THE INCOME APPROACH TO VALUATION
6.2 The Direct Capitalization Method
The direct capitalization method capitalizes the current NOI at a rate known as the capitalization rate, or cap rate for short. If we think about the inverse of the cap rate as a multiplier, the approach is analogous to an income multiplier. The direct capi- talization method differs from the DCF method, in which future operating income (a proxy for cash flow) is discounted at a discount rate to produce a present value.
6.2.1 The Capitalization Rate and the Discount Rate
The cap and discount rates are closely linked but are not the same. Briefly, the discount rate is the return required from an investment and comprises the risk- free rate plus a risk premium specific to the investment. The cap rate is lower than the discount rate because it is calculated using the current NOI. So, the cap rate is like a current yield for the property whereas the discount rate is applied to current and future NOI, which may be expected to grow. In general, when income and value are growing at a constant compound growth rate, we have:
Cap rate = Discount rate – Growth rate (1)
Exhibit 5 (Continued)
The growth rate is implicit in the cap rate, but we have to make it explicit for a DCF valuation.
6.2.2 Defining the Capitalization Rate
The capitalization rate is a very important measure for valuing income- producing real estate property. The cap rate is defined as follows:
Cap rate = NOI/Value
where the NOI is usually based on what is expected during the current or first year of ownership of the property. Sometimes the term going- in cap rate is used to clarify that it is based on the first year of ownership when the investor is going into the deal.
(Later, we will see that the terminal cap rate is based on expected income for the year after the anticipated sale of the property.)
The value used in the above cap rate formula is an estimate of what the property is worth at the time of purchase. If we rearrange the above equation and solve for value we see that:
Value = NOI/Cap rate
So, if we know the appropriate cap rate, we can estimate the value of the property by dividing its first- year NOI by the cap rate.
Where does the cap rate come from? That will be an important part of our discus- sion. A simple answer is that it is based on observing what other similar or comparable properties are selling for. Assuming that the sale price for a comparable property is a good indication of the value of the subject property, we have:
Cap rate = NOI/Sale price of comparable
We would not want to rely on the price for just one sale to indicate what the cap rate is. We want to observe several sales of similar properties before drawing conclu- sions about what cap rates investors are willing to accept for a property. As we will discuss later, there are also reasons why we would expect the cap rate to differ for different properties, such as what the future income potential is for the property—that is, how it is expected to change after the first year. This is important because the cap rate is only explicitly based on the first- year income. But the cap rate that investors are willing to accept depends on how they expect the income to change in the future and the risk of that income. These expectations are said to be implicit in the cap rate.
The cap rate is like a snapshot at a point in time of the relationship between NOI and value. It is somewhat analogous to the price–earnings multiple for a stock except that it is the reciprocal.6 The reciprocal of the cap rate is price divided by NOI. Just as stocks with greater earnings growth potential tend to have higher price–earnings multiples, properties with greater income growth potential have higher ratios of price to current NOI and thus lower cap rates.
It is often necessary to make adjustments based on specific lease terms and char- acteristics of a market. For example, a similar approach is common in the United Kingdom, where the term fully let property is used to refer to a property that is leased at market rent because either it has a new tenant or the rent has just been reviewed.
In such cases, the appraisal is undertaken by applying a capitalization rate to this rent rather than to NOI because leases usually require the tenant to pay all costs. The cap rate derived by dividing rent by the recent sales prices of comparables is often called the all risks yield (ARY). Note that the term “yield” in this case is used like a “current yield” based on first- year NOI. It is a cap rate and will differ from the total return that an investor might expect to get from future growth in NOI and value. If it is assumed,
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6 In the United Kingdom, the reciprocal of the cap rate is called the “years purchase” (YP). It is the num- ber of years that it would take for income at the current level to be equal to the original purchase price.
however, that the rent will be level in the foreseeable future (like a perpetuity), then the cap rate will be the same as the return and the all risks yield will be an internal rate of return (IRR) or yield to maturity.
In simple terms, the valuation is:
Market value = Rent/ARY
Again, this valuation is essentially the same as dividing NOI by the cap rate as discussed earlier except the occupant is assumed to be responsible for all expenses so the rent is divided by the ARY.7 ARY is a cap rate and will differ from the required total return (the discount rate) an investor might expect to get by future growth in NOI and value. If rents are expected to increase after every rent review, then the investor’s expected return will be higher than the cap rate. If rents are expected to increase at a constant compound rate, then the investor’s expected return (discount rate) will equal the cap rate plus the growth rate.
EXAMPLE 13
Capitalizing NOI
A property has just been let at an NOI of £250,000 for the first year, and the capitalization rate on comparable properties is 5 percent. What is the value of the property?
Solution:
Value = NOI/Cap rate = £250,000/0.05 = £5,000,000
Suppose the rent review for the property in Example 13 occurs every year and rents are expected to increase 2 percent each year. An approximation of the IRR would simply be the cap rate plus the growth rate; in this case, a 5 percent cap rate plus 2 percent rent growth results in a 7 percent IRR. Of course, if the rent review were less frequent, as in the United Kingdom where it is typically every five years, then we could not simply add the growth rate to the cap rate to get the IRR. But it would still be higher than the cap rate if rents were expected to increase.
6.2.3 Stabilized NOI
When the cap rate is applied to the forecasted first- year NOI for the property, the implicit assumption is that the first- year NOI is representative of what the typical first- year NOI would be for similar properties. In some cases, the appraiser might project an NOI to be used to estimate value that is different from what might actually be expected for the first year of ownership for the property if what is actually expected is not typical.
An example of this might be when a property is undergoing a renovation and there is a temporarily higher- than- typical amount of vacancy until the renovation is complete. The purpose of the appraisal might be to estimate what the property will be worth once the renovation is complete. A cap rate will be used from properties that are not being renovated because they are more typical. Thus, the appraiser projects what is referred to as a stabilized NOI, which is what the NOI would be if the property were not being renovated—in other words, what the NOI will be once the renovation is complete. This NOI is used to estimate the value. Of course, if the
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7 In practice, management costs should also be considered, although operating costs falling on the landlord are typically much lower than in the United States.
property is being purchased before the renovation is complete, a slightly lower price will be paid because the purchaser has to wait for the renovation to be complete to get the higher NOI. Applying the cap rate to the lower NOI that is occurring during the renovation will understate the value of the property because it implicitly assumes that the lower NOI is expected to continue.8
EXAMPLE 14
Value of a Property to be Renovated
A property is being purchased that requires some renovation to be competitive with otherwise comparable properties. Renovations satisfactory to the purchaser will be completed by the seller at the seller’s expense. If it were already renovated, it would have NOI of ¥9 million next year, which would be expected to increase by 3 percent per year thereafter. Investors would normally require a 12 percent IRR (discount rate) to purchase the property after it is renovated. Because of the renovation, the NOI will only be ¥4 million next year. But after that, the NOI is expected to be the same as it would be if it had already been renovated at the time of purchase. What is the value of or the price a typical investor is willing to pay for the property?
Solution:
If the property was already renovated (and the NOI stabilized), the value would be:
Value if renovated = ¥9,000,000/(0.12 – 0.03) = ¥100,000,000
But because of the renovation, there is a loss in income of ¥5 million during the first year. If for simplicity we assume that this would have been received at the end of the year, then the present value of the lost income at a 12 percent discount rate is as follows:
Loss in value = ¥5,000,000/(1.12) = ¥4,464,286 Thus, the value of the property is as follows:
Value if renovated ¥100,000,000
Less loss in value – ¥4,464,286
= Value ¥95,535,714
An alternative approach is to get the present value of the first year’s income and the value in a year when renovated.
{¥4,000,000 + [¥9,000,000(1.03)]/(0.12– 0.03)]}/(1.12) = ¥95,535,714
6.2.4 Other Forms of the Income Approach
Direct capitalization usually uses NOI and a cap rate. However, there are some alter- natives to the use of NOI and a cap rate. For example, a gross income multiplier might be used in some situations. The gross income multiplier is the ratio of the sale price to the gross income expected from the property in the first year after sale. It may be obtained from comparable sales in a similar way to what was illustrated for cap rates.
The problem with using a gross income multiplier is that it does not explicitly con- sider vacancy rates and operating expenses. Thus, it implicitly assumes that the ratio
8 Some readers may correctly think that, rather than use a stabilized NOI, a lower cap rate could be used to reflect the fact that the NOI will be higher in the future. The problem is that it is not easy to know how much lower the cap rate should be if there are no sales of comparable properties intended for renovation.
of vacancy and expenses to gross income is similar for the comparable and subject properties. But if, for example, expenses were expected to be lower on one property versus another because it was more energy efficient, an investor would pay more for the same rent. Thus, its gross income multiplier should be higher. Use of a gross rent multiplier is also considered a form of direct capitalization but is generally not considered as reliable as using a capitalization rate.