Chapter 38
Appraising Income Property
INTRODUCTION
The income appraisal approach estimates the current market value for a real
property by projecting and analyzing the income that the property could
generate. Income-earning properties include single-family homes, duplexes,
apartment buildings, shopping centers, freestanding retail stores, office buildings and
warehouse and industrial buildings. The appraiser converts the projected income of
the property into an estimate of market value. The formula for doing so is derived
from the valuation of fixed income securities such as long term corporate and
government bonds: Value = Income / capitalization rate.
The definitions of the elements of the formula are:
(a)
Income = a periodic income payment received by the owner of the
asset after deducting operating expenses of the property and
(b)
Capitalization rate = an income rate that converts income into
value.
As applied to real estate appraisal, this equation simply states the following
relationship: the value of the income-generating real property is equal to the
periodic (net) income (usually annual) generated by the property divided by a
capitalization rate (cap rate) appropriate for the market in which the property will
trade, the period of time when it will trade, and the risk associated with this type of
property. If a parcel of real estate generates an income payment of $10,000 per
year and the appraiser estimates a capitalization rate of 10 percent per year, the
value of the real property is $10,000 divided by 0.1 equals $100,000.
ANALYSIS OF REVENUE
An appraisal of income property starts with projecting the income that the property
will generate as that income would be projected by qualified buyers in that market at
that time. An appraisal of current market value relies on the current prevailing rents
in the market and the amount of space that the property can offer to prospective
tenants. The appraiser uses three income definitions in an income property
appraisal. These three income concepts are: (1) potential gross income, (2)
effective gross income, and (3) net operating income. These three income concepts
rely on an understanding of:
(a)
market rent and contract rent;
(b)
vacancy and collection losses; and
(c)
operating expenses.
POTENTIAL GROSS INCOME
Potential gross income is the total number of dollars that the income-producing
property could generate if the property obtained the prevailing market rent for each
unit of space in the property plus any other income generating activities of the
property. Understanding two different rent concepts, contract rent and market rent,
is critical to understanding potential gross income. Contract rent is the rent that the
tenant actually pays to the property owner under by the lease contract. In contrast,
market rent is the rent the property owner would receive if a tenant paid the current
rent prevailing in the market. The value of a fee simple estate is based on the
market rents at the time of valuation. The value of a leased fee estate is based on
the contract rents for occupied space, plus market rents on vacant space to be
occupied, less an adjustment for a rent-up period and expenses.
The property's potential gross income is the total of the rents for each of the rentable
units in the property plus income from miscellaneous sources. Market rent and
contract rent need not be the same. The current market rent can be greater than,
equal to, or less than the contract rent based upon a lease that is one, two, or even
ten years old. At the time of the original lease, the economic circumstances in the
market were more than likely different from the current economic climate. To
determine a property's potential gross income, the appraiser first identifies all
rentable space in that structure. The appraiser prices this space, whether it is the
number of apartment units or the floor area in square feet, at the prevailing market
rent rate for similar space in competitive properties. In addition to the rentable
space, the appraiser must identify any other sources of potential income such as
parking fees, vending machine revenue, and laundry room receipts. In developing
the market rent rate, the appraiser must analyze the difference between the
effective market rent and the asking or quoted rents. Commercial tenants rarely pay
the asking rents because owners give various concessions to these tenants. The
magnitude of these rent concessions increases as the amount of vacant space in the
market increases. Rent concessions may take the following forms:
(a)
periods when the tenant does not owe rent;
(b)
funds for the decoration or the finishing of the tenant’s space (tenant
improvement allowances),
(c)
free parking spaces;
(d)
assistance with the tenant's moving costs;
(e)
assistance with space planning expenses; and
(f)
funds to buy out the tenant's obligation in an existing lease.
EFFECTIVE GROSS INCOME
Effective gross income is an estimate of the subject property's maximum incomeearning potential, given current and future effective market rent conditions, reduced
by an allowance for vacancies and collection losses. When the appraiser is
considering the earning potential of an income property, he or she recognizes that
some space in that structure may be vacant for some period and that all the rent due
may not be collected. This situation could occur even if the property is fully occupied
at the time by reliable and financially stable tenants. To establish effective gross
income projections, the appraiser must reduce potential gross income to reflect the
vacancy levels the property will experience and the inability to collect all the rent
earned. The result of this reduction for vacancy and collection losses is effective
gross income.
ANALYSIS OF OPERATING EXPENSES
The operating expenses of an income-producing property are the total cash
payments that are necessary to generate effective gross income. The important
phrase in this definition is "necessary to generate effective gross income." As
operating expenses of the property, the appraiser considers only expenditures that
are necessary for the operation of the property; therefore, expenditures associated
with the owner's personal needs or the operation of another property do not
count. For example, the owner's income taxes are not an operating expense;
depreciation claimed for income tax purposes is not an operating expense; nor are
payments on mortgages secured by the property operating expenses. The three
operating expense categories are variable expenses, fixed expenses, and reserves
for replacement. Variable expenses include cash outlays that change with the level
of occupancy in the structure including the following:
(a)
management fees for rent collection, tenant selection, property
marketing, and other administrative work;
(b)
payroll and personnel expenses such as salaries, social security
contributions, unemployment insurance, and all other fringe benefits
provided by the property owner to the employees;
(c)
utility expenses paid by the owner for electricity, natural gas, heating
oil, water, sewer service, and trash collection;
(d)
maintenance and repair expenses;
(e)
leasing commissions;
(f)
supplies and materials expenses for items to make the property
habitable and clean such as light bulbs, rug cleaning solutions, floor
wax, and paint; and
(g)
grounds care expenses to maintain improvements other than the main
building such as parking lots, access roads, sidewalks, the lawn and the
landscaping, the swimming pool, tennis courts, and patios.
The second operating expense category, fixed expenses, does not vary with the level
of occupancy of the building. Consequently, they remain relatively constant whether
the property is fully occupied or entirely vacant. The two most important fixed
expenditures are (a) real property taxes and special assessments and (b) property
insurance for hazards such as fire, theft, and vandalism, and liability insurance.
The third category of operating expense is a reserve for replacement of short-lived
items such as appliances and carpets in an apartment unit, heating and cooling
equipment, elevators, escalators, light fixtures, revolving doors, and plumbing
fixtures. The economic life of these fixtures is much shorter than the economic life
of the structural components of the building, and every five or ten years the owner
will find it necessary to replace them. Therefore, the owner may need to create a
reserve of funds to cover the outlay to replace these items as they wear out.
NET OPERATING INCOME (NOI)
Net operating income is effective gross income minus total operating expenses. The
importance of net operating income (NOI) to the appraiser is simple to
understand. NOI is the numerator in the valuation formula discussed above. The
appraiser divides NOI by a capitalization rate to obtain an estimate of the property's
current market value.
THE DIRECT CAPITALIZATION METHOD
Direct capitalization is the process of converting net operating income into an
estimate of market value. The appraiser estimates the property's net operating
income. Then the appraiser derives the appropriate capitalization rate by using one
of two procedures: (a) derivation from the property market or (b) derivation from
the financial market.
(a)
DERIVATION OF THE CAP RATE FROM PROPERTY MARKET DATA - To derive the overall rat
in the recent past and obtains both their sales prices and net operating incomes. As an ex
was $35,000 at the time of sale. In this case, the overall rate of capitalization is NOI ¸ Sa
investment properties, the appraiser can use the overall rate of capitalization from such m
available. Moreover, if the properties are not similar, the appraiser will have to make a si
then loses its validity and its applicability.
In order for the overall capitalization rate extracted from the market to be accurate and u
(1)
physical characteristics of the improvements and the site;
(2)
neighborhood and locational characteristics;
(3)
financing involved in the purchase;
(4)
terms of sale and market conditions prevailing at the time of the sale;
(5)
income streams that represent the same timing, risk, and stability;
(6)
buyer and seller motivations underlying the transaction; and
(7)
arm's length transactions surrounding the sale. The term "arm's length" rep
negotiations as might be true in the case of a transaction between parties th
If these elements of comparability do not exist in the current market, the overall capitalization ra
the capitalization rate.
(b)
THE BAND OF INVESTMENT CAPITALIATION RATE - This method of developing a capitaliza
benefit monetarily from investing in real estate: lenders and buyers (equity investors). M
investment differ. In the vast majority of cases, buyers require some borrowed money an
of loan to value and the interest rate) plus the equity investor's expectation of return is im
example, in a given market, purchasers of income-producing real estate may obtain 70 pe
expect a 16% annual income return on their investment in equity. Using that information
technique in its simplest formulation.
Rate = (L/SP)(RM) + (E/SP)(RE)
L/SP = the ratio of the loan to the sales price (70% or 0.7)
RM =
the annual payment rate on borrowed funds (10% or 0.10) including both in
E/SP = the ratio of funds that the buyer pays as a down payment (the equity) to the
RE =
the expected buyer's expected rate of income return on the investment in th
Given the assumed payment rates and portions, the calculation of the capitalization rate is
(c)
THE VALUE ESTIMATE FROM DIRECT CAPITALIZATION - After the appraiser calculates the
property market or by the band-of-investment technique, he or she can divide NOI by R to
property is $322,034. The next step is to round the estimate to reflect the appraiser’s jud
the estimate. In this situation, while some appraisers would round to the nearest thousan
thousand figure and thereby present the client with the value estimate of $320,000.
AN EXAMPLE OF DIRECT CAPITALIZATION
Exhibit A displays the relevant information for a property that has 12 apartment
units that will sell in a market that has $800 per month market rent and an 8%
vacancy rate. An investor has requested an appraisal to help set an offering price.
The historic operating expenses for the past few years are obtained from the owner
or the property owner. These operating expenses need to be “reconstructed” which
means that they are evaluated for “necessity”. Are the stated expenses necessary to
operate the property? The data for the property might have included “income taxes”,
“depreciation as per the IRS” and “mortgage interest rates”; these expenses are not
necessary to operate the property so they are removed from the list of necessary
operating expenses.
The reconstructed operating expenses are then evaluated for their applicability to the
future. If property taxes for the last 3 years averaged $16,500 will this level exist in
the near future? Over the last few days the investor discovered that the local
jurisdiction must build a new school and a prison and a new public safety facility (fire
station or police station). Would $18,000 be a more relevant estimate for property
tax over the next few years?
From the data provided in Exhibit A the appraiser generates the cash flow statement
in Exhibit B. PGI is $115,200 ($800 per month times 12 months times 12
apartments). EGI is PGI les the vacancy loss of $9,216 due to the market vacancy
rate of 8%. Total Operating Expenses are $40,419 so NOI is $65,565.
The Cap Rate is calculated from a sales comparison approach of the property market
in which the subject property will sell using the procedure presented in the previous
discussion. It is 9.20% or, in decimal terms, 0.092.
The market value estimate is NOI of $65,565 divided by 0.092 = $712,664 rounded
to $713,000.
THE GROSS INCOME OR RENT MULTIPLIER TECHNIQUE
The gross income multiplier (GIM) or gross rent multiplier (GRM) technique is
another form of direct capitalization to estimate the market value of income-earning
property that attempts to model actual investor behavior, usually for smaller
properties. The term "gross income multiplier" (GIM) usually refers to annual gross
income while the term "gross rent multiplier" (GRM) usually refers to monthly gross
income. Sometimes appraisers will use the term "gross monthly rent multiplier"
(GMRM) for clarity. In any event, the multiplier converts a gross income measure
such as rent into an estimate of market value.
To apply the GIM or the GRM, the appraiser draws a judgment, based on his market
research, that investors in income-earning properties act upon financial self-interest
and have good information about the real estate market. The appraiser makes a
second judgment that the sales prices of recently sold comparable properties
adequately reflect the investors' judgments about the future NOI of those
properties. Inherent in this second judgment is the idea that the sales prices paid
for these comparable properties adequately reflect future trends in operating
expenses and vacancy rates as well as future trends in the market value of the
rentable space being provided by those structures. On the basis of these judgments,
the appraiser obtains an estimate for the gross rent or gross income multiplier by
dividing the sales price of each of the comparable properties by the monthly or
annual gross rent.
By developing GRM’s or GIM’s for several comparable properties that have sold
recently, the appraiser establishes a range for the current multiplier. If the appraiser
chooses comparables carefully, the several gross rent or income multipliers should
be approximately the same or reasonably close to each other. This small level of
deviation more than likely reflects differences in age, condition, special features,
room size, and/or location of the property. For this reason the appraiser does not
adjust gross rent or income multipliers. The appraiser selects from the group of
properties a comparable property that is most like the subject property and uses its
GRM or GIM to estimate the market value of the subject. The gross multipliers of
the other comparable properties serve as a check on the accuracy of the market, in
other words, on the consistency of the different investors' judgments about the
market value of the similar properties.
As an example of the use of the gross rent multiplier technique, an appraiser selects
several comparable properties and finds GRM’s for these properties to be in the
range of 90 to 95. The most comparable property has a GRM of 91.5. The appraiser
estimates that market rent is $425.00 per unit for each of 12 apartments in the
structure. The market value estimate then is GRM times the market rent or 91.5
times $425/month times 12 apartments which equals $466,650.
The appraiser must recognize limitations when using the gross income or rent
multiplier. Since the gross income multiplier relates the appraiser's estimate of
market value to a gross income concept, that is, to potential gross income or to
effective gross income rather than to net operating income, its use is only valid for
certain types of property. The properties used for comparison must exhibit a high
degree of uniformity among their operating expense ratios, and this uniformity must
be present among the whole set of comparable properties and the subject property
itself. Without uniformity in operating expense ratios, the gross income estimate
cannot reflect comparability in net operating income among the properties and the
subject property. If this uniformity among operating expense ratios exists, the
appraiser can assume comparability among the net operating incomes of the
comparable properties and the subject property. Despite the limitations of the
technique, the gross income or rent multiplier is very appealing because of its
simplicity. By obtaining estimates of gross income multipliers from the comparable
properties, checking to be sure that the divergence among these estimates is not
excessively large, and identifying the comparable property most like the subject
property, the appraiser can reliably estimate current market value.
YIELD CAPITALIZATION
The second class of techniques available to the appraiser to estimate current market
value uses the NOI estimates for a number of years into the future and the net
proceeds from the anticipated future sale of the property to estimate market
value. This technique is more complex than direct capitalization technique which is
only an initial year analysis. A complete discussion of this technique is beyond the
scope of this guide because it involves time value of money considerations and
investment analysis concepts. A complete presentation of yield capitalization is
available in any appraisal text that discusses income property valuation.