Chapter 13
The Income Approach
Basic Real Estate Appraisal: Principles & Procedures – 9th Edition
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STUDENT LEARNING OUTCOMES
• Distinguish between the Tangible and Intangible
Benefits of Property Ownership
• Name the Six Steps in Income Approach to Value
• Explain the Use of Gross Income Multipliers
• Define the terms Contract Rent and Market Rent
• Name the Three Main Categories of Expenses
and give examples of items in each
• Outline the Procedure Used for Reconstructing
the Owner’s Operating Statement
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13.1 INTRODUCING INCOME PROPERTY
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Any Type of Property Purchased for Income
and/or Investment Purposes…
• Multiple-Family Residential, such as Apartments
• Commercial Buildings, such as Stores, Offices,
Medical Offices, Hotels & Motels, Shopping Centers
• Industrial Properties, such as Warehouses and
Factories
Some types could also be purchased for full
or partial Owner-Occupancy
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MOTIVES & BENEFITS OF OWNERSHIP
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Tangible Benefits
• Return on Investment (Interest, Net Income)
• Return of Investment (Recapture)
• May be Enhanced by Tax Shelter and Appreciation
Intangible Benefits
• Live in One Unit and Rent Out Others
• Pride of Ownership
• Sense of Security
• Opportunity to Develop/Apply Management Skills
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THE INCOME-VALUE RELATIONSHIP
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The Economic Relationship
• Utility – The Degree of Utility is Best Measured
by the Rental Income it can Produce
• Income – The annual money received (cash
flow), or the Net Income after Expenses
• Value – The Present Worth of Future Benefits;
the Relationship Between the amount of Net
Income produced and the Rate of Return
required by a typical investor
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MONETARY RELATIONSHIPS
Savings Account Example
• Earns Interest at 8% (R) – Annual Rate of Return
• Amount of Interest (I) Paid in One Year = $160
(The $160 in the Return on Investment)
• What is the Deposit Amount (V)?
•
•
•
•
$1,280
$2,000
$12,800
$20,000
$160 (I) ÷ .08 (R) = Deposit (V)
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MONETARY RELATIONSHIPS (Con’t.)
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Income Capitalization Example
• Capitalization is the Process of Converting an
Income Estimate into a Value Estimate…
• $50,000 (Income) ÷ 0.08 (Rate) = $625,000 (Value)
• 0.08 (Rate) X $625,000 (Value) = $50,000 (Income)
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THE “IRV” FORMULA
Formulas
Value = I ÷ R
Rate = I ÷ V
Income = R x V
÷
X
• Horizontal line indicates division (÷)
• Vertical line indicates multiplication (x)
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BASIC STEPS IN INCOME APPROACH
• Estimate the Potential Gross Annual Income (PGAI)
• Estimate typical Vacancy & Collection Loss (V&C)
• PGAI minus V&C = Effective Gross Income (EGI)
• Estimate and Subtract Annual Operating Expenses
from EGI to get Net Operating Income (NOI or I)
• Analyze Comparable Investments to arrive at a
Capitalization Rate (R) and Capitalization Method
• Divide the Net Operating Income (I) by the
Capitalization Rate (R) to estimate Value (V)
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SUMMARY OF DIRECT CAPITALIZATION
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USING GROSS INCOME MULTIPLIERS
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Gross Income Multiplier (GIM) = Sales Price ÷ Gross Income
Sales Price
$600,000
$514,000
$428,500
Gross Income
$60,000
$60,000
$60,000
GIM
10.0
8.6
7.1
As Expenses Go Up ↑, the GIM Goes Down↓
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REASONS WHY GIM’S VARY
• Location and Neighborhood
• Intangible Amenities
• Expense Ratios (see previous slide)
• Number of Dwelling or Store Units
• Size per Unit
• Services Included (Lease Terms)
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13.3 ESTIMATING GROSS INCOME
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Potential Gross Income
• Total Income that could be generated on the
Date of Value – Assuming 100% Occupancy
• Rents from all tenant spaces (Rent Roll), plus…
• Service Income from sources such as Laundry
Facilities, Vending, Utilities (Reimbursements),
Storage and other incidental services
• Parking Revenue may be part of the Rent Roll or
categorized as Service Income
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CONTRACT VS. MARKET RENT
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Market Rent
• In some Appraisal Assignments – the basis for
deriving a Fee Simple Value ( as if free from all
encumbrances) – Measures all Property Rights
• Rent if placed on Open Market on Date of Value
• Unencumbered by an existing lease
• Assume Efficient Management
• Historically referred to as “Economic Rent”
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CONTRACT VS. MARKET RENT (Con’t.)
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Contract Rent
• Rent being paid under some form of Contract that is
binding on both Owner (Landlord) and Tenant
• Rental Contracts (Agreements) can range from Oral
Agreements to Complex Leases
• May be Month-to-Month, or Years in Length
Contract Rent may be the same as Market Rent, or
may be different in amount and/or as to terms
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TYPES OF LEASES AND TERMS
Types of Leases
• Straight (Flat)
• Step-Up (Graduated)
• CPI Lease
• Percentage Lease
• Combinations
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Income & Lease Terms
• Minimum or Base Rent
• Overage Rent
• Excess Rent
Who Pays Expenses?
• Landlord
• Tenant
• Shared
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GROSS INCOME POSSIBILITIES
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• Annual Income (12 months)
• Possible Choices are…
•
•
•
•
Rents paid over prior 12 months; Trailing 12 (T12)
Rents on Rent Roll on Date of Value
Rents on Rent Roll (factor in increases/changes)
Market Rents (ignore all/some of Contract Rents)
• Consider...
• Market Conditions / Trends in Rents
• Is Market Changing? What Does Market Expect?
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GROSS INCOME POSSIBILITIES (Con’t.)
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Rule 1 – The More Data, the Better
• Obtain Three Years Operating History
• Get Detailed Rent Roll / Copies of Leases
• How do Contract Rents compare to Market Rents
Rule 2 – Always Be Aware of the Market
• What would the Market / Investor Consider?
• Consider more than the Rent Level
Rule 3 – Be Consistent
• Apply Rates and Multipliers to Subject Income in
the same manner by which they were abstracted
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HOW TO MAKE A RENT SURVEY
• Survey Rents of Competitive Properties
• Analyze Rent Schedules of Comparable Sales
used in Sales Comparison Approach
• Document Characteristics and Amenities
• Verify Rent / Lease Terms; Who pays what?
• Where there Rent Concessions?
• For Commercial – What Level of Tenant
Improvements are included with the rent
• Rental Rate based on Gross or Rentable Area?
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ANALYSIS OF SURVEY RENTALS
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Consider the following factors:
• Time (of agreement vs. commencement)
• Location
• Physical Features
• Services, Utilities & Personality Included
• Vacancy Rates
• Rent Control Regulations
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CONSTRUCTION OF A RENT SCHEDULE
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ALLOWING FOR VACANCY & CREDIT LOSS
• Long-term outlook rather than Actual
Vacancies on the Date of Value - Stabilized
• Relate Vacancy Rates from Market to the
Specific Marketability of Subject
• Assumes Competent Management
• Allowance for Rent or Credit Losses
recognizes nonpayment of rent
• Results in a Realistic Prediction of Effective
Gross Income (i.e. a Buyer’s Expectation)
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13.4 OPERATING EXPENSES & RATIOS
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Include Property-Related Expenses
• Those Necessary to Produce Income
• Examine Past or Current Operating Expenses
• Consider Projected Expenditures
Exclude Owner-Related Expenses, such as:
• Loan or Interest Payments
• Income Taxes
• Depreciation Write-Off’s
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OPERATING EXPENSE CATEGORIES
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Variable Expenses
• Day-to-Day, Out-of-Pocket Expenditures
• May Fluctuate with Occupancy – Utilities, etc.
• Management (typically a % of collected rents)
Fixed Expenses
• Insurance and Real Estate Taxes
• Consider Anticipated Taxes vs. Actual
Reserves for Replacement
• Funds Theoretically set aside each year for larger
Capital Expenditures anticipated over the long term
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INCOME AND EXPENSE RATIOS
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• NOI = Net Operating Income
• EGI = Effective Gross Income
Net Income Ratio = NOI ÷ EGI
$65,000 ÷ $100,000 = 0.65 (65%)
Operating Expense Ratio = Expenses ÷ EGI
$35,000 ÷ $100,000 = 0.35 (35%)
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13.5 RECONSTRUCTION OF THE
OPERATING STATEMENT
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RECONSTRUCTED STATEMENT
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CHAPTER SUMMARY
An overview of the income approach as it
applies to various types of residential income,
commercial, and industrial properties was
covered. The income approach can either
analyze the income year-by-year, or by
emphasizing one year. Income property
appraisals require an estimate of income and
expenses for the property. A knowledge of
typical expense ratios assists in the
reconstruction
of
operating
expense
statements.
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IMPORTANT TERMS & CONCEPTS
Amenities
Gross Income Multiplier (GIM)
Capital Recovery
Income Property
Capitalization
Intangible Benefits
Capitalization Rate
Lease Terms
Contract Rent
Market Rent
CPI Lease
Minimum or Base Rent
Direct Capitalization
Net Income Ratio
Effective Gross Income
Net Operating Income
Excess Rent
Operating Expense Ratio
Fixed Expenses
Operating Expenses
Gross Income
Operating Statement
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IMPORTANT TERMS & CONCEPTS
Overage Rent
Return of Investment
Percentage Lease
Return on Investment
Potential Gross Income
Step-Up (or “Graduated”) Lease
Present Worth of Future Benefits
Straight (or “Flat”) Lease
Recapture
Tangible Benefits
Rent Roll
Variable Expenses
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Reserves for Replacements
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