Chapter 4
4
Applications of the
Approaches to Value
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Chapter Objectives
4
• Upon completion of this chapter, the
participant will be able to:
– Choose the most appropriate income methodology to
apply in an assignment
– Apply gross rent and income multipliers derived from
market data as part of the appraiser’s income analysis
– Estimate and apply rates of capitalization using market
derived data and band of investment techniques
– Recognize how the sales comparison approach and cost
approach are applied in assignments of a two- to fourunit or multi-family property
– Identify the most applicable indicators of value leading to
the appraiser’s reconciliation and final value opinion
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Key Terms
• Band of
Investment
• Direct
Capitalization
• EGIM (Effective
Gross Income
Multiplier)
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•Equity
Capitalization Rate
•External
Obsolescence
•Functional
Obsolescence
3
Key Terms
•Mortgage
Capitalization Rate
•Mortgage
Constant
•Physical
Deterioration
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continued
4
•PGIM (Potential
Gross Income
Multiplier)
•Replacement Cost
•Reproduction Cost
•Unit of Comparison
4
Income Approach
4
• Reliable indicator of value when
highest and best use of property is
determined to be for use as an
income property
– Given there is sufficient and reliable data
available
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Using a GRM
4
• A GRM can be derived from
transactions of properties rented at the
time of sale, or shortly thereafter
• GRM considers gross rent on a
monthly basis
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Deriving a GRM
4
• The appraiser uses a formula known
as VIM:
V (Sale Price) ÷ I (Gross Monthly Rent) = M (Multiplier)
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GRM Example
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4
8
Applying a GRM
4
• To develop an opinion, the appraiser
multiplies the monthly market rent of
the subject by the multiplier:
M (Multiplier) x I (Monthly Market Rent) = V (Value)
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Using a GIM
4
• Appropriate when subject property
produces ongoing income in addition to
rent from living units
• Income used could be PGI or EGI
• GIM derived from similar properties with
similar rent and (other) income flows
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Using a GIM
4
• Is the source of additional income
based upon occupancy level of living
units?
• This assists the appraiser in choosing
to apply the GIM, defining the factor
as a:
– Potential gross income multiplier (PGIM)
– Effective gross income multiplier (EGIM)
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PGIM
4
• Derived from, and applied to, the total
gross income generated by the property
without vacancy or collection losses being
considered
• This is probably the most common
application of a GIM
• Appropriate when the source of the
additional income is not influenced by the
occupancy of the living units
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EGIM
4
• Derived using EGI—the amount after
estimated vacancy and/or collection loss
has been deducted from PGI
• Warranted when living unit occupancy is
related to the potential for income from
other sources
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Deriving a GIM
4
• Using VIM:
Value ÷ (Annual) Income = Multiplier
• In reality, data with exact similarities is
rarely available and appraiser must seek
to simply analyze data that has a similar
benefit to the investor
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Applying a GIM
4
• GIM is applied to the total market
income of subject
• Appraiser must be careful to apply
the GIM consistently with how the
multiplier was derived
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Applying the PGIM
4
• The subject: A 3-unit property generating
$21,600 annually in market rent
– A storage building on the property produced
$1,200 annually in other income
– Indicated PGIM = 15.67
$22,800 ($21,600 + $1,200) x 15.67 = $357,276
• The appraiser would probably round the
indication to $357,000
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Applying the EGIM
4
• The subject is a 4-unit apartment
building:
– Generates $2,800 monthly market rent
– $100 per month from the coin-operated
laundry
– Market-extracted vacancy rate = 4.8%
– Indicated EGIM = 12.93
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Applying the EGIMcontinued 4
• To develop an indication of value for the
subject, PGI for the subject must first be
calculated:
$33,600 ($2,800 Rent x 12 Months)
+
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1,200 ($100 Laundry Income x 12 Months)
$34,800 PGI
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Applying the EGIMcontinued 4
• Now, the vacancy factor must be calculated and
subtracted from PGI to result in EGI:
$34,800 x 4.8% (0.048) = $1,670.40 Vacancy
$34,800 - $1,670.40 = $33,129.60 EGI
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Applying the EGIMcontinued 4
• Finally, the subject’s EGI is multiplied by
the EGIM to indicate a value conclusion:
$33,129.60 x 12.93 = $428,365.72
• The appraiser would probably round the
developed value indication to $428,000
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Direct Capitalization
Using an Overall Rate
4
• Direct Capitalization: An income method that
converts a property’s single-year NOI into a
value indication by applying an overall
capitalization rate using a formula commonly
known as IRV:
NOI ÷ Overall Capitalization Rate = Value
• Interprets typical investor reactions and
motivations of a particular process
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Deriving an Overall
Capitalization Rate
4
• The two most common techniques for
deriving an overall capitalization rate
involve:
– Utilizing comparable sales of similar
income properties or market data
– The analysis of mortgage and equity
components, known as band of
investment (a technique for determining
an overall capitalization rate by weighting
and combining the various components of
an investment)
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Using Market Data
4
• NOI calculations of comparable must be
consistent with how the NOI of subject was
estimated
• Lease terms of comparable must be similar to
those of the subject
• Rents/income generated by comparables
should represent those typical for the market
• Element of comparison of comparable data
should be consistent with those found in an
arm’s length transaction
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Overall Capitalization
Rate Example
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4
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Using the Band of
Investment Technique
4
M x RM + (1-M) x RE = RO
•
•
•
•
•
M = LTV ratio
RM = Mortgage capitalization rate
1-M = Equity investment
RE = Equity capitalization rate
RO = Overall capitalization rate
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Applying an Overall
Capitalization Rate
4
• Here, the appraiser divides the NOI by the
overall capitalization rate
(Net
(Overall
Operating) ÷ Capitalization) = Value
Income
Rate
• Formula commonly known as IRV
• Example: A subject property has an NOI of
$12,700. The overall capitalization rate indicated
in this assignment is 10.25%:
$12,700 ÷ 10.25% = $123,902
(rounded to the nearest dollar)
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Reconciling the Income Approach
4
• The appraiser considers:
– Quantity and quality of data used
– The indications produced by the analysis
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Sales Comparison Approach 4
• Will usually be developed in support of, or
supported by, the income approach
• This approach provides evidence of
actions taken within the marketplace
• There must be a presence of market data
from which conclusions can be drawn that
lead to credible results
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Comparable Analysis
4
• Comparable data chosen must have the
same highest and best use as the
subject
• Ideally, truly comparable data will be
very similar and can be wholly
compared to the subject property
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Units of Comparison
4
• A component with which a property can be
divided for the purpose of comparison
• Common units of comparison for a small
residential income property might include the
comparable’s sale price per:
– Square foot
– Living unit (or apartment)
– Bedroom
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Units of Comparison Example 4
• Interpolate somewhere between the per-unit sale
price of the two- and four-unit properties (such as
the median of this range, $77,000) to determine a
sale price of a 3-unit property:
3 units x $77,000 = $231,000
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Reconciling the
Sales Comparison Approach
4
• Relevance is most related to the quantity
and quality of data that is available to the
appraiser for analysis
• With sufficient and relevant data, the
indications produced can be a reliable and
valuable tool for developing a value opinion
for a small residential income property
• Useful for supporting the:
– Presence of investor action and reaction in
the marketplace for such properties
– Highest and best use
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Cost Approach
4
• Not typically developed if:
– Comparable data for income and sales
comparison approaches is plentiful and
the indications produced by both are
not contradictory
– Subject is an older or historic structure
• Can be useful in some assignments
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Rationale for Employing
the Cost Approach
4
• Applicable when:
– Sales/income data is scarce and sales
comparison/income approach is not a
particularly good indicator
– Improvements are new or relatively new
• Requires thoughtful analysis of any physical
deterioration or functional/external obsolescence
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Rationale for Employing
4
the Cost Approach continued
• Which cost is appropriate?
– Reproduction Cost
– Replacement Cost
• Primary indicator of value when the
appraisal’s intended use is for insurance
purposes
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Difficulties of Employing
the Cost Approach
4
• Reproduction cost for older structures can
be difficult to estimate
• More complex and challenging when
factoring in depreciation (functional or
external)
• Can produce misleading indications and
poor results when conclusions do not reflect
typical market reaction
• Economic characteristics of the market and
locational elements of the property must be
correctly determined
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Chapter 4 Quiz
4
1. A small residential income property has
two units that generate $950 rent per
month each. If the property recently
sold for $130,000, what is the indicated
GRM?
a.
b.
c.
d.
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57.37
68.42
75.87
81.36
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Chapter 4 Quiz
4
2. If a three-unit property generates a total
monthly income of $1,975, and sold
recently in an arms-length transaction
for $185,000, what is the EGIM if
vacancy loss was estimated at 4.35%?
a. 6.74
b. 7.92
c. 8.16
d. 9.47
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Chapter 4 Quiz
4
3. When the cost approach is developed
in a market value assignment of a small
residential income property and the
appraiser overlooks an oversupply
situation in the market, which would
likely result?
a.
b.
c.
d.
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credible results
functional obsolescence
misleading value indication
replacement cost
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Chapter 4 Quiz
4
4. What is the overall capitalization
rate indicated for a property that
generated NOI of $42,628 and sold
recently for $535,000?
a.
b.
c.
d.
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7.97%
8.32%
9.17%
10.21%
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Chapter 4 Quiz
4
5. A $250,000 mortgage has been
provided to an investor at 7% interest
for 20 years. If monthly debt service is
$1,938.25, what is the mortgage
constant?
a.
b.
c.
d.
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0.0762
0.0805
0.0837
0.0930
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Chapter 4 Quiz
4
6. Using the band of investment technique,
what is the overall capitalization rate
indicated for 70% LTV financing with a
loan amount of $300,000 and an annual
debt service of $31,360, if the equity
dividend rate is 9%?
a. 8.26%
b. 9.71%
c. 10.02%
d. 11.98%
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Chapter 4 Quiz
4
7. The primary difference between an
EGIM and a PGIM is attributed to
a.
b.
c.
d.
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net income ratio.
operating expense.
replacement reserve.
vacancy.
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Chapter 4 Quiz
4
8. Which element is considered in a
GIM but is NOT considered in a
GRM?
a.
b.
c.
d.
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debt service
income from sources other than rent
net operating expenses
series of annual income flows
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Chapter 4 Quiz
4
9. A four-unit property generates $500 per month,
per unit. Using the mean of the following GRM
data, what is the value of the property?
GRM
a.
b.
c.
d.
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Comparable #1
Comparable #2
Comparable #3
95.67
100.32
98.34
$175,360
$181,750
$190,670
$196,220
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Chapter 4 Quiz
4
10. In which stage of the appraisal process
does the appraiser initially determine
the approaches to value that will be
developed in a particular assignment?
a.
b.
c.
d.
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highest and best use analysis
market analysis
reconciliation
scope of work
46