Question

You are a real estate valuer for Bank of Brunei. You are valuing an apartment complex in Kuala Lumpur, that your client wishes to purchase. They have provided you with the following details:

Rental income for 2021 is expected to be $5,000,000 if all apartments are occupied. The vacancy rate is expected to be 25% if the economy goes into recession, or 3% if the economy grows. The probability of a growing economy is 40%. Expenses per year include government taxes ($130,000), insurance ($120,000), maintenance ($200,000), and compulsory Malaysian property levy tax ($80,000). Assume that only the revenue stream varies with the type of economy faced.

1. Use the capitalisation of net income method to find the expected value of this apartment complex if the discount rate of your client is 8%.

2. Explain whether or not the capitalisation of net income approach is superior to the cost approach, as applied to the above scenario.

Answer 1

Rental Income (R) = $5,000,000

Probability of growing economy(Pg) = 40%

Probability of Recession(Pr) = 60% (1-40%)

Vacancy rate (Vg) = 3% (97%)

Vacancy rate (Vr) = 25% (75%)

Expected Revenue = R*Pg*Vg + R*Pr*Vr

= 5000000*40%*97% + 5000000*60%*75%

= 1940000 + 2250000

= 4,190,000

Particulars	Amount
Expected Revenue	4190000
Less: Government Taxes	(130000)
Less: Insurance	(120000)
Less: Maintenance	(200000)
Less: Property tax	(80000)
Net Income(NI)	3,660,000
Capitalization rate	8%

Value of property (NI/Cap Rate) 45,750,000

Cost approach is the method of calculating the value of an asset based upon its cost to acquire + further capital costs - depreciation. Since this method does not take into account the time value of money this method cannot be used in case of old assets.

Since the capitalization method takes into account the expected future cashflows and this approach is perfect for assets which have rental income.

Hence for assets from which rental income is to be earned, Capitalization method is more suitable.