The Income Approach Basic Real Estate Appraisal: Principles & Procedures – 9 th Edition © 2015 OnCourse Learning Chapter 13

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 2 Page 408 © 2015 OnCourse Learning

13.1 INTRODUCING INCOME PROPERTY 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 3 Page 409 © 2015 OnCourse Learning

MOTIVES & BENEFITS OF OWNERSHIP 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 4 Page 410 © 2015 OnCourse Learning

THE INCOME-VALUE RELATIONSHIP 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 5 Page 412 © 2015 OnCourse Learning

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$160 (I) ÷.08 (R) = Deposit (V) $12,800 $20,000 6 Page 413 © 2015 OnCourse Learning

MONETARY RELATIONSHIPS (Con’t.) 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) 7 Page 413 © 2015 OnCourse Learning

THE “IRV” FORMULA Formulas Value = I ÷ R Rate = I ÷ V Income = R x V Horizontal line indicates division (÷) Vertical line indicates multiplication (x) 8 Page 413 © 2015 OnCourse Learning ÷ X

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) 9 Page 414 © 2015 OnCourse Learning

SUMMARY OF DIRECT CAPITALIZATION 10 Page 415 © 2015 OnCourse Learning

USING GROSS INCOME MULTIPLIERS Gross Income Multiplier (GIM) = Sales Price ÷ Gross Income Sales Price Gross Income GIM $600,000 $60, $514,000 $60, $428,500 $60, As Expenses Go Up ↑, the GIM Goes Down↓ 11 Page 416 © 2015 OnCourse Learning

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) 12 Page 417 © 2015 OnCourse Learning

13.3 ESTIMATING GROSS INCOME 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 13 Page 419 © 2015 OnCourse Learning

CONTRACT VS. MARKET RENT 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” 14 Page 420 © 2015 OnCourse Learning

CONTRACT VS. MARKET RENT (Con’t.) 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 15 Page 421 © 2015 OnCourse Learning

TYPES OF LEASES AND TERMS Types of Leases Straight (Flat) Step-Up (Graduated) CPI Lease Percentage Lease Combinations 16 Page 421 © 2015 OnCourse Learning Income & Lease Terms Minimum or Base Rent Overage Rent Excess Rent Who Pays Expenses? Landlord Tenant Shared

GROSS INCOME POSSIBILITIES 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? 17 Page 424 © 2015 OnCourse Learning

GROSS INCOME POSSIBILITIES (Con’t.) 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 18 Page 425 © 2015 OnCourse Learning

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? 19 Page 426 © 2015 OnCourse Learning

ANALYSIS OF SURVEY RENTALS Consider the following factors : Time (of agreement vs. commencement) Location Physical Features Services, Utilities & Personality Included Vacancy Rates Rent Control Regulations 20 Page 429 © 2015 OnCourse Learning

CONSTRUCTION OF A RENT SCHEDULE 21 Page 429 © 2015 OnCourse Learning

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) 22 Page 431 © 2015 OnCourse Learning

13.4 OPERATING EXPENSES & RATIOS 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 23 Page 431 © 2015 OnCourse Learning

OPERATING EXPENSE CATEGORIES 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 24 Page 432 © 2015 OnCourse Learning

INCOME AND EXPENSE RATIOS 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%) 25 Page 436 © 2015 OnCourse Learning

13.5 RECONSTRUCTION OF THE OPERATING STATEMENT 26 Page 437 © 2015 OnCourse Learning

RECONSTRUCTED STATEMENT 27 Page 440 © 2015 OnCourse Learning

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. 28 Page 441 © 2015 OnCourse Learning

IMPORTANT TERMS & CONCEPTS AmenitiesGross Income Multiplier (GIM) Capital RecoveryIncome Property CapitalizationIntangible Benefits Capitalization RateLease Terms Contract RentMarket Rent CPI LeaseMinimum or Base Rent Direct CapitalizationNet Income Ratio Effective Gross IncomeNet Operating Income Excess RentOperating Expense Ratio Fixed ExpensesOperating Expenses Gross IncomeOperating Statement 29 Page 443 © 2015 OnCourse Learning

IMPORTANT TERMS & CONCEPTS Overage RentReturn of Investment Percentage LeaseReturn on Investment Potential Gross IncomeStep-Up (or “Graduated”) Lease Present Worth of Future BenefitsStraight (or “Flat”) Lease RecaptureTangible Benefits Rent RollVariable Expenses Reserves for Replacements 30 Page 443 © 2015 OnCourse Learning