Rev. of Rates and Ratios Used in the Income Capitalization Approach

Rates and Ratios Used in the Income Capitalization Approach

by Clifford Fisher Jr., MAI
Published by Appraisal Institute, Chicago, 1995

Review by Stephen Traub, ASA

[Bookcover]

BEGINNING WHERE ITS predecessor, Mathematics for Real Estate Appraisers, leaves off, this booklet focuses exclusively on the math used in the income capitalization approach. It is a handy reference that can be used similarly to the way in which one would look up a word in a dictionary. Not only will one get a description of the many rates, ratios, and techniques, but also one will get examples and their accompanying caveats.

"Too often, a method or technique is misused, or even worse, an appropriate method ... is deemed invalid. This handbook was written to prevent these types of scenario from occurring," states the author.

One check for "reasonableness" is to compare the overall yield rate, Y_(O), to the mortgage interest rate. If the interest rate is higher, the appraiser should check his/her calculations, rethink his/her reasoning, or if left as is, should provide a convincing explanation for this unusual situation.

The booklet contains four parts: 1) background; 2) frequently used rates and ratios, common names, symbols, and their relationship to other rates; 3) traditional extraction techniques and frequently misunderstood aspects; and 4) non-traditional, but legitimate techniques.

Rates

Common rates on the whole property include R_(O) also depicted as OAR or Y_(O). Rates, however, may represent just a component of the whole: financial components include those on the mortgage component, R_(M); the equity component, R_(E); and yields, Y_(M) and Y_(E). Legal components include: the yield of the leased fee component, Y_(LF); the leasehold component, Y_(LH); and the sub-leasehold (sandwich), R_(SAND1).

The OAR or R_(O) is derived with the formula I_(O)/V_(O) = R_(O). This is different from the equity cap rate component also known as the equity dividend rate, or cash-on-cash rate, or cash-flow rate, R_(E) (though without financing, R_(E) will equal R_(O)). R_(E) can be extracted from a sale using the formula, I_(E)/V_(E) = R_(E). R_(E), however, should be extracted before a cash equivalency adjustment.

The yield rate, Y_(E), on the other hand (also known as the risk rate, "return on" rate, IRR, or discount rate), considers more than just the first year cash return. It considers all cash attributable to the equity investment over a holding period including proceeds from sale at termination

In a case in which discounted cash flow analysis is applied, resale value at the end of the holding period is calculated using a "going out" cap rate, R_(N). R_(N) rarely will be less than the "going in" rate, R_(O), because investors typically factor in the uncertainty for time and improvements will be closer to the end of their economic life.

[Reaping Rates and Ratios]

Ratios

Common ratios include loan-to-value (M), debt coverage ratios (DCR), and operating expense ratios (OER). DCR is calculated by comparing a property's annual net operating income (NOI) to its debt service costs. It measures the ability to meet the mortgage payments from the NOI, so the DCR is usually required to be greater than 1.0. DCR can be extracted by dividing the NOI by the annual debt service costs. It is commonly seen in the following formula: R_(O) = M * R_(M) * DCR.

The expense ratio or OER is the total operating expenses divided by the effective gross income or TOE/EGI. The OER is useful in testing the "reasonableness" of the operating expenses estimated in a reconstructed operating statement. Benchmark OERs can be derived from an analysis of similar properties.

Techniques

In Part 3, extraction techniques include a simple extraction of an R_(O) from a sale. The author also illustrates the extraction of an equity dividend rate, R_(E).

To extract the R_(E), debt service costs are subtracted from the NOI. The difference is divided by the equity amount, resulting in the equity dividend rate, or cash-on-cash rate. In formulaic terms this is written as:

NOI - Debt Service Costs = I_(E)

I_(E)/V_(E) = R_(E)

In the final chapter, Chapter 4, the booklet closes with examples of more complex, two variable extractions (similar to sensitivity analysis) with an example of the results of a two variable extraction illustrated below:

Change
Rate -- Y_(O)

-2% -- 10%

0% -- 12%

+2% -- 14%

Change Rate	--	Y_(O)
-2%	--	10%
0%	--	12%
+2%	--	14%

If you like brief, simple, and handy reference booklets, Rates and Ratios Used in the Income Capitalization Approach will rate highly with you.

The book above is available on-line at Amazon Books.

Stephen Traub, ASA, the reviewer, is chief commercial appraiser for Property Valuation Advisors, 63 Hill St., Newburyport, MA 01950. He is a certified general appraiser in NH, ME and MA.

To contact the author of this review, e-mail to: straub@shore.net or contact him at the address above, or call 978-462-4347.