The main steps to calculate value by capitalizing income are:

  • Determine the net annual income;
  • Select the appropriate cap rate by market comparisons; and Capitalize the income (divide the net annual income by the cap rate).

Determining Net Annual Income

The procedures for determining net annual income are:

  • Estimate potential gross income the property is capable of producing.
  • Deduct from potential gross income an annual allowance for vacancy factor and rent collection loss. The remainder is called "effective" gross income or adjusted gross income.
  • Deduct from adjusted gross income the estimated probable future annual expenses of operation (fixed expenses, variable expenses, reserves for replacements for building components or short-lived items) to obtain the net income of the investment property.

Income and expenses. The potential gross income used is the expected future income. In many cases, the immediate past or current income may be an indicator of future income. However, reliance solely upon past or current income is incorrect. The income to use is the one which the purchaser and seller anticipate over the remaining productive life of the improvement, as adjusted for foreseeable economic changes.

Income estimates. The gross income estimate for an income property is the potential or anticipated gross income from all sources (market rents, services, parking space fees and rentals, and coin-operated equipment, etc.). Gross income is estimated as of the date of the appraisal. Contract rent is the actual, or contracted, rent received from the property. Market rent is the rent the property should bring in the open market at the date of appraisal. Rents and vacancy factors and collection losses are based on current market rent data. The appraiser uses his/her judgment of the area in arriving at an allowance for vacancy and collection losses.

Rent data is obtained from the subject property's rent schedule and the appraiser's review of rents from similar recent sales in the area. Individual apartments or units of the comparables are compared with the subject property, using square footage, number of bedrooms, or similar items of comparison. It is assumed management for all properties is adequate. Cost of deferred maintenance or repairs is an adjustment item.

Market rent schedules and expenses are usually maintained on a monthly basis. Both must be converted to an annual basis.

Expenses must be realistic. The operating expenses (all expenditures necessary to produce income) are to be deducted from the effective gross income to find the net operating income expected from the property. The appraiser must use caution in extracting expense information from owner's operating statement as some items included on the operating statement, such as principal and interest payments on mortgages and depreciation allowance for income tax purposes, must be disregarded by the appraiser as not being allowable expense items.

These non-allowables may include entertainment expenses and other items of personal expense, and capital improvement expenditures. Since most operating statements are prepared by accountants for tax and accounting purposes, appraisers usually must reconstruct them to properly forecast annual expenses.

Expenses are generally classified as being one of the following:

  • Fixed expenses. These are incurred annually with relatively little change from year to year. They are to be paid whether the property is fully occupied or not. These items include taxes, insurance, licenses and permits.
  • Variable expenses. These expenses are incurred continually in order to maintain and give service to the property. They are variable depending upon the extent of occupancy and include items such as utilities, management fees, security, costs of administration, maintenance and repairs for structures, grounds and parking area maintenance, contracted services (e.g. rubbish removal) and payroll.
  • Reserves for replacements. This is an annual allowance for replacing worn out equipment and building components, such as stoves, carpets, draperies, roof covering.

Selecting the Cap Rate

The appraiser selects an appropriate overall capitalization rate ("present worth" factor) after market analysis of similar properties. This rate provides for return of invested capital plus a return on the investment).

The rate is dependent upon the return which investors will actually demand before they will be attracted by such an investment. The greater the risk of losing the investment, the higher will be the accompanying rate as determined in the market for such properties. By analyzing market prices, the rate can be approximated at any given time.

A variation of only 1 percent may make a substantial difference in the capitalized value of the income.

For example, based on an annual net income of $30,000, and a capitalization rate of 6 percent, the capitalized property valuation would be $500,000 (income divided by rate). Capitalizing this same income at a rate of 7 percent would result in a value of only $428,500 (rounded).

Capitalizing Net Annual Operating Income

The final step after having determined the net annual income and the capitalization rate is to capitalize the income. This may be merely the mathematical calculation of dividing the income by the rate if the income is considered to be in perpetuity. For example, the valuation of property which has an assumed perpetual annual net income of $30,000 and a capitalization rate of 5 percent is $600,000. The lower the rate, the greater the valuation, and the greater the assumed security of the investment. So 'called annuity tables are used in capitalizing incomes for fixed periods of varying duration.

As stated earlier, an important element in all capitalization rates is provision for a return of the investment on the improvements to the property during their remaining economic life. This may be called an amortization of such investments. It may be provided for by straight-line depreciation, which recovers a definite sum every year for the period of years estimated to be the economic life of the improvement, at the end of which time the cost of improvement will be accrued. It may also be provided for by other methods, such as establishing "sinking funds" or a declining balance depreciation. These are more technical procedures which are used by professional appraisers.

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