (or other unit of currency) due in the future is worth today. The present value of one is one of the six functions of one found in standard financial tables; also called present worth of one. This series of factors shows the present worth of a single amount of money to be collected after a given number of years at a given interest rate (the interest rate is also known as the discount rate ). Present Worth of 1 Example 6-4 What is the present value of a $1,000 received 5 years from now if the interest rate is 6% compounded annually? Answer: Looking to the 6% Annual Table, Column 4 (Present Worth of 1) for 5 years shows a factor of Thus, a one-time payment of $1,000 received 5 years from now is worth $ today. $1,000 x = $ (HP Keystrokes: 1000 FV, 6 i, 5 n, PV ) = Note: When you solve for PV, the answer is negative indicating that it is money paid out today. The formula used to derive the Present Worth of 1 (compounded annually) Factor is: 1 PW $1 = ( 1+ i )n 43

44 Where PW $1 is the Present Worth of 1, i is the interest rate expressed as a decimal, and n is the number of years in the compounding period. In the above example, the Present Worth of 1 Factor can be calculated as follows: 1 PW $1 = ( )5 = = Column 5: Present Worth of 1 per Period: Present Worth of 1 Per Period (PW $1/P) Present Value of 1 Per Period Ordinary Level Annuity present value of one per period (a n ) - A compound interest factor that indicates how much $1 (or other unit of currency) paid periodically is worth today. The present value of one per period is one of the six functions of one found in standard financial tables; also called present worth of one per period or ordinary level annuity factor. This series of factors shows the present value of the right to receive $1 deposited each year (at the end of the year) at a given rate of interest for a given number of years. Present Worth of 1 Per Period Example 6-5 What is the present value of $1,000 received each year (at the end of the year) for 5 years if the interest rate is 6% compounded annually? Answer: Looking to the 6% Annual Table, Column 5 (Present Worth of 1 Per Period) for 5 years shows a factor of Thus, an income stream of $1,000 each year (at the end of the year) for 5 years is worth $4, today. $1,000 x = $4, (HP Keystrokes: 1000 CHS PMT, 6 i, 5 n, PV ) display The formula used to derive the Present Worth of 1 Per Period Factor is: i n PW $1/P = 44 ( ) i

45 Where PW $1/P is the Present Worth of 1 Per Period, i is the interest rate expressed as a decimal, and n is the number of years in the compounding period. In the above example, the Present Worth of 1 Per Period Factor can be calculated as follows: PW $1/P = 1 1 ( 1+.06).06 5 = = PW $1/P = = Column 6: Partial Payment Factor Partial Payment Amount to Amortize $1 Installment to Amortize $1 (ITAO) Direct Reduction Loan Factors installment to amortize one - The compound interest factor that represents the installment needed to repay one unit of currency with interest at a specified rate for a specific number of periods; the reciprocal of the level annuity factor. Sometimes abbreviated ITAO; also called the partial payment factor or amortization factor. When expressed annually, it may be referred to as the mortgage constant, loan constant, annual constant, or mortgage capitalization rate. This series of factors shows the amount required to amortize principal and interest on an investment or loan at a given rate of interest in a given number of years. Partial Payment Example 6-6 An investor wants to know what to pay per year (at the end of the year) to pay off a $1,000 loan in 5 years at an interest rate of 6% compounded annually. Answer: Looking to the 6% Annual Table, Column 6 (Partial Payment) for 5 years shows a factor of Thus, in order to pay off a loan of $1,000 in 5 years at 6% interest the annual payments are $ $1,000 x = $

46 (HP Keystrokes: 1000 PV, 6 i, 5 n, PMT ) display Note: When you solve for PMT, the answer is negative indicating that it is money paid out. The formula used to derive the Partial Payment Factor or Installment to Amortize 1 is: ITAO = 1 1 ( 1+ i) n i Where ITAO is the Partial Payment Factor, i is the interest rate expressed as a decimal, and n is the number of years in the compounding period. In the above example, the Partial Payment Factor can be calculated as follows:.06 ITAO = 1 1 ( 1+.06) 5 = = = = Interrelationships Among the Tables The Reciprocal A reciprocal is defined in Merriam-Webster s Collegiate Dictionary as: either of a pair of numbers (as 2/3 and 3/2 or 9 and 1/9) whose product is one In other words, reciprocals are numbers divided into 1. For example, the reciprocal of 10 is 1/10 (10 x 1/10 = 1). A look at the compounded interest tables shows us that the functions of $1 are reciprocals. Using the 6% Annual Table for 5 Periods results in the following factors: FW of $ FW of $1 Per Period SFF PW of $ PW of $1 Per Period Partial Payment Factor If you have been paying close attention, you may have noticed that many of the numbers appear over and over again. This is because some of the factors are reciprocals of the others. 46

47 The proof is in the math presented below: The PW of $1 is the reciprocal of the FW of $1 ( x = 1.0). The Partial Payment Factor is the reciprocal of the PW of $1 Per Period ( x = 1.0). The SFF is the reciprocal of FW of $1 Per Period ( x = 1.0). Another important relationship is between the sinking fund factor and the partial payment factor. The partial payment factor considers both a return on and return of the investment. Adding the interest rate or return on of to the sinking fund factor or return of results in the partial payment factor This relationship will be revisited in the recapture provision methodologies detailed later in the course. Important Notes: All of the previous discussions and examples were based on the following two assumptions: Payments were made annually. Payments were made at the end of the year. If the payments are made at the beginning of the period, the factors identified in the tables cannot be used without modification. If you have a HP-12C calculator, the window shows nothing when the payments are made at the end of the period. To calculate the factors for payments made at the beginning of the period, touch g then BEG in blue (the number 7 key). To get it back to the end of the period, touch g and END in blue (the number 8 key). For the purpose of this course, always assume that the payments are made at the end of the period. Compounding Periods So far we have looked at annual compounding (or when the interest is calculated only once a year). This is not the only compounding method available. The following table summarizes some of the compounding options and the periods per year: 47

48 Compounding Periods Per Year Annual 1 Semi-Annual 2 Quarterly 4 Monthly 12 Daily 365 Let s take on a problem to show the differences in investment growth amounts depending on the type of compounding. We have $100 to put into a savings account and five different savings accounts (A E) choices. Each pays a nominal rate of 6% interest. However, the way they compound the interest differs. Savings Account Deposit Compounding Nominal Interest Rate A $ Annual 6.00% B $ Semi-Annual 6.00% C $ Quarterly 6.00% D $ Monthly 6.00% E $ Daily 6.00% nominal interest rate (I) - A stated or contract rate; an interest rate, usually annual, that does not necessarily correspond to the effective or compound interest rate. In which account should we invest our $100? Savings Account Deposit Compounding Nominal Interest Rate Periods Per Year Interest Rate Per Period FV Factor 1 Year Future Value A $ Annual 6.00% % $ B $ Semi-Annual 6.00% % $ C $ Quarterly 6.00% % $ D $ Monthly 6.00% % $ E $ Daily 6.00% % $ Be aware there are also Monthly Tables, Quarterly Tables, and Semi-Annual Tables. Make sure you are looking at the correct table! 48

49 Chapter 6 Quiz: Compound Interest Tables The 11% annual interest rate table is provided on the page following the quiz questions. 1.) An investor purchased a parcel of land 10 years ago for $25,000. Ignoring holding costs, how much must the investor sell the subject property for to have earned 11% on the investment over the 10-year period? This problem illustrates what compound interest factor? 2.) A landowner just sold a parcel for $84,000. He claims that his return on his original investment was 11% over a 15-year holding period. Assuming his claim is true, what did he pay for the parcel 15 years ago? This problem illustrates what compound interest factor? 3.) How much must be set aside each year to accumulate to $50,000 in 15 years at 11% interest? This problem illustrates what compound interest factor? 4.) What should an investor pay today for the right to receive $40,000 in 10 years if the rate of discount is 11% annually? This problem illustrates what compound interest factor? 5.) An investment is forecast to yield $1,500 per year for 25 years. The rate of discount is 11%. What should an investor pay for the right to receive this income stream? 49

50 This problem illustrates what compound interest factor? 6.) A $100,000 mortgage calls for interest at 11%, with full amortization in level annual payments over 23 years. What is the amount of annual debt service? This problem illustrates what compound interest factor? Bonus Question: What is the mortgage constant? 7.) A client is thinking of purchasing an improved property for $120,000. The lender will finance 75% of the purchase price, with a 25-year loan at 11% interest with annual payments. What is the anticipated annual debt service? Bonus Question 2: What is the indicated mortgage constant (RM)? 8.) A dollar today is worth the same as a dollar in the future? a.) True b.) False 9.) The present worth of $1 factor is the reciprocal of the future worth of $1 factor? a.) True b.) False 10.) You are anticipating leasing your warehouse to a local distributor. Your future tenant has offered to pay you $12,000 per year at the end of each year for 5 years. You are in desperate need of cash but don t want to sell your warehouse. A local investor has offered to buy the rights to the 5 yearly lease payments, but only if his yield is 11%. How much will the investor have to pay today to meet the required yield? 50

51 11% Annual Table Amount Sinking- Present Present Amount of 1 per fund worth worth of 1 Partial Years of 1 period factor of 1 per period payment ( i) n n S = 1+ S n n S 1 1 = i = i Sn S n 1 V n 1 = n S A n n = = n An 1 1 S 1 1 S i 1 i 51

52 Chapter 7: Leases: Types and Terminology Before determining the subject s rent and in turn its potential gross income, it is helpful to understand the different types, classifications and terminology of leases. lease - A contract in which the rights to use and occupy land or structures are transferred by the owner to another for a specified period of time in return for a specified rent. See also gross lease; modified gross lease; net lease. Leases terms fall into three categories depending upon which party has the responsibility for paying operating expenses. In a gross rent lease, the lessor (landlord) pays all operating expenses for the property. In a net lease, the lessee (tenant) pays these operating expenses. There are also leases (modified gross or net) with the lessor and the lessee sharing the responsibility for paying certain operating expenses. Leases can be classified in the following categories: gross lease - A lease in which the landlord receives stipulated rent and is obligated to pay all of the property s operating and fixed expenses; also called full-service lease. Example: Apartment leases are typically written on a gross basis. The tenant makes one payment to the landlord and the landlord pays all the operating expenses for the property (i.e. maintenance, insurance, utilities, taxes). net lease - A lease in which the landlord passes on all expenses to the tenant. Example: Industrial and retail leases are typically written on a net lease basis. The tenant makes one payment to the landlord for rent and then pays for the operating expenses (maintenance, insurance, utilities, taxes). A pure net lease is also termed triple net or NNN in many markets. For example an industrial building is leased for $4.25/SF NNN. modified gross lease - A lease in which the landlord receives stipulated rent and is obligated to pay some, but not all, of the property s operating and fixed expenses. Since assignment of expenses varies among modified gross leases, expense responsibility must always be specified. In some markets, a modified gross lease may be called a double net lease, net net lease, partial net lease, or semi-gross lease. 52

53 Example: Medical office users typically use more water and electricity than general office users. For this reason medical office space is commonly leased on a modified gross basis such as $25/per SF plus utilities. The tenant would pay the $25/SF rent plus the cost of the utilities. The landlord would remain responsible for all of the other operating expenses. Appraisers study the existing and proposed leases that apply to the subject property. The leases provide data on base rent, other income and the division of expenses. Keep in mind that different markets can use different terminology so it is important to be clear on the definitions of the lease terms. Market Rent and Contract Rent Market Rent is the rental income which a property would most probably command in the open market. Market rent is established by the current rents being paid and asked for comparable properties as of the appraisal date. market rent - The most probable rent that a property should bring in a competitive and open market reflecting all conditions and restrictions of the lease agreement, including permitted uses, use restrictions, expense obligations, term, concessions, renewal and purchase options, and tenant improvements (TIs). Contract rent is the actual rent paid for the use of the property as defined in the lease. Contract rent can be equal to, less than or greater than market rent. When contract rent is less than market rent an advantage flows to the lessee and lessee's interest or leasehold estate is benefitted. contract rent - The actual rental income specified in a lease. Effective rent is the rent net of financial concessions. For example an apartment unit that charges $900 per month but gives the 13th month free on a year lease has an effective rent of $830 per month ($900 x 12 months = $10,800 / 13 months = $830 per month) effective rent - The rental rate net of financial concessions such as periods of no rent during the lease term and above- or below-market tenant improvements (TIs). 53

54 The month of free rent in the earlier apartment example is called a concession. concession - An inducement for a tenant to lease space, most often observed in overbuilt markets. Concessions can include free rent at the front of the lease term or applied throughout the life of the lease, moving and related cost reimbursement or credit, above-standard tenant improvements, buyout of tenant s existing lease, below-standard escalation clause, naming rights for the building, and other items. Sometimes due to changes in the economy, supply and demand fluctuations may force the contract rent to exceed market rent. The amount in which the contract rent is above the market rent is called excess rent. excess rent - The amount by which contract rent exceeds market rent at the time of the appraisal; created by a lease favorable to the landlord (lessor) and may reflect unusual management, unknowledgeable parties, a lease execution in an earlier, stronger rental market, or an agreement of the parties. Due to the higher risk inherent in the receipt of excess rent, it may be calculated separately and capitalized at a higher rate in the income capitalization approach. Excess rent is the portion of contract rent that exceeds market rent at the time of the appraisal. It is usually short term in nature. Excess rent creates an advantage to the lessor and commonly occurs from a lease negotiated in a previously stronger rental market. The tenant may honor the higher rent over the lease term but will then seek to relocate or renegotiate the rental rate downward. This type of income may be calculated separately to reflect the greater risk of this portion of the income stream. Example: If market rent is $10/SF and the contract rent is $12/SF, the excess rent is the difference or $2/SF. Lease Classifications Most leases fall into one of the following lease classifications: Flat Rental Lease Variable Rental Lease Graduated Lease Revaluation Lease Percentage Lease 54

55 Flat Rental Lease A flat lease or fixed rate lease is structured so the tenant pays a fixed amount of rent throughout the term of the lease flat rental lease - A lease with a specified level of rent that continues throughout the lease term. Variable Rental Leases Are a category of leases that have periodic changes to the rent and are common in gross or modified gross leases where the landlord is responsible for paying operating expenses. The escalation clauses could call for fixed changes to the rent, fixed percentage adjustments, be tied to an economic index (eg CPI), or be the greater or lower of the two amounts. An annual increase lease simply increases the amount specified in a lease annually. Graduated Leases Graduated leases or step-up or step-down lease provide for specific changes in the amount of rent at one or more points in the lease term. Most graduated leases are the step up variety however a property with reduced tenant appeal may have a step down lease. A step down lease could consider a rent reduction after initial tenant improvements costs are recaptured. step-up or step-down lease - A lease that provides for a certain rent for an initial period, followed by an increase or decrease in rent over stated periods. Revaluation Lease Provides for periodic rent changes based on revaluation of market rent for the property based on the then prevailing market conditions. Common with long term leases with renewal options. revaluation lease - A lease that provides for periodic rent adjustments based on the market rental rate of the space. 55

56 Percentage Lease Sometimes rental income is not based on the area occupied but as a percentage of gross sales. Percentage rent is typically found in retail and restaurant leases. Percentage rent is the rental income related to the tenant's gross sales in excess of a specified amount. Typically, a minimum rent is charged before the provisions for percentage rent apply. percentage rent - Rental income received in accordance with the terms of a percentage lease; typically derived from retail store and restaurant tenants and based on a certain percentage of their gross sales. Example: A restaurant lease calls for rent equal to 6% of sales. If the sales are $1,000,000, the rent equates to $60,000 per year. overage rent - The percentage rent paid over and above the guaranteed minimum rent or base rent; calculated as a percentage of sales in excess of a specified breakpoint sales volume. See also percentage rent. Example: The lease calls for overage rent of 2% of sales in excess of $1,000,000. If sales were $1,100,000, the overage rent would be 2% of $100,000 or $2,000. breakpoint - The level of sales at which a percentage clause in a lease is activated; also referred to as sales breakpoint. In the previous example: 2% of sales in excess of $1,000,000. The $1,000,000 is the breakpoint or the amount which activates the overage rent. natural breakpoint - The level of sales at which the percentage rent equals the base rent as specified in a lease. It can be calculated by dividing base rent by the stated percent. Example: A lease calls for annual rent of $20,000 plus 2% of sales over $1,000,000. The 2% of $1,000,000 calculation of $20,000 matches the base rent. This is an example of a natural breakpoint in a lease. escalation clause A clause in an agreement that provides for the adjustment of a price or rent based on some event or index, e.g., a provision to increase rent if operating expenses increase; also called expense recovery clause or stop clause. 56

57 The escalation can be fixed such as $0.50/SF annual increases or 3% per year increases or linked to an index such as Consumer Price Index (CPI) changes over the base year of the lease. The rent can also be set to change upon an event such as a reappraisal. In such a case, rental payments can be adjusted based upon a reappraisal of the real estate under the then current market conditions. Example: A lease calls for rental payments of $10,000 per month. It also contains an escalation clause that calls for 3% annual increases. The rent in the 13th month would be $10,000 x 1.03 = $10,030 per month for each month for the next year. expense stop - A clause in a lease that limits the landlord s expense obligation, which results in the lessee paying any operating expenses above a stated level or amount. Example: A gross lease of 2,000 SF with a base year stop. What this means is that the tenant pays the expenses in future years that exceed the expenses of the property for the first year (base year). If the first year expenses are $7.00 per SF, and the second year expenses are $7.25 per SF, the tenant will pay an additional $0.25 per SF in the second year ($7.25/SF $7.00/SF = $0.25/SF). To derive the dollar amount, the $0.25 per SF is multiplied by 2,000 SF, which equals $

58 Chapter 7 Quiz: Leases: Types and Terminology 1.) An office building lease calls for the tenant to pay monthly rent of $5,000, plus all utility charges. In this case, what type of lease exists? a.) b.) c.) d.) Net lease Gross lease Modified gross or modified net lease Long-term lease 2.) The actual rental income specified in a lease is known as: a.) b.) c.) d.) Contract rent Market rent Overage rent Excess rent 3.) The rental income that a property would most probably command in the open market; indicated by the current rents paid and asked for comparable space as of the date of appraisal (based on comparable data). This is the income used in determining the fee simple value of a property: a.) b.) c.) d.) Contract rent Market rent Overage rent Excess rent 4.) The amount in which contract rent exceeds market rent at the time of the appraisal is known as: a.) b.) c.) d.) Contract rent Market rent Overage rent Excess rent 5.) The percentage rent paid over and above the guaranteed minimum rent or base rent is known as: a.) b.) c.) d.) Contract rent Market rent Overage rent Excess rent 58

59 6.) A clause in a lease that limits the landlord s expense obligation, which results in the lessee paying any operating expenses above a stated level or amount is known as: a.) b.) c.) d.) Contract rent Step up lease Overage rent Expense stop 7.) A restaurant lease calls for rent equal to 8% of sales. If the annual sales are $600,000, what is the annual rent? a.) $60,000 b.) $600,000 c.) $4,800 d.) $48,000 8.) A lease with a specified level of rent that continues throughout the lease term is known as a lease. a.) b.) c.) d.) flat contract step up percentage 9.) A graduated lease calls for 3% annual increase to the base rent at each anniversary of the lease commencement. The initial lease rate was $10,000 per month. What is the current monthly rent 28 months after lease commenced? a.) b.) c.) d.) $10,000 per month $10,300 per month $10,609 per month $10,927 per month 10.) A 10,000 SF industrial building has an annual contract rent of $5.00/SF. Market rents have dropped to $4.25/SF. Based on these changes, how much excess rent is the tenant paying annually? a.) $50,000 b.) $7,500 c.) $42,500 d.) $

60 Chapter 8: Potential Gross Income As you may recall from the introduction to this course, the income approach consists of a series of steps to determine net operating income and in turn capitalizing the NOI into value using IRV. Below is a summary outline of the income approach. Outline of the Income Approach Potential Gross Income (PGI) Less Vacancy and Collection Loss Plus Miscellaneous/ Other Income Equals Effective Gross Income (EGI) Less Operating Expenses Equals Net Operating Income (NOI) Less Annual Debt Service (ADS) Equals Cash Flow (CF) The proper income amount is then treated by the capitalization process for conversion into a value estimate. Potential Gross Income The first step in the income approach is to estimate the potential gross rental income the subject property can command. Potential gross income is the total rental income that the property can generate at 100% occupancy before deductions for vacancy loss and operating expenses. Typically, we express potential gross rental income on an annual basis. potential gross income (PGI) - The total income attributable to real property at full occupancy before vacancy and operating expenses are deducted. For assessment purposes, we are concerned with estimating the market rent for the subject property. The following is a list of potential sources to identify market rent for a property. 60

61 Sources of Market Rent Historical and current performance of the subject property Interviews with landlords, tenants, leasing agents or brokers Rent surveys performed by appraisers, planning agencies, other parties Requests for rental information mailed to property owners Published rental surveys "Apartment Guides", "Office Rental Survey." Newspaper or magazine articles Property websites, broker websites or online listing data When evaluating a lease, carefully review the following areas: Rent: Concessions: Expense Responsibilities: Lease Term/ Renewal options: From all sources including base rent, percentage rent or escalation clauses. Is there free rent, above market tenant improvements or other incentives at this property. Who pays the expenses for heat, utilities or maintaining the property? Is the lease month-to-month, short term (5 years or less) or long term (10 years or more)? Can the term be extended through renewal options? Are their purchase options or cancellation provisions within the lease? The analysis of potential gross rental income begins with examination of the rent schedule of the subject property. An inspection of existing leases and interviews with management and tenants is important to verify the accuracy of current rent schedules. A review of several past years rent history is helpful in estimating trends or patterns in the income stream. Once obtained, the rental data can be reduced to common units of measurement called units of comparison for purposes of analyses. units of comparison - The components into which a property may be divided for purposes of comparison, e.g., price per square foot, front foot, cubic foot, room, bed, seat, apartment unit. These units usually facilitate analysis even when the properties are not very comparable. 61

62 The following list contains units of comparison for some common property types. Apartments Office Buildings Retail Industrial Special Use Rent per month Rent per room Rent per SF/net leasable area/month Rent per SF Rent per office suite Rent per SF Rent per SF Rent per cubic foot Rent per door/warehouses Rent per dock/truck terminals Restaurants/dollars per seat Theaters/dollars per seat Parking garage/rent per car space Hotels/rent per room Mobile home parks/rent per pad or site Example: Units of Comparison 8-1 A 24 unit apartment project has 16 one bedroom apartments containing (4 rooms and 700 SF each) with current monthly rents of $700 and 8 two bedroom apartments (5 rooms and 850 SF each) with current monthly rents of $800. What are the rent per room and the rent per SF per month for each type of unit? 1 Bedroom $700/month $175/room per month 4 rooms 2 Bedroom $800/month /room per month 5 rooms In this example, the rent per room is the unit of comparison. 62

63 1 Bedroom $700/month /SF per month 700 SF 2 Bedroom $800/month /SF per month 850 SF In this example, the rent per SF is the unit of comparison. A 12,000 square foot strip center has two 2,000 SF bays which lease for $1,375 per month and five 1,600 SF bays which lease for $1,200 per month. What is the rent per SF for each type of unit? $1,375 x 12 mos. = $16,500 = $ /SF for the 2,000 SF units 2,000 SF $1,200 x 12 mos. = $14,400 = $ /SF for the 1,600 SF units 1,600 SF In this example the $/SF is the unit of comparison. A 25,000 SF industrial building leases for $7,500 per month or $90,000 annually. What is the rent per SF? In this example the $/SF is the unit of comparison. $90,000 = /SF 25,000 SF Rents from comparable properties provide the information necessary to estimate market rent for the subject property. The appraiser gathers information on rental properties which compete in the same market. It may be necessary to apply market based adjustments to the comparable rentals to account for differences between them and the subject property. 63

64 Developing Units of Comparison When using the square foot unit of comparison for office buildings, shopping centers and retail properties, the appraiser should use care in developing rent comparisons. Some leases refer to rentable area also known as gross leasable area (GLA), while other leases are negotiated on the basis of usable area also called net leasable area (NLA). rentable area or gross leasable area - is the actual space occupied by the tenant plus a pro rata percentage of common area. This additional area is obtained by applying the appropriate load factor. load factor - A measure of the relationship of common area to usable area and therefore the quality and efficiency of building area layout, with higher load factors indicating a higher percentage of common area to overall rentable space than lower load factors; calculated by subtracting the amount of usable area from the rentable area and then dividing the difference by the usable area: Load Factor = (Rentable Area Usable Area)/Usable Area. Also known as add-on factor. usable area or net leasable area - is the space actually occupied by the tenant. The rentable area or gross leasable area of a building includes all common areas, such as halls, restrooms, and entryways. The rentable area does not include elevators, stairwells and shafts penetrating the floors of a building. A tenant's GLA and rent includes its pro rata share of these common areas. The usable includes only the actual floor area occupied by the tenant. Another term used to describe this measurement is net leasable area (NLA). 64

65 Below is a floor plan of a one-story office building containing 4,800 SF. This exhibit demonstrates the proper method to develop rentable and usable SF units of comparison. The common areas are shaded. Eight units measure 16 x 25 containing 400 SF each and one unit measures 16 x20 containing 320 SF. Rentable or Gross Leasable Area Example: The building contains 4,800 SF of rentable area and is leased on a rentable basis of $12.00 per SF per year. Calculate the annual rental income generated by this property. Number of SF (Rentable Area): 4,800 Annual Rent per SF x $12.00 Annual Rental Income: $ 57,600 65

66 Usable or Net Leaseable Area The offices in the same building are leased to 9 separate tenants at a rate of $16.37 per usable SF per year. Calculate the annual rental income generated by this property. Number of SF (Usable Area) 3,520 SF Annual Rent per SF x $16.37/SF Annual Rental Income $57,622 With usable SF as the rental basis, only the actual area leased to the tenant is used to develop the annual rent. If the usable area rent of $16.37 per SF is multiplied by the rentable building area, the incorrect indicated potential income of $78,576 would result. This is a significant error in the value estimate if utilized in the capitalization process. Consistent methodology must be used when developing the rent per SF unit of comparison. For clarity it is necessary that all rents be expressed in terms of either rentable (gross leasable area) or usable (net leasable area). Example: Estimating Market Rent 8-2 You have the assignment to appraise a suburban office building. The purpose of the appraisal is to estimate market value of the property. The subject is a two story building containing 6,500 square feet of rentable area per floor. Current lease rates at the subject and comparables are based on rentable area. The subject rent includes janitorial services with the individual tenants paying utility charges. You have surveyed rental rates from several competitive buildings. Based on this data, what is the subject s market rent per SF? Rental Number 1 is a 12,000 SF office building in an inferior location to the subject. Current lease rates are $11.50 per SF including utilities and janitorial service. Rental Number 2 is a 14,800 SF two story office building in an inferior location. Current lease rates in this building are $10.00 per SF and include janitorial service. Tenants pay utility charges. Rental Number 3 is a 10,500 SF office building in a similar location to the subject property. This building includes neither utilities nor janitorial service in the rental rate. Current rents are $9.70 per SF. 66

67 Rental Number 4 is a 12,000 SF office building in an inferior location to the subject property. Rental rates are $9.20 per SF. The tenants pay for both utilities and janitorial service. What adjustments derived from the market are appropriate for the differences between the comparable rentals and the subject property? Major differences appear to be janitorial service, utility charges and location. Identifying Adjustment Amounts An adjustment for janitorial service can be derived by comparing properties 2 and 4. Both properties have a similar location to one another (though inferior to the subject) and both do not include utility charges in their rental rates. The difference between these properties is that rental number 2 includes janitorial service and rental number 4 does not. Otherwise the properties are nearly identical. The difference in rental rates is $.80 per SF ($ $9.20). Based on this comparison, the adjustment for janitorial service is reasonably supported at $.80 per SF. This comparison is an example of paired data analysis. paired data analysis - A quantitative technique used to identify and measure adjustments to the sale prices or rents of comparable properties; to apply this technique, sales or rental data on nearly identical properties is analyzed to isolate and estimate a single characteristic s effect on value or rent. An adjustment for utility charges can be estimated from comparing rental numbers 1 and 2. Both properties are inferior in location to the subject property. Rental 1 at $11.50 per SF includes both utility charges and janitorial service. Rental 2 at $10.00 per SF includes janitorial service but not utilities. By comparing these two properties the adjustment of $1.50 per SF ($ $10.00) can be attributed to utility charges. An adjustment for location can be estimated from comparison of rental numbers 3 and 4. Rental number 4 has an inferior location to rental number 3 and the subject property. Both properties have the tenant responsible for janitorial and utility charges. Comparing the difference between rent comparable #3 and #4 ($9.70/SF - $9.20/SF = $0.50/SF) identifies the amount of a location adjustment. The grid which follows summarizes the adjustments applied to the comparable rental properties. What is the indicated rent per SF for the subject property? 67

68 Subject Rent #1 Rent #2 Rent #3 Rent #4 Rent? $11.50/SF $10.00/SF $9.70/SF $9.20/SF Location Suburban Inferior Inferior Similar Inferior Location Adj. +$0.50/SF +$0.50/SF $0.00/SF + $0.50/SF Janitorial Yes Yes Yes No No Janitor Adj. $0.00/SF $0.00/SF +$0.80/SF +$0.80/SF Utilities No Yes No No No Utilities Adj. -$1.50/SF $0.00/SF $0.00/SF $0.00/SF Total Adj. -$1.00/SF +$0.50/SF +$0.80/SF +$1.30/SF Indicated Rent $10.50/SF $10.50/SF $10.50/SF $10.50/SF Example: Developing Potential Gross Income 8-3 Your assignment is to appraise a newer strip retail center. The center has 22,500 SF of usable area with tenant spaces ranging from 1,800 to 4,500 SF. There are 2 corner spaces with 3,600 SF each, an interior anchor space with 4,500 SF and 6 smaller tenant bays with 1,800 SF each. Your research of the local strip center market indicates rents are based on usable area and are typically on a total net rent basis with differences according to size and corner visibility. Market rents are $11.00/SF per year for smaller spaces under 2,000 SF, $10.00/SF for spaces up to 5,000 SF and $11.50/SF for corner spaces. 68

69 Develop a projected rent schedule and an estimate of potential gross income for the subject property. What is the indicated average rent per SF for the subject property? The first step is to calculate the rent per unit per year and then multiply this by the number of spaces for each unit style. The table below summarizes the data. Unit Size Rent $/SF Rent/Unit Bays Annual Income 1,800 x $11.00 = $19,800 x 6 = $118,800 4,500 x $10.00 = $45,000 x 1 = $45,000 3,600 x $11.50 = $41,400 x 2 = $82,800 Unit Size Spaces Total SF 1,800 x 6 = 10,800 4,500 x 1 = 4,500 3,600 x 2 = 7,200 22,500 The potential gross income for this property is $246,600. The average rent per SF is $246,600 / 22,500 SF = $10.96/SF Example: Estimating Market Rent 8-4 $246,600 You have been retained by a local bank to appraise a 60 unit apartment project. Your inspection of the subject property indicates there are five 12 unit apartment buildings with 8 one bedroom and 4 two bedroom apartments in each building. The one bedroom apartments contain 650 SF and the two bedroom apartments contain 780 SF. Each apartment unit contains appliances. Heating is provided by the landlord as part of the monthly rent. There are no carports but there is a swimming pool at the property. To assist you in estimating the market rent of the subject property you have gathered information on four other apartment properties. Each of these properties is located in the subject property neighborhood and considered direct competition. 69

70 Rental number 1 contains 72 apartment units in four buildings. There are 36 one bedroom apartments containing 650 SF and 36 two bedroom apartments with 785 SF. The one bedroom apartments currently lease for $575 per month while the two bedroom apartments lease for $665 per month. Each apartment unit has appliances similar to the subject property. Heating costs are the responsibility of the tenant in addition to the monthly rent. There are carports available; however, the landlord charges an additional $25 per month for that amenity. A swimming pool is available for the resident's use. Rental number 2 contains 48 apartment units in three buildings. There are 36 one bedroom and 12 two bedroom apartments. The one bedroom apartments contain 640 SF and lease for $599 per month. The two bedroom apartments contain 770 square feet and lease for $700 per month. All appliances similar to the subject property are included in each apartment unit. Heating is furnished by the landlord. There are no carports but the property does have a swimming pool. Rental number 3 contains 80 apartment units in five buildings. There are 60 one bedroom apartments and 20 two bedroom apartments. The one bedroom apartments contain 660 SF and currently lease for $625 per month. The two bedroom apartments contain 790 SF and lease for $725 per month. The monthly rent includes heat and a carport. All appliances similar to the subject property are included in the apartment unit. The property has a swimming pool on the site for tenant use. Rental number 4 is a 60 unit apartment project in five buildings. There are 36 one bedroom apartments containing 650 SF and 24 two bedroom apartments containing 780 SF. The one bedroom apartments currently lease for $600 per month and the two bedroom apartments lease for $690 per month. The monthly rent includes the use of a carport but the tenant is responsible for paying the heating bill. All appliances similar to the subject property are included in the apartment unit. A swimming pool is located on the site for use of the apartment residents. From the information presented complete the grids on the following pages which illustrate the features of these rental properties compared to the subject property. What units of comparison can be utilized for these properties? What is the range of rent per month for both one and two bedroom apartments? 70

71 What adjustments should be considered when comparing these properties to the subject property? What dollar amounts would you estimate for these adjustments? Based on these four rental properties what would you estimate the market rent to be for the subject property one bedroom and two bedroom apartments? What is the potential gross income for this property? 1 Bedroom Grid Subject Rent #1 Rent #2 Rent #3 Rent #4 Monthly Rent? $575 $625 Unit Size Heat Included Yes Yes Yes No Carports No No* Yes Pool Yes Yes Yes Yes Rent/SF?

72 2 Bedroom Grid Subject Rent #1 Rent #2 Rent #3 Rent #4 Monthly Rent? $665 $725 Unit Size Heat Included Yes Yes No Carports No No* Yes Pool Yes Yes Yes Yes Rent / SF? The solutions to these problems are on the following pages. 72

73 What units of comparison can be utilized for these properties? Rent $ per apartment per month Rent $ per SF per month What is the range of rent per month for both one and two bedroom apartments? 1 BR Range $575 to $625 per month 2 BR Range $665 to $725 per month What adjustments should be considered when comparing these properties to the subject property? Heating Expense and Carports No need to adjust for pools because all are similar What dollar amounts would you estimate for these adjustments? The carport adjustment is easy. Comparable #1 charges a $25/month premium for the use of a carport. This is good market support for the amount of a carport adjustment. To isolate the amount of heat adjustment we have to look for candidates for paired data analysis. For a heat adjustment, comparables #1 and #3 can be used after an interim step of adding the value of the carport to comparable #1. For the one bedroom units the difference due to heat is $25/month or about 4 cents per SF per month. For the two bedroom units the amount is $35/month and also about 4 cents per SF per month. This is shown on the next page. One could also have compared comparable 3 and 4 to extract the adjustment. 73

74 1 Bedroom Heat Adjustment 1 BR Units Rent #1 Rent #3 Monthly Rent $575 $625 Add Carport $25 0 Monthly Rent $600 $625 Unit Style 1 BR 1 BR Unit Size Heat Included No Yes Pool Yes Yes 2 Bedroom Heat Adjustment 2 BR Units Rent #1 Rent #3 Monthly Rent $665 $725 Add Carport $25 0 Monthly Rent $690 $725 Unit Style 2 BR 2 BR Unit Size Heat Included No Yes Pool Yes Yes Based on these four rental properties what would you estimate the market rent to be for the subject property one bedroom and two bedroom apartments? You need to adjust the comparable properties to liken them to the subject. Fill in the amount of the adjustments on both the one bedroom and two bedroom adjustment grids. 74

75 1 Bedroom Adjustment Grid Subject Rent #1 Rent #2 Rent #3 Rent #4 Monthly Rent? $575 $599 $625 $595 Unit Size Heat Included Yes Yes Yes Carports No No Pool Yes Yes Yes Yes Yes Net Adj. Adjusted Rent Adj. Rent/SF 2 Bedroom Adjustment Grid Subject Rent #1 Rent #2 Rent #3 Rent #4 Monthly Rent? $665 $700 $725 $690 Unit Size Heat Included Yes Yes Yes Carports No No No Pool Yes Yes Yes Yes Yes Net Adj. Adjusted Rent Adj. Rent/SF Based on these four rental properties what would you estimate the market rent to be for the subject property one bedroom and two bedroom apartments? Based on the review of the adjusted comparables, a monthly rent of $599 to $600 is supported. Based on the rent/sf unit of comparison the data supports a rental range 75

76 from 650 SF x.91 = $592/month to 650/ SF x.94 = $611/month. A monthly rent of $600 is concluded for the one bedroom units. Based on the review of the adjusted comparables, a monthly rent of $700 is supported. Based on the rent/sf unit of comparison the data supports a rental range from 780 SF x.89 = $694/month to 780 SF x.91 = $710/month. A monthly rent of $700 is concluded for the two bedroom units. 1 Bedroom Adjustment Grid Subject Rent #1 Rent #2 Rent #3 Rent #4 Monthly Rent? $575 $599 $625 $600 Unit Size (SF) Heat Included Yes No +25 Yes Yes No +25 Carports No No No Yes -25 Yes -25 Pool Yes Yes Yes Yes Yes Net Adj Adjusted Rent $600 $599 $600 $600 Adj. Rent/SF $0.92 $0.94 $0.91 $ Bedroom Adjustment Grid Subject Rent #1 Rent #2 Rent #3 Rent #4 Monthly Rent? $665 $700 $725 $690 Unit Size (SF) Heat Included Yes No +35 Yes Yes No +35 Carports No No No Yes -25 Yes -25 Pool Yes Yes Yes Yes Yes Net Adj Adjusted Rent $700 $700 $700 $700 Adj. Rent/SF $0.89 $0.91 $0.89 $

77 What is the potential gross income for this property? 40 1 Bedroom units x $600/mo. = $24,000/month x 12 mos. = $288, Bedroom units x $700/mo. = $14,000/month x 12 mos. = $168,000 Potential Gross Income = $456,000 77

78 Chapter 8 Quiz: Potential Gross Income 1.) In an office building, the space the tenant actually occupies is known as? a.) b.) c.) d.) Contract area Market area Rentable area Usable area 2.) A quantitative technique used to identify and measure adjustments to the sale prices or rents of comparable properties. In this technique, sales or rental data on nearly identical properties is analyzed to isolate and estimate a single characteristic s effect on value or rent is known as: a.) b.) c.) d.) Adjustments Market rent Paired data analysis Potential gross income 3.) A 10 unit apartment generates a market rent of $800 per month. What is the potential gross income for this property? a.) $8,000 b.) $9,600 c.) $96,000 d.) $80,000 4.) A 2,000 SF retail unit is leased for $600 per month. What is the annual rent per SF? a.) $3.60 b.) $600 c.) $0.30 d.) $7,200 5.) What is a common unit of comparison for retail space: a.) b.) c.) d.) Per SF Per space Per room Per cubic foot 78

79 6.) The total income attributable to real property at full occupancy before vacancy and operating expenses are deducted. a.) b.) c.) d.) Effective gross income Market rent Net operating income Potential gross income 7.) A building contains two units each containing 10,000 SF. If the annual economic rent is $7.25 per SF, what is the potential gross income? a.) $72,500 b.) $1,450,000 c.) $145,000 d.) $1,740,000 8.) A three unit retail building generates a potential gross income of $40,500. Economic rent is $10 per SF. What is the building size in SF? a.) 4,900 b.) 4,050 c.) 1,350 d.) 405,000 9.) The components into which a property may be divided for purposes of comparison, e.g., price per SF, front foot, cubic foot are known as? a.) b.) c.) d.) Units of comparison Potential gross income Usable area Rent comparables 10.) A 4 unit apartment building has contract rents of $800 per month. Market rent is $900 per month. What is the potential gross income? a.) $9,600 b.) $3,200 c.) $43,200 d.) $38,400 79

80 Chapter 9: Vacancy and Collection Loss Vacancy and collection loss is an allowance for the reduction in potential gross income attributable to vacancies, tenant turnover, and nonpayment of rent. Vacancy allowances consider physical vacancies and collection lost by the default of tenants. If a building is charging market rent it is normal to assume some loss in rental income over its economic life. The allowance for vacancy and collection loss is typically expressed as a percentage of potential gross rental income and converted into a dollar estimate. vacancy and collection loss - A deduction from potential gross income (PGI) made to reflect income reductions due to vacancies, tenant turnover, and nonpayment of rent; also called vacancy and credit loss or vacancy and contingency loss. Often vacancy and collection loss is expressed as a percentage of potential gross income and should reflect the competitive market. Its treatment can differ according to the interest being appraised, property type, capitalization method, and whether the property is at stabilized occupancy. In this course we are concerned with fee simple valuation using market rents. Be aware that different vacancy rates could apply to the same property if using contract rents depending on if the rents were above or below market. The appraiser recognizes an allowance for vacancy and collection loss according to the property type, type of tenants and general economic conditions. The type of property being appraised can influence vacancy and collection loss. Multitenant properties may have tenants paying market, above market and below market rents at the same time. Single tenant and owner occupied space still need an allowance for vacancy and collection loss because the income approach assumes that there is a tenant paying rent. Vacancy levels are sensitive to economic conditions. In poor economic times, high unemployment or overbuilding with supply exceeding demand, vacancy levels may increase. The converse is true in times of a strong economy with low unemployment or expending demand with limited supply. 80

81 Physical Vacancy Physical vacancy is the actual amount of available space either in a property or a market. physical vacancy - The actual amount of available space, either in a property or a market, expressed in one of two ways: 1) actual vacancy in square feet or 2) a physical vacancy rate i.e., (Vacant Units / Total Units) or (Vacant Square Feet / Total Square Feet). Physical Vacancy Rate or Number of Vacant Units Total Number of Units Amount of Vacant SF Total SF For example, a 100 unit apartment building has 6 vacant units the physical vacancy is 6/100 or 6%. A 20,000 SF office building has 1,000 SF vacant. The physical vacancy is 5% Economic Vacancy Economic vacancy is the estimated percentage of potential gross income lost due to the lack of occupancy in a building. Economic Vacancy Total rent lost to vacant space Total potential rent A 100 unit apartment building rents for $900 month. Rent lost to vacant space is $75,600. The economic vacancy loss is $75,600 / $1,080,000 ($900/month x 100 units x 12 months) = 7% A 20,000 SF office building has annual rent of $15/SF. Rent lost to vacant space is $6,000. The economic vacancy loss is $6,000/$300,000 (20,000 SF x 15/SF)= 2%. Part of physical and economic vacancy is what is known as frictional vacancy. Frictional vacancy relates to the move-ins and move-outs of tenants and measures the lost rental income as leases roll over and expire. This tenant turnover is normal but the frequency 81

82 at which tenants move out and a unit must be re-leased is a concern. A review of tenant turnover patterns is essential in estimating a proper vacancy and collection loss allowance. frictional vacancy - The amount of vacant space needed in a market for its orderly operation. In a stabilized market, where supply and demand are in balance, frictional vacancy allows for move-ins and move-outs. In markets for income-producing property, frictional vacancy measures the lost rental income as leases roll over and expire. Collection Loss Collection loss is typically applied to potential gross income and can occur from existing tenants not paying all the rent owed. Depending on eviction and bankruptcy laws, collection loss can have a significant adverse impact on effective gross income. Buildings with different construction types and quality may have dramatically different vacancy rates. An overall office market vacancy rate of 10% may reflect a rate of 15% for Class C office space but only 5% for Class A space. Also the vacancy rate for a submarket may differ than the overall market. The Northwest Quadrant vacancy rate of 8% may be lower than the entire metropolitan area rate of 14%. Sources of Vacancy Data Good market research is the best source of data. Obtaining data from the leasing agents and property managers is best. However, there are other sources of vacancy data for some property types. For office and industrial markets, the major brokerage houses provide quarterly surveys inventorying the amount of space in the market and the amount that is vacant. Typically this data is arranged by sub-market. Comparable rent and sale data is also helpful. The estimation of the proper allowance for vacancy and collection loss reflects the appraiser's perception of the quality and durability of the projected rents. Reviewing the past history of vacancy in the subject property may be helpful but this does not indicate what will happen in the future. Remember, the allowance for vacancy and collection loss tests the appraiser's judgment as to how this property will perform in the future. 82

83 Vacancy and Collection Loss Indicate whether each condition below would tend to increase or decrease the vacancy and credit loss percentage of a property or area. Place an X mark in the proper column. Increases Vacancy Decreases Vacancy a. property rented on a short term basis b. contract rent lower than current market rent c. limited supply of apartment units in area d. property occupied by tenant under long term lease e. high rent building with short term tenants f. contract rent above market rent g. a decrease in area population h. property in a highly competitive area Example Vacancy Calculation 9-1 Based on the following information Unit Count Unit Type Sizes Monthly Rent Vacant Units 10 1 Bedroom 800 $ Bedroom 1,000 $975 3 What is the physical vacancy percentage based on unit count? What is the physical vacancy percentage based on square footage? What is the economic vacancy? 83

84 Solutions What is the physical vacancy percentage based on unit count? 4 / 50 = 8% What is the physical vacancy percentage based on square footage? 1 BR 800 SF / 8,000 SF = 10% 2 BR 3,000 SF / 40,000 = 7.5% Total 3,800 SF / 48,000 = 7.91% What is the economic vacancy? One Bedroom $810 / $8,100 = 10% Two Bedroom $975 x 3 units = $2,925 / $39,000 ($975 x 40 units)= 7.50% Total $3,735 / $47,100 = 7.93% Example: Vacancy and Collection Loss 9-2 You are reconstructing an income and expense statement for a multiple tenant office building with 24,000 SF of usable area in your city. The building is five years old and has the amenities, management and features that are typical for this market. The following office buildings are similar to the subject in location, age, condition, amenities and management. Building 1: This building has 22,000 SF of usable area with 20,450 SF currently occupied. The potential gross income is $234,465 and there is $3,465 of anticipated collection loss. Building 2: This building has 27,500 SF of usable area with 1,950 SF unoccupied. The potential gross income is $330,000. The anticipated collection loss is $3,300. Building 3: The building has 18,000 SF of usable area with 16,750 SF occupied. The potential gross income is $198,000 and $2,500 of uncollectible income is anticipated. 84

85 What vacancy loss rate will you use in your reconstructed income and expense statement? Vacant SF Comp 1 Comp 2 Comp 3 Building SF Vacancy Rate What collection loss would be reasonable? Comp 1 Comp 2 Comp 3 Collection Loss Potential Gross Income Collection Loss Rate Briefly explain your answer. 85

86 Chapter 9 Quiz: Vacancy and Collection Loss 1.) An office building located in an area of increasing population and demand could expect vacancy rates to go in which direction? a.) b.) increase to vacancy rate decrease to vacancy rate 2.) A market contains 1 million SF and 30,000 SF are vacant. What is the overall market vacancy rate? a.) 30.00% b.) 33.33% c.) 3.00% d.) 3.33% 3.) A deduction from potential gross income (PGI) made to reflect income reductions due to vacancies, tenant turnover, and nonpayment of rent is called? a.) b.) c.) d.) effective gross income non-payment loss potential gross income vacancy and collection loss 4.) A building has potential gross income of $55,000. Of this, $2,000 is expected to be uncollectable. What is the anticipated collection loss? a.) 3.64% b.) $53,000 c.) $55,000 d.) ) What direction would you expect vacancy rates to go in an area that is experiencing an oversupply of hotels and has new hotel development planned? a.) b.) increase in vacancy decrease in vacancy 86

87 6.) The subject contains ten 3-bedroom apartment units. Based on the following data what vacancy allowance should be applied? Comp. 1 Comp. 2 Comp. 3 Style 2 BR 3 BR 3 BR # Units # Vacant a.) 20% b.) 14% c.) 14.89% d.) 11% 7.) The foregone income that occurs when tenant do not pay their rent is known as? a.) b.) c.) d.) vacancy loss collection loss physical vacancy frictional vacancy 8.) A three unit retail building generates a potential gross income of $40,500. The vacancy and collection loss rate is 5.5%. What is the amount of vacancy and collection loss? a.) $2,228 b.) $2,025 c.) $38,475 d.) $38,272 9.) The actual amount of available space, either in a property or a market, expressed in one of two ways: 1) actual vacancy in square feet or 2) a vacancy rate i.e., (Vacant Units / Total Units) or (Vacant Square Feet / Total Square Feet) is known as? a.) b.) c.) d.) economic vacancy potential gross income vacancy physical vacancy frictional vacancy 87

88 10.) A 4 unit apartment building has market rent of $900 per month. If the vacancy and collection loss rate is 10%, what is the amount of vacancy and collection loss? a.) $960 b.) $320 c.) $4,320 d.) $3,840 88

89 Chapter 10: Miscellaneous Income & Effective Gross Income Miscellaneous income also known as other income is income generated by a property that is not directly attributed to the rental of the real property. other income - All income generated in the operation of the property that is not derived directly from space rental. This income may be obtained from the use of personal property or the profit from services supplied to the tenant. Examples of other income: Coin-operated laundry equipment in apartment buildings. Typically, the equipment is not owned by the owner of the building. Rather, a concessionaire places the equipment, maintains it and collects the income. The building owner may be paid either a percentage of the collected income or a flat rate per unit per month. The building owner supplies the location and utilities for the equipment. Furniture in an apartment may either be owned by the building owner or leased. A higher rate is charged to the tenants of furnished units. Carports/Garages: While often included in the base monthly rent, if a lesser number of carports or garages exist, they may be leased at an additional charge per month. Utilities, particularly electricity, may be purchased wholesale and resold retail to retail tenants in addition to the monthly rent. Telecommunications or internet services may be available to the tenant through an arrangement which the property owner receives a commission, royalty or a percentage of sales. Beverage/vending/arcade machines are a form of other income if the owner receives a percentage of the revenue generated. Pet fees may be charged by those apartment buildings which allow pets. 89

90 Community building/clubhouses may be leased for entertaining. Late payment charges, lease termination fees and lease application fees are specialized types of miscellaneous income which may pertain only to certain property types. It is important for the appraiser to analyze the quality, quantity and durability of miscellaneous income. It may prove to be irregular in nature, short-lived or sensitive to external pressures. Carports may lease in the winter but not the summer. Lease termination fees may increase in worsening economic times as tenants seek to break a lease. The best source of information is typically the actual history of the subject property. Published information may also be helpful if careful comparisons are made. Miscellaneous income can be estimated either before an allowance for vacancy loss or after an allowance. It is important to be consistent in its application. Note: If the miscellaneous income is assumed to reflect the actual collected amount, there is no need to deduct a vacancy allowance from this figure. Example: Miscellaneous Income 10-1 The subject has two washers and dryers that combine for $1,000 per month in collected revenue. What is the annual miscellaneous revenue? $1,000 per month x 12 months = $12,000 in miscellaneous income. Effective Gross Income Effective gross income is the anticipated income from all operations of the real estate (rents and miscellaneous income and after a vacancy and collection loss allowance). The following is a partial summary outline of the income approach. 90

91 Partial Outline of the Income Approach Potential Gross Income (PGI) Less Vacancy and Collection Loss Plus Miscellaneous/ Other Income Equals Effective Gross Income (EGI) This is the appraiser's estimate of either the actual income to be received or the anticipated future income on an annual basis. effective gross income (EGI) - The anticipated income from all operations of the real property after an allowance is made for vacancy and collection losses and an addition is made for any other income. Example: Effective Gross Income 10-2 The subject property has 20 one-bedroom apartments rented for $400 per month each. Economic rent from comparable one-bedroom apartments is estimated at $425 per month each. The vacancy and collection loss allowance in this market is 5%. The subject generates $10 per unit per month in other income that is not subject to a vacancy and credit allowance. Step 1: Estimate Potential Gross Rental Income 1-bedroom $425 (market rent) x 20 units = $8,500 x 12 (annualize) = $102,000 Step 2: Calculate Vacancy and Collection Loss $102,000 x.05 = $5,100 Step 3: Calculate Other Income Other income $10/unit/month x 20 units = $200/month x 12 (annualize) = $2,400 Step 4: Calculate Effective Gross Income Subtract the vacancy and collection loss from the PGI to arrive at effective gross income 91

92 Potential Gross Income $102,000 Less Vacancy and Credit Loss - $ 5,100 Plus Other Income $ 2,400 Effective Gross Income $ 99,300 Effective gross income equals $99,300 92

93 Chapter 10 Quiz: Miscellaneous Income & Effective Gross Income 1.) Assuming a property has no miscellaneous income, subtracting a vacancy and collection loss allowance from potential gross income results in net operating income? a.) b.) true false 2.) All income generated in the operation of the property that is not derived directly from space rental is known as? a.) b.) c.) d.) potential gross income other income rental income net operating income 3.) A 5,000 SF office building has annual market rent of $12/SF. If the vacancy and collection loss rate is 7%, what is the effective gross income? a.) $55,800 b.) $4,200 c.) $60,000 d.) $35,000 4.) A building has potential gross income of $55,000. Operating expenses are $20,000 and the vacancy and collection loss is $3,500. What is the effective gross income? a.) $31,500 b.) $35,000 c.) $51,500 d.) $55,000 5.) Miscellaneous income should be applied in the same manner it is extracted. If it is based on actual collected amounts then no vacancy and collection deduction should be applied. a.) b.) true false 93

94 6.) The subject contains ten 3-bedroom apartment units that generate $25 per month in laundry charges. What is the miscellaneous or other income? a.) $9,000 b.) $75 c.) $900 d.) $3,000 7.) The anticipated income from all operations of the real property after an allowance is made for vacancy and collection losses and an addition is made for any other income is known as? a.) b.) c.) d.) vacancy loss collection loss potential gross income effective gross income 8.) A three unit retail building generates a potential gross income of $40,500. The vacancy and collection loss rate is 5.5%. What is effective gross income? a.) $2,228 b.) $2,025 c.) $38,475 d.) $38,272 9.) The additional income from renting vending machines, laundry machines and pet fees is known as? a.) b.) c.) d.) potential gross income other income or miscellaneous income net operating income effective gross income 10.) A 4 unit apartment building has market rent of $900 per month. If the vacancy and collection loss rate is 10%, what is the effective gross income? a.) $38,880 b.) $9,720 c.) $3,240 d.) $43,200 94

95 Chapter 11: Operating Expense Analysis Operating expenses are those annual expenses necessary to maintain the projected income stream at a property. Operating expenses are deducted from effective gross income to arrive at net operating income. The principle of change illustrates that neither income nor expenses remain constant. Each may fluctuate based upon changes in the purchasing power of money and the cost of goods or services. operating expenses - The periodic expenditures necessary to maintain the real property and continue production of the effective gross income, assuming prudent and competent management. While many of the operating expenses items reported on an operating statement maintain the projected income stream of a property, some expenses items do not. The examples below reflect operating expenses that are typically excluded form a reconstructed income and expense statement. Ownership structure costs such as corporation taxes and partnership tax returns Financing costs such as mortgage interest and principal payments Depreciation charges for buildings and equipment Federal and state income taxes Special assessment charges Capital expenditures Property taxes (ad valorem appraisals only) The appraiser obtains factual information on the past operating performance of a property and along with comparable data reconstructs that information into a reasonable projection of future operations. The purpose of a reconstructed operating statement is to reflect a typical pattern of operation for the foreseeable future as viewed by investors in the market. 95

96 reconstructed operating statement - A statement prepared by an appraiser to reflect potential future performance of a property allowing consideration of the historical income and expenses of an investment property. In preparing reconstructed operating statements, appraisers may consult accountants financial balance sheets, comparable properties, auditors statements, or historical data provided by the ownership entity. Three general expense classifications to consider: Fixed expenses Variable expenses Reserves for replacement Fixed Expenses are considered fixed not because they remain unchanged over time. Rather, they generally must be paid regardless of the occupancy or use of a property. Examples in include insurance and real estate taxes. fixed expenses Operating expenses that generally do not vary with occupancy and that prudent management will pay whether the property is occupied or vacant. Insurance expense should be based on an adequate amount of coverage and at prevailing rates for the building type and location. Insurance coverage generally includes fire and casualty loss, extended coverage, owner's liability and business interruption. Insurance amounts should be annualized. Many times owners of multiple properties have blanket policies that cover more than one property making it necessary to estimate stand-alone policy costs. Insurance agents, property managers and expense costs at comparable properties are good sources of insurance data. Real estate taxes are not included in the fixed expense category when appraisals are performed for ad valorem tax purposes. To use existing taxes presupposes that the valuation is accurate. Property taxes based upon a preconceived value could distort the net operating income and resulting value estimate. Instead of deducting a dollar amount for real estate taxes, an effective tax rate, or taxes as a percentage of a property's value, can be determined and added to the capitalization rate to account for taxes at the property. The effective tax rate is simply the amount of annual property taxes divided by the 96

97 property value. For example, a property with a value of $100,000 and annual taxes of $2,750 has an effective tax rate of $ 2,750 Annual taxes = 2.75% Effective Tax Rate $100,000 Value The effective tax rate may also be calculated from the statutory level of assessment and the local millage rate ($55.00 mills/1000 x 50.00% assessment ratio =.0275 or 2.75%). The addition of the effective tax rate to the capitalization rate compensates for the effect of property taxes on net operating income. In appraisals where an effective tax rate is not used, the appraiser obtains the current and historical property taxes from the local governmental unit. Possible changes in assessed valuation (reassessment or uncapping) and millage rates are considered. The appraiser then attempts to reflect the reasonable anticipation of an investor regarding the amounts and changes in property taxes. Variable Expenses are those expenses incurred in operating the property, providing services to the tenants and maintaining the income stream. These expenses are directly related to occupancy levels. variable expenses Operating expenses that generally vary with the level of occupancy or the extent of services provided. Major variable expense categories include: Management Fees: This is the expense of obtaining professional management services for the property. Even if the owner self manages the property and does not include this expense in the operating statement, it is appropriate to recognize a professional management expense. A considerable amount of time and expertise is required for the proper management of an income producing property. The appraisal of income producing properties assumes prudent ownership and competent management. The amount included for management fees should be based on normal industry standards. Local property management companies are a good source of this information. Management fees are usually expressed as a percentage of effective gross income. 97

98 Administrative & Leasing Expenses: Are those expenses associated with the day-today operation of the property. Included in this category are the following: On-Site Management: Particularly for larger multi-tenant properties, it is common to have a property manager on the site. In smaller properties, on-site management may be provided by a tenant who is reimbursed with a free rental unit and/or minimum salary. Office and Leasing Expense: Payroll and benefit costs associated for leasing agents, secretarial and general office personnel where necessary for the operation of the property. Other expenses could include office supplies, materials, telephone, internet, credit bureau reports, postage and office equipment. Mileage reimbursement expenses may be included in this category. Advertising expense includes newspaper, yellow pages, billboards, radio, internet and other special promotions. Advertising expenses can fluctuate and are closely associated with occupancy. Legal and accounting expense includes charges for an accountant's preparation of financial statements, attorney expenses for landlord-tenant disputes and expenses for collection efforts. Utilities Expense includes gas, electricity, water and sewer charges. Heating costs if provided by the landlord as part of the monthly rental can be a major expense for a property. Electricity is typically metered and paid by the tenant. Landlord charges for electricity could include lighting for common areas such as hallways, lobby areas, restrooms and laundry rooms, exterior lighting on buildings and parking lots. Water and sewer charges are a function of occupancy and use. These costs can vary in rural areas if well and septic systems are in place. These expenses are generally a landlord expenses although sub metering in multiple tenant buildings has become more common. When reviewing utilities expense for a property it is important to determine which expenses are paid by the landlord and which are paid by the tenant. This is especially true when comparing expenses between properties. Grounds Maintenance Expenses are those expenses incurred in maintaining lawns, parking areas and private streets. Included in this category could be grounds labor for lawn and landscaping care, snow removal and repairs to sidewalks, curbs, parking areas and streets. Swimming pool related expenses may fall within this category. This 98

99 expense would also include costs for supplies and lawn, snow removal and other necessary equipment. Grounds charges could be in the form of lawn care contractor, snow removal contractor and contractor-related expenses for concrete and asphalt repair. Building Maintenance Expenses are incurred in maintaining the exterior of the buildings as well as common areas. Labor charges can include roof repair, exterior painting, structural repair work, window washing and general cleaning. Building repair supplies includes electrical, plumbing and heating repair parts, window glass replacements, exterior paint and stain and building cleaning supplies. Building contractor expenses include trash removal, exterminator, elevator maintenance, cleaning, roofing, plumbing and HVAC contractors. Expenses for building maintenance vary with property type, age and condition, lease provisions and management philosophy. Redecorating Expenses. This category includes the labor expense of cleaning, painting interior walls, cleaning floor coverings. Redecorating supplies include paint, cleaning supplies and miscellaneous supplies. Redecorating expense can vary with occupancy levels. High vacancy or rapid turnover of tenants can increase this expense. Management practices can influence expenditures in this category. Appraisers should be careful to inquire if reserve for replacement items such as carpet and appliances are included within this category. Miscellaneous Operating Expenses include those small expenditures not assigned to another expense category. Security expenses and community building costs are typical for this category. This expense category should be a minor percentage of effective gross income. Replacement Allowance is an allowance that provides for the periodic replacement of building components that wear out more rapidly than the structure itself and must be replaced during a buildings economic life. If a reserve for replacement is used, these items should not be included in repair and maintenance categories in the reconstructed income and expense statement. replacement allowance - An allowance that provides for the periodic replacement of building components that wear out more rapidly than the building itself and must be replaced during the building s economic life; sometimes referred to as reserves or reserves for replacement. 99

100 Items to be considered in a reserve for replacement include floor coverings, roof, HVAC equipment, window covering, parking lots and for apartments appliances. The annual allowance for reserves is calculated by taking the total replacement cost of the items divided by their useful lives. For example useful lives may range from 6-8 years for carpeting, 10 years for appliances, 5 years for parking areas, 20 years for a roof. This concept of providing for reserves embodies a straight-line method of recapture. Example: Replacement Allowance 11-1 The following example calculates an annual replacement allowance on a straight-line basis for a 48 unit apartment project. Calculate the annual reserves for each item. Item Cost New Life Annual Reserve Per Unit Units Annual Reserve Appliances $ $95 48 Carpeting $800 6 $ Roof $36, Lump Sum Paving $100, Lump Sum HVAC Units $1, $ $4,800 Total $25,893 To highlight, the HVAC line item will be used for illustration. There are 48 units at a replacement cost of $1,500 per unit or a total replacement cost of $72,000. With a 15 year life the annual replacement allowance is ($72,000 / 15 years) $4,800 per year. Building components or items of equipment which are expected to have a useful life equal to the remaining economic life of the structure do not require a replacement allowance. 100

101 A sinking fund methodology (amount deposited annually to accumulate a future value) may also be used to estimate the reserve allowance if that pattern is typical for investors in the market. In this method, the annual deposit is made into an interest bearing account and the funds grow to reach the amount needed to replace the item. The use of a reserve for replacement should be carefully scrutinized when reviewing the repairs and redecorating categories of an expense statement. Historical operating statements may include reserve items in these categories. The use of a reserve for replacement category may decrease annual repair and decorating expenses in an older property. When developing capitalization rates from market data, it is important to know what expense items are included in the operating statement from the sale properties. A capitalization rate developed from a sale that does not include reserves for replacement in the expense statement may not be appropriate for application to a projection of net operating income that included reserves within the expense estimate. The following example illustrates the importance of treating the reserves for replacement category in a consistent manner when extracting or applying rates. The subject property has a net operating income of $96,500 which includes an allowance for reserves for replacement in the operating expenses in the amount of $3,500. Capitalization rates from market sales which also include an allowance for reserves are typically The indicated value of the subject property is $975,000 ($96,500 /.0990 = $974,747 or $975,000 rounded). Example: Reserves Deducted vs. Not Deducted 11-2 Reserves No Reserves NOI Before Reserves $100,000 $100,000 Reserves $3,500 $0 NOI After Reserves $96,500 $100,000 OAR 9.90% 10.26% Value (rounded) $975,000 $975,

102 If reserves are not included in the expense analysis, the net operating income of $96,500 will increase to $100,000. Market sales from properties which did not include a reserve for replacement category indicate a higher capitalization rate of The indicated value of the subject property is $975,000 ($100,000 /.1026 = $975,610 or $975,000). A higher capitalization rate is appropriate because the purchaser/investor is accepting the additional risk of future, unforeseen expenses. Expense Units of Comparison Units of Comparison for operating expenses are useful for comparing the experiences of other similar properties. The following are some common units of comparison. Operating Expense Ratio is the ratio of total operating expenses to effective gross income. operating expense ratio (OER) - The ratio of total operating expenses to effective gross income (TOE/EGI); the complement of the net income ratio, i.e., OER = 1 NIR. If operating expenses are $100,000 and effective gross income is $222,222 the operating expense ratio is 45%. Dollars per square foot per year. Expenses can be viewed on a per SF basis. Remember to use care in applying these rates on a useable (NLA) or rentable (GLA) area. If a property has annual operating expenses of $100,000 and contains 20,000 SF the expense per SF is $5.00/SF Dollars per unit show the relationship of dollars of operating expenses to the unit of comparison typical for the property type. Apartment units for apartments, room nights for hotels, parking spaces for parking garages.. If a 22 unit apartment has annual operating expenses of $100,000 then the expense represents $4,545 per unit. Net income ratio (NIR) - Ratio of net operating income (NOI) to effective gross income (NOI/EGI). This is the complement to the operating expense ratio. 102

103 In our earlier example if the operating expense ratio was 45% the net income ratio is 55%. Effective gross income is $222,222 less $100,000 expenses equals $122,222 remaining for NOI. The NIR therefore is $122,222 / 222,222 = 55% Sources of Operating Expense Information Subject Property: A review of the present and historical operation of the property is the first step in the projection of future expenses. Review of three to five years of actual expenses may indicate trends or patterns useful in the projection of future expenses. The appraisal of real estate presumes competent management and prudent ownership. This assumption may not be reflected in the actual operating statements of the subject property. Comparable properties: Income and expense statements from comparable properties in the same geographical area are a good source of information. There is a tendency for expense items to be consistent among similar types of properties within an area. Publications: There are publications for different property types with income and expense information useful to appraisers. In using any of these publications it may necessary to adapt information from the subject property to the particular format of these publications. The following organizations provide operating expense information, most for an annual fee. Apartments Office Buildings Shopping Centers Hotels Institute of Real Estate Management (IREM), Urban Land Institute (ULI) Building Owners and Managers Association (BOMA), Institute of Real Estate Management (IREM) International Council of Shopping Centers (ICSC), Institute of Real Estate Management (IREM), Urban Land Institute (ULI) Smith Travel Research (STR) PKF Hospitality Research 103

104 Operating Expense Analysis In the list below, place an X mark before each item that would be considered an operating expense from an assessor's point of view. Capital expenditure for a new roof Principal and interest on mortgage Painting and decorating charges Repairs to buildings Property taxes Depreciation building Management expense Reserves for replacement Building insurance Gas and electric charges Salaries and wages of employees Income tax of owner Water and sewer bills Legal and accounting fees Corporation franchise tax 104

105 If the statement is true place an X mark in the T column; if false, place an X mark in the F column. T F Potential gross income is the total income earned by a property less an allowance for vacancy and credit loss. The appraiser's estimate of potential gross income is based on market rent. If real estate is currently leased at its fair market rent, contract rent and market rent are the same. Effective gross income is based strictly on rental income. Mortgage interest and principal payments are considered fixed expenses. Rent free spaces which are occupied by owners or employees should be assigned rental values which are comparable to the values assigned to similar spaces in the building or area. Actual contract rents should be used in estimating gross income. 105

106 Chapter 11 Quiz: Operating Expenses Analysis 1.) A property is situated in jurisdiction that assesses at a 50% ratio. The millage rate is $60 per $1,000. What is the effective tax rate? a.).0600 b.).0300 c.).0030 d.) ) An allowance that provides for the periodic replacement of building components that wear out more rapidly than the building itself and must be replaced during the building s economic life is known as? a.) b.) c.) d.) potential gross income operating expense ratio replacement allowance operating expenses 3.) A 5,000 SF office building has annual market rent of $12/SF. The operating expense total $20,000. What is the operating expense ratio? a.) 33.33% b.) 25.00% c.) $40,000 d.) $20,000 4.) A building has potential gross income of $55,000. Operating expenses are $20,000 and the vacancy and collection loss is $3,500. What is the net operating income? a.) $31,500 b.) $35,000 c.) $51,500 d.) $55,000 5.) Depreciation and debt service payments should be deducted from effective gross income to derive at net operating income. a.) b.) true false 106

107 6.) The subject contains ten 3-bedroom apartments. It is anticipated to cost $900 per unit to replace the carpeting in each unit and carpet has an estimated life of 6 years. What is the annual replacement allowance for carpeting at this property? a.) $9,000 b.) $150 c.) $1,500 d.) $2,700 7.) The periodic expenditures necessary to maintain the real property and continue production of the effective gross income, assuming prudent and competent management is known as? a.) b.) c.) d.) operating expenses replacement allowance potential gross income operating expense ratio 8.) A statement prepared by an appraiser to reflect potential future performance of a property allowing consideration of the historical income and expenses of an investment property. In preparation the appraisers may consult accountants financial balance sheets, comparable properties, auditors statements, or historical data provided by the ownership entity is known as? a.) b.) c.) d.) operating expense ratio appraisal report affidavit replacement allowance reconstructed operating statement 9.) The ratio of total operating expenses to effective gross income; the complement of the net income ratio, i.e., OER = 1 NIR is known as? a.) b.) c.) d.) operating expense ratio replacement allowance net operating income operating expense 10.) A recent sale of a property displayed an overall rate of 9%. The purchaser did not deduct a replacement allowance in determining the NOI. You are appraising a similar property and are deducting a replacement allowance. Should the overall rate you apply to the appraised property be... a.) higher than 9% b.) lower than 9% c.) the same 9% 107

108 Chapter 12: Net Operating Income, Debt Service and Equity Dividend The foundation of the income approach is an estimate of the stabilized net operating income (NOI) available for capitalization. Net operating income is the annual sum remaining after stabilized expenses have been subtracted from effective gross income. net operating income (NOI) - The actual or anticipated net income that remains after all operating expenses are deducted from effective gross income but before mortgage debt service and book depreciation are deducted. Example: Net Operating Income 12-1 An office property has a potential gross income of $280,000. The vacancy and collection loss allowance is 10%. The operating expense ratio is 40%. What is the net operating income for this property? Potential Gross Income $280,000 Less Vacancy and Collection Loss (10%) $ Effective Gross Income $ Less Operating Expenses (40% OER) $ Net Operating Income $151,200 Net operating income is also referred to as net operating income before recapture or net operating income before debt service. The net operating income estimate then provides for the following items in order of priority: A. Payment of principal and interest on financing on the property, if any, B. Recapture of the equity invested, C. Return on the equity invested. We use the term stabilized to refer to net income because the income stream is expected to reflect a typical pattern of operation throughout the term of ownership. 108

109 Net income ratio The net income ratio is the net incomes percentage of effective gross income. In our earlier example. The net income ratio is $151,200 / $252,000 = 60%. Mortgage Debt Service Debt service is simply the annual sum of all mortgage payments. These are the periodic payments that cover the interest on, and the retirement of, the outstanding principal of the mortgage loan. It is also called mortgage debt service or when annualized annual debt service (ADS). This amount is deducted from NOI to drive the equity dividend. debt service (IM) - The periodic payment that covers the interest on, and (for an amortizing loan) retirement of, the outstanding principal of the mortgage loan; also called mortgage debt service. Another important term and concept is the mortgage constant. While we discussed this earlier, the mortgage constant is simply the ratio of the annual debt service to the mortgage loan amount. It is calculated by dividing the annual payments by the loan amount. Remember the mortgage constant always reflects an annual amount. It is annual debt service / loan amount not the monthly debt service. An example should reinforce this concept. Example Mortgage Debt Service 12-2 Presume we are buying a 5,000 SF office building. The price we are paying is $500,000, and our down payment is $125,000 or a 25% equity ratio. The mortgage will be in the amount of $375,000 (75% loan-to-value), with an 11% interest rate and monthly payments spread over a 20-year amortization period. Based on this information, we can identify the monthly payment and annual debt service for our new loan by looking in the tables to get the partial payment factor for a 20-year term at 11% interest with monthly compounding to obtain a factor of Applying this factor to our loan amount of $375,000 gives us the monthly payment of $3, What is the annual debt service? It is simply the monthly payment of $3, x 12 months or $46,449. What is the mortgage constant for this property? The mortgage constant (or annual constant as it is also called) is simply the annual debt service divided by the loan amount. In our example, it is $46,449 / $375,000 or

110 Example: Net Operating Income 12-3 The table below summarizes the income and expense information. Potential Gross Income $81,000 Vacancy and Collection Loss $ 4,000 Effective Gross Income $77,000 Operating Expenses $19,250 Net Operating Income $57,750 Typically, mortgage lenders want to know if a commercial property will generate enough income (NOI) to cover the mortgage payments. Often, they like to see a cushion (more NOI than annual debt service before making a loan). This cushion is called the debt service coverage ratio or debt coverage ratio (DCR). The debt coverage ratio is calculated by dividing NOI by the annual debt service (ADS). For our office building example, the debt service coverage ratio is calculated as follows: Net Operating Income $57,750 = Annual Debt Service $46,449 Therefore, the debt coverage ratio is This means our NOI is 124% of our annual mortgage payments. Debt Coverage Ratio was defined earlier in the text. As you can see, not all of the net operating income goes to mortgage payments with some returning to the investor. The amount of NOI that remains after paying annual debt service is called the cash flow and is also known as equity dividend or cash throw off. equity dividend - The portion of net operating income that remains after total mortgage debt service is paid but before ordinary income tax on operations is deducted. Therefore, by subtracting the ADS (annual debt service) from the NOI results in the equity dividend as calculated below: Net Operating Income $57,750 Annual Debt Service $46,449 Cash Flow (Equity Dividend $11,

111 The bottom line is that after paying the mortgage payments the property throws off $11,301 to the owner. The entire property generates income and has a value. The ratio of its income to its value is called a rate. For the entire property this rate is called the overall rate. The mortgage has an income (annual payments) and a value (loan amount) and has a ratio of its income to its value. This ratio is called the mortgage constant (also can be viewed as the mortgage capitalization rate). The equity portion also has a ratio between its income and value. The ratio of cash flow to down payment is known as the equity dividend rate (EDR also called cash on cash rate). Using IRV and dividing the equity dividend (cash throw off) by the amount of our initial investment or down payment results in the equity dividend rate as shown below: Cash Flow (Equity Dividend) $ 11,301 = Down Payment (Equity Investment) $125,000 Equity Dividend Rate In our first year of the investment, the property generates a 9.04% return on our cash investment. The EDR can be viewed as the equity capitalization rate. The 9.04% rate contains a component for discount (return on) and recapture (return of) the equity investment. 111

112 Chapter 12 Quiz: Net Operating Income, Debt Service and Equity Dividend 1.) Subtracting operating expenses from potential gross income results in net operating income? a.) b.) true false 2.) The actual or anticipated income that remains after all operating expenses are deducted from effective gross income but before mortgage debt service and book depreciation are deducted is known as? a.) b.) c.) d.) potential gross income other income rental income net operating income 3.) A purchaser acquired a property for $1,000,000 with an 80% loan to value ratio. The monthly debt service payments are $7, What is the mortgage constant for this loan? a.) b.) c.) d.) ) A building has potential gross income of $55,000. Operating expenses are $20,000 and the vacancy and collection loss is $3,500. What is the net operating income? a.) $31,500 b.) $35,000 c.) $51,500 d.) $55,000 5.) Cash flow or the equity dividend is the income remaining after debt service payments are deducted from net operating income. a.) b.) true false 112

113 6.) A property has an NOI of $100,000, operating expenses of $200,000 and annual debt service of $82,000. What is the cash flow or equity dividend? a.) $118,000 b.) $218,000 c.) $300,000 d.) $18,000 7.) What is the net operating income of a property with a value of $2,000,000 with an appropriate overall capitalization rate of 11% and a mortgage interest rate of 7%? a.) $140,000 b.) $80,000 c.) $111,111 d.) $220,000 8.) A three unit retail building generates an effective gross income of $40,000. The operating expenses are $25,000. What is the net income ratio? a.) $15,000 b.) 37.50% c.) 62.50% d.) $65,000 9.) The ratio of net operating income to effective gross income (NOI/EGI); the complement of the operating expense ratio is known as? a.) b.) c.) d.) operating expense ratio net income ratio net operating income effective gross income multiplier 10.) A 4 unit apartment building has market rent is $900 per month. If the vacancy and collection loss rate is 10% and the expense ratio is 60%, what is the net operating income? a.) $17,280 b.) $5,832 c.) $23,328 d.) $15,

114 Chapter 12 Challenge: Reconstruction of Operating Expense Statement The following is a three year statement of income and expense for an 18 unit apartment property. The property is the subject of a property tax appeal assignment. Income and Expense Statement 3 Years Ago 2 Years Ago Last Year Income $100,530 $105,800 $107,750 Repairs & Maintenance $5,500 $5,400 $6,600 Real Estate Taxes $10,095 $10,370 $10,710 Salaries & Wages $10,900 $11,600 $12,100 Utilities $10,080 $10,870 $12,190 Miscellaneous $875 $915 $990 Management $5,125 $5,410 $5,550 Insurance $1,550 $1,825 $2,200 Mortgage Principal & Interest $17,150 $17,150 $17,150 Depreciation $11,175 $10,950 $10,700 Market rent is estimated at $550 per month for each of the 18 units subject to 4% vacancy and collection loss. There is no miscellaneous or other income. Your adjustments relating to operating expenses are as follows: Operating Expenses Management Fee: 5% of effective gross income. Insurance: $125 per unit annual expense Repairs & Maintenance: $375 per unit annual expense Miscellaneous: 1% of effective gross income Utilities: 2% increase to prior year amount Salaries and Wages: 4% increase to prior year amount. No replacement allowance is needed in this assignment 114

115 Assignment: Complete the reconstructed operating statement on the next page to be used in the appraisal assignment and to answer the following questions: What is the... a.) the potential gross income estimate b.) the effective gross income c.) the operating expense estimate d.) the net operating income estimate 115

116 Reconstructed Operating Statement Potential Gross Income Less Vacancy/Collection Loss Plus Miscellaneous Income Effective Gross Income $ $ $ $ Operating Expense Analysis Fixed Expenses $ $ Variable Expenses $ $ $ $ $ $ Total Expenses $ Net Operating Income $ 116

117 Chapter 13: Capitalization Rate Components Capitalization is the conversion of income into value. This capitalization procedure takes the anticipated future benefits of ownership and processes them into a present worth estimate. In direct capitalization, the connection between the estimate of net operating income and the value of a property is the rate. This is shown below in the IRV formula. Up to this point we have learned the components used in developing net operating income or the I in the IRV formula. In this section we are concerned with the components of the rate or R in the IRV formula. overall capitalization rate - An income rate for a total real property interest that reflects the relationship between a single year s net operating income expectancy and the total property price or value. This rate must be adequate to attract equity to the investment considering the assumptions, income patterns and risks involved. The selection of the appropriate rate to be used in the capitalization process is of paramount importance. But what is included within the capitalization rate? The overall capitalization rate considers an investor s total expected return including both the return on invested capital and a return of capital. The return on investment is termed the discount rate or yield rate and reflects the rate of return ON capital. This is usually expressed by a percentage. 117

118 return on capital- The additional amount received as compensation (profit or reward) for use of an investor s capital until it is recaptured. The rate of return on capital is the yield rate or the interest rate earned or expected. This rate reflects the compensation or return necessary to attract capital to an investment. The discount rate or return on capital is influenced by the risk in the investment and includes not only the cost of borrowing money to finance an investment but also an anticipated return on the equity investment. The second component of the capitalization rate is the recapture rate or the rate of return of a real estate investment. return of capital- The recovery of invested capital, usually through income and/or reversion. The recapture provision addresses the return to the investor of a sum equal to the amount of invested capital. This recapture provision is required to return to the investor the value of the improvements over the term of ownership. In appraisals used for ad valorem tax purposes where the property taxes are not deducted as an operating expense, the effective tax rate is also added or loaded to become part of the capitalization rate. As we learned earlier, the use of existing taxes presupposes that the valuation the taxes were based upon is accurate. Property taxes based upon a preconceived value could distort the net operating income and resulting value estimate. effective tax rate - The ratio between the annual property tax on real estate and its market value; also computed as the tax rate times the assessed value divided by the market value. To summarize the direct capitalization rate implicitly allows for both return on and return of invested capital. In ad valorem valuation assignments the direct capitalization rate will also include the effective tax rate. Therefore, within each direct capitalization rate are provisions for discount rate (return on), recapture rate (return of), and the effective tax rate. Determining the Discount Rate There are three methods for determining the discount rate. These include the summation method, band of investment method and market comparison method. 118

119 Summation Method The summation method (of developing a discount rate) is a theoretical concept of adding together the four components of the discount rate. These components are: Safe Rate Non-Liquidity Rate Risk Rate Management Rate The safe rate is the rate of return available from a safe investment such as a government bonds, insured savings accounts or money market accounts. The second consideration is compensation for illiquidity. Real estate is not an asset which can be readily converted to cash. Marketing times for real property can be months or even years. Compensation is due the investor to address this delay in exiting the investment. Next is compensation for risk. Real estate is not a riskless investment. Compensation must be sufficient to overcome the preference to invest in safe investment such as long term government bonds. These risks can vary widely. A long term lease to a credit tenant in a desirable area is much less risky than month to month leases with tenants with poor credit in a less desirable area. The fourth consideration is compensation for management. To maximize the value of a real estate investment requires the expenditure of significant time and energy. The greater the time and effort necessary to manage the investment, the greater the compensation the investor requires for management. Example of Summation Method Safe rate 1.75% Rate for non-liquidity 1.00% Risk Rate 4.00% Management Rate 0.75% Discount Rate 7.50% 119

120 Keep in mind that in practice it is difficult to precisely quantify these components and the different return each requires. Band of Investment Mortgage / Equity Method Another method for determining a discount rate is the band of investment method. This method utilizes the debt and equity portions of an investment to develop a discount rate. A percentage is allocated to each portion (to the mortgage and to the equity) and multiplied by the respective interest rates. To apply the band of investment method you need to know. Debt (or mortgage) interest rates and the loan amount as a percentage of value Equity return on investment rates and the equity investment s percentage of value For example, an investor acquired a mortgage covering 75% of the investment. The balance was the 25% owner s equity. The interest rate on the mortgage is 7.0%. The investor expects a 9% return on investment. By organizing the data in a table, one can solve for the discount rate which is a blended rate of the mortgage and equity rates. On the first line the mortgage interest rate is 7% and it applies to 75% of the value of the property. By multiplying Rate x Value we can determine the income needed to support the interest portion of the mortgage payment. The resulting return on payment for the mortgage or the income needed to support the interest on the mortgage is.0525 Income Rate Value Mortgage % 75% Equity % 25% Total % 100% You may have noticed that across the top of the table is IRV. In this example we do not know the actual amounts borrowed just their percentages. In these situations, we can view the subject as having a value of $1. So the income needed to support the return on investment is 7.5 cents or 7.5% of the $1 value. This is divided between the interest 120

121 on the mortgage of 5.25 cents and the return on equity invested of 2.25 cents. Market Comparison Method The third method of determining a discount rate is the market comparison method. This method is best utilized when adequate and verifiable sales data is available. The net operating income (NOI) attributable to discount is divided by the sales price of a property to determine the discount rate. In this method the net income remaining after deductions for recapture and taxes is divided by the sales price or market value. For example, a property just sold for $800,000. The building value is $600,000. The recapture rate is 3% requiring $18,000 of NOI for recapture. The property taxes are 2% or $16,000. If the NOI for the entire property is $94,000 what is the discount rate? Income Rate Value Discount?? $800,000 Recapture $18, % $600,000 Taxes $16, % $800,000 Total $94,000? $800,000 Procedurally, the next step is to determine the amount of net operating income remaining for discount. Income Rate Value Discount $60, % $800,000 Recapture $18, % $600,000 Taxes $16, % $800,000 Total $94, % $800,

122 By dividing the income remaining for discount of $60,000 by the value of the total investment $800,000 results in a discount rate of 7.5%. Determining the Recapture Rate A recapture rate measures the portion of net operating income required annually to provide a return of the wasting asset over the projection period. Just as an investor seeks a return on invested capital, it is even more important to recover invested capital. Investment capital may be recovered gradually in increments of annual income or it may be recovered at the time of sale (reversion). It is important to recognize the recapture rate is the return OF the investment and that it only applies to the improvement value and not to the land. There are two methods of calculating the recapture rate: the remaining economic life method and the market comparison method. Remaining Economic Life Method Remaining economic life method (of developing the recapture rate) is based on reciprocals. A reciprocal is either of a pair of numbers (as 2 3 and 3 2 or 9 and 1 9) whose product is one. The recapture rate is simply the reciprocal of the remaining economic life. For example, if the remaining economic life of the improvements is 40 years the recapture rate is simply: 1 / 40 =.025 or 2.5% The opposite is also true. If you know the recapture rate is 2.5% the remaining economic life is: 1 /.025 = 40 or 40 years Remaining economic life is the number of years from the appraisal date to the time in which the improvements will no longer have value. Investors have come to view remaining economic life as the period over which they anticipate the recapture of the investment. If the investor intends to own an income-producing property 15 years, recapture (straight-line) should occur at the rate of 6.67% per year (100% / 15 year holding period = 6.67%/year). This assumes the total depreciation of the improvements over the 15 year period. 122

123 Example: Recapture Rates 13-1 Complete the following table: Remaining Economic Life Recapture Rate 50 years 2.00% 45 years 40 years 33 years 3.03% 30 years 25 years 4.00% 20 years 5.00% 15 years As these recapture rates illustrate, the shorter the remaining economic life of the improvements the greater the annual recapture rate. Conversely, if the improvements are relatively new with a long remaining economic life, the recapture rate is lower. Market Comparison Method The second method of developing a recapture rates is the market comparison method. Just as we solved for a discount rate using this method, we will solve for the recapture rate. Again, this method is best utilized when adequate and verifiable sales data is available. The net operating income (NOI) attributable to recapture is divided by the improvement value to determine the recapture rate. Using our example: A property just sold for $800,000. The building value is $600,000. The discount rate is 7.5% requiring $60,000 of NOI. The property taxes are 2% or $16,000. If the NOI is $94,000 what is the recapture rate? 123

124 Income Rate Value Discount $60, % $800,000 Recapture?? $600,000 Taxes $16, % $800,000 Total $94,000? $800,000 Procedurally, the next step is to determine the amount of net operating income remaining for recapture. Income Rate Value Discount $60, % $800,000 Recapture $18, % $600,000 Taxes $16, % $800,000 Total $94, % $800,000 By dividing the income remaining for recapture of $18,000 by the value of the improvements of $600,000 results in a recapture rate of 3.0%. The above examples reflect straight line recapture. We will learn later additional methods of providing for recapture dependent upon the shape and behavior of the income stream. Determining the Effective Tax Rate The effective tax rate the direct relationship between the property taxes and the value of a particular property. Simply stated the effective tax rate is the annual real estate taxes divided by the property value. 124

125 There are two methods of calculating the effective tax rate. They are the assessment level and tax rate method and the market comparison method Assessment Level and Tax Rate Method The assessment level and tax rate method utilizes the statutory assessment level of a jurisdiction multiplied by the local tax rate. Before this method can be used, a tax rate expressed in mills must be converted to a decimal equivalent. This can be accomplished by dividing the mill by one thousand; a mill is a dollar per thousand, or by moving the decimal point three places to the left. Example: 40 mills would be the equivalent of mills / 1000 = x 1000 = 40 mills Determining an Effective Tax Rate Millage Rate x Assessment Ratio 1 mill =.001 so 40 mills =.040 Example: Effective Tax Rates 13-2 Tax Rate Assessment Ratio Effective Tax Rate.040 x 50% AV ratio =.040 x 35% AV ratio =.060 x 50% AV ratio =.042 x 100% AV ratio = 125

126 Market Comparison Method Market comparison method may also be used to develop an effective tax rate. The net operating income (NOI) attributable to effective taxes is divided by the sales price or value of a property to determine the effective tax rate. Continuing with our example: A property just sold for $800,000. The building value is $600,000. The discount rate is 7.5% requiring $60,000 of NOI. The recapture rate is 3% requiring $18,000 of NOI. If the NOI is $94,000 what is the effective tax rate? Income Rate Value Discount $60, % $800,000 Recapture $18, % $600,000 Taxes?? $800,000 Total $94,000? $800,000 Procedurally, the next step is to determine the amount of net operating income remaining for taxes. Income Rate Value Discount $60, % $800,000 Recapture $18, % $600,000 Taxes $16, % $800,000 Total $94, % $800,000 By dividing the income remaining for taxes of $16,000 by the value of the entire property of $800,000, the result is an effective tax rate of 2.0%. 126

127 Summary of Capitalization Rate Components The following exhibit identifies the components involved in solving for discount, recapture and effective tax rates by use of the market comparison method. Income Rate Value Discount Annual Return On Investment Discount rate Property Value Recapture Annual Return Of Building Investment Recapture Rate Building Value Taxes Annual Tax Bill Effective Tax Rate Property Value Total NOI Overall Rate Property Value 127

128 Direct Capitalization Comments Advantages: Direct capitalization is easy to understand (and explain) by appraisers, clients and taxpayers. Direct capitalization develops the relationship between a property's income and market value estimate in one step. Direct capitalization through an overall rate can be used with all types of incomeproducing properties. Direct capitalization does not attempt to allocate an overall rate into discount rate and recapture rate segments. Direct capitalization does not require specific assumptions regarding investor expectations such as holding periods, changes in future property value (reversion) or income changes. Direct capitalization can be applied to either current year income (actual) or stabilized income (first year projection). Disadvantages: Overall rates require market information from similar properties including sale price, income and expenses, financing terms and market conditions. Overall rates should be developed from properties with similar physical and economic characteristics such as land-to-building ratio and remaining economic life. Overall rates extracted from comparable properties in a consistent manner with the subject property. The preferred method for developing overall rates is through market extraction. 128

129 Chapter 13 Quiz A: Discount Rate 1.) Through analysis of an investment an investor has determined that the safe rate is 5% and the rate of risk is 3%. Associated with this investment is a management rate of 1% and the non-liquidity rate has been determined to be 1%. What is the resulting discount rate? 2.) The same investor from Problem 1 has decided to analyze a similar investment but in a more undesirable area. Only two of the components have been affected by this decision. The management rate is 1% higher and risk rate is 2% higher. What is the resulting discount rate? 3.) An investor has acquired a mortgage on a property in the amount of 70% of value with an interest rate of 10%. He expects a return of 12% on equity of the remaining 30% of value. What is the resulting discount rate? 4.) An investor has acquired a mortgage on a property at an interest rate of 9% and equates to 75% of value while obtaining a second mortgage at an interest rate of 10% which equates to 10% of value. He expects a return of 12% on the remaining 15% of value. What is the resulting discount rate? 129

130 5.) Five comparable properties have been analyzed for both sales price and NOI attributable to discount. NOI for recapture and effective taxes has been satisfied. Property # NOI (Discount) Sales Price Discount Rate 1 $10,000 $100,500 2 $12,000 $121,500 3 $ 9,500 $ 96,000 4 $13,500 $136,000 5 $11,500 $115,000 Based on the five comparable discount rates, what discount rate would you apply to the subject? 6.) An appraiser has gathered information in regard to a particular property. She has found the sales price to be $750,000 with a NOI of $82,500. Land sales in the area are plentiful and the appraiser has determined that the land value is $187,500. The recapture rate for this property is 2% and the effective tax rate is 1.5%. What is the resulting discount rate? 7.) An appraiser has gathered information in regard to a particular property. He has found the sales price to be $500,000 with a NOI of $62,500. Land sales in the area are plentiful and the appraiser has determined that the land value is $125,000. The recapture rate for this property is 2% and the effective tax rate is 1%. What is the resulting discount rate? 130

131 Chapter 13 Quiz B: Recapture Rates 1.) Four properties have been analyzed and determinations of their remaining economic lives (REL) have been made. What are the indicated recapture rates? Property Remaining Economic Life Recapture Rate ) Five properties have been analyzed for both improvement value and NOI attributable to recapture. NOI for discount and effective taxes has been satisfied. Property # NOI (Recapture) Improvement Value Recapture Rate 1 $ 1,600 $ 80,000 2 $ 2,100 $110,000 3 $ 2,020 $ 96,000 4 $ 5,000 $250,000 5 $ 2,400 $125,000 Based on the data, what is the resulting recapture rate? 3.) An appraiser has gathered information in regard to a particular property. She has found the sales price to be $750,000 with a NOI of $82,500. Land sales in the area are plentiful and the appraiser has determined that the land value is $187,500. The discount rate for this property is 8% and the effective tax rate is 1.5%. What is the resulting recapture rate? 131

132 4.) An appraiser has gathered information in regard to a particular property. He has found the sales price to be $500,000 with a NOI of $62,500. Land sales in the area are plentiful and the appraiser has determined that the land value is $125,000. The owner of the property has secured a mortgage for 9% equating to 75% of the property value. The expected return on equity is 13% and the effective tax rate is 1%. What is the resulting recapture rate? 132

133 Quiz Chapter 13 C: Effective Tax Rates 1.) Convert the following tax rates to millage rates and millage rates to tax rates. Fill in the blanks below. Millage Rate Tax Rate ) Calculate the appropriate effective tax rates for the properties listed below. Property Assessment Level Tax Rate Effective Tax Rate 1 50% % % % 80 mills mills 3.) Five properties have been analyzed for both sale price and NOI attributable to effective taxes. NOI for discount and recapture has been satisfied. Property # NOI(Effective Taxes) Sale Price Effective Tax Rate 1 $ 1,575 $105,000 2 $ 1,850 $125,000 3 $ 1,425 $ 95,000 4 $ 3,800 $250,000 5 $ 2,750 $185,000 What is the resulting effective tax rate? 133

134 4.) An appraiser has gathered information in regard to a particular property. She has found the sales price to be $750,000 with a NOI of $82,500. Land sales in the area are plentiful and the appraiser has determined that the land value is $187,500. The discount rate for this property is 8% and the recapture rate is 2%. What is the resulting effective tax rate? 5.) An appraiser has gathered information in regard to a particular property. He has found the sales price to be $500,000 with a NOI of $62,500. Land sales in the area are plentiful and the appraiser has determined that the land value is $125,000. The owner of the property has secured a mortgage for 9% equating to 75% of the property value. The expected return on equity is 13% and the remaining economic life of the building is 50 years. What is the resulting effective tax rate? 6.) An appraiser has gathered information in regard to a particular property. He has found the sales price to be $1,250,000 with NOI of $162,500. Land sales in the area are plentiful and the appraiser has determined that the land value is $312,500. The owner of the property has secured a mortgage for 9.5% equating to 70% of the property value. The expected return on equity is 12% and the remaining economic life of the building is 40 years. What is the resulting effective tax rate? 134

135 Chapter 14: Deriving Capitalization Rates As we learned in the previous chapter both investors and lenders seek return on and return of their invested capital. We also learned that an overall capitalization rate contains a blend of return on and return of components and that the rates can fluctuate based on investment risk and recapture provisions. Capitalization rates are derived from market data. As we will learn in this section, capitalization rates can be derived by several methods. These include market extraction method, mortgage equity band of investment method, debt coverage ratio method and the EGIM/OER Method Market Extraction Method The purest form of determining an overall capitalization rate is by market extraction (also known as abstraction). This is simply the IRV formula at work and is the preferred method for developing overall rates. extraction - A method of deriving capitalization rates from property sales when sale price and net operating income are known. Market extraction of overall rates involves dividing the net operating income of the sale property by the sale price. NOI $165,000 =.0971 or 9.71% Sale Price $1,700,000 Example: Overall Rate Extraction 14-1 An apartment complex has effective gross income of $214,000 and expenses of $58,200. The property sold for $1,200,000. Calculate the overall capitalization rate. Effective Gross Income $214,000 Operating Expenses - 58,200 Net Income $155,800 Sale Price $1,200,

136 Using the IRV formula, we can now extract the overall capitalization rate from this property. NOI $155,800 =.1298 or 13% Sale Price $1,200,000 Similarity between the sale properties and the subject is important. Just as the inclusion or exclusion of replacement allowances can influence overall rates, so does the comparability of land-to-building ratios and remaining economic lives. Land-to-building ratios should be consistent as shown in the following illustration. Sale 1 Sale 2 Land-To-Building Ratio ($) 1:2 Ratio 1:4 Ratio Sale Price $500,000 $500,000 Land Value $166,667 $100,000 Building Value $333,333 $400,000 Discount Rate Recapture Rate (25 Year Life-Straight Line) NOI Required for Discount $32,500 $32,500 NOI Required for Recapture $13,333 $16,000 Total NOI $45,833 $48,500 Overall Rate As the above table indicates, as the ratio of building value to total property value increases, more net operating income is required to satisfy the recapture provision thus increasing the overall capitalization rate. 136

137 The recapture provision is also impacted by the remaining economic life of the improvements. As the remaining economic life decreases, the recapture rate provision is increased which increases the overall rate. Conversely, as remaining economic life increases, the recapture rate is decreased thereby decreasing the overall rate. The following example illustrates this relationship. Remaining Economic Life (Years) 40 Annual Recapture Rate 5.00% 4.00% 3.33% 2.50% Discount Rate 8.00% 8.00% 8.00% 8.00% Building Capitalization Rate 13.00% 12.00% 11.33% 10.50% Land Capitalization Rate 8.00% 8.00% 8.00% 8.00% Weighted Building Rate of Overall Rate (80%) 10.40% 9.60% 9.06% 8.40% Weighted Land Rate of Overall Rate 1.60% 1.60% 1.60% 1.60% (20%)* Total Overall Rate 12.00% 11.20% 10.66% 10.00% Improvement value equals 80% of total property value with the land value comprising the remaining 20%. While the land capitalization rate remains constant at 8% the building capitalization rates decrease as the remaining economic life increases. This is due to the lowering of the recapture provision. Band of Investment Mortgage Equity Method Most real estate investments are purchased through a combination of debt and equity. Each of these components must achieve a market based return. The mortgage lender needs to receive a competitive interest rate or return on their investment. Similarly, the borrower is also anticipating a competitive return on the equity invested and both seek return of their investment. When market information is available for the required returns on both debt and equity, it is possible to develop a capitalization rate. This rate is the 137

138 composite average of the weighted proportions of debt and equity. This method of developing a capitalization rate is called the band of investment technique. band of investment - A technique in which the capitalization rates attributable to components of a capital investment are weighted and combined to derive a weighted-average rate attributable to the total investment. To use this technique it is necessary to gather information on available mortgage interest rates and terms, loan-to-value ratios and equity dividend rates. The formula for the band of investment is: Loan Value % (M) x Mortgage Constant (R M ) + Equity Value % (1-M) x Equity Dividend Rate (R E ) Total Value (100%) Overall Rate The components needed to perform the band of investment technique are summarized in the table below. Notice the heading of the box is IRV. The following example will derive an overall capitalization rate by the mortgage equity band of investment technique. Mortgage funds are available for 70% of the property's value and current mortgage interest rates are 7.00% amortized over 25 years with monthly payments of principal and interest. Based on these mortgage terms the mortgage constant (amount of annual debt service payments for each dollar borrowed) is Again, this represents the 138

139 partial payment factor for the loan annualized. Typical investors require a 9% equity dividend rate. As a beginning step, insert the data we have from the problem up to this point into a table. Income Rate Value Mortgage % Equity % Total 100% By using IRV we can multiply the rate x the value to get the income needed to support this property as shown below. Remember when using percentages it may be helpful to consider the property having a value of $1. Income Rate Value Mortgage % Equity % Total % 100% For ad valorem assignments, once the overall rate is developed by the band of investment technique, the appropriate effective tax rate is added to complete the capitalization rate. To reinforce this topic, we will use the same example giving dollar amounts instead of percentages. The property is worth $1,000,000. Mortgage funds are available for 70% of the property's value at a 7.00% interest rate, amortized over 25 years with monthly payments. The mortgage constant is Typical investors require a 9% equity dividend rate. 139

140 Income Rate Value Mortgage Equity Total $86,370 $1,000,000 Calculating an overall rate from the band of investment technique is straight forward and accurate when market data is available. However, while typical lending terms can be developed from surveys of local lenders, equity dividend rates are more difficult to obtain. The equity dividend rate is the ratio of annual cash flow (net operating income less debt service) to the original equity investment. It is the equity's capitalization rate. Typically, the equity dividend rate is the investor's anticipated rate of return for the first year of the projection (ownership) period. The equity dividend rate measures both return on and of invested equity capital. Example: Equity Dividend Rate 14-2 Here is another example using dollar amounts. An office building recently sold for $1,100,000 with a net operating income of $96,500. The property can be financed with a conventional mortgage at a 70% loan to value ratio, 7.00% interest and 25 year amortization (mortgage constant = ). What is the equity dividend rate? Mortgage Amount: $770,000 ($1,100,000 x.70) Equity Amount: $330,000 ($1,100,000 - $770,000) Net Operating Income $96,500 Annual Debt Service: $65,307 ($770,000 x ) Annual Cash Flow: $31,193 ($96,500 - $65,307) Equity Dividend Rate ($31,193 / $330,000) 140

141 Equity dividend rates can be developed if the overall rate is known and typical financing terms can be accurately estimated. Here is another example: An industrial building recently sold for $750,000 with net operating income of $72,000. Similar properties can be financed at a 75% loan-to-value ratio, 7.50% interest rate and 20 year amortization (mortgage constant = ). What is the implied equity dividend rate? Mortgage Amount: $562,500 ($750,000 x.75) Equity Amount: $187,500 ($750,000 x.25) Net Operating Income $72,000 Annual Debt Service: $54,377 ($562,500 x ) Annual Cash Flow: $17,623 ($72,000 - $54,377) Equity Dividend Rate ($17,623 / $187,500) Debt Coverage Ratio Method The debt coverage ratio (DCR), or the ratio of net operating income to annual debt service, can also be used to estimate an overall rate in conjunction with other mortgage information. The debt coverage ratio is a risk rating measure used by lenders. Its purpose is to provide a margin of net income which exceeds the level of annual debt service. In the event of a decline in net operating income, this margin provides assurance that debt service payments can be maintained. A commercial property has a current net operating income of $72,000.Debt service payments are $4,925 monthly ($59,100 annually). What is the debt coverage ratio? NOI $72,000 = DCR ADS $59,

142 The interrelationship between NOI, annual debt service and debt coverage ratios can be used to determine an overall capitalization rate. This is a simple calculation that multiplies the debt coverage ratio by the mortgage constant and the loan to value ratio to develop a capitalization rate. Debt coverage ratio x mortgage constant x loan-value-ratio = capitalization rate The following is an example of how the formula is applied. The net operating income is $66,300 with annual debt service of $54,350.The mortgage is 75% of value with a mortgage constant of (10.25%/25 years/monthly payments). Lenders require a 1.22 debt coverage ratio. The calculation to determine the capitalization rate by this method is presented below. With Rm the symbol for the mortgage constant and LTV being the loan to value ratio. Capitalization Rate = 1.22 DCR x Rm x.75 LTV = or 10.17% By combining the terms dictated by the lender (DCR, mortgage constant, and loan to value ratio) a capitalization rate of 10.17% is derived. Debt coverage ratios increase or decrease depending on the risk associated with a property's income stream. This measure is used in mortgage underwriting but not typically used in assessment appraisals. This method provides an overall capitalization rate that meets the lenders requirements. Equity investors may seek returns greater returns to equity than provided for by the lenders requirements. In our example, the implied equity dividend rate is 7.34% which may or may not be sufficient to attract equity capital. The calculation of this rate follows: 142

143 Income Rate Value Mortgage % Equity % Total % Effective Gross Income Multiplier/Operating Expense Ratio Method Capitalization rates can also be extracted from market sales where effective gross income multipliers (sale price - effective gross income) and operating expense ratios (ratio of operating expenses to effective gross income) are available. The formula for deriving a capitalization rate by this method is as follows: Capitalization Rate = 1 - Operating Expense Ratio (OER) Effective Gross Income Multiplier A property recently sold for $825,000. The effective gross income multiplier at the time of sale was 4.85 with operating expense ratio of 45.00%. What is the capitalization rate? Operating Expense Ratio =.55 EGIM 4.85 Capitalization Rate =.1134 or 11.34% As we learned earlier, IRV represents income / value = rate. In this method (1-OER) actually equals the net income ratio or NIR. The following calculations confirm the EGIM/OER methodology. 143

144 Using VIF formula Sale Price $825,000 / 4.85 EGIM gives Effective Gross Income of $170,103 Effective Gross Income $170,103 Operating Expenses OER (45%) $ 76,546 Net Operating Income $ 93,557 NOI $ 93,557 =.1134 or 11.34% Sale Price $825,000 By dividing the NIR by the EGIM we are simply converting a factor into a rate. 144

145 Chapter 14: Deriving Capitalization Rate Challenge Develop a capitalization rate by market extraction method, mortgage equity band of investment method, debt coverage ratio method and the OER/EGIM method based on the following market information: Sale Price $1,185,000 Effective Gross Income $167,000 Net Operating Income $100,000 Operating Expense Ratio 40% Debt Coverage Ratio 1.50 Loan-to-value ratio 65% Interest rate 7.25% Amortization period 25 years Annual mortgage constant Equity dividend rate 8.00% What is overall capitalization rate using market extraction method? What is overall capitalization rate using mortgage equity band of investment method? What is the overall capitalization rate using debt coverage ratio method? What is overall capitalization rate using OER/EGIM method? 145

146 Market extraction method Using IRV NOI = Overall Rate Sale Price Mortgage equity band of investment method First, complete the box with the information provided, then complete the box by solving for the missing amounts. Mortgage Equity Income Rate Value Total Debt coverage ratio method x x = OER/EGIM method First Solve for EGIM / = ( - ) / = 146

147 Chapter 14 Quiz: Direct Capitalization Problems 1.) Show the formula and the value for a property that has a net income of $5,000 and capitalization rate of 12%: 2.) Show the capitalization formula and the capitalization rate for a property that has net income of $12,000 and value of $96,000: 3.) Show the capitalization formula and the net income for a property that has a value of $65,000 and a capitalization rate of 10%: 4.) In question 1, what number represents a ratio between the net income and the property value? 5.) The assessment ratio is 50%, and the tax rate is 45 mills. Calculate the effective tax rate: 6.) An apartment building has potential gross income of $12,000. A study of the market indicates that it is producing economic rent. There is a vacancy and bad debt ratio in this market of 5%. The subject generates miscellaneous income of $1,600 per year (hint: no need to deduct vacancy from this amount). The expense ratio is 40% for comparable properties. The appropriate capitalization rate is 12%. Calculate the value of this apartment building: 147

148 7.) You are considering the purchase of a restaurant building. Conventional financing is available at a maximum 60% loan to value ratio, 8.00% interest rate and 20 year amortization and monthly payments. Seller financing is typical for this type of property and the seller will finance 20% of the sale price. Interest would be at 10.00% with a 10 year amortization and monthly payments. You require a 12.00% equity dividend rate. What is the indicated capitalization rate? Mortgage Constant Loan 1 (Rm) = (8.00%, 20 year amortization) Mortgage Constant Loan 2 (Rm) = (10.00%, 10 year amortization) 8.) Which of the following statement is true for developing a capitalization rate using the Debt Coverage Ratio method? a.) Debt coverage ratio x interest rate x mortgage constant b.) DCR x NIR x OER c.) Debt coverage ratio x loan to value ratio x mortgage constant d.) (1-OER) / EGIM 9.) A property that sold for $400,000 has an operating expense ratio of 40% and an EGIM of What is the capitalization rate? a.) 7.00% b.) 10.50% c.) 17.51% d.) 10.00% 10.) What data is not required to determine an overall rate by the band of investment technique? a.) Loan to value b.) Equity dividend rate c.) Mortgage constant d.) Debt coverage ratio 148

149 Chapter 15: Residual Capitalization Techniques Just as the mortgage-equity analysis divided the property into two components mortgage and equity so do the residual capitalization techniques. These techniques, separate the property into two components--land and building. If the value of one of the components is known, the income necessary to satisfy the return on that value can be subtracted from net operating income. The term residual applies to the net income remaining after the income required to satisfy the return on the known portion of value has been satisfied. The physical residuals of land, building and property are commonly applied in direct capitalization. residual techniques - Procedures used to capitalize the income allocated to an investment component of unknown value after all investment components of known values have been satisfied; may be applied to a property s physical components (land and building) or financial interests (mortgage and equity). Building Residual Technique is commonly used when the subject property is improved with an older building and when the land value can be reasonably determined from comparable sales. It can be used to check the value indicated by the cost approach on new buildings. In order to use this technique, you must know the following: The net operating income The land value The proper discount rate The proper recapture rate The proper effective tax rate Land Residual Technique is used when the building value is known and when there are no unimproved land sales to support the land value. The building must be new (or a hypothetical improvement), and it must represent the highest and best use of the land. In order to use this technique, you must know the following: The net operating income The building value The proper discount rate The proper recapture rate The proper effective tax rate 149

150 Property Residual Technique is normally used when neither land nor building value can be estimated reliably. An estimate of the amount of recapture is required. In order to use this technique, you must know the following: The net operating income The proper discount rate The proper recapture rate The proper effective tax rate In order to complete residual analysis, the appraiser must develop land and building capitalization rates for proper application within this framework. The methods of determining land and building capitalization rates should look familiar. Deriving Land Capitalization Rates Land Capitalization Rate is the relationship between NOI attributable to land and land value. The land capitalization rate consists of two components; the discount rate and the effective tax rate. land capitalization rate (R L ) - The rate used to convert land income into an indication of land value; the ratio of land income to land value. There are two methods of calculating the land capitalization rate. The first is to sum of the discount rate and the effective tax rate. The second is the market comparison method. Summation Method for Developing Land Capitalization Rate The land capitalization considers the return on the investment in the land and a sum necessary to address property taxes on the land. Remember, because the land is assumed to exist at the end of the economic life of the improvements, the land does not need a recapture provision. Therefore, adding together the discount rate and the effective tax rate results in the land capitalization rate. Discount Rate Effective Tax Rate Land Capitalization Rate

151 Market Comparison Method for Developing Land Capitalization Rate The market comparison method is best utilized when verifiable land sale information is available or land value can be extracted from improved sales. It is necessary to derive NOI attributable to land. The table below summarizes the data used within the market comparison method. Once again, the headings along the top are IRV. Income Rate Value Building NOI for Building Building Cap Rate Building Value Land NOI for Land Land Cap Rate Land Value Total NOI Overall Rate Property Value The known data is entered and used to solve for unknowns. Use addition when moving down a column, subtraction when moving up a column, multiplication when moving from right to left and division when moving from left to right. For example, a property with an NOI of $50,000 recently sold for $500,000 with the improvement equating to 75% of the total value. The building capitalization rate is 10.67% resulting in the NOI attributable to the improvement of $40,000. What is the land capitalization rate? Income Rate Value Building $40, % $375,000 Land $10,000? $125,000 Total $50,000 $500,

152 By using IRV, we can calculate the land capitalization rate by the dividing land income by land value. The resulting land capitalization rate is 8%. Income Rate Value Building $40, % $375,000 Land $10, % $125,000 Total $50, % $500,000 Deriving Building Capitalization Rates The building capitalization rate is the relationship between NOI attributable to the improvement and improvement value and consists of the discount rate, recapture rate, and the effective tax rate. building capitalization rate (R B ) 1.The rate used in certain residual techniques or in a band of investment to convert building income into an indication of building value. 2. The ratio of building income to building value. There are two methods of calculating the improvement (or building) capitalization rate. The first is the sum of the discount rate, recapture rate, and the effective tax rate. The second is the market comparison method Summation Method for Developing Building Capitalization Rate Adding together the discount rate, recapture rate, and the effective tax rate results in the development of the building capitalization rate. Building Capitalization Rate Discount Rate Recapture Rate (straight line 1/50 REL) Effective Tax Rate Building Capitalization Rate

153 Market Comparison Method for Developing Building Capitalization Rate Again, the market comparison method is best utilized when verifiable property sale information is available and improvement value can be extracted. For example, a property with an NOI of $50,000 recently sold for $500,000 with the improvement equating to 75% of the total value. The land capitalization rate is 8% resulting in the NOI attributable to the land of $10,000. What is the building capitalization rate? Income Rate Value Building $40,000? $375,000 Land $10, $125,000 Total $50,000 $500,000 By using IRV, we can calculate the building capitalization rate by the dividing building income by building value. The resulting land capitalization rate is 10.67%. Income Rate Value Building $40, % $375,000 Land $10, % $125,000 Total $50, % $500,

154 Building Residual Technique In the building residual technique, the value of the building is estimated based on the quantity of its contribution to total net operating income. This technique is appropriate when the land value can be estimated from comparable sales yet the building improvements have suffered substantial depreciation. building residual technique - A capitalization technique in which the net operating income attributable to improvements is isolated and capitalized by the building capitalization rate (R B ) to indicate the improvements contribution to total property value. When the improvements value is added to land value, a total property value opinion is produced. To use the building residual technique the following elements must be: 1. Current Land Value 2. Net Operating Income 3. Discount Rate 4. Recapture Rate 5. Effective Tax Rate The appraiser multiplies the discount rate and effective tax rate by the land value to estimate the amount of net operating income necessary to support the land component. This income is subtracted from total net operating income to indicate the residual income available to support the value of the building improvements. This residual income is then capitalized by the combined discount rate, recapture rate and effective tax rate to indicate the present value of the building improvements. The addition of the land value to the improvements value indicates the total property value. The building residual technique can be used with the straight- line, sinking-fund or annuity methods of capitalization depending upon the assumptions regarding the income stream and capital recovery. These different recapture techniques are discussed in the next chapter. Example of the Building Residual Technique 15-1 The subject property is an older two story retail building in a center city area currently experiencing rehabilitation and increasing land values. Due to this activity, land value has been estimated at $150,000 based on comparable sales. The property currently 154

155 generates a net operating income of $65,000. The discount rate extracted from the market for this property type is 8.0% while the remaining economic life of the building is estimated at 25 years. The effective tax rate is 3.15%. What is the value of the building and the overall property? Because we have the necessary data, we can first solve for the land and building capitalization rates using the summation method. Land Capitalization Rate Discount Rate Effective Tax Rate Land Capitalization Rate Building Capitalization Rate Discount Rate Recapture Rate (1/25 REL Method) Effective Tax Rate Building Capitalization Rate We can now input the land value ($150,000), land capitalization rate (.1115), building capitalization rate (.1515) and net operating income ($65,000). We can solve for the other components to derive the building value and total value by the building residual technique as shown below: Income Rate Value Building 15.15% Land $16, % $150,000 Total $65,000 Land Residual Technique In the land residual technique, the value of the land is estimated by its contribution to total net operating income. This technique is used when the value of the building improvements can be reliably estimated. The value of the improvements is typically the current cost of construction when the building represents the highest and best use 155

156 of the site. The building should not suffer depreciation. The land residual technique can be used as a test of highest and best use for proposed construction. land residual technique - A method of estimating land value in which the net operating income attributable to the land is capitalized to produce an indication of the land s contribution to the total property. To apply the land residual technique the following elements must be known: 1. Current Building Value 2. Net Operating Income 3. Discount Rate 4. Recapture Rate 5. Effective Tax Rate The appraiser multiplies the building capitalization rate which includes the discount rate, recapture rate and the effective tax rate by the building value to estimate the amount of net operating income needed to support the building value. After subtracting this income from the total net operating income, the residual income is capitalized by the discount rate and effective tax rate to indicate the present value of the land. The addition of the land value to the building value indicates the total property value. Similar to the building residual technique, the land residual technique can be used with any of the three (straight line, sinking fund and annuity) direct capitalization recapture methods. Example of Land Residual Technique 15-2 A 12 story office building is proposed for the downtown area. This area is fully developed except for the subject site which is a surface parking lot. The proposed building on the subject site will contain 120,000 square feet is estimated to cost $10,800,000. The property is anticipated to generate a net operating income of $1,840,000 when complete and occupancy has stabilized. Investors in this type of development currently require a 9.00% rate of return on investment. The building is estimated to have a 50 year economic life and the effective tax rate in this location is 3.00%. Because we have the necessary data, we can first solve for the land and building capitalization rates using the summation method. 156

157 Land Capitalization Rate Discount Rate Effective Tax Rate Land Capitalization Rate Building Capitalization Rate Discount Rate Recapture Rate Effective Tax Rate Building Capitalization Rate We can now input the building value ($10,800,000), land capitalization rate (.1200), building capitalization rate (.1400) and net operating income ($1,840,000). We can solve for the other components to derive the land value and total value by the land residual technique as shown below: Income Rate Value Building $1,512, % $10,800,000 Land 12.00% Total $1,840,000 Therefore, the land value contributes $328,000 of the NOI and in turn contributes a value of $2,733,333 to the property. Property Residual Technique The property residual technique is primarily used in valuing the leased fee (lessor) interest in a long term lease. In such a situation the lessor receives periodic lease payments and the lump sum reversion of the property at the termination of the lease. This methodology will be reinforced in advanced income courses. 157

158 property residual technique - A capitalization technique in which the net operating income is attributed to the property as a whole, not to separate land and building components. In yield capitalization, the present value of the income stream is computed and added to the present value of the reversion at the projected termination of the investment. This method takes us back to the compound interest tables. In the annuity method, the property residual technique is reflected by the following formula: Income stream x present worth of $1 per period + Reversion x Present worth of $1 Present value The property residual technique is used in those situations where neither land nor building values can be independently estimated. The net operating income is capitalized directly without separating it into allocations for land and building. An important assumption is that the future value or reversion of the property can be reliably estimated. The following are necessary elements for using the property residual technique. 1. Net Operating Income 2. Reversion Value 3. Discount Rate 4. Recapture Rate 5. Effective Tax Rate Property Residual Technique Example 15-3 A small strip shopping center has a net operating income of $25,000 annually. The income stream is expected to remain level over a 15 year remaining economic life. Investors in this type of property require an 8.00% discount rate. The effective tax rate is 2.55%. At the end of the economic life, the property is anticipated to have a land value of $150,000. Net Operating Income $25,000 = $175,648 Capitalization Rate for Income Stream Plus Present Value of Reversion 2 $ 47,286 Total Present Value $222,

159 Net Operating Income $25,000 = Present Value $222,934 Overall Rate 11.21% 1 Partial Payment factor at 8% for 15 years (reflects discount and recapture) Plus Effective Tax Rate Capitalization Rate for Income Stream Present value of reversion Reversion value in 15 years $150,000 PV $1 Factor at 8% for 15 years x Present Value $ 47,

160 Chapter 15 Quiz: Residual Capitalization Techniques 1.) The rate used to convert land income into an indication of land value; the ratio of land income to land value is known as? a.) b.) c.) d.) Building capitalization rate Overall rate Band of investment Land capitalization rate 2.) What is the difference between a land capitalization rate and a building capitalization rate? a.) b.) c.) d.) The recapture provision Operating expenses The replacement allowance There is no difference 3.) A capitalization technique in which the net operating income attributable to improvements is isolated and capitalized by the building capitalization rate (R B ) to indicate the improvements contribution to total property value. When the improvements value is added to land value, a total property value opinion is produced is known as? a.) b.) c.) d.) Land residual technique Building residual technique Property residual technique Band of investment technique 4.) A building generates $55,000 in net operating income. If the building capitalization rate is 14%. What is the value of the building? a.) $392,857 b.) $7,700 c.) $51,500 d.) $55,000 5.) You would use the land residual approach if you had plentiful land sales and a building that has suffered substantial depreciation? a.) b.) true false 160

161 6.) A property shows a building capitalization rate of 11% and a land capitalization rate of 8.2%. What is the remaining economic life of the improvements? a.) b.) c.) d.) nearly years nearly 9 years nearly 12 years nearly 36 years 7.) You are appraising a newer building in an area where land sales are scarce. What capitalization method should be used? a.) b.) c.) d.) Hoskold method land residual technique property residual technique building residual technique 8.) A site on Haggerty Road is improved with a retail store that has a remaining economic life of 20 years. The appropriate discount rate is 10 percent and the effective tax rate for this jurisdiction is 3 percent. Using straight line capitalization: a.) What is the capitalization rate for the land? b.) What is the capitalization rate for the building? 9.) A site on Novi Road is improved with a retail store that has a remaining economic life of 25 years. The appropriate discount rate is 6 percent and the effective tax rate for this jurisdiction is 3 percent. a.) What is the capitalization rate for the land? b.) What is the capitalization rate for the building? 10.) A proposed 5,000 SF retail building is to be built for $100 per SF in an area where there are no land sales. The building is to be leased and the property will produce a net operating income before discount, recapture and real property taxes of $90,000. The proper recapture rate is 2% and the appropriate discount rate is 9%. Real estate taxes are baed on a 50% level of assessment and a current annual tax rate of 40 mills. What is the value of the property? a.) $750,000 b.) $727,000 c.) $1,000,000 d.) $900,

162 Chapter 16: Income Streams and Selection of Capitalization Methods Before a capitalization method can be selected the appraiser needs to examine the characteristics of the income stream. The appraiser considers the quality, quantity, durability and shape of the income stream. Quality: Quantity: Durability: Shape: Refers to the strength of the income stream. Is it comprised of payments from a financially strong tenant? Is it comprised of payments from a weaker tenant? What is the credit rating of the tenant and is there the likelihood that payments will be prompt during the duration of the lease? Refers to the amount of the income stream. How long will the income stream last? Is the income stream the result of month-to-month leases, short term or long term leases? Refers to the pattern of payments in the income stream. Are the payments level, increasing or decreasing? Valuation models can be applied to the following patterns of income in regard to shape and durability. Level Perpetual Series - The investor anticipates receiving equal periodic payments for the duration of the holding period. Typically applied in the valuation of land, this method assumes no change in value and no time limit for the investment. Because land is considered to be a non-wasting asset, the income from the land is assumed to be perpetual. 162

163 Level Terminal Series - The investor anticipates receiving equal periodic payments which will end at some future date. The termination of the payments could coincide with the end of the economic life of the building or the termination of the lease. Declining or Increasing Terminal Series In a declining terminal series, the investor anticipates that the periodic payments will decrease over the holding period and finally cease at the end of the lease or the end of the economic life of the building. As a corollary, the increasing terminal series is also an income stream pattern. 163

164 Future Payment - The investor anticipates receiving a lump sum payment at some future date. The investor could receive this payment from the resale of land or the purchase of a property held for future speculation in anticipation of selling at a profit. The capitalization method selected has an effect on the value produced by the income approach. The characteristics of the income stream for the property being appraised direct the assessor to the appropriate capitalization method. There are three capitalization methods and their differences relate to how the investment is recaptured. The three capitalization methods are: Straight-Line Capitalization Sinking-Fund Capitalization (Hoskold) Annuity Capitalization (Inwood) 164

165 Straight-Line Capitalization Certain assumptions regarding the shape and durability of the income stream are necessary in the straight-line method. Straight-line capitalization is appropriate under the following circumstances: The income is likely to decline over the economic life of the improvement. The improvement will be recaptured in equal amounts over its economic life. The discount will be received each year on the remaining balance of the investment. The tenant ranks financially average or poor on a scale of good, average, and poor. The lease is month-to-month or short-term. Note: When using straight-line capitalization, the recapture rate is calculated by either the market comparison method or the remaining economic life method (dividing the remaining economic life into 100%, for example, if the remaining economic life is 25 years, the recapture rate = 100% / 25 Years = 4%). As the exhibit displays, while the amount of recapture remains constant, the amount of NOI for discount and overall property NOI decline. 165

166 Sinking-Fund Capitalization (Hoskold Method) Sinking fund capitalization, also known as the Hoskold Method, produces a value that is somewhat higher than exhibited by the straight-line method. In this method, it is assumed that as the recapture is received, the amount is invested in a sinking fund at a safe rate. It is appropriate under the following conditions: The estimated net income remains level and constant during the economic life of the improvements,* Recapture of the improvements is invested in a sinking fund at a safe rate of interest, Discount is based on the total original investment value and remains level during the economic life of the improvements, The tenant has an above average credit rating, The lease is long term and favorable to the landlord and The improvements are modern and in a good location. This method has its roots in the valuation of mining operations. As the minerals are extracted and sold, the dollars recaptured are invested into a safe interest bearing account. At the end of the life of the mining operation the recaptured amounts plus the compound interest on those amounts will total the original investment amount. *This can also include an irregular income stream which can be converted into an equivalent level income stream. Note: When using sinking-fund capitalization, the recapture rate is found by looking in the Compound Interest Tables to get the Sinking-Fund Factor at the Sinking-Fund Rate for the number of years of Remaining Economic Life. 166

167 As the exhibit displays, the amount of recapture, discount and NOI remain constant over the life of the improvements. Annuity Capitalization (Inwood Method) Using annuity capitalization produces a value that is higher than both the straight-line and sinking-fund methods. This method provides for return both on and of the investment in one payment. The Amount to amortize 1 or as it is also known the partial payment factor is used in this method. Characteristics of income streams which can be capitalized using the annuity method include: Income is assumed to be periodic payments of stipulated amounts. The income estimates can be level, increasing or decreasing provided that they occur at regular intervals,* Discount income is based on the remaining unrecovered value of the investment and decreases during the economic life of the improvements, Recapture income increases periodically by the same amount that discount decreases by during the economic life of the improvements, 167

168 The tenant has an above average credit rating, The lease is long term and favorable to the landlord and in a good location. The income stream is level. The discount amount decreases because the discount is on the remaining improvement value. The recapture amount increases by the same amount that the discount decreases. *This can also include an irregular income stream which can be converted into an equivalent level income stream. Note: When using annuity capitalization, there is no recapture rate. Instead, one uses the Partial Payment Factor at the Discount Rate for the number of years of Remaining Economic Life. As the exhibit displays, the amount of recapture increases over the term as the amount of discount decreases and NOI remain constant over the life of the improvements 168

169 Example: Straight-Line Capitalization Method 16-1 You are analyzing the recent sale of a small strip shopping center. The sale price was $1,125,000 with $225,000 the estimated current land value. The building is 5 years old with an estimated remaining economic life of 25 years. Interviews with typical investors in this type of property indicate a discount rate of 9.00% is required. This example assumes the property taxes have been paid so effective tax rates do not need to be considered. What net operating income would be required to justify this sale price and required discount and recapture rates? One way to view this investment is by separating the investment into its land and building components similar to the land and building residual technique examples. The net operating income would be required to justify this sale price and required discount and recapture rates? Straight Line Method Return on Land Value $225,000 X.0900 = $ 20,250 Return on Building Value $900,000 X.0900 = $ 81,000 Return of Building Value $900,000 X.0400 = $ 36,000 Net Operating Income = $ 137,250 An NOI of $137,000 generates enough return on and return of this investment to justify the purchase price. What this example does not show is the pattern of recapture. In straight line recapture the $36,000 per year of recapture is deducted from the outstanding balance. 169

170 Year Building Income 9.00% Discount Recapture Remaining Bldg. Value 0 $900,000 1 $117,000 $ 81,000 $ 36,000 $864, ,760 77,760 36, , ,520 74,520 36, , ,280 71,280 36, , ,040 68,040 36, , ,800 64,800 36, , ,560 61,560 36, , ,320 58,320 36, , ,080 55,080 36, , ,840 51,840 36, , ,640 35,640 36, , ,440 19,440 36, , ,240 3,240 36, Example: Sinking-Fund Capitalization Method 16-2 Sinking-fund capitalization is a method which provides for the recapture of an investment through the use of a sinking-fund. As we know a sinking-fund is an account used to accumulate a sum of money at the end of a specified period through periodic deposits of equal annual amounts which grow at compound interest. Sinking-Fund Capitalization Return on Land Value $225,000 X = $ 20,250 Return on Building Value $900,000 X = $ 81,000 Return of Building Value $900,000 X * = $ 24,685 Net Operating Income = $ 125,935 *Sinking fund factor at 3.00% safe rate for 25 years. 170

171 Year Building Income Discount Recapture Interest Accurn. Remaining Bldg. Value 0 $900,000 1 $105,685 $ 81,000 $ 24, $ 24,685 $875, ,685 81,000 24, , , ,685 81,000 24,685 1,503 76, , ,685 81,000 24,685 2, , , ,685 81,000 24,685 3, , , ,685 81,000 24,685 3, , , ,685 81,000 24,685 4, , , ,685 81,000 24,685 5, , , ,685 81,000 24,685 6, , , ,685 81,000 24,685 7, , , ,685 81,000 24,685 12, , , ,685 81,000 24,685 18, , , ,685 81,000 24,685 25, , Example: Annuity Capitalization Method 16-3 Using annuity capitalization produces a value that is higher than both the straight-line and sinking-fund methods. This method provides for return both on and of the investment in one payment. Annuity Capitalization Return on Land Value $225,000 X = $ 20,250 Return on and of Building Value $900,000 X = $ 91,625 Net Operating Income = $111,875 Note: *Partial payment factor (col. 6) at 9.00% interest rate for 25 years is This factor contains two components; a return on at the interest rate (9.00%) and recapture of at the sinking fund factor at 9% of ( ). 171

172 Year Building Income 9.00% Discount Recapture Remaining Bldg. Value 0 $900,000 1 $ 91,625 $ 81,000 $ 10,625 $889, ,625 80,044 11, , ,625 79,001 12, , ,625 77,865 13, , ,625 76,627 14, , ,625 75,277 16, , ,625 73,806 17, , ,625 72,202 19, , ,625 70,454 21, , ,625 68,549 23, , ,625 56,117 35, , ,625 36,991 54, , ,625 7,563 84, Each of the three capitalization methods differ in the provision for recapture. Straightline recapture provides for a fixed amount per year during the economic life of the improvements. Sinking-fund recapture provides for a periodic annual amount invested at compound interest at a safe rate which will accumulate an amount equal to the cost of the investment at the end of the economic life of the improvements. Annuity recapture provides for the periodic return of a portion of the investment together with a return on the investment in the same payment. 172

173 The provision for recapture can be compared to the loading of the investor's rate of return to provide for future depreciation. Straight-line recapture provides the greatest recapture provision while annuity recapture provides the least recapture provision. Because both the sinking-fund and annuity methods invest the periodic recapture deposits at compound interest, the amount required to be recaptured over a period of time is less than the recapture amount required under the straight-line method. Recapture Rates* Straight-Line Sinking-Fund Annuity % Annually % Annually % Annually *25 year remaining economic life, 9.00% discount rate, 3.00% safe rate. 173

174 The following is a summary of capitalization procedures for different income streams with various methods and techniques. Income Stream Method Technique Level Perpetual Series Direct Direct Level Terminal Series Sinking Fund Land Residual Annuity Building Residual Property Residual Declining Terminal Series Straight Line Land Residual Building Residual Property Residual Single Future Income Series Straight Line Property Residual Sinking Fund Annuity Example: Capitalization Methods 16-4 Consider the effect on the building value estimates and building capitalization rates under each recapture methods. Which method has the highest building capitalization rate and which has the lowest building capitalization rate? The subject property has a building net income of $100,000, the discount rate is 8.0%, the safe rate is 3.0%, recapture is anticipated over 20 years and the effective tax rate is 2.5%. The sinking fund factor at 3% for 20 years is and the partial payment or annuity factor at 8% for 20 years is

175 Straight-Line Method NOI to Building $100,000 = $645, Discount Recapture Effective Tax Rate.1550 Building Capitalization Rate Sinking-Fund Method NOI to Building $100,000 = $703,156 Annuity Method Discount Recapture Effective Tax Rate Building Capitalization Rate NOI to Building $100,000 = $788, Discount & Recapture (PPMF) Effective Tax Rate Building Capitalization Rate 175

176 Example: Recapture Provisions of Capitalization Methods 16-5 An industrial building recently sold for $350,000. The following information was developed from the sale. Potential Gross Income $46,000 Vacancy and Collection Loss 3% Operating Expenses Management Fee 3% of EGI Miscellaneous Expense $1,200 Discount Rate 7.40% Effective Tax Rate 2.75% Land Value $87,500 Develop the recapture rate assuming straight-line recapture using the market comparison method. Assuming the sinking fund method of capitalization, what is the recapture rate with a safe rate of 3% and a 40 year remaining economic life (SFF = ). Assuming the annuity method of capitalization, what is the recapture rate with a 7.4% discount rate and 40 year remaining economic life (partial payment factor = ). Which capitalization method develops the highest recapture rate? Which capitalization method develops the lowest recapture rate? Why? 176

177 Solution to Example Recapture Provisions of Capitalization Methods 16-5 Develop the recapture rate assuming straight-line recapture. First develop the properties NOI Potential Gross Income $46,000 Vacancy and Collection Loss (3%) $ 1,380 Effective Gross Income $44,620 Operating Expenses Management Fee (3% EGI) $ 1,339 Miscellaneous Expense $ 1,200 Total Operating Expenses $ 2,539 Net Operating Income $42,081 Income Rate Value Discount $25, % $350,000 Recapture $ 6, % $262,500 Taxes $ 9, % $350,000 Total $42, % $350,000 The recapture rate is 2.50% using straight line recapture. Assuming the sinking fund method of capitalization, what is the recapture rate with a safe rate of 3% discount rate and 40 year remaining economic (SFF = ) This is easy. It is given in the problem. The recapture rate is the SFF of 1.326% Assuming the annuity method of capitalization, what is the recapture rate with a 7.4% discount rate and 40 year remaining economic life (partial payment factor = ). 177

178 If you recall, the partial payment factor consists of return on and return of investment in one factor. By subtracting the discount rate (return on) from the partial payment factor the remainder is the return of investment or recapture rate provision. Partial Payment Factor Less Discount Rate Recapture Rate or 0.45% Which capitalization method develops the highest recapture rate? Straight-Line Method Which capitalization method develops the lowest recapture rate? Why? Annuity Method it develops the lowest recapture rate because recapture is based on the discount rate. 178

179 Chapter 16 Quiz: Income Streams and Selection of Capitalization Methods 1.) The capitalization method that would result in the lowest capitalization rate: a.) b.) c.) d.) Inwood or annuity method Hoskold or sinking fund method Straight line method Ackerson method 2.) The capitalization method that would result in the highest capitalization rate: a.) b.) c.) d.) Inwood or annuity method Hoskold or sinking fund method Straight line method Ackerson method 3.) The capitalization method that would result in the mid-range capitalization rate: a.) b.) c.) d.) Inwood or annuity method Hoskold or sinking fund method Straight line method Ackerson method 4.) This capitalization method is appropriate under the following circumstances: The income is likely to decline over the life of the improvements The improvement is recaptured in equal amounts over its economic life The discount is received each year on the remaining balance of the investment The tenant ranks financially average to poor a.) b.) c.) d.) Inwood or annuity method Hoskold or sinking fund method Straight line method Ackerson method 5.) Which capitalization method would be appropriate for a gravel pit where the income received could not be reinvested in the property but would be placed in a safe investment vehicle until the end of the holding period? a.) b.) c.) d.) Inwood or annuity method Hoskold or sinking fund method Straight line method Ackerson method 179

180 6.) A site on Warren Avenue is improved with a retail store that has a remaining economic life of 20 years. The appropriate discount rate is 10%, the effective tax rate for this jurisdiction is 3%, and the sinking fund factor based on a safe rate of 6 percent is Using sinking-fund capitalization: a.) b.) What is the capitalization rate for the land? What is the capitalization rate for the building? 7.) A site on Warren Avenue is improved with a retail store that has a remaining economic life of 20 years. The appropriate discount rate is 10%, the effective tax rate for this jurisdiction is 3%, and the partial payment factor is Using the Inwood annuity capitalization: a.) b.) What is the capitalization rate for the land? What is the capitalization rate for the building? Questions Use the following information to solve for the values. A new neighborhood shopping center is located in an area where there are no recent land sales. The property is leased and produces a net operating income before discount recapture and real estate taxes of $500,000. The property is estimated to have a remaining economic life of 20 years. The proper discount rate is 9%. Real estate taxes are based on a 50% level of assessment and a 40 mill current annual tax rate. The local assessor's property record card indicates a building value of $3,000,000 which matches your cost estimate. The sinking fund rate is based on a safe rate of 6% is The partial payment factor for 20 years at 9% is ) Using straight line capitalization, estimate the property's value. 9.) Using sinking-fund capitalization, estimate the property's value. 10.) Using annuity capitalization, estimate the property's value. 180

181 Chapter 17: Putting It All Together Land Residual Technique Challenge A 12 story office building is proposed for the downtown area. This area is fully developed except for the subject site which is a surface parking lot. The proposed building with 120,000 SF is estimated to cost $10,800,000 and the property should generate a net operating income of $1,840,000 when complete and occupancy has stabilized. Investors in this type of development currently require a 9.00% rate of return. The building is estimated to have a 50 year economic life. The effective tax rate is 3.00%. The sinking fund factor at the safe rate of 3% for 50 years is The annuity factor at 9% for 50 years is Solve for the value of the value of the property using straight line recapture, sinking fund recapture and annuity capitalization method. Straight Line Recapture Sinking Fund Method Annuity Method 181

182 Building Residual Technique Challenge The subject property is an older two story retail building in a center city area currently experiencing rehabilitation and increasing land values. Due to this activity, land value has been estimated at $150,000 based on comparable sales. The property currently generates a net operating income of $65,000. The discount rate extracted from the market for this property type is 8.0% while the remaining economic life of the building is estimated at 25 years. The effective tax rate is 3.15%. The sinking fund factor at the safe rate of 3% for 25 years is The annuity factor at 8% for 25 years is Solve for the value of the value of the property using straight line recapture, sinking fund recapture and annuity capitalization method. Straight Line Recapture Sinking Fund Method Annuity Method 182

183 Land Residual Technique Challenge Solution Straight Line Recapture Straight Line Building Capitalization Rate Discount Rate Recapture Rate Effective Tax Rate Building Capitalization Rate Straight line 1/50 yr. REL Straight Line Method Income Rate Value Building $1,512, % $10,800,000 Land $328, % $2,733,333 Total $1,840, % $13,533,333 Sinking Fund Method Discount Rate Recapture Rate Effective Tax Rate Building Capitalization Rate SFF at 3% for 50 years 183

184 Sinking Fund Method Income Rate Value Building $1,391, % $10,800,000 Land $448, % $3,735,442 Total $1,840, % $14,535,442 Annuity Method Discount & Recapture Effective Tax Rate Building Capitalization Rate Annuity factor (PPMT) at 9% for 50 years Annuity Method Income Rate Value Building $1,309, % $10,800,000 Land $530, % $4,422,917 Total $1,840, % $15,222,917 Method Comparison of Methods Building Value Capitalization Rate Recapture Rate Straight-Line $13,500, Sinking-Fund $14,535, Annuity $15,223,

185 Building Residual Technique Challenge Solution Straight Line Recapture Land Capitalization Rate Discount Rate Effective Tax Rate Land Capitalization Rate Straight Line Building Capitalization Rate Discount Rate Recapture Rate Effective Tax Rate Building Capitalization Rate Straight line 1/50 yr. REL Straight Line Method Income Rate Value Building $48, % $318,647 Land $16, % $150,000 Total $65, % $468,647 Sinking Fund Method Land Capitalization Rate Discount Rate Effective Tax Rate Land Capitalization Rate

186 Sinking Fund Building Capitalization Rate Discount Rate Recapture Rate Effective Tax Rate Building Capitalization Rate Straight line 1/50 yr. REL Sinking Fund Method Income Rate Value Building $48, % $347,482 Land $16, % $150,000 Total $65, % $497,482 Annuity Method Land Capitalization Rate Discount Rate Effective Tax Rate Land Capitalization Rate Discount & Recapture Effective Tax Rate Building Capitalization Rate Annuity factor (PPMT) at 8% for 25 years 186

187 Annuity Method Income Rate Value Building $48, % $385,648 Land $16, % $150,000 Total $65, % $535,648 Comparison of Methods Method Value Building Capitalization Rate Recapture Rate Straight-Line $13,500, Sinking-Fund $14,535, Annuity $535,

188 Problem: Reconstructed Operating History/Direct Capitalization You are appraising a 50 unit apartment property for a pending assessment appeal. There are 30 one bedroom apartments (650 square feet) and 20 two bedroom apartments (800 square feet). Your survey of comparable rental properties indicate that a one bedroom apartment should lease for $450 per month and a two bedroom apartment has a market rent of $500 per month. Vacancy and collection loss surveys indicate 8.0% annually to be the market vacancy rate. Miscellaneous income for the subject property is 3.00% of potential gross rental income on a stabilized basis. Your study of the market expense comparables and the subject's actual expenses indicate the following expense estimates: Management Fee: 4.00% of effective gross income. Administrative & Leasing: $200 per apartment unit annually. Utilities: 4% increase anticipated over last year s levels. Grounds Maintenance: 4% increase projected over last year s levels. Building Maintenance: $0.75/square foot of total net rentable area Redecorating: $150 per apartment unit annually. Insurance: 2% of effective gross income. Miscellaneous: $500 per year. The market information you have gathered indicates that a reserve for replacement category is warranted. A reserve is estimated for the following items. Stove $300 Refrigerator $400 Disposal $ 75 Carpeting $600 (one bedroom apartment) $800 (two bedroom apartment) Appliances are estimated to have a useful life of 10 years and carpeting has an 8 year useful life. 188

189 Three comparable apartment properties have sold in the past 2 years. The net operating income developed from each sale property was based on the purchaser's pro forma and included reserves for replacement and property taxes. What overall rates are developed from these sales? Sale 1 Sale 2 Sale 3 Number of Units N. O. I. $ 118,450 $ 202,590 $ 179,160 Sale Price $1,220,000 $2,080,000 $1,830,000 Overall Rate The local millage rate is $55.00 per thousand of assessed valuation with a 50% level of assessment. Reconstruct the income and expense statement for the subject property. What is the: Potential gross rental income? Effective gross income? Operating expenses? Reserves for replacement? Net operating income? 189

190 What are the operating expense ratios and expenses per square foot for the past three years? What is the projected operating expense ratio including reserves for replacement? How does that ratio compare to prior years. What conclusions can you draw concerning the operating expenses? Test your capitalization rate developed by market abstraction. Conventional financing available at a maximum 70% loan-to-value ratio, 8.00% interest rate, 10 year term and 25 year amortization (Mortgage Constant Rm = ). Equity dividend rates are trending at 10.00%. What is the indicated value of the subject property? 190

191 Actual Income and Expense History 3 Years Ago 2 Years Ago Last Year Rental Income $235,000 $244,200 $252,000 Miscellaneous Income 7,630 8,050 8,510 Vacancy & Credit Loss 21,385 23,930 21,420 EFFECTIVE GROSS INCOME $221,245 $228,320 $239,090 Expenses Management Fee $ 9,620 $ 10,165 $ 10,680 Administrative & Leasing 7,457 10,562 9,808 Utilities 17,500 18,500 20,500 Grounds Maintenance 11,795 11,171 12,002 Building Maintenance 22,310 24,582 26,010 Redecorating 4,390 6,125 6,930 Insurance 4,870 4,985 5,160 Property Taxes 25,435 28,500 29,790 Miscellaneous ,346 TOTAL OPERATING EXPENSES $104,187 $115,490 $122,226 NET OPERATING INCOME $117,058 $112,830 $116,864 Operating Expense Ratio Expenses/Unit Expenses/SF 191

192 Reconstructed Operating Statement Potential Gross Rental Income Less Vacancy/Collection Loss Plus Miscellaneous Income Effective Gross Income $ $ $ $ Operating Expense Analysis Fixed Expenses $ $ Variable Expenses $ $ $ $ $ $ $ Replacement Allowance $ $ Total Expenses Net Operating Income $ $ 192

193 Solution: Reconstructed Operating History/Direct Capitalization What overall rates are developed from these sales? Sale 1 Sale 2 Sale 3 Number of Units N. O. I. $ 118,450 $ 202,590 $ 179,160 Sale Price $1,220,000 $2,080,000 $1,830,000 Overall Rate ETR = Reconstruct the income and expense statement for the subject property. What is the: Potential gross rental income? 30-1 Bedroom (675 $450 $ 13, Bedroom $500 $ 10,000 $ 23,500 x 12 mos $282,000 Effective gross income? Potential Gross Rental Income $282,000 Vacancy & Credit Loss ($282,000 x.08) 22,560 Miscellaneous Income ($282,600 x.03) 8,460 $ 267,900 Operating expenses? $ 103,188 Reserves for replacement? $ 8,125 Net operating income? $164,

194 What are the operating expense ratios and expenses per SF for the past three years? What is the projected operating expense ratio including reserves for replacement? How does that ratio compare to prior years. What conclusions can you draw concerning the operating expenses? 3 yrs. Ago 2 yrs. Ago Last Year Projection OER 35.59% 38.10% 38.66%' 38.52% Expenses/Unit $1,575 $1,740 $1,849 $2,064 Expenses/SF $2.17 $2.40 $2.55 $2.85 Test your capitalization rate developed by market extraction. Conventional financing available at a maximum 70% loan to value ratio, 8.00% interest rate, 10 year term and 25 year amortization (RM = ). Equity dividend rates are trending at 10%..70 X = X = % What is the indicated value of the subject property? NOI $164,712 = $1,317,696 or $1,320,000 If reserves for replacement were excluded, what would be the indicated value? NOI $172,837 (w/o reserves) = $1,382,696 or $1,385,

195 Reconstructed Operating Statement Potential Gross Rental Income $ _282,000_ Less Vacancy/Collection Loss (8.0% of PGI) $ 22,560_ Plus Miscellaneous Income {3.00% of PGI) $ +8,460_ Effective Gross Income $ 267,900_ Operating Expense Analysis Fixed Expenses Real Estate Taxes (use ETR) $ 0 Insurance (2.00% of EGI) $_ 5,358_ Variable Expenses Management Fee (4.00% of EGI) $_ 10,716 Administrative/Leasing ($200/unit ) $ 10,000 Utilities (last year x 1.04) $ 21,320 Grounds Maintenance (last year x 1.04) Building Maintenance (36,250 X.75/SF) $ 12,482_ $ 27,187 Redecorating ($150/unit) $ 7,500 Miscellaneous $ 500_ Replacement Allowance Appliances ($775/unit /10 yrs.) $ 3,875 Carpeting $ 4,250_ [(30 x $600/unit) + (20 x $800/unit) / 8 yrs] Total Expenses Net Operating Income $ 103,188_ $ 164,712_ 195