1. Chapter 8 Valuation Using the Income Approach
Real Estate
FIN 331
Fall 2015

2. The Income Approach to Appraisal
Rationale: Value = present value of future income
Income capitalization: converting future income into a present value
The present value is a function of the capitalization rate
The capitalization rate reflects investor requirements for return on investments
ROIs are adjusted for riskiness of investment
Two Approaches To Income Valuation
Direct capitalization using a single overall cap rate
Discount all expected future cash flows (CFs) at a discount rate

3. The Income Approach to Appraisal
Direct capitalization
Find value as a multiple of first year net income (NOI)
“Multiple” is obtained from sales of comparable properties
Similar in spirit to valuing a stock using a price/earnings multiple
Discounted cash flow (DCF)
Project net CFs for a standard holding period (say, 10 years).
Discount all expected future CFs at required return (IRR)
DCF valuation models require:
Estimate of typical buyer’s expected holding period
Estimates of net (annual) CFs over expected holding period, including net income from expected sale of property
Appraiser to select discount rate (required IRR)

4. Rental Property Operating Statement
PGI Potential Gross Income
- VC Vacancy & Collection Losses
+ MI Miscellaneous Income
= EGI Effective Gross Income
OE Operating Expenses
- CAPX Capital Expenses
= NOI Net Operating Income

5. Estimating Net Operating Income
Potential gross income (PGI)
Rental income assuming 100% occupancy
Sometimes referred to as potential gross revenue (PGR)
Should forecast of PGI be based on contract rent (signed leases) or current market rents?
Types of Commercial Leases
Straight lease: “level” lease payments
Step-up or graduated lease: Rent increases on a predetermined schedule
Indexed lease: Rent tied to an inflation index; ex., consumer price index
Percentage lease: rent includes percentage of tenant’s sales

6. Estimating Net Operating Income
Effective Gross Income
VC-vacancy & collection loss is based on:
Historical experience of subject property
Competing properties in the market
“Natural vacancy” rate: Vacancy rate that is expected in a stable or equilibrium market
Miscellaneous income
Garage rentals & parking fees
Laundry & vending machines
Clubhouse rentals
Operating Expenses
Ordinary & regular expenditures necessary to keep a property functioning competitively
Fixed: Expenses that do not vary with occupancy (at least in the short-run)
hazard insurance,
local property taxes
Variable: Expenses that tend to vary with occupancy
Utilities
Maintenance & supplies
OE do not include: mortgage payments, tax depreciation, capital expenditures

7. Estimating Net Operating Income
Net Operating Income equals Effective Gross Income minus Operating Expenses
NOI is property's "dividend“: Why is it not investor’s dividend?
Projected stream of NOI is fundamental determinant of property’s value
NOI must be sufficient to:
service the mtg debt and
provide equity investor with an acceptable return on equity
Be careful of NOI vs. NCF (net cash flow)
Sources Of Industry Expense Data
Institute of Real Estate Management
Building Owners and Managers Association
International Council OF Shopping Centers
Urban Land Institute

8. First Income Valuation Method: Direct Capitalization
Basic Value Equation: V = NOI ÷Ro
Where: Ro is a capitalization rate NOT a discount rate
A Cap Rate is defined simply as: Net Operating Income1 ÷ Sale Price
See Exhibit 8-5 for an example of how cap rates are estimated
Note that the NOI is the expected or anticipated first year net operating income
Effective Gross Income Multiplier
EGIM = sale price ÷ effective gross income
Quick indicator of value for smaller rental properties
Requires no operating expense information
Critical assumptions
Roughly equal operating expense percentages across subject and comparable properties
Assumes market rents are paid
Best used for properties with short-term leases (apartments & rental houses)

9. First Income Valuation Method: Direct Capitalization
Problems with Valuation by Direct Capitalization
Inadequate data on comparable sales due to:
Above- or below-market leases
Differing length of leases and rent escalations
Comparable vs. subject
Differing distributions of operating expenses between landlord and tenant
Differing prices between institutional and private investors for similar properties
Result: Discounted cash flow (DCF) analysis can be preferable

10. Terminal Cash Flow Analysis
Selling an income property at the end of the investment horizon
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

11. Appraisal Work Requires Analytical and People Skills
Developed a network of data contacts
Collect, read, interpret, and organize data and reports
Be skilled in data analysis and report production
Be able to meet tight deadlines

12. Homework Assignment
Key terms: Capital Expenditures, Direct capitalization, effective gross income, effective gross income multiplier, capitalization rate, natural vacancy rate, net operating income, operating expenses
Study Questions: 1, 4 - part a, 5, 6, 8 (Some calculations are required for 4a, 5, & 6.)