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Collateral Valuation: Credit Risk: Income Capitalization Approach for real estate

The Income Capitalization Approach is another valuation methodology for real estate. The post provides a step by step process of how the income capitalization approach works and presents situations where it should or should not be used. It also covers the type of data and data sources used for carrying out the analysis.

Income Capitalization Approach

a. Methodology

The income capitalization approach follows the steps below:

Step 1: Estimate the annual gross income

One way of estimating the annual gross income is to calculate a geographically weighted average rent price per unit. The process is the same as the one followed in the sales comparison approach above but instead of using sales prices of similar properties we use the rent per unit for similar properties. Again the weights are the distances of these properties in relation to the property being considered.

Step 2: Estimate the effective gross income

Once the annual gross income per unit has been calculated for the property, the next stage is to reduce this income for the vacancy rate and rent collection losses. These are estimated using historical data for similar properties in the area.

Step 3: Net operating income (NOI)

The net operating income (NOI) is the effective gross income less annual operating expenses that are incurred in running the property. These include management expenses but not cost of capital items.

Step 4: Estimation of the Capitalization Rate

The capitalization rate is the rate that is used to discount the income stream to the present day in order to arrive at an estimate of the property value.  It is a function of the investor’s desired return on the property and a combination of the costs of debt and equity of the investment. It is usually taken as the rate of return or yield that the other investors are getting in the local market. Capitalization rates are extracted from the sales values and net operating incomes of similar investment properties.  A more simplified way of arriving at the capitalization rates is to use the existing loan rates on similar investments. However, when using these loan rates the lender must be aware of the fact that these rates do not account for the risks inherent in that particular investment and so by using the interest rates without adjusting for these risks the lender may be overvaluing the property.

Step 5: Estimating the property value

There are two methods of estimating the value of the property , direct capitalization method and yield capitalization method.  The direct capitalization method is the most widely used as well as simplest approach. It assumes that the income stream will not vary significantly over time.   It involves deriving a single year’s net operating income (or an average over a number of years) and then dividing this NOI by a capitalization rate to arrive at the property value.

Yield capitalization employs a more sophistical valuation technique such as the discounted cash flow (DCF) analysis. Under this method the income stream has to be projected into the future over a given holding period. What also needs to be projected is the property’s future resale or reversion value. The computation of the first component, the projected incomes over a holding period tends to be relatively predictive. The holding period is usually considered to be a period of between 10 to 12 years depending on the lender’s loan policy. The second component, the projected future sale, reversion or residual value of the property tends to be more speculative. The property value is the discounted value of the income stream and the projected resale value where the discount rate is taken as a typical investor’s yield rate.

b. Appropriate Uses

This method is appropriate for income producing real estate.

c. Inappropriate Uses

Usually this approach would not be the sole or main basis for estimating the value of owner-occupied residential properties as these properties do not generate a regular income which is a necessary input into the income capitalization approach. It may however be used in conjunction with another method to derive a final appraisal value.

d. Sources of Data/ Information

Extensive market research is required to obtain the requisite data. The data includes:

  • the gross income expected from the property,
  • estimates regarding the vacancy rate and rent collection losses that will be used to reduce the gross income,
  • the anticipated operating expenses,
  • the pattern and duration of the income stream and
  • the anticipated resale value if the property is eventually going to be sold
  • rates that will be use for discounting the income stream and future resale value, i.e. for capitalization

We have detailed the Income Capitalization Approach to collateral valuation of real estate above. In the next post we will look at how real estate is valued using the Cost Approach.

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