**The common capitalization method of valuation for
investment properties, the initial yield
method, assumes two things; that the rent is paid at the end of the
period and yearly. However, in practice, these assumptions do not
apply. For example, rents are paid in advance and the payment period is
usually monthly. However, adjustments can be made to the common
capitalization method to take these factors into account.**

CONSTRUCTING CAPITALIZATION RATES

Wherever possible capitalization rates should be analyzed from sales of investment properties comparable to the subject property. However, there are circumstances where the investment property is so unique that there are no comparable sales. In such a case various methods have been devised to enable the construction of capitalization rates from other investment data.

The band of investment method uses typical mortgage data and returns on equity to construct the

EXAMPLE

An investment property has a net annual income of 15 000.

Assuming that the mortgage for this type of property is as follows:

Principal: 75% of purchase price

The overall capitalization rate can be found with the following 3 steps:

1. DETERMINE THE ANNUAL MORTGAGE REPAYMENT FACTOR

This factor is found by multiplying the mortgage interest rate by the ratio of the amount borrowed to the total purchase price:

3. CALCULATE THE OVERALL CAPITALIZATION RATE

The overall capitalization rate is found by summing the two factors:

CALCULATE THE MARKET VALUE OF THE PROPERTY:

THE ELLWOOD METHOD

R = Y - MC - AS

Where:

M = ratio of mortgage to purchase price or market value

A = expected capital gains

S = sinking fund factor for period of loan at Y%

EXAMPLE

Value the following property using the Ellwood method:

Net annual return: 65 000

Mortgage term: 20 years

Mortgage interest rate: 15% per annum

Required return on equity: 19% per annum

The market value is found with the following 4 steps:

1. DETERMINE THE "C" COEFFICIENT

The "C" coefficient is the annual mortgage repayment factor that is, the repayment for each $1 borrowed:

2,DETERMINE THE SINKING FUND OR REPLACEMENT OF CAPITAL FACTOR (SFF)

The sinking fund factor is the annual amount required to replace $1 in the future at the rate of return on equity. The period is the mortgage period:

OCR = 0.19 - (0.75 * 0.1598) - (0.12 * 0.0060) = 0.0695

Therefore, the overall capitalization rate = 6.95% pa

4. DETERMINE MARKET VALUE

Market value = 65000 * 100/ 6.95 = 935 871 say 936 000

The residual method of valuation recognises the dichotomy in the nature of the value of land and buildings. The

THE "LAYER" CAPITALIZATION METHOD

The layer method of capitalization splits the expected cash flow into two components:

**The initial of "passing" cash flow****The market rent****- see diagram below.**

THE "LAYER" CAPITALIZATION METHOD

The initial cash flow accounts for the majority of the property's value and is valued with the "initial yield" formula and the "stepped" part of the diagram is capitalized separately. Suppose the net lettable area of the investment property represented is 2500 m

**The net annual income for the initial yield part = 2500 * 200****= 500 000 per annum****The net annual income for the market rent part = 2500 * 20****= 50 000 per annum**

Assuming a vacancy rate of 4% per annum the value of the initial rent part:

(500 000*.96) * 100/8 = 6 000 000

The expected marginal rate to bring the rent to market rent ($20/m

The value of the marginal market rent part is as found as follows assuming a margin of risk of 1.5% per annum net:

(50 000*.96) * 100/(8+1.5) = 505 263

The present value over 2 years is found.

Assuming the applicable discount rate is 10% per annum:

PV(1) = 1/(1+i)

Where:

n = period = 2

The advantage of the layer method is that it splits the expected income streams into two parts; a low risk part and a high risk part. Therefore, the resultant capitalized value better reflects the relevant weighting of the two parts compared to the simple initial yield method.

REFERENCES

Ellwood L W, "Ellwood Tables - Part 1 - Explanatory Text", American Institute of Real Estate Appraisers, Chicago, 1974.

PROBLEMS

11. List 3 advantages and 3 disadvantages from a valuation point of view of using the CAPM method.

13. Determine the market value of the following property using the "layer" capitalization method:

14. Value the above property using the "shortfall method". Assume a capitalization rate of 6%pa.

15. Determine the market value of the above property using the "increasing annuity" method and the following extra information: