Chapter 2
2
Income Concepts
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Chapter Objectives
2
• Upon completion of this chapter, the
participant will be able to:
– Contrast the concepts of income versus rent
– Identify the measures of income and benefits which will
be used in the appraiser’s income analysis
– Classify the different types of operating expenses
– Recognize specific income factors and rates of return
and their key elements
– Distinguish the identifying characteristics of leasehold
and leased fee interests
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Key Terms
•
•
•
•
Contract Rent
Debt Service
Deficit Rent
Effective Gross
Income (EGI)
• Excess Rent
• Fixed Expenses
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• Gross Income
Multiplier (GIM)
• Gross Rent
Multiplier (GRM)
• Leased Fee
Interest
• Leasehold Interest
3
Key Terms
• Market Rent
• Net Operating
Income (NOI)
• Operating
Expenses
• Overall
Capitalization Rate
• Overall Yield Rate
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continued
2
• Potential Gross
Income (PGI)
• Reserves for
Replacement
• Reversionary
Benefit
• Variable Expenses
4
Income vs. Rent
2
• In some cases, a property’s rent may be
its income
• There may be other types of income
aside from rent
– Examples: income from parking, garage, or
storage spaces, vending machines, etc.
• Two types of rent we will discuss:
– Contract Rent
– Market Rent
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Contract Rent
2
• What tenant is actually paying in rent, as
stated in the terms of the lease
• May or may not reflect what a typical:
– Lessor would expect
– Lessee would pay
• Appraiser must determine if rent being
generated actually reflect that which would
be typical in that marketplace
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Market Rent
2
• What the property could rent for in the open
market if currently vacant and available
– Also referred to as economic rent
• When market rent exceeds contract rent, the
difference is called deficit rent
– Lessee has advantage
• When contract rent exceeds market rent, the
difference is known as excess rent
– Lessor has advantage
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Measures of Income
and Benefits
•
•
•
•
2
Potential Gross Income (PGI)
Effective Gross Income (EGI)
Net Operating Income (NOI)
Reversionary Benefit
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Potential Gross Income (PGI)
2
• The income that could be produced by a
property in an ideal situation, with no
vacancy or collection losses
• In most cases, based on an annual
amount
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Effective Gross Income
2
• The potential gross income, less vacancy
and collection losses
• The formula for EGI is:
PGI - Vacancy and Collection Losses = EGI
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Net Operating Income
2
• The income after expenses.
• Do not confuse NOI with cash flow
• The formula for NOI is:
PGI - Vacancy and Collection Losses =
EGI – Operating Expenses = NOI
• Like PGI and EGI, most commonly
expressed in annual terms
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Reversionary Benefit
2
• Typically a sum, often stated in a dollar
amount, that a property owner will receive
when or if he sells the property at the end of
the investment term
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Operating Expenses
2
• Day-to-day costs of running a building, like
repairs and maintenance, but not including
debt service or depreciation
– Debt Service: The amount of funds
required to make periodic payments of
principal and interest to the lender
• Considered on an annual basis when
income is analyzed at an annual level
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Operating Expenses
continued
2
• Typically, operating expenses are
categorized as:
– Fixed expenses
– Variable expenses
– Reserves for replacement
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Fixed Expenses
2
• Ongoing expenses that do not vary based on
occupancy levels:
– Real estate taxes
– Insurance
– Services contracted at a level rate for, perhaps,
a year at a time (e.g., refuse collection)
– Cost of a security light for a parking area where
the expense is a reoccurring flat fee
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Variable Expenses
2
• Operating expenses necessary to the property,
but dependent on the property’s occupancy
level:
– Maintenance, repairs, and utilities to units
furnished by lessor
– Management fees (often expressed as a percent)
• Legal and accounting fees that are charged on a
non-consistent basis might be variable
expenses, as well as other miscellaneous
expenses
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Reserves for Replacement
2
• Refers to an amount of money set aside
for future replacement of major items
– Sometimes just called reserves
• Most often applied as an annual dollar
amount (sometimes as a percentage)
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Rent and Income Multipliers
2
• Multiplier: A factor derived by dividing the
sale price, or sometimes value, of a
comparable property by its gross income, or
in some cases, rent
– Not a percentage
• Derived using this formula:
Sale Price (or Value) ÷ Gross Income (or Rent)
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Rent and Income Multipliers
continued
2
• Two types of multipliers can be applied:
– Gross rent multipliers
– Gross income multipliers
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Gross Rent Multipliers (GRMs)
2
• A factor derived from comparable rental
data, which is then used to develop an
opinion of value of the subject property
– Used when the property has income that is
derived only from rental of living units
• Most commonly derived on a monthly
basis
– GMRM (gross monthly rent multiplier)
emphasizes the factor is expressed as
monthly
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Gross Income Multipliers (GIMs)
2
• A factor that takes into account income
derived from all sources of a property
• Commonly derived from and applied to
annual income
• Could be based on PGI or EGI
– Resulting multiplier could therefore be a
potential gross income multiplier (PGIM)
or an effective gross income multiplier
(EGIM)
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Rates of Return
2
• Overall Capitalization Rate
– An income rate
• Yield Rate
– Reflects the anticipation of all future
benefit returns
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Overall Capitalization Rate
2
• Used to interpret a property’s single year net
operating income to the property’s value
using direct capitalization
M x RM + (1-M) x RE = RO
• Formula in which the rate, stated as a
percent, is extracted for application in direct
capitalization (known as IVR):
(Net Operating) Income ÷ Value = Rate
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Overall Yield Rate
2
• Considers a series of annual figures over
the entire investment period as well as
reversion
• Use of yield capitalization in most
residential appraising is not common
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Type of Value in the Assignment 2
• Type of value prompts appraiser to utilize
valuation methods that will produce the most
credible result
– Also alerts appraiser of transaction characteristics
to look for when choosing comparable data
• Types of value typically requested:
– Market value of fee simple estate (most
common)
– Investment value
– Value in use
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Leasehold and
Leased Fee Interests
2
• Scope of work may include valuing only
leasehold or leased fee interest, or the
leasehold or leased fee estate
• Income techniques most likely used to
value these interests
– GRM technique is the most simple and
common
• Sales comparison approach is of little
value unless comparable sales can be
located
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Leasehold and
2
Leased Fee Interests continued
• When contract rent is less than market rent, an
advantage to the lessee occurs and creates a
positive leasehold
• When contract rent is more than market rent, an
advantage to the lessor occurs and creates a
negative leasehold
• Leasehold interest: Defined by the amount of rent
that is less than market rent (amount of difference
between contract and market rent)
• Leased fee interest: Defined by the amount of
contract rent over and above market rent
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Leasehold and
2
Leased Fee Interests continued
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Positive Leasehold Example
2
• Property’s contract rent = $1,200 per month
• Appraiser determines property should have a
market rent of $1,350 per month
• Appraiser selects a GRM of 110
$1,350 x 110 = $148,500
$1,200 x 110 = $132,000
$148,500 – $132,000 = $16,500
• Therefore, the value of the leasehold interest is
$16,500, the amount of the advantage to the
lessee, in dollars
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Negative Leasehold Example
2
• Property contract rent = $1,500 per month
• Appraiser determines property should have a
market rent of $1,250 per month
• Appraiser selects a GRM of 95
$1,250 x 95 = $118,750
$1,500 x 95 = $142,500
$118,750 - $142,500 = - $23,750
(stated as a negative—negative leasehold)
• Therefore, the value of the leased fee interest is
$23,750, the amount of the advantage to the
lessor, in dollars
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Chapter 2 Quiz
2
1. The potential gross income for a
property less any vacancy and
collection losses is known as
______________
effective gross income.
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Chapter 2 Quiz
2
2. The net proceeds, if and when a
property is sold, are known as a
_____________
reversionary benefit.
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Chapter 2 Quiz
2
3. A type of expense that could be
associated with the occupancy level of
variable
a property is known as a __________
expense.
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Chapter 2 Quiz
2
4. A GIM
_____ is an appropriate factor to be
used in developing the income
approach when the property generates
income from sources in addition to rent
from the living units.
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Chapter 2 Quiz
2
5. When the contract rent of a
property is greater than market
Leased ___
fee interest results.
rent, a ______
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Chapter 2 Quiz
2
6. An overall capitalization rate is used to
interpret a series of annual net income
figures over the entire investment
period.
TRUE
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FALSE
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Chapter 2 Quiz
2
7. Regardless of the type of value
identified in an assignment, market rent
is used in the appraiser’s income
analysis.
TRUE
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FALSE
37
Chapter 2 Quiz
2
8. Debt service is not included in the
analysis of operating expenses when
determining net operating income.
TRUE
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FALSE
38
Chapter 2 Quiz
2
9. For an appraisal in which investment
value is specified, the appraiser’s value
opinion is based upon an income or
level of return reflecting the investor’s
specific criteria.
TRUE
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FALSE
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Chapter 2 Quiz
2
10. A positive leasehold is created when
contract rent is greater than market
rent.
TRUE
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FALSE
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