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Chapter 3
INVESTMENT METHOD/
CAPITALIZATION
Contents

1. The concept and meaning of the method

2. Principles
3. Benefits to be valued
4. Capitalization rate
5. Capitalization Methods
6. Calculate net income from real estate rental
7. Implementation process
8. Applications
9. Limitations of the method
1. The concept and meaning of the method

The concept
• Capitalization is the process of converting future cash
flows into present capital value.
• The capitalization method is based on the principle that
the annual value and the value of the invested capital are
related. When the annual income generated by the
property is known in advance, the capital value of the
property can be found.
Meaning
Widely used to value income generating real estate sold
to buyers for investment purposes.
2. Principles

❖ Forecasting principles
❖ Principle of change
❖ Supply and demand
❖ Substitute Principle
❖ Principle of balance
❖ Externality Principle
3. Interests to be valued

Legal
Financial assets
Ownership Interests

• Lessors
• Borrower • lessees
•Owner • Lender
•Shareholders

Interests in real estate

3. Interests to be valued

Types of values
Non-real estate
that need to be
interests
evaluated

Intangible
Market
personal
value
property

Tangible
Investment
personal
value
property
3. Interests to be valued

1 Potential gross income(PGI)

2 Effective gross income(EGI)

Future
Benefits 3 Net operating income(NOI)

4 Before tax cash flow(BTCF)

5 After tax cash flow (ATCF)

6 Recovery money (recovery value) (RV)

4. Capitalization rate
4.1 Types of capitalization rates
❖Definition:
The ratio used to convert future cash flows to
present value.
❖ Classification:
▪ Income rates
▪ Rates of return
4. Capitalization rate
4.1 Types of capitalization rates
❖Income Rates:
An income rate expresses the relationship
between one year’s income and the corresponding
capital value of a property.
Including:
▪ Overall capitalization rate, Ro
▪ Equity capitalization rate, Re
4. Capitalization rate
4.1 Types of capitalization rates
❖ Overall capitalization rate, Ro
• is an income rate for a total property that reflects the
relationship between a single year’s net operating
income and the total property price or value.
• It is used to convert net operating income into an
indication of overall property value.
4. Capitalization rate
4.1 Types of capitalization rates
❖ Equity capitalization rate, Re
• is an income rate that reflects the relationship between a
single year’s equity income expectancy and the equity
investment
• Used to capitalize the target real estate’s before tax cash
flow into the value of equity
• Note: Income Rates are not a rate of return on capital
4. Capitalization rate
4.1 Types of capitalization rates
❖Rates of return:
Is the rate of return on invested capital, expressing
the annual percentage profit.
❖Including:
▪ Discount Rates, r
▪ Internal rate of return, IRR
▪ Overall yield rate, Yo
▪ Equity yield rate, Ye
4. Capitalization rate
4.1 Types of capitalization rates
❖ Discount Rates, r
The rate of return used to convert future cash flows into
present value
❖ Internal rate of return, IRR
Considered the rate of return received for a given
investment capital during the period of real estate ownership
4. Capitalization rate
4.1 Types of capitalization rates
❖ Overall yield rate, Yo
Is the rate of return on invested capital. It is calculated on
the basis of real estate purchased for investment, which is
the weighted average of the rate of return on equity capital
and loan capital.
❖ Equity yield rate, Ye
Is the rate of return on equity capital, which is IRRe,
influenced by debt capital on pre-tax cash flow. Ye can be
bigger than Yo
4. Capitalization rate
4.2 Estimate capitalization rate
❖ Factors affecting capitalization rate:
-Level of associated risks-Inflation in the future.
-The expected rate of return of the alternative
investment.
-Profit rates of comparable real estates in the past.
-Supply and demand for mortgage loans
4. Capitalization rate
4.2 Estimate capitalization rate
❖ Component parts in the capitalization rate:
• Capitalization rate R(nominal) = R base+ R risk+ R
inflation
• Capitalization rate R (real) = R base+ R risk
5. Capitalization methods
5.1 Direct Capitalization
❖ Concept:
Is a method used in the income capitalization approach to
convert a single year’s income expectancy into a value
indication. This conversion is accomplished in one step, by
dividing the net operating income estimate by an
appropriate income rate.
❖ Formula
❖ Capital value of real estate
V= NOI/ Ro or
V=NOI xYP
• YP(income multiplier) =100/Ro
5. Capitalization methods
5.2 Yield Capitalization, and Discounting
❖ Concept:
Yield capitalization is used to convert future benefits
into an indication of present value by applying an
appropriate discount rate
Formula
V= CF1/(1+r)1 +CF2/(1+r)2+….+CFn/(1+r)n
5. Capitalization methods
5.3 Compare two capitalization methods
Direct Capitalization
Use a single year's income
Capitalization rates are derived
from the market
The general capitalization rate
only applies to one property
characteristic
Determine the market value or
capital value of real estate
Applicable to valuing real estate
with full ownership
Yield Capitalization
Forecasting income streams, costs and
vacancy levels and financial costs during
the real estate holding period, recovery
value when selling real estate at the end
of the investment period
The rate of return concluded according to
market orientation, market views and
expectations must be interpreted - This is
the investor's forecasted return
Rates of return are applied to discount
many characteristics of real estate
Only the capital value of real estate can be
determined
Applied to value real estate with partial
ownership
6. Calculating net income from real estate rental

❖ Income streams from real estate can be actual or

predicted income
❖ Full rental value is the maximum rental amount of real
estate on the free market.
❖ Ways to set rent levels in contracts
- Set a fixed rent level (applies to residential rentals)
- Set the rental rate as a percentage (applies to commercial real
estate)
- Net lease (applies to industrial real estate)
❖ Unit of comparison: In cases where direct comparison is
not possible due to the different sizes of the properties, it
is necessary to use the unit of comparison. Comparison
units: m2, square meter, land lot
6. Calculating net income from real estate rental

❖ Ex 1: A 1-storey house with a surface of 6m and a depth of 13m

needs to determine the rental price. There is information about a
similar property nearby with a surface of 5 m and a depth of 13
m, recently rented for 10 million VND per year.
❖ Solution: Analysis of a new house for rent
❖ Method 1: According to the comparison unit, m2: 10 million
VND: (5m x13m) = 0.153 million VND/m2.
Target real estate rental price: (6m x 13m) x 0.153 million VND/m2
= 12 million VND/year
❖ Method 2: According to the front of the house: 10 million VND: 5
m = 2 million VND/m
Target real estate price 6m x 2 million VND/m = 12 million
VND/year
❖ Note: These two houses have the same depth, so both
comparison units can be used
7. Procedure

1. Estimate the average annual income of real estate

taking into account all factors affecting income
2. Estimate all real estate operating costs to deduct from
annual income such as taxes, maintenance and
repair costs, management fees and utility costs.
3. Find the capitalization rate by analyzing sales of
similar properties
4. Apply the capitalization rate to net income to calculate
the value of the property
8. Applications
8.1 Valuation of real estate with full ownership for rent at
full rent
Ex 2: Determine the market value of a fully owned store with an
area of 20m2. The rental price according to the current market
price after deducting all expenses is 5 million VND/month. Market
evidence shows that the profit margin of this type of store is 5% per
year.
Solution:
Actual annual rental price
5 million VND x 12 months = 60 million VND
Market value of the store
60 million VND: 5% = 60 million VND x 20 = 1200 million VND
8. Applications
8.2 Valuation of lease benefits under the contract
❖ Contract rental is another form of profit on real estate for a
term. This means that profits are only earned during the
rental period. Contractual rental benefits are very common
in real estate.
- The land owner leases the land to the lessee to develop and enjoy
the benefits of the development project during the land lease period.
-The owner rents the house or the tenant sublets the rented house to
earn interest on the rent
❖ The valuer's job is to determine the value of the lease
8. Applications

Ex3: A real estate leased under a 10-year contract with a fixed

rent of 20 million VND/month. To keep the rent fixed in the
contract, the tenant must be responsible for repainting the house
in the 3rd year at a cost of 8 million VND and in the 7th year
replacing the heat-resistant roof at a cost of 25 million VND.
Therefore, what is the current value of the contract?
Know that the current cumulative rate is 5%/ year.
According to market evidence, the profitability rate of this type of
real estate is 8%/year
8. Applications
Solution:
❖ The value of 1 year's rental is:
20 million VND/month x12 months= 240 million VND
❖ Present value of rent in 10 years:
240 million VND x {(1+8%)10-1}/{(1+8%)10 x 8%}= 1610.4 million VND
❖ Present value of paint rolling and heat-resistant roof repair work
8 million VND /(1+5%)3 + 25 tr.đ/ (1+5%)7= 24.68 million VND
❖ Value of contract:
1610.4 million VND + 24.68 million VND= 1635.08 million VND​
8. Applications

Ex 4: Valuing a commercial center with a construction area of 3,000

square meters and a rental rate of 75%. Rental price is 0.8 million VND/
m2/ month (10% VAT included). Annual maintenance and repair costs are
1 billion VND, management costs are 1.2 billion VND, and electricity and
water costs for common areas are 2 billion VND. Lease term is 3 years
left. After that, the new rental price is expected to increase by 20%,
maintenance and repair costs increase by 15%, and other costs increase
by 10%. The capitalization rate is 12%. Corporate income tax is 25%
8. Applications
Solution:
1- Calculate net income during the rental term
Revenue from 1 year rental is:
3000m2 x0,75 x0,8 million VND/m2/month x12 month =21.600 million VND
• V.a.t tax (10%):
21.600 million VND : 11= 1963,63 million VND
- Annual operating costs:
1 billion VND + 1.2 billion VND + 2 billion VND = 4.2 billion VND
- Income subject to corporate income tax
21,600 million VND - 1963.63 million VND - 4,200 million VND = 15,436.37 million VND
- Net income
15,436.37- (15,436.37 x 25%)= 15,436.37 million VND - 3,859 million VND = 11,577.37
million VND
8. Applications
2. Calculate net income after contract termination
Total income:
21,600 million VND x 1.20=25,920 million VND
-Value added tax (10%):
25,920 million VND:11= 2,356.36 million VND
- Estimated operating costs
(1 billion VND x1.15)+ (1.2 billion VND x1.1)+ (2 billion VND x1.1)= 4.67
billion VND
- Income before tax
25,920 million - 2,356.36 million – 4,670 million = 18,893.64 million
- Net income
18,893.64 million VND – (18,893.64 million VND x25%)=14,170.24 million
VND
8. Applications
3. Value of shopping center
- Present value of rent for the next 3 years
11.577,37 million VND x {(1+0,12)3-1}/{(1+0,12)3x 0,12}
= 11.577,37 million VND x 2,4018 = 27806,53 million VND
- Real estate value after the end of the lease contract (at the end of the
4th year)
14,170,24/0,12=118.085,33 million VND
- Current value of real estate:
27.806,53 million VND + 118085,33/(1+0,12)4= 102.876,66
million VND
rounding 102.876 million VND
8. Applications

8.3 Mortgage loan valuation (equity approach)

Example 5: A person is considering buying a real estate
property that generates a net income of 250 million VND per
year, but this person only has 1 billion VND, the remaining
balance will have to be borrowed from the bank. The bank's
loan interest rate is 12%/year. The required rate of return on
equity capital is 15%. So what is the maximum price the
investor can pay for real estate?
8. Applications
Solution:
❖ Required return on equity capital
1 billion VND x15% = 150 million VND
❖ Net income remaining to pay interest
250 million VND - 150 million VND = 100 million VND
❖ The amount of money that can be borrowed from the bank
MC= 100 million VND: 12%=833.3 million VND
❖ The maximum price an investor can pay for real estate
1 billion VND + 833.3 million VND = 1833.3 million VND
8. Applications
8.4 Application to allocate external effects to land and
buildings
❖ Allocation method: According to the proportional
relationship of each component in the value of real estate.
❖ Estimate the price reduction due to externalities
❖ Use the comparison method to calculate the loss of rent
due to the negative effects of external factors
❖ Capitalize the annual rental loss due to the negative impact
of external factors to calculate the total depreciation.
8. Applications
Example 6: Allocating external effects due to environmental
pollution to land and buildings of a free hold real estate for
rent located in a polluted area.
Knowing that the annual net rent of this property is 300 million
VND. The construction cost of the project is 1,000 million
VND, the capitalization rate of the land is 8%/year, the
capitalization rate of the project is 12%/year. The rent for this
property compared to similar properties currently being rented
is calculated to be 20 million VND/year lower.
8. Applications
Solution
❖ Calculate the building's contribution to the net rental value
1000 million VND x 0.12=120 million VND
❖ The remaining contribution value of the land is
300 million VND - 120 million VND = 180 million VND
❖ Value of land
180 million VND: 0.08 = 2250 million VND
❖ Total value of real estate
2250 million VND + 1000 million VND = 3250 million VND
8. Applications
❖ Proportional relationship of land and construction in the total value of
real estate
Land: 2250: 3250x100%=69.2%
Construction: 1000:3250x100%= 30.8%
❖ Capitalization rate of real estate
(0.692 x 8%)+(0.308 x12%)=9.23%
❖ Total price reduction due to environmental pollution
20 million VND: 9.23%= 216.68 million VND
❖ Allocate total depreciation to land and buildings
Land: 216.68 million VND x 0.692= 149.94 million VND
Construction: 216.68 million VND x 0.308= 66.74 million VND
9 Limitations of the method
❖ This method requires the valuer to forecast future cash
flows. There may be many factors that cannot be predicted
so the accuracy will not be high.
❖ There is no consensus in determining the capitalization
rate, but is entirely based on the subjective opinion of the
valuer.
❖ This method, if applied properly, will give an accurate
investment value for the target real estate.
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