Inputs of Direct Capitalization and Discounted Cash Flow Valuation Methods

Net Operating Income

The net operating income (NOI) is calculated when using the income approach to evaluate properties. The number of revenues collected from a commercial property net of operating expenses before interest and taxes.

However, NOI is guided by the relevant terms on the lease agreements. Specific clauses may require the occupant to carter their utility bills, which is excluded when calculating NOI.

NOI is calculated as follows:

1. Determine the potential gross income derived from the property, i.e., rent income + income generated from parking, etc., assuming full occupancy.
2. Determine the effective gross income by deducting costs related to vacant units and loss on rent collection from the potential gross income.
3. Determine the operating expenses, excluding interest expense and income taxes.
4. Deduct the operating expenses from the effective gross income to get the net operating income.

Capitalization Rate

The direct capitalization valuation method embraces both the NOI and cap rate.

The capitalization rate, commonly referred to as the cap rate, is a resulting proportion of NOI compared to the commercial property asset value and is derived as follows:

$$ \text{Capitalization rate (CR)} = \frac {\text{Net operating income (annual NOI)}}{\text{Property cost (value)}} $$

The cap rate is important in commercial real estate valuation since various properties differ in size and scale and thus provide a platform to benchmark similar properties. It also permits for property valuation based on a year’s NOI.

The downside of the cap rate is that it ignores any subsequent increase or decrease in expected cash flows generated over the investment property’s lifetime, making it misrepresentative in determining property market performance.

Discount Rate

The discounted cash flow valuation method utilizes the discounting rate to determine the net present values of future cash flows generated from commercial real estate property.

Typically, the required rate of return or the weighted average cost of capital (WACC) acts as the discounting rate whereby future cash flows are compounded and ensures that the investors’ capital injection into the property investment guarantees the anticipated returns light of the projected property cash flows.

The discount rate utilizes all future cash flows in the holding period to generate the present values instead of the cap rate, which only focuses on a single years’ NOI.

Question

The below information relates to an office building.

• Size of the property 250,000 sq. ft
• Gross rental income $30 per sq. ft
• Other income $85,000
• Vacancy and rent collection loss 5% of gross rental income.
• Property taxes and insurance $350,000
• Utilities and maintenance $900,000
• Interest expense $395,000
• Income tax rate 30%

Calculate NOI.

1. $5,565,000
2. $5,960,000
3. $3,895,500

Solution

The correct answer is B.

Step 1: Calculate the potential gross income:

$$ \begin{array}{rr} \text{Gross rental income} =(250,000\text{sq. ft} \times $30) = & $7,500,000 \\ \text{Add: Other income } = & $85,000 \\ & \overline{$7,585,000} \end{array} $$

Step 2: Calculate the effective gross income:

$$ \begin{array}{rr} \text{Potential gross income } = & $7,585,000 \\ {\text{Less: vacancy and collection loss } 5\% } & \\ {\times \text{Gross rental income } (5\% \times $7,500,000) }= &\frac{($375,000)}{$7,210,000} \end{array} $$

Step 3: Determine the operating expenses:

$$ \begin{array}{rr} \text{Utilities and maintenance }= & $900,000 \\ \text{Property taxes and insurance }= & $350,000 \\ & \overline {$1,250,000} \end{array} $$

Step 4: Determine the net operating income (NOI):

$$ \begin{array}{rr} \text{Total gross income }= & $7,585,000 \\ \text{Less: Vacancy and collection loss }= & ($375,000) \\ \text{Operating expenses }= & ($1,250,000) \\ & \overline{$5,960,000} \end{array} $$

A is incorrect. The amount considers the deduction of interest expense as part of operating expenses when calculating NOI.

C is incorrect. The amount has factored in the interest and income tax deduction when calculating NOI.

Reading 36: Investment in Real Estate Through Private Vehicles

LOS 36 (c) Estimate and interpret the inputs (for example, net operating income, capitalization rate, and discount rate) to the direct capitalization and discounted cash flow valuation methods.