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Welcome to. Integra Realty Resources One Company - Infinite Solutions. Edward K. Wadsworth, MAI, CRE David L. Cary, MAI INTEGRA REALTY RESOURCES Boston. INCOME CAPITALIZATION PRIMER. Why Use the Income Approach?.

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  1. Welcome to Integra Realty Resources One Company - Infinite Solutions

  2. Edward K. Wadsworth, MAI, CREDavid L. Cary, MAIINTEGRA REALTY RESOURCESBoston INCOME CAPITALIZATION PRIMER

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

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

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

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

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

  8. Economic Profile of Property

  9. Market Rent Estimate

  10. Gross Potential Income

  11. Stabilized Net Income Statement Before RE Taxes

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

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

  14. Extraction of Capitalization Rate from Sale Comparable

  15. Extraction of Equity Return (Dividend Rate) from Sale Comparable (RE)

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

  17. Or

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

  19. Capitalization Rate Surveys

  20. Range of Investment Capitalization Rates • Extraction from Comparable Sale 8.1% • Band of Investment Method 7.1% • Debt Coverage Ratio Method 7.0% • Cap. Rate Surveys 7.0%

  21. FACTORS THAT IMPACT CAP RATES • Quality of Tenancy • Duration of Leases • Terms of Lease • Market Conditions

  22. EFFECTIVE TAX RATE • Tax Rate per $1,000 of assessed value ÷ 1,000 • Assume CIP Tax Rate = $15.00/$1,000 of assessed value Then $15.00/1,000 = 1.5%

  23. Stabilization Costs $1.50/s.f. Leasing Fee 3 months to lease 5K s.f. $10/s.f. TI Allowance Capitalization Capitalization of Income

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

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

  26. Economic Status of Property

  27. Competitive Rent Survey

  28. Analysis of Competitive Rents

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

  30. Stabilized Income Statement

  31. Comparative Analysis of Expenses

  32. Extraction of Investment Cap. Rates From Sales

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

  34. Investor Surveys

  35. Effective Tax Rate • $15.00/$1,000 AV = $15 / 1,000 = 1.5% • Capitalization Rate of Tax Purposes 6% + 1.5% = 7.5%

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

  37. Capitalization of Income

  38. Integra Realty Resources – Boston Edward K. Wadsworth, MAI, CRE David L. Cary, MAI

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