Instructor’s Manual: Basic Real Estate Appraisal, 8th. Edition
Chapter 13
CHAPTER 13
THE INCOME APPROACH
STUDENT LEARNING OUTCOMES
Introducing income property and the income approach, this chapter covers:
13.1
13.2
13.3
13.4
13.5
Introducing Income Property and Its Appraisal
Gross Income Multiplier Analysis
Estimating Gross Income and Market Rent
Operating Expenses and Expense Ratios
Reconstruction of the Operating Statement
Class Activities
[Instructor: Complete as needed.]
Lecture [ ] Discussion [ ] Breakout Groups [ ] Other _____________[ ]
13.1 INTRODUCING INCOME PROPERTY AND ITS APPRAISAL
This section covers the types of income property, the motives and benefits of its ownership, and a first
look at the methods of appraising it.
Types of Income Property
Property types usually treated as income property include the following:
1. Multiple-family residential properties
2. Commercial stores, offices, hospitals, hotels and motels, shopping centers, etc.
3. Industrial properties, such as warehouses, distribution facilities, and factories
Motives and Benefits of Ownership
Tangible Benefits
1. Return on the investment (like interest), usually primarily in the form of “net” income
2. Return of the investment (capital recovery), for example, when the property is sold
Intangible Benefits
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Pride of ownership
A sense of security
Opportunity to develop and apply management skills
[Instructor: Investment criteria are covered in the next chapter.]
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Chapter 13
The Income-Value Relationship
Utility, Income, and Value
1.
Utility is a basic characteristic of value.
2. Income is the annual money received from an investment.
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Future earnings on money invested.
Stocks pay dividends; bonds pay interest.
Real estate produces rent.
3. Value is defined as:
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The present worth of future benefits
The relationship (often complex) between the amount of return (net income) and the rate of
return
Examples of Monetary Relationships
1. A savings account that earns $160 for one year at 8% interest is worth $2,000, because $160 is
8% of $2,000.
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The income is $160.
The value is $2,000.
The return rate is 8%.
2. Real estate producing $50,000 annual net income is worth $500,000 if the required annual return
is 10%.
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The income is $50,000.
The value is $500,000.
The return rate is 10%.
3. In both examples, value is the relationship between the amount of return and the rate of return. It
can be expressed by the following income capitalization formulas:
Value = Income ÷ Rate of Return or, V = I ÷ R
Alternatively, by algebra, Income = Rate x Value
Methods of Appraising Income Property
There are two general methods:
1.
Income capitalization – summarized in this section
2.
Gross Income Multiplier – discussed in Section 13.2
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Chapter 13
The Income (Capitalization) Approach
As an introduction, here are the six basic steps in the income approach (direct capitalization method):
1. Estimate the potential gross annual income.
2. Estimate typical vacancy and collection losses.
3. Subtract vacancy and collection losses from potential gross annual income to arrive at the
effective gross income (EGI).
4. Estimate annual operating expenses, and subtract to calculate net operating income.
5. Analyze comparable investments and arrive at a capitalization rate and capitalization method (in
this example, direct capitalization).
6. Divide the net operating income by the capitalization rate.
Example 13.1 Direct Capitalization
Potential gross income
Less: Vacancy and collection loss
Equals: Effective gross income
Less: Annual operating expenses
Equals: Net operating income
Divided by: Capitalization rate
Equals: Value Estimate
Rounded:
$ 150,000
- 8,000
$ 142,000
- 45,000
$ 97,000
÷ .08
$1,212,500
$1,210,000
Definition of Terms Used in Income Capitalization

Potential gross annual income (PGAI) - potential or scheduled rent plus service income.

Vacancy and collection loss – potential gross income lost to vacancy, bad debts, and other
collection losses.

Effective gross income (EGI) – potential gross income less vacancy and collection loss.

Operating expenses - expenses needed to maintain the property income.

Net operating income (or NOI) - effective gross income less operating expenses.

Capitalization rate - the rate, percentage, or ratio used to convert income into its value
equivalent.
[Instructor: Estimating income and expenses are covered later in this chapter. Capitalization
methods and rates are covered in the next chapter.]
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Chapter 13
13.2 GROSS INCOME MULTIPLIER ANALYSIS
This section covers deriving, selecting and using gross rent or income multipliers.
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The gross income multiplier method is often used as the income approach in the appraisal of
single-family homes.
The gross income multiplier is often labeled as a sales comparison method in the appraisal of
income property.
Formula:
Gross Income Multiplier (GIM, GRM) = Sales Price ÷ Gross Income.
Deriving Gross Income Multipliers
The procedure:
1. Make an adequate search for comparable sales.
2. Estimate the market rent for each comparable, and add other income, if any.
3. Divide each selling price by its gross income.
4. The result is the gross income multiplier (GIM).
What rents and adjustments are used?
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Use either monthly or annual rent in single-family house appraisals.
Use annual rent in the appraisal of most other property types.
Usually reflect market rent, not the actual rent, but sometimes worth trying both.
Exception: under rent control, use allowable or existing rent.
Traditionally, adjust the selling prices only for unusual financing or conditions of sale.
Selecting and Using Gross Income Multipliers
Gross income multipliers nearly always vary with property characteristics. Here are some important
factors to consider:
1.
Location and neighborhood
2.
Intangible amenities
3.
Expense ratio
4.
Number of dwelling or store units
5.
Size per unit
6.
Services included
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Chapter 13
Example 13.3 in your text displays gross rent or income multipliers produced by comparable sales.
Importantly, property characteristics are shown for each sale. The subject property is a 10-unit building
with unfurnished apartments with Scheduled Gross Rent of $84,000.
Conclusion: Comparables number 2 and 5 are the most like the subject, and a GRM of 9.75 is suggested.
(See text for reasoning.)
13.3 ESTIMATING GROSS INCOME AND MARKET RENT
Potential gross income refers to the total income from all sources, assuming 100% occupancy. It is
sometimes referred to as an income forecast. The income estimate may be for a single period, or for a
series of periods. It includes:
1. Rent for tenant space (i.e. Rent Roll)
2. Service income (laundry, vending machines, parking, etc.)
Contract versus Market Rent
Market rent is usually the rent looked for in appraisals.
Market Rent Defined
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It is the potential gross rent in an open market on the effective date of the appraisal.
It assumes the space is available and free from leases and encumbrances.
It assumes efficient management.
It is used to measure the market value of all of the property rights.
Understanding Contract Rent
Contract rent informally means the rent the tenants are currently paying (per agreement).
Types of tenancies:
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Month-to-month rentals
Short-term leases
Long-term leases
Types of Leases
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Straight (or “flat”) leases
Step-up (or graduated) leases
Indexed (or “CPI”) leases
Percentage leases (with minimum or base rent specified)
Combinations of these
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Types of rent involved in leases:
1. Minimum rent is the base or minimum contract rent, in a percentage lease.
2. Overage rent is the amount paid over the base or minimum rent.
3. Excess rent is the amount by which the total contract rent exceeds the market rent.
Importantly, lease terms usually spell out responsibility for expenses. “Who has to pay what” can vary by
property type and within each property type.
Review: A Summary of Key Income and Lease Terms
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Base rent
Contract rent
CPI lease
Excess rent
Minimum rent
Overage rent
Percentage lease
Potential gross rent
Rent roll
Step-up (graduated) lease
Straight (flat) lease
Choosing the Time Period for the Gross Income Estimate
Usually, a twelve-month period is selected, but which twelve months?
What Are the Possibilities?
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The 12 months just before the date of value
The calendar year before the date of value
The rent roll on the date of value times twelve
The market rent roll on the date of value
The estimated income for the 12 months after date of value
The Importance of Future Income
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Value is the present worth of future benefits.
The anticipation of future rent changes strongly influence property prices.
What does the market anticipate?
How to Select a Gross Rent Number
Rule 1 – The More Data, the Better
 The more you know about the past and present income, and the market, the better.
 Past income versus present (get three years operating history if you can).
 Contract income versus market income.
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Chapter 13
Rule 2 – Always Be Aware of the Market
 On occasion, only contract rents will be relevant.
 Nearly always, market rents must also be considered. It could matter.
Rule 3 – Be Consistent
 If the GIMs from the sales were calculated using the rent roll at the time of sale, they need to be
applied to the same type of data from the subject property.
 The same rule applies to capitalization rates, or any other data obtained from comparable sales.
How to Make a Rent Survey
Market rent should be based on a neighborhood rent survey of similar units.
[Instructor: See text Figure 13.4 for a sample apartment rent-survey form.]
1. Data Required--for each property surveyed, gather data as follows (using apartments as the
example):
a.
Location and physical description:
1)
2)
3)
4)
5)
6)
b.
Schedule of existing rents, along with:
1)
2)
3)
4)
5)
c.
d.
e.
Number of units
Size, age and condition
Quality
Mix of unit sizes and numbers of bedrooms and baths
Furnished/unfurnished
Amenities (parking, swimming pool, etc.)
Breakdown of unit types (1 or 2 bedroom, etc.)
Dates that the spaces were occupied, or current rents set
Deposits and/or leases required; any rent concessions
Units subject to rent control; annual increase allowed
Fixturizing and tenant improvement data (commercial space)
Tenant obligations (for utilities, etc.)
Services provided to tenants by landlord (utilities, renovations, etc.)
Typical vacancy rate: vacancy history and trend
2. Rental units of comparison--rent may be compared by:
a.
b.
c.
d.
Rent per apartment or by number of bedrooms and baths
Rent per square foot of living area
Rent per square foot of rentable area (as in office buildings)
Rent per front foot (as in some strip commercial)
Estimating the Market Rent
Market rent for the subject property is usually based on analysis of the rental survey data and a
comparison with the existing rent schedule and its history.
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Chapter 13
Analysis of Survey Rentals
1. Observe the factors causing rents to vary.
2. Adjust rent comparables to the subject property, considering:
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Time: reflect any notable trend in rental prices.
Location: adjust as indicated by the data if significant.
Physical features: adjust for size, age, quality, appeal, condition, amenities, etc.
Services: reflect differences in utilities, furniture, etc. provided.
Vacancy rates: high or low vacancy may suggest improper pricing.
Limitations of any rent control: reflect the legal income of the property.
Construction of the Market Rent Schedule
Analyze and adjust if necessary, the subject property rent schedule, considering:
1. The history of rents and vacancy rates for the subject property.
2. Efficiency of existing management.
3. Income omissions, such as rent for owner’s unit, service income, etc.
4. Adjusted rental rates of similar units noted in the rent survey.
5. Any special use limitations, e.g., rent control.
[Instructor: Operating statements are covered in Section 13.5.]
Allowance for Vacancy and Credit Losses
To arrive at effective gross income, subtract an estimate for vacancy and credit losses from the estimated
potential gross market income.
1. Vacancy: reflect typical vacancy rates for each type of unit.
2. Rent losses: assume efficient management and pricing of units.
3. The goal: predict the future experience for the property, not the past, as anticipated by buyers.
4. Long-term losses (overall) – not just last year or next year.
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Chapter 13
13.4 OPERATING EXPENSES AND EXPENSE RATIOS
Operating expenses are deducted from the effective gross income to estimate net operating income.
Expenses to Be Included
1. Include all property-related expenses needed to procure the gross income:
a.
b.
c.
Historical operating expenses
Projected expenditures
The value of operating effort by the owner (as in owner-managed and/or ownermaintained units)
2. Exclude owner-related expenses, such as:
a.
b.
c.
Loan and interest payments
Income taxes
Depreciation deductions (for income tax purposes)
Operating Expense Categories
The three common operating expense categories are (1) variable expenses, (2) fixed expenses, and (3)
reserves for replacement.
Variable Expenses
These are day-to-day out-of-pocket expenses, such as:
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Administration and management
Payroll and contracted services
Maintenance and repairs
Grounds and pool maintenance
Painting and decorating
Utility costs (who pays what?)
Fixed Expenses
These are the relatively stable or predictable expenses that are paid on a regular basis and usually do not
vary with the occupancy rate. For example:
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
Insurance coverage (for one year)
Property taxes
Because property taxes change upon sale in many jurisdictions, it may be very important to consider the
post-sale tax as well as the current.
Reserves for Replacement
These are amounts needed to replace building components that are expected to wear out from age and
usage. Annual amounts are theoretically set aside as reserves until the component is replaced.
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Examples of what might be included in replacement reserves:
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Roof replacement
Built-in kitchen equipment
Carpeting, floor covering
Furniture and accessories
Water heaters, boilers, heating and air conditioning units
Other machinery and equipment
How to project on an annual basis:
1. Estimate the projected replacement cost for each individual item.
2. Divide this cost by the anticipated useful life of the item.
3. The result is the annual allocation for the item.
Example: Assume that the replacement cost of a built-in kitchen appliance is $900, and it will last 15
years. Calculate the annual reserve for the future cost of replacement as $900 ÷ 15 = $60.
Reserves should be applied consistently to the subject and comparable sales—included
or excluded. Generally, reserves should only be taken as an expense when the market is actually doing
that, and only for the items that the market is taking a reserve for. Consistency is essential!
Income and Expense Ratios
These demonstrate the relationships between the various income and expense amounts. They can be used
to check on the expense information given or the net operating income estimate.
1. The net income ratio is the net operating income (NOI) divided by the effective gross
income (EGI).
Where NOI is $65,000 and the effective gross is $100,000, the net income ratio is 65%
($65,000 ÷ $100,000 = .65 or 65%).
2. The operating expense ratio is the total operating expense amount divided by the effective gross
income. Using the example above,
$100,000 - $65,000 = $35,000 of operating expense
$35,000 ÷ $100,000 = .35, or 35%
Also: 1 - net income ratio: 1 - 65% = 35%.
3. A knowledge of typical expense ratios assists in the reconstruction of operating expense
statements.
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Chapter 13
13.5 RECONSTRUCTION OF THE OPERATING STATEMENT
The owner’s actual operating statement is reconstructed for inclusion in the appraisal report.
Why We Reconstruct the Statement
1. The statement contains a useful history of the specific property, which could be more accurate
than any comparable data.
2. Expense items that are not relevant to actual operation of the property should be deleted.
3. Stabilized amounts usually are used instead of actual operating statement amounts for:
a.
b.
c.
Market rents
Vacancy and collection losses (annual average / long-term)
Annual expenses to operate the property
Income and expenses can be estimated on a year-by-year future basis, instead of using a single year’s
stabilized amount. Usually, this is only done for large or unique projects. Advanced capitalization
techniques and/or computer models may be used.
[Instructor: See text Examples 13.5 and 13.6, demonstrating an original owner’s operating
statement versus a reconstructed operating statement.]
Adjustments to Rentals and Vacancy
1. List the manager’s unit in the rent schedule if it has been omitted.
2. Usually adjust the existing rental rates to market rent.
3. Estimate the stabilized vacancy and credit losses, considering:
a.
b.
c.
Vacancy information developed in the rent survey.
History of vacancy and credit losses for this property (caused by management or business
cycle?).
The effect of rent adjustments made to reflect the current market.
Reconstructing Expenses
1. Exclude any expense items that reflect the owner’s particular financing expenses and income tax
bracket. Items to exclude:
a.
b.
c.
Loan principal and interest
Income taxes
Depreciation deductions
2. Adjust the reported expenses as follows:
a.
b.
c.
d.
Add for expenses not yet paid (for example, delinquent taxes).
Prorate any paid insurance premiums and service contracts that extend beyond one year.
Adjust for any prepaid property taxes.
Add the cost for any omitted services, such as a resident manager or work performed by
an owner.
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Chapter 13
Comparing Expenses with Industry Standards
1. Compare expenses (category by category) with amounts reported for similar properties, or with
industry “norms.” Published expense reports are available from:
a.
b.
c.
The Institute of Real Estate Management (IREM)
The Building Owners and Managers Association (BOMA)
The Urban Land Institute (ULI), and other management groups
2. Industry expenses are usually reported by one of two methods:
a.
b.
As a percentage of the effective gross income
As expense amounts per square foot of rentable area (or unit)
SUMMARY
[Instructor: To review the session, refer to your text Chapter Summary, or go back to the
beginning of this chapter outline. The list of important terms presented below may assist in your
summary.]
Important Terms and Concepts
Amenities
Capital recovery
Capitalization
Capitalization Rate
Contract rent
CPI lease
Direct capitalization
Effective gross income (EGI)
Excess rent
Fixed expenses
Gross income
Gross income multiplier
(GIM)
Income property
Intangible benefit
Lease term
Market rent
Minimum or base rent
Net income ratio
Net operating income
Operating expenses
Operating statement
Overage rent
Percentage lease
Potential gross income
Present worth of
future benefits
Recapture
Rent roll
Reserves for replacement
Return of investment
Return on investment
Step-up (or “graduated”)
lease
Straight (or “flat”) lease
Tangible benefit
Variable expenses
REVIEWING YOUR UNDERSTANDING
[Instructor: See your text chapter for student review questions.]
STUDENT EXERCISES
[Instructor: Suggested Multiple Choice and True/False questions are available to use for Chapter
13.]
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