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Capitalizing on Income Capitalization

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An appraiser who desires to become certified in income capitalization may find themselves spending many hours researching this topic. Real estate appraisals are very important to investors, since they are the basis of making a very large purchase. The problem that some real estate appraisers face when being certified in income capitalization is the process itself. They must learn all about this subject in order to be prepared to pass the certified exam.

An alternative method which will typically be covered on the Real Estate License Examination for valuing property based on its current income is called the income capitalization method. This method converts an income-producing property’s current income into an estimate of its future profits. Appraisers usually use this method particularly for commercial properties like office buildings, shopping centers, and large apartment complexes. It’s an easy and accurate way to determine what properties are suitable for investment. You will be well prepared for the licensing exams when you learn the proper way to conduct a business valuation.

The income capitalization approach makes use of an even earlier mathematical formula called the Pearls Formula, which was developed by a real estate appraiser named W.H. Pearls. In this method, a future income producing property’s value is estimated using the present condition, existing rents, and existing income from other similar properties.

The advantage of using the income approach is that it is based solely on the existing and future income of the property. If there is no existing income, it’s not considered in the process. This appraisal, unlike the Realtor’s appraisal, is not affected by recent market trends. Therefore, it can be used by any investor, realtor or not, who is simply looking to make an informed decision about their rental property.

The second method is the net operating income or the cost of doing business, which is also known as the gross profit rate or the gross margin. This is more difficult than the previous method, but is nevertheless effective. To calculate the capitalization rate, all expenses incurred are added up, and the gross profit figure is then calculated. The net operating income figure is then subtracted from the expenses to get the net profit figure. As one can see, both methods are extremely complex, involving numerous factors and assumptions.

One of the most important assumptions made by the investors is the amount of future leases. Potential gross income and net operating income are therefore not taken into consideration when calculating the capitalization rate. On the other hand, a lease with a long term perspective allows for the calculation of future operating costs that will affect the gross margin more so than the gross income figure. A homeowner would thus do well to factor in potential gross income in calculating the lease rent to net income ratio.

The last method used is the income capitalization approach, which uses the present value of money, known as PV, as a yardstick of valuation. Basically, a typical valuation will involve current and future cash flows, interest rates, depreciation, amortization, and reinvestment (reinvestment). All these factors, primarily, have to be considered when calculating the present value of the property being evaluated. There are several advantages to the income capitalization method over the previous two. First, due to the more accurate representation of future cash flows, the valuation of property tends to be much more accurate, especially for short-term investments.

The cap on the gross margin is still applied in the income capitalization approach, for the same reason, namely, to cover potential losses during the initial period of operations. It is also applied for the long-term value of the property. With the cap, the value of the business’s retained assets is less than the amount of its direct capital. This refers to the company being unable to generate enough cash flow from rents, profits, or other direct means to support its operations. The cap on the gross margin, therefore, ensures that the company can maintain an acceptable level of operations until it can raise enough capital to cover the gap between the lost income and the capital needed to finance ongoing operations. This gap is called the net working capital or the NCF.

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