Chapter 8
Valuation Using the Income
Approach
Real Estate
FIN 331
Fall 2014
The Income Approach to Appraisal
A. Rationale: Value = present value of future income
1. Income capitalization: converting future income into
a present value
2. The present value is a function of the capitalization
rate
3. The capitalization rate reflects investor requirements
for return on investments
4. ROIs are adjusted for riskiness of investment
B. Two Approaches To Income Valuation
1. Direct capitalization using a single overall cap rate
2. Discount all expected future cash flows (CFs) at a
discount rate
The Income Approach to Appraisal
C. Direct capitalization
1. Find value as a multiple of first year net income (NOI)
2. “Multiple” is obtained from sales of comparable properties
3. Similar in spirit to valuing a stock using a price/earnings
multiple
D. Discounted cash flow (DCF)
1. Project net CFs for a standard holding period (say, 10
years).
2. Discount all expected future CFs at required return (IRR)
3. DCF valuation models require:
a. Estimate of typical buyer’s expected holding period
b. Estimates of net (annual) CFs over expected holding period,
including net income from expected sale of property
c. Appraiser to select discount rate (required IRR)
Rental Property Operating Statement
+
=
-
PGI
VC
MI
EGI
OE
Potential Gross Income
Vacancy & Collection Losses
Miscellaneous Income
Effective Gross Income
Operating Expenses
=
CAPX
NOI
Capital Expenses
Net Operating Income
Estimating Net Operating Income
A. Potential gross income (PGI)
1. Rental income assuming 100% occupancy
2. Sometimes referred to as potential gross revenue (PGR)
3. Should forecast of PGI be based on contract rent (signed
leases) or current market rents?
B. Types of Commercial Leases
1. Straight lease: “level” lease payments
2. Step-up or graduated lease: Rent increases on a
predetermined schedule
3. Indexed lease: Rent tied to an inflation index; ex.,
consumer price index
4. Percentage lease: rent includes percentage of tenant’s sales
Estimating Net Operating Income
C. Effective Gross Income
1. VC-vacancy & collection loss is based on:
a.Historical experience of subject property
b.Competing properties in the market
c.“Natural vacancy” rate: Vacancy rate that is
expected in a stable or equilibrium market
2. Miscellaneous income
a.Garage rentals & parking fees
b.Laundry & vending machines
c.Clubhouse rentals
Estimating Net Operating Income
D. Operating Expenses
1. Ordinary & regular expenditures necessary to keep a
property functioning competitively
2. Fixed: Expenses that do not vary with occupancy (at
least in the short-run)
a. hazard insurance,
b. local property taxes
3. Variable: Expenses that tend to vary with occupancy
a. Utilities
b. Maintenance & supplies
4. OE do not include: mortgage payments, tax
depreciation, capital expenditures
Estimating Net Operating Income
E. Net Operating Income equals Effective Gross
Income minus Operating Expenses
1. NOI is property's "dividend“: Why is it not
investor’s dividend?
2. Projected stream of NOI is fundamental
determinant of property’s value
3. NOI must be sufficient to:
4. service the mtg debt and
5. provide equity investor with an acceptable return
on equity
6. Be careful of NOI vs. NCF (net cash flow)
Estimating Net Operating Income
F. Sources Of Industry Expense Data
1. Institute of Real Estate Management
www.irem.org
2. Building Owners and Managers Association
www.boma.org
3. International Council OF Shopping Centers
www.icsc.org
4. Urban Land Institute www.uli.org
First Income Valuation Method:
Direct Capitalization
A. Basic Value Equation: V = NOI ÷Ro
1.Where: Ro is a capitalization rate NOT a
discount rate
2.A Cap Rate is defined simply as: Net Operating
Income1 ÷ Sale Price
3.See Exhibit 8-5 for an example of how cap
rates are estimated
4.Note that the NOI is the expected or
anticipated first year net operating income
First Income Valuation Method:
Direct Capitalization
B. Effective Gross Income Multiplier
1.EGIM = sale price ÷ effective gross income
2.Quick indicator of value for smaller rental
properties
3.Requires no operating expense information
4.Critical assumptions
a. Roughly equal operating expense percentages across
subject and comparable properties
b.Assumes market rents are paid
5.Best used for properties with short-term leases
(apartments & rental houses)
First Income Valuation Method:
Direct Capitalization
C. Problems with Valuation by Direct
Capitalization
1. Inadequate data on comparable sales due to:
a.
b.
c.
d.
Above- or below-market leases
Differing length of leases and rent escalations
Comparable vs. subject
Differing distributions of operating expenses between
landlord and tenant
2. Differing prices between institutional and private
investors for similar properties
3. Result: Discounted cash flow (DCF) analysis can
be preferable
Terminal Cash Flow Analysis
A. Selling an income property at the end of
the investment horizon
1.
2.
3.
4.
5.
Sales Price (SP)
- Selling Expenses (SE)
= Net Sale Proceeds (NSP)
Year N cash flows = rental income + NSP
Value analysis best handled using the PV
methodology. (see Example 8-3 page 207)
PV = S CFn / Cap rate
for all n =1 to N
Appraisal Work Requires Analytical
and People Skills
A. Developed a network of data contacts
B. Collect, read, interpret, and organize data
and reports
C. Be skilled in data analysis and report
production
D. Be able to meet tight deadlines
Homework Assignment
A. Key terms: Capital Expenditures, Direct
capitalization, effective gross income,
effective gross income multiplier,
capitalization rate, natural vacancy rate,
net operating income, operating expenses
B. Study Questions: 1, 4 - part a, 5, 6, 8 (Some
calculations are required for 4a, 5, & 6.)