InstructorsManual:BasicRealEstateAppraisal,8th.

Edition
Chapter14

CHAPTER 14
INCOME CAPITALIZATION: RATES AND TECHNIQUES
STUDENT LEARNING OUTCOMES
Thischaptercompletestheincomeapproach.Herearethetopicstocover:
14.1
14.2
14.3
14.4

PurposeandTheoryofCapitalization
SelectionoftheCapitalizationRate
DirectandResidualCapitalizationTechniques
Estimating,Measuring,andDiscountingCashFlows

Class Activities
[Instructor:Completeasneeded.]
Lecture[]Discussion[]BreakoutGroups[]Other_____________[]

14.1 PURPOSE AND THEORY OF CAPITALIZATION

Capitalizationisamethodofvaluingincomeproperty.Techniquesavailabledependupon:
1)thenatureoftheappraisalproblem,and2)thekindofdataavailable.Commonlyusedtechniquesare
describedinSection14.3.

Capitalization Defined
Capitalizationisaprocessofconvertingincomeintoitscapitalequivalent.
1. Capitalizationfocusesonthepresentworthoffuturebenefits.
2. Itdiscountsfutureincometorecognizethetimevalueofmoney.Discountingisexplainedin
Section14.4.
3. Itisananalysisofthequantity,quality,anddurationofthefutureincometobeproducedbyan
investment.

Capitalization Rate Defined

Acapitalizationrateis generally definedasanyrateusedtoconvertincomeintoitsvalueequivalent.
Therearedifferenttypesofcapitalizationratesandcapitalizationtechniques.
Itdirectlyorindirectlyprovidesforbothareturnonandreturnofthemoneyinvested.
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TypesofratesarediscussedinSection14.2.
The most common capitalization rate is the overall capitalization rate, overall rate, or OAR,
calculatedbydividingapropertysnetoperatingincomebyitssaleprice.
Capitalizationtechniquesaredividedintotwofamilies:ratiocapitalizationandyieldcapitalization,
tobeexploredfurther.

Comparing Investment Property

1.

Realestatecompetesfortheuseofcapitalwithothertypesofinvestments.

2.

Investmentcriteriaincludethefollowing:
Safety
Yield
Liquidity
FreedomfromManagementBurden
ProspectsforAppreciation

BurdenofPropertyTaxes
ShelterfromIncomeTaxes
SizeorDenomination
Hypothecation
Leverage

[Instructor: Wehavecometobelievethatstudentsreallyneedtounderstandthesecriteria,in
ordertoestimatetheneededreturnsforaparticularproperty!]

Current and Future Returns

1.

Currentreturns:
a.
Thecurrentreturnisthenetoperatingearnings,oftencalledtheincomestream.
b.
Thecurrentincomeafterloanpayments(debtservice)iscalledequitycashflow orthe
equitydividend.

2.

Futureordeferredreturns:
a.
Thefundsavailablewhenaninvestmentissold;thereversion.
b.
Suchreturnsmayincludeamountsfromloanpayoff (equitybuildup), aswellasfrom
propertyappreciationinvalue.[seeExample142intext]

3. Returnsmaybecalculatedoneither:
a.
Apropertyorequitybasis(ifaloanisinvolved)
b.
Apretaxorposttaxbasis(i.e.incometaxeffects)

Yield versus Recapture

1.

Yieldisthereturnoninvestedcapital;butcanbefromacombinationofincomestreamandfuture
capitalgain.

2.

Recaptureisthereturnoftheinvestedcapital;capitalrecovery.

In finance, the loan is the investment; recapture is usually provided for in the principal
portionofmonthlyorannualloanpaymentsonanamortizedloan.
Intheinvestorsmind,recaptureofarealestateinvestmentislessclear.Itcancomefrom
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Theannualnetoperatingincome
Proceedsoffuturesale
Acombinationofthetwoyieldtomaturityandinternalrateofreturn
Inyieldcapitalizationtechniques, recapturemust bespecified,butinratiocapitalization,
recaptureoccursinanunspecifiedmanner.
Investmentrecapture(recovery)inappraisalswillbecoveredinthenextsection.

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Relating Income Capitalization to Economic Principles

Specificeconomicprinciplesunderlayincomecapitalization.(SeeChapter5.)
Principle of Anticipation
Incomecapitalizationdiscountstheanticipatedfutureincometoitspresentcapitalworth.
Principle of Agents of Production
Labor,coordination,capital,andlandarepaidoutofincome,intheformof(1)operatingexpensesfirst,
andthen(2)theremainingnetincomeattributedtolandandimprovements.
Principle of Contribution
Selectedportionsoftheproperty(e.g.,theland,thebuilding,ortheequityinvestment)arevaluedby
capitalizingthenetincometheycontribute.Relatestospecificresidualcapitalizationtechniques.
Principle of Highest and Best Use
Landisvaluedbytheincomeitcancontributewheninitshighestandbestuse(i.egreatestreturnto
land).

14.2 SELECTION OF THE CAPITALIZATION RATE

Thecapitalizationrateistheconnectinglinkbetweenincomeandvalue.
Selectingtheappropriaterateisacriticalpartoftheincomeapproach.

Distinct Types of Rates

Thefourdistincttypesofratesusedinappraisalsarelistedanddefinedhere.

Interest Rate
Rateofreturnoninvestedcapital;synonymouswithyieldrateanddiscountrate,itdoesnotincludeany
recaptureofinvestmentcapital.
Overall Capitalization Rate (Cap Rate)
TheOARistherelationshipbetweennetincomeandvalue.Bothreturnoninvestmentandrecaptureof
investmentcapitalarehiddenwithinit.
Recapture Rate
Therateatwhichinvestedfundsarebeingreturnedtotheinvestor.Rarelyusedtodayinpractice.
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Composite Capitalization Rate
Arateprovidingforbothinterestandrecapture,inseparatelyselectedamountsandknownproportions.

The Relationship of Yield and Overall Rates

Ifanincomeproducingpropertyisexpectedtohaveincreasingincomeandvalueinthefuture,someof
thereturnoninvestmentwillcomefromthereversion.Here,theoverallcapitalizationrate(R)wouldbe
lessthantheinterestrate(Y).
When the property value is expected to decline, some return or recapture must come from income,
becausethereversionwillbetoosmall.Therefore,theoverallrate(R)wouldbemorethantheinterest
rate,becauseithastoincludearecapturecomponent.
Thelinkbetweentheoverallcapitalizationrateandtheinterestrateistheexpectedfuturechangeinvalue,
labeleddelta(Greekletter).
If an incomeproducing property is expected to have a level net income and value for many years,
recapturewillcomefromresaleandyieldfromtheincome.Therefore,theinterestrateoryield(Y)will
bethesameastheoverallcapitalizationrate.
Deltaistheannualequivalentoftheexpectedfuturevaluechange.Ifvalueisexpectedtogodowna
steady1%peryear,thendeltaisaplus1%.Ifvalueisexpectedtodoubleintwoyearswhenanewlease
issignedandthengoupat2%peryear,thevaluechangemustbeconvertedtoitsannualequivalent,
usingtechniquesstudiedinadvancedcapitalizationclasses.Anotheralternativeistoestimateeachfuture
yearsincomeandvalueasacashflow,discussedinSection14.4.

Methods of Estimating Rates

The Direct Comparison Method
Thisisgenerallythepreferredmethodofderivingacapitalizationrate.
Analyzeeachcomparablesale,anddividethenetincome(I)bythesalesprice(V)(afteradjustingfor
nonmarketfinancing).Theresultistheindicatedoverallcaprate(OARorR o).
Example:
Netoperatingincome(Io)
Dividedby:Sellingprice(Vo)
Equals:Overallrate(Ro)
Inpercent

$80,000
$800,000
0.10
10%

The data obtained from sales can be made stronger by studying published surveys of OARs, or by
interviewingactivebrokersandinvestorsregardingOARsandtheissuesthataffectthem.
Thedirectcomparisonmethodcanalsobeusedtoestimatetheequitydividendrate(R e).
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Netoperatingincome(Io)
Less:Annualdebtservice(Im)
Equals:Equitycashflow(Ie)
Dividedby:Equityinvestment(Ve)
Equals:Equityoverallcaprate(Re)
Inpercent

$80,000
73,440
$6,560
160,000
0.041
4.1%

[Instructor: Wehavestartedtointroducethestandardcapitalizationlabelsinthisedition.We
alsorecommendstressingtothestudentshowmanyterms,suchasR e,haveanumberofdifferent
namesandsymbolsonthestreet!]
Toextractthepropertyinterestrateratherthantheoverallrate,deductthedeltafromtheOAR,whereby
YoRo=.
Thelessreliableclassicanalysiscanalsobeused.Deductanyrequiredannualrecapturefromthenet
operatingincome,togettheannualinterestincome.Dividebythesalepricetogettheannualinterest
rate.Thisismostvalidwhen1)landvalueisnotchanging,and2)improvementcontributiontovalueis
expectedtoslowlydecline.
[Instructor:SeetextExample14.3todemonstratethismethod.]
The Band of Investment Method
Thismethodproducesaweightedaveragerate,combiningratesformortgageloanmoneyandforequity.
Therearetwoseparateversionsofthismethod.
1.

Usetheprevailingmortgageinterestrateandtheyieldrateforequity.Anexamplefromyourtext
follows(Example144).Notethatgoodevidenceofequityyieldratesishardtofind:
Example144:
Assumea75%loanat9%,anda12%yieldonequityinvestment.
Loan
Plus:Equity
Equals:Propertyinterestrate
Inpercent

2.

0.75x0.09 =
0.25x0.12 =

0.0675
+0.0300
0.0975
9.75%

Alternatively,usethemortgageconstantinsteadoftheloaninterestrate,andtheequitycashon
cash(dividend)rateinsteadoftheequityyieldrate.
a.
b.

Themortgageconstantistheratiooftheannualloanpaymenttotheloanamount,thatis,
thepaymentdividedbytheloan,ortheoverallrateforthemortgage(R m).
Here,therateforequityistheratioofsocalledcashflowtotheequityinvestment.
Hereisanexamplefromyourtext(Example145):
Example145:

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Assumethatan80%loanpaysoffataconstant8%peryearandthebuyerrequiresa7%
firstyearcashflowonthedownpayment.
Loan
0.80x0.08=
Plus:Equity
0.20x0.07=
Equals:Indicatedoverallrate(Ro)
Inpercent

147

0.64
+0.014
0.078
7.8%

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The Summation Method
Thismethodratesthepropertybyvariousinvestmentcriteria.Thereturnonariskfreeinvestment,such
asagovernmentbond,isusedforthesaferate.Otherratesareaddedtoit.Inpractice,thisisrarelyused,
astheamountstobeaddedareverydifficulttojustify.Sometimescalledabuiltuprate.
Hereisanexamplefromyourtext:
Example:
Saferate
Plus:InvestmentRisk
Plus:Lackofliquidity
Plus:Burdenofmanagement
Equals:Indicatedinterestrate

6.75%
+3.00%
+1.25%
+1.00%
12.00%

Other Methods of Calculating Rates

1.

Addarecapturecomponenttoaninterestrate(asderivedabove).Theresultisacompositerate.

2.

Addacomponentforanticipatedfuturevaluechangeand/orcapitalrecovery.Thisconvertsan
interestrateintoanoverallrate.

3.

UsetheEllwoodmethod.ThisprovidesaweightedaverageloanandequityOARthatadjustsfor
mortgage payoff and property appreciation. However, financial calculators, spreadsheets, or
incomeprojectionprogramsareusuallyusedtomaketheseanalyses.

Adjusting Rates to Apply to the Subject Property

Capitalizationratesfromcomparablesalesmayneedadjustingfordifferencesinphysicalcharacteristics
andeconomicconditions.Consideradjustingratesforthefollowingfactors:
1.

Propertylocation

2.

Theage,quality,andconditionofanyimprovements

3.

Theremainingeconomiclifeoftheimprovements

4.

Theratioofbuildingvaluetototalvalue

5.

Expenses that need to be reflected as a percentage of market value (e.g., ad valorem

propertytaxes)

How to Allow for Capital Recovery

In some capitalization methods, the appraiser must explicitly consider capital recovery. None are
commonlyusedtoday!
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Thethreerecognizedmethodsofestimatinganexplicitamountofcapitalrecoveryfollow.

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Straight-Line Recapture
Assumesthatequalannualrecapturepaymentsareprovidedoutoftheannualnetincome,inoneoftwo
ways:
1.

Therecaptureistreatedasanexpenseindollarsor,

2.

Itismadeacomponentofthecapitalizationrate.

Whilenotrecommendedtoday,severalcapitalizationtechniquesmakeuseofthismethod.Moreabout
straightlinerecapturelater.
The Sinking Fund or Hoskold Method
Assumes that annual recapture amounts are deposited into a sinking fund account, where they earn
compoundinterestatasaferate.Themethodisrarelyusedbyappraiserstoday.Asimilarconceptis
usedbyportfoliomanagerstoanalyzereturnsoftheentireportfoliothemodifiedinternalrateofreturn.
The Annuity or Inwood Method
Providescapitalrecoveryoutoflevelannualincome,inexactlythesamemannerthataloanispaidoff.
Annualrecaptureamountsareassumedcapableofearningcompoundinterestattheyieldorinterest
rateoftheproperty.
Agivenamountofincomerecapturesalargerinvestmentthaninthestraightlinemethod.
Theannuityoryieldcapitalizationmethodissuitableforanytypeofproperty,iftheyieldrateis
adjustedtoreflecttheriskinvolved.
[Instructor:YieldcapitalizationtechniquesarediscussedinSection14.3.)
The Recapture Time Period
Theperiodofrecovery(recapture)ofinvestorcapitalcoulddependupon:

Theinvestorsholdingperiodorotheroption
Theestimatedremainingeconomiclifeoftheimprovements
Theageandconditionoftheimprovements
Theriskofbuildingobsolescence

The Mechanics of Straight-Line Recapture

Straightlinerecaptureuseseitheracompositebuildingcapitalizationratetovaluetheimprovements,ora
calculated overall rate to value the total property. The steps in calculating a composite rate for
improvementsare:
1.

Dividethecapitalrecoveryperiodinto100%tofindtheannualrecapturerate.

2.

Addtherecaptureratetotheyieldorinterestrate.

3.

Thetotalisthecompositecapitalizationrate.
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4.

Applytotheportionofthenetincomethatisearnedbytheimprovements.

5.

Theresultisanestimateofimprovementvalue.

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Fromthetext,Example146:
Example:

Themarketanticipatesa9%yieldonthepropertyinvestment.
Recaptureperiodis40years.

Interestrate
Plus:Recapturerate:(100%40)
Equals:Compositerateforimprovements

9.0%
+2.5%
11.5%

Analternativeinvolvescalculatinganoverallrate.Thisrequiresthatyouknowthebuildingratio,thatis,
thebuildingtototalvalueratio.

1.
Multiplythebuildingratiobytherecapturerate.

2.
3.
4.

Addtheresultstotheinterestrate.

Theresultisthecalculatedoverallrate.
Capitalizethetotalnetincometoestimatetotalpropertyvalue.

[Instructor:Seeyourtextbookforanexampleofthiscalculation.]

14.3 DIRECT AND RESIDUAL CAPITALIZATION TECHNIQUES

Directcapitalizationmeasuresthetotalpropertyvalue.Thethreeothermethodspresentedhereseekto
valueaspecifiedportionofthetotalpropertyvalue.Thetotalvaluecanthenbesolved.

Direct Capitalization Technique

Thisisthemostsimpleandreliablemethodofincomecapitalization,andthemostcommonlyused.Itis
recommendedforusewhenthereissomesimilarityinthe:
Sizeandcharacterofproperties
Ratiooflandtobuildings
Outlookforinvestmentrisksandvaluetrends
Example14.7DirectCapitalizationTechnique
Netoperatingincome(Io)
Dividedby:Overallcapitalizationrate(Ro)
Equals:Indicatedvalue(Vo)

Equity Residual Technique

Thistechniqueisrecommendedforusewhen:
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10%
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Analyzingthecashflowfromaninvestment.
Seekingtovaluethebuyersequitypositionrelativetoaproposedorexistingloan.
Seekingthevalueasfinanced,ortheinvestmentvalue.
Example14.8EquityResidualTechnique
Assumeanetoperatingincomeof$100,000, aloanamountof$600,000,annualloan
paymentsof$70,000,andanequitycashoncashrateof7%.
Solution
Netoperatingincome(Io)
Less:Loanpayments(Im)

Equals:Equitycashflow(Ie)
Dividedby: Equitycashoncashrate(Re)
Equals:Indicatedequityvalue(rounded)(Ve)
Plus:Loanamount(Vm)
Equals:Totalvalueestimate(Vo)
Rounded

$100,000
70,000
$30,000
_0.07
$429,000
+600,000
$1,029,000
$1,000,000

Building Residual Technique

Recommendedforusewhen:
Landvalueisknown(orcanbedemonstrated).
Olderbuildingsarebeingappraised.
Thesalesdataareinadequatetoderiveareliableoverallrate.
Example14.9TheBuildingResidualTechnique
AssumeaNOIof$91,000;alandvalueof$200,000;aninterestrateof7%forbothland
andimprovements;andarecapturerateof4%.
Netoperatingincome
Less:Returnrequiredonland:
Landvalue
$200,000
Times:Landinterestrate
x0.07
Equals:Landreturn
Equals:Netincometoimprovements
Dividedbycompositerate:
Interestrate
0.07
Plus:Recapturerate
+0.04
Equals:Compositebuildingcaprate
Equals:Indicatedimprovementvalue
Plus:Landvalue
Equals:Propertyvalue

Land Residual Technique

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$91,000

14,000
$77,000

0.11
$700,000
+200,000
$900,000

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Recommended when the building value can be reliably estimated but the land value is unclear or
unknown.Alsousedwhenimprovementsarenewornearnew,andrepresentthehighestandbestuse.

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Example14.10LandResidualTechnique
Assumeanetoperatingincomeof$70,000;abuildingcostnewof$600,000;aninterest
rateof6.5%,andarecapturerateof2.5%.
Netoperatingincome
Less:Incometobuilding:
Improvementvalue
Times:Compositerate:
Interestrate
Plus:Recapturerate
Equals:Compositerate
Equals:Incometobuilding
Equals:Incometoland
Dividedby:Interestrate
Equals:Landvalue(rounded)
Plus:Improvementvalue
Equals:Propertyvalue
Rounded

$70,000
$600,000
0.065
+0.025

x0.09

$54,000
$16,000
0.065
$246,000
+$600,000
$846,000
$850,000

Other Capitalization Theories

All income capitalization techniques fall into two basic groups: ratio capitalization, and yield
capitalization.
Ratiocapitalizationincludesthedirectcapitalizationtechniquespresentedabove,whennospecificyield
assumptionsaremade.

Itcapitalizestheincomeattributedtothepropertycomponentunderstudywithasinglecaprate,
orvalueratio.
Ratiocapitalizationdoesnotexplicitlyaddressanypossiblefutureincomeandvaluechangesfor
theproperty.

Yieldcapitalizationisamoresophisticatedmethodofanalyzinganinvestment.Itusesdiscountmath
(inoneformortheother)tovalueeitherthepropertyortheequityincome.Eithershorttermorlongterm
investmentscanbeappraised.
Trueinvestmentyieldcanbeanalyzedbyfactoringinallorsomeofthefollowing:
1.

Anticipatedchangesinpropertyorequityincomeovertime

2.

Buildupofequityfromloanamortization

3.

Valueappreciationordepreciationovertime

Discountedcashflow(oftenreferredtoasDCF)isthemostcommonexampleofyieldcapitalization.

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14.4 ESTIMATING, MEASURING, AND DISCOUNTING CASH

FLOWS
Yield capitalization is used to estimate the present value of a stream of future cash flows. It requires an
explicit estimate of:
1. Future cash flows or their pattern
2. The time period of the projection the holding period
3. The yield rate (discount rate, interest rate or internal rate of return)

The Use of Cash Flows in Appraisals

The analysis of cash flow lies at the heart of income property investment, appraisal, financing, and
management.Cashflowcomesinvariousforms,includinginvestmentincomeorprofit,retirementof
debt, and/or projected sales proceeds. The mathematical tools are the same as those used in yield
capitalization.
Yieldcapitalizationcanleadtoeitheranestimateofmarketvalueoranestimateofinvestmentvalue.The
typeofvalueestimateddependsonwhetherthecashflowsanddiscountfactorsaremarketderivedor
uniquetotheinvestor.
Yieldcapitalizationisparticularlyusefulwhenthenetincomecashflowsand/orvalueareexpectedto
changesignificantlyovertime.[Instructor:seetextforlistofreasonsforchange]

Estimating Cash Flows

Allofthecashflowsinaninvestmentcanbeattributedtoeitherperiodicincome,ortotheproceedsfrom
thesale(orrefinance)oftheproperty.Cashflowscanbemeasuredeitherbeforeorafterincometaxes,
butonlypretaxcashflowsarediscussedhere.Theactualcashflowamountsdependupon:
a.
b.
c.

Theincomeproducingabilityoftheproperty
Thefinancinginvolved
Thevalueofthepropertyuponfuturesale

Measuring Cash Flow from Periodic Income

Cashflowtotheequityinvestorisdefinedasnetoperatingincomelessdebtservice.Cashflowscanbe
eveneachperiod,oruneven.
Example of Even Cash Flow
Assumethatapropertyhasanincomeof$100,000froma30yearnetflatlease.Thereisanamortized
30year,$700,000loancommitmentonthepropertyat9%interest,payableannually.Thecashflowis
calculatedasfollows(usingfinancialtablestosolvefortheamountoftheannualdebtservice):
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Annualnetincome(Io)
Less:Annualdebtservice(Im)
Equals:Annualequitycashflow(Ie)

$100,000
68,135
$31,865

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Example of Uneven Cash Flow
Usethesameassumptions,exceptassumethattheleaseincomestepsupafter15yearsto$150,000per
year.Cashflowswouldbeasfollows:
Years115
Annualnetincome
Less:Annualdebtservice
Equals:Annualequitycashflow

$100,000
68,135
$31,865

Years1630
$150,000
68,135
$81,865

Income Projections

Step one is to select the time period (holding period) to be analyzed

Step two is to understand market rents on the date of value
Step three is to examine changes in the market rents in the past and try to understand what forces
in the local economy are behind the past income changes
Step four is to use this understanding to consider future forces in the market and their impact on
market rents
Step five is to consider any leases and their impact on rents (income) for each future period

Measuring Cash Flow from Sale Proceeds

Estimatethevalueofthepropertyattimeofeventualsale,anddeduct:
1.

Anymarketingandescrow/titlecostsexpectedtobeincurred

2.

Anyremainingloanbalanceorpayoff

Referringtotheearlierexample,assumeasalesubjecttotheexistingleaseafter15years,andcashtoa
newloan.Useacapitalizationrateof10%oftheleaseincome.Assumeabrokersfeeandclosingcosts
totaling6%.(Text,Example1411.)

Saleprice:
Annualnetincome,Io
$150,000
Dividedby:Caprate,Ro
0.10
Equals:Saleprice,Vo
Less:Marketingandclosingcosts:
Saleprice
$1,500,000
Times:Costsinpercent
x6%
Equalsclosingcosts
Equals:Netpricebeforeloanpayoff

Less:Loanbalance(fromtables)
Equals:Cashflowfromsaleproceeds,Ve

Estimating the Future Sale Price

Two common methods to estimate future sale price:

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$1,500,000

90,000
$1,410,000
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$860,781

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1. Capitalize the projected income at that time (more commonly used)
2. Estimate future value as an annual percent change from value on the date of value
The projected income method uses:
The existing annual cash flow projection
An estimate of income and cash flow for the year following the projection (estimated income for the
year following the resale date) i.e. 11th year net in the case of a 10-year projection
Capitalize the projected income, using a going-out OAR.
The projected value change method involves:
An estimate of value on the date of value
An estimate of value change for each year of the projected time period the same each year, or
changing based on market interviews.

Discounting Cash Flows

The Theory of Discount Math
1.

Whenyouplace$1.00ina5%account,youarerecognizingthatthe$1.05promisedinoneyear
hasonlya$1.00presentvalue.
a.
b.

2.

Thedepositislessthanthefutureamount.
Hence,$1.00isthediscountedpresentvalueof$1.05,toearn5%.

Thediscountfactorinthepreviousexampleistheratioof$1.00to$1.05,or$1.00$1.05=.
95238.
a.
b.

The same factor can be used for any sum that is due one year in the future, when
discountedat5%.
Forthelumpsumamountof$1.05dueinoneyear,herearethecalculationsthatshow
thepresentvaluetobeonedollar:
Amountdueinthefuture $1.05
Times:Discountfactor:x.95238
Equals:Presentvalue
$1.00

How to Estimate a Factor

Using discounting math requires using a factor
The factor is a number that adjusts for the time value of money
Sources of factors:
- Look up in a table (Example 14-12)
- Calculate with a financial calculator
- Calculate using the formula for the factor
Six common factors (i.e. six functions of the a dollar); forming three pairs:

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- The present value of a future dollar (the reversion factor), and the future worth of a present
lump-sum (the future value factor)
- The present value of a future income stream, and the future worth of an income stream
- The periodic payment to pay off a present sum (the loan constant or loan factor), and the
periodic payment to accumulate to a future lump-sum (the sinking fund factor)
All six factors involve:
- An interest rate
- A time period
Periodic payments are always level
Financial Calculators
Often used to calculate financial factors many brands, such as Hewlett Packard, Texas Instruments, and
others many models, with the HP12C the most common.
Method:
1. Enter a number
2. Hit a key to identify what the number is:
a.
b.
c.
d.
e.

present value (PV)

future value (FV)
periodic payment (PMT)
time period (N)
a rate (usually i)

3. After the known numbers have been entered, hit the key for the answer, the unknown, to start the
calculation.
Printed tables have been essentially replaced by financial calculators.
Discount Formula for a Single Payment
Discountfactors,builtintofinancialtablesandcalculatorsarebasedonsinglepaymentamountsof$1.00,
sothatanydollaramountcanbeappliedagainstthefactor.Hereisthebasicmathematicalformulaused:
Presentvalueof$1.00=1(1+i)n
Where

i=discountrate
n=numberoffuturetimeperiods

Usingafinancialcalculatortosolveforthediscountfactorshownearlier,thevariablesareentered,and
thesolutionfoundisasfollows,whereFVreferstofuturevalue,andPVtopresentvalue:
Given:n=1;i(in%)=5;FV=$1.00
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Tosolve:PV=$0.95238
Discounting a Stream of Payments
Wecandiscountanincomestreamusingfinancialtables,orwithacalculator.
Usingthe15yearincomestreamgivenintheexampleabove,wewilldiscountastreamofpayments,
usingfinancialtables:

1.

Assuminganinvestorwouldrequirea12%yield,werefertoa12%financialtable,inthe
columnreferredtoasthepresentworthofoneperperiod.

2.

For15years,wefindlistedthefactorof6.8109.

3.

Whenthispresentworthfactorismultipliedtimestheannualincome(afterdebtservice,
theequitycashflow),thepresentworthoftheincomestreamiscalculated:
$31,865X6.8109=$217,000(rounded).

Usingafinancialcalculator,thesamevariablesareentered,andtheproblemsolvedasfollows,where
PMTistheannualcashflowamount:
Given:n=15;i(in%)=12;PMT=$31,865(besureFV=0)
Tosolve:PV=$217,000(rounded)
Discounting the Sale Proceeds
Thesaleproceedsisasinglecashflow,projectedtobeavailablewhenaninvestmentpropertyissold.
Referring again to the investment analysis example cited above, we discount the net proceeds of
$860,781,usingfinancialtables.
1. Theprojectednetsaleproceedsof$860,781willbeavailablein15years.
2. Werefertoa12%presentworthofonetableat15yearstofindthediscountfactoratthe
investorsrequiredyield,0.1827.
3. Wemultiplythefactortimesthenetproceeds,asfollows:
$860,781X0.1827=$157,250(rounded)
Usingafinancialcalculator,thesameansweriscalculated,asfollows:
Given:n=15;i(in%)=12;FV=$860,781(besurePMT=0)
Tosolve:PV=$157,250(rounded)

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Chapter14
Summary of Anticipated Cash Flows
1.

Equitycashflow:
Netannualincome

Less:Debtservice(fromabove)
Equals:Netannualequitycashflow

2.

$100,000
68,135
$31,865

Equitysaleproceeds:
Futuresaleprice
Less:Sellingcosts
Less:Loanbalance
Equals:Equitysaleproceeds

$1,500,000
90,000
549,219
$860,781

Summary of Discounted Cash Flows

Thecashflowsshownabovearediscountedtosolveforthepresentworthoftheequityinvestment,
suggestingtheamountofdownpaymentwarranted,giventheinvestorsyieldrequirementof12%:
CashFlow

Amount

IncomeStream
SaleProceeds

$31,865
$860,781

DiscountFactor
x
x

6.8109
0.1827

TotalPresentWorthofEquity
Rounded:

PresentValue
=
=

$217,000
+157,250
$374,250
$374,000

SUMMARY

[Instructor:Thelistofimportanttermsmayassistinyoursummary.]
Important Terms and Concepts

Annuityrecapturemethod
Hypothecation
Bandofinvestmentmethod
Interestrate
Buildingresidualtechnique
Capitalrecovery
Capitalizationrate
Cashflow
Compositecapitalizationrate
Debtservice
Delta(valuechange)
Directcapitalization
technique
Directcomparisonmethod
Discountrate

Discountedcashflow(DCF)
Equitydividendrate
Equityresidualtechnique
Yieldcapitalization
Equityyieldrate
GoinginOAR
GoingoutOAR
Hypothecation
Incomestream
Interestrate
Internalrateofreturn
Investmentvalue
Landresidualtechnique
Leverage
Mortgageconstant
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Overallcapitalizationrate
(OAR)
Periodicrate
Ratiocapitalization
Recapturerate
Reversion
Saferate
Straightlinerecapture
method
Summationmethod
Timevalueofmoney
Yieldcapitalization
Yieldrate

InstructorsManual:BasicRealEstateAppraisal,8th.Edition
Chapter14

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InstructorsManual:BasicRealEstateAppraisal,8th.Edition
Chapter14
REVIEWING YOUR UNDERSTANDING

[Instructor:Seeendoftextchapterforstudentreviewquestions.]
STUDENT EXERCISES

[Instructor:SuggestedMultipleChoiceandTrue/FalsequestionsareavailabletouseforChapter
14.]

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