Posted by DD on December 13, 1999 at 24:34:25:
COMMERCIAL CAP RATE ANALYSIS
CAPITALIZATION METHOD: A method of measuring values of realty for purpose of determining values of mortgages by expertly estimating the gross income which property should realize, and separately the expenses reasonably required to carry it, and thus arriving at a fair estimate of net income and using a capitalization figure or factor, expertly chosen. Depreciation must
be taken into consideration in use of such method. (Black?s Law) In re New York Title & Mortgage Co. (Series B K), 21 N.Y.S.2d 575, 594, 595.
CAPITALIZATION OF INCOME: refers to an appraisal technique for determining value by dividing the net income by an appropriate percentage rate “the capitalization rate. (CAP)”
INVESTOR ADVICE: When you review an appraisal in which income has been capitalized, you should carefully examine the justification of the capitalization rate employed. Any value may be obtained by adjusting the capitalization rateÑthe higher the rate, the lower the value and vice versa.
EXAMPLE: An income property has a net income of $1,000,000 per year. If a 8.5 % CAP capitalization rate is used, the value (V) becomes:
V = Income / CAP Rate
V= $1,000,000 /.085 = $11,764,706
CAPITALIZATION RATE: is the percentage rate by which the net income is divided to determine value.
A proper capitalization rate will have been derived by the band of investment or other approved technique, using current data from the market place. The current value of mortgages and the size of the mortgage will have been considered along with the investor risk and amount of investment.
INVESTOR ADVICE: The most accurate method of determining value is by the direct capitalization method, where the rate has been determined from recent comparable sales data. In this method, actual net income is divided by the cash sales price to determine the overall rate (OAR). The following illustration uses the formula:
Income / Sales Price = OAR
Net Income Sales Price OAR
$150,000 $1,650,000 .091
200,000 2,100,000 .095
230,000 2,447,000 .094
To make assure that the rate is accurate, the appraiser would have to select his comparables so that the land/building ratios are similar; the comparables have approximately the same economic life; and more importantly, the net income figures are accurate. It is not unusual for sellers to conveniently forget some expense items, such as reserves for replacement, in order to show a higher rate of net income.
INCOME APPROACH TO VALUE: is an appraisal technique in which the income produced by a property is capitalized to produce an estimate of value of that property.
INVESTOR ADVICE: three basic approaches to determining property value are:
- INCOME APPROACH TO VALUE is mandatory and the most applicable method in the evaluation of income-producing property. A buyer of income property is interested in three things:
(A) The annual income produced, after payment of expenses;
(B) Potential capital gains at the time the property is sold;
(C) The cash flow from the operation.
In the income approach, it is normal for the appraiser to use the net income plus the increase in equity through mortgage payments in his/her calculations.
The income derived from the investment is most critical in an investor’s decision to buy, hence the importance of the income approach to value. It is not unusual for the appraiser to refrain from deducting taxes payable from these figures, as various individuals are taxed at different rates. The the passage of the 1986 tax laws, which reduce the tax rate to a maximum (after the transition period) rate of 28% for most real estate investors, appraisers will undoubtedly begin to include the tax deduction. When you review an appraisal of a prospective purchase, you must pay particular attention to the following aspects of the appraiser’s income analysis:
Has the appraiser included all expenses, cash and non-cash, when computing the net income or not income after taxes?
Are the appraiser’s estimates of unknown or estimated expenses logical?
Are the appraiser’s projections of future gross income and vacancy factors reasonable?
Has the appraiser developed the capitalization rate accurately and logically.
Is that capitalization rate supported by current market data? It is not uncommon to find an appraisal which does an excellent job of determining projected income, but fails to indicate how the capitalization rate was obtained.
- Cost or replacement value, An investment buyer cares little about the reproduction cost. The cost approach to value is an appraisal approach in which the appraiser builds the subject structure on paper using current building costs, and then depreciates it to reflect its current physical and economic condition thereby arriving at a value.
- Market value is what the market is saying about the value, as the investor does not want to pay more than
absolutely necessary, even though a certain asking price may meet investment objectives. The income multiplier is a very useful tool of the market approach, as it gives a quick evaluation of a property in comparison with other properties recently sold. The
multiplier (factor) is derived by dividing the true sales price by the income (net or gross) produced by that property.
INCOME MULTIPLIER: is a factor equal to the selling price (of a property) divided by the income from an investment property. Income multipliers may be expressed as annual or monthly factors of either gross or net income.
NET INCOME: Total revenues less all expenses chargeable to the operation. Also known as net profit.
INVESTOR ADVICE: When reviewing the income statement of various operations, it should be remembered that sole
proprietorships and partnerships do not include wages of the owners as an expense. To obtain a true picture of the net income, a deduction equal to the value of labor furnished, by the owners, should be made. Thus, the resulting net income figure will represent the true return of the operation and the investment.
OPERATING EXPENSES: are those necessary tax-deductible expenses required to conduct a business operation.
INVESTOR ADVICE: You should not confuse operating expenses with other cash flow requirements. Basically, a rental property has four types of outward cash flow. These are:
- Operating expenses, which are paid periodically in order to keep the business operating efficiently.
- Debt service, which is not a tax deductible expense but a necessary outward cash flow. Debt service payments may also include some operating expenses, such as taxes and insurance.
- Depreciation expense, which is a non cash item but is deductible for income tax purposes.
- Reserves for redecoration and equipment replacement, which normally involves a deposit of a certain amount set aside at interest, to provide for future large expenses and equipment replacements. These large cash outlays could not easily be provided from the normal cash flow available.
DEPRECIATION: is a loss in value of a property which is due to physical deterioration, or economic or functional obsolescence. Depreciation provides an increase in cash flow, since it is a non-cash expense, which reduces income taxes payable.
INVESTOR ADVICE: The actual physical depreciation rate of a property is a controllable factor, which largely depends upon timely repairs and maintenance. You have little control of the economic and functional rates of depreciation. However, proper selection of the area can minimize this latter loss. Tax laws strictly control the amount of depreciation, which may be claimed as an expense of doing business. The various methods used in the calculation of these deductions bear little relationship to actual depreciation, especially accelerated methods.
DEPRECIATION NOTE: Office Buildings: 85% Building and 15% Land. 39 year Total Depreciation. Cost of Building x 85% / 39 x years held = Depreciation.
DEPRECIATION RECAPTURE: is the increase of base cost by an amount of depreciation taken for tax purposes, which
exceeds the straight-line depreciation value. Recapture is required when an asset is sold prior to being fully depreciated.
INVESTOR ADVICE:If a property is expected to be sold prior to full depreciation, accelerated depreciation may not be the most cost effective alternative even though it temporarily increases your cash flow. Your accountant can suggest the best method to select, based upon your future intentions. The following example illustrates the principle of depreciation recapture.
You buy an apartment house for $130,000. The land value is $30,000. The expected lifetime of the property is estimated to be twenty years. STRAIGHT LINE depreciation would allow:
$100,000 / 20 = $5,000 / year
ACCELERATED COST RECOVERY (double declining balance) “The Accelerated Cost Recovery System” (ACRS): refers to the method by which cost of real estate and other business properties are depreciated in less than the normal lifetime in order to reduce income taxes.
If ARCS is used, the following depreciation schedule would apply:
Year Value at Beg. Yer Dec. Bal. Factor Dep. Allow.
1 $100,000 1/20 x 2 = 10% $10,000
2 90,000 1/20 x 2 = 10% 9,000
3 81,000 1/20 x 2 = 10% 8,100
4 72,000 1/20 x 2 = 10% 7,200
Total Depreciation Taken… $34,300
INVESTOR ADVISE: If you sell the property at the end of the fourth year, his base cost would be $130,000 less depreciation taken of $34,300, or $95,700.
NOTE: There are other methods of accelerated depreciation which are applicable in certain cases. Those most often used are single declining balance and sum of the digits. Straight-line depreciation for the same period would have been $20,000; therefore, the difference between straight line and the accelerated depreciation ($34,300 Ñ $20,000 = $14,300) taken must be recaptured. The base cost would be recalculated at:
$130,000 - $20,000 = $110,000
ACCRUED DEPRECIATION: Each taxable year after purchase of a depreciable asset the purchaser is allowed to deduct from income an applicable amount referred to as depreciation allowance. This process continues during the lifetime of the asset or until it is fully depreciated. Each year additional depreciation is taken, which is added to all prior depreciation taken to obtain a sum known as “accrued depreciation.” In the event the asset is sold, the accrued depreciation is deducted from the cost in determining the current cost base. The selling price less the base cost equals the capital gains attributed to the asset held for business purposes. The tax form, filed each year, lists each asset purchased, date of purchase, cost, total years over which the asset will be depreciated, type of depreciation, accrued depreciation to date, and book or remaining depreciation to be taken.
INVESTOR ADVICE: The total allowable depreciation becomes a non-cash expense to the business and a source of cash to the operation. Your ability to make required mortgage payments or obtain a required rate of return on your investment can be greatly enhanced by the depreciation cash flow. In preparing a proforma income or proforma cash flow analysis for a proposed purchase, it is important that you obtain an accurate list of depreciable assets and are fully informed as to the maximum tax relief possible. For this purpose, the current owner’s list may not be accurate as all fully depreciated assets will not appear on the depreciation schedule.
These assets, when purchased, may have value and a useful remaining life. They may also be eligible for additional depreciation to you, the new owner.
INVESTOR ADVICE: The allowable depreciation on all real and other business property drastically changed by enactment of the Tax Reform Act of 1986. You are advised to become acquainted with the provisions of the Tax Reform Act of 1986 or to seek the advice of a competent tax authority. The act requires both residential and nonresidential properties to be depreciated using the straight line method. Further, the recovery periods were extended to 271/2 years for residential property and to 311/2 years for nonresidential.
Section 202 of the 1986 act also established Asset Classes, Recovery Periods, and Depreciation Methods for personal properties. The cost of these personal properties are to be recovered over three-, five-, seven-, ten-, fifteen- and twenty-year periods, based
on the type of property involved. The depreciation method allowed for three-, five-, seven- and ten-year properties is 200% (double) declining balance with a switch in later years to straight line to maximize depreciation. (NOTE: The switch to straight line would be made at the point at which the double declining balance rate is less than the straight line rate.) The allowable depreciation method for fifteen- and twenty-year properties is 150% declining balance with a switch to straight line to maximize depreciation.
Cars and light trucks are listed in the five-year class. Other items of equipment are classified in accordance with Section 202 of the tax act.
NOTICE: As a real estate buyer, you should be aware of the requirement that 80% or more of rental income must be from dwelling units to be classified as residential. Hotels and motels do not qualify for residential classification. Section 206 of the 1986 tax reform act provides for an increased expensing deduction. A taxpayer may elect for this in lieu of the normal depreciation method under ARCS. Effective January 1, 1987, and thereafter, property placed in service may be expensed during the taxable year up to a maximum of $10,000. Qualifying property is depreciable property that is placed in use in a trade or business. This provision is modified as follows:
If the property placed in use exceeds $200,000, the credit is reduced dollar-for-dollar by the excess amount over $200,000. Married persons filing separately are limited to $10,000 each.
The amount expensed cannot exceed the taxable income received from the business or trade.
Any conversion of the property to personal use prior to the end of the normal recovery period is subject to recapture of income over that allowable under ACRS for the applicable period.
CASH FLOW: is gross income, less all cash expenses, less debt service, ie. spendable cash.
INVESTOR ADVICE: Actual income from the property will equal the cash flow, less non-cash depreciation expenses, less reserves set aside for redecoration expenses and equipment replace ments, plus the equity portion of the debt service payments.
Disclaimer: The above information is for general use only, deemed reliable but not guaranteed and subject to change without notice. The reader is advised to consult with an independent third praty attorney, tax consultant or other real estate professionals for specific real estate, legal, tax and investment advice.