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The Income Approach to Appraisal

-Value of a property is the present value of its anticipated income.
Often called "income capitalization"
-Capitalize: to convert future income into a present value

Two Approaches to Income Valuation

Direct capitalization (with an "overall" rate)
Discount all future cash flows at required yield (discount rate)

Direct capitalization (with an "overall" rate)

Find value as a multiple of first year net income (NOI)
"Multiplier" is obtained from sales of comparable properties
Similar in spirit to valuing a stock using price/earnings multiple

Discounted cash flow (DCF)

Project net cash flows for a standard holding period (say, 10 years).
Discount all future CFs at required yield (discount rate)

DCF models require:

1. an estimate of the expected holding period of the typical buyer
2. estimates of net cash flows over the entire expected holding period, including the net income from sale
3. the appraiser to select the appropriate yield (required IRR) at which to discount all future cash flows.

Potential gross income:

Rental income assuming 100% occupancy

Types of Commercial Leases

Straight lease
Step-up or graduated lease
Indexed lease
Percentage lease

Straight lease

"Level" lease payments

Step-up or graduated lease

Rent increases on a predetermined schedule

Indexed lease

Rent tied to an inflation index: Consumer Price Index, Union wage index, etc.

Percentage lease

Rent includes percentage of tenant's sales

VC-vacancy & collection loss is based on:

Historical experience of subject property
Competing properties in the market
"Natural vacancy" rate:

"Natural vacancy" rate

Vacancy rate that is expected in a stable or equilibrium market

Net Operating Income

PGI Potential Gross Income
-VC Vacancy & Collection Loss
+ MI Miscellaneous Income
= EGI Effective Gross Income
-OE Operating Expenses
-CAPX Capital Expenditures
= NOI Net Operating Income

Miscellaneous income

Garage rentals & parking fees
Laundry & vending machines
Clubhouse rentals

Operating Expenses

Ordinary & regular expenditures necessary to keep a property functioning competitively.


Expenses that do not vary with occupancy.
-property taxes


Expenses that vary with occupancy.
-Maintenance & supplies
-Trash and garbage removal

Operating Expenses does not include

Mortgage payments
Tax depreciation
Capital expenditures

Capital Expenditures (CAPX)

Expenditures that materially increase value of structure or prolong its life:
-Roof replacement
-HVAC Replacement
-Resurfacing of parking areas
-Tenant improvements

Most appraisers treat CAPX as "above line" expense

Above Line:
- OE

Institutional investors usually treat CAPX as "below line" expense.

Below Line:
- OE
= Net Cash Flow

Institute of Real Estate Management (IREM):

Detailed information on apartments, offices, shopping centers, federally assisted housing and condominiums, co-ops and planned communities.

Building Owners and Managers Association (BOMA):

Large office buildings

Net Operating Income

NOI is property's "dividend"
-Why is it not investor's dividend?
Projected stream of NOI is fundamental determinant of 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

Basic value equation:


Ro is a "cap" rate
Ro is NOT a discount rate!!!!

Steps in Direct Capitalization

1. Obtain estimates of cap rates, Ro,, from the
market using the "direct market extraction"
equation: R = NOI/Selling Price
2. Divide the subject's NOI1 by a weighted average of the abstracted Ros to obtain an estimate of value for the subject


Overall rate of capitalization, or "going-in" cap rate.
A ratio of initial cash flow to value
Not a yield/discount rate.

Direct capitalization only uses first year NOI, but Ro reflects all future cash flows:

Transaction prices of the comparables reflect the value of future cash flows.
In turn, the cap rates extracted from these purchases do so as well.

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 properties
Assumes market rents are paid
Best used for properties with short-term leases (apartments & rental houses)

Problems with Valuation by Direct Capitalization

Inadequate data on comparable sales due to:
Differing prices between institutional and private investors for similar properties
Result: Discounted cash flow (DCF) analysis can be preferable

Inadequate data on

Above- or below-market leases
Differing length of leases and rent escalations
Differing distributions of operating expenses between landlord and tenant

Is direct capitalization using Ro superior to valuation by DCF?

Fewer explicit assumptions and forecasts are required
What implicit assumption are you making?

Work of Appraiser Requires Analytical AND People Skills

Develop network of data contacts
Collect, read, interpret, and organize data and reports
Be skilled in data analysis and report production
Fight time deadlines

Alternate Methods of Estimating Cap Rates: Mortgage-Equity Rate:

Problem: Cannot estimate cap rates without actual sales
Solution 1: Since income-producing real estate has both equity and debt financing, think of the cap rate as a weighted average of equity cap rate and mortgage cap rate
Equity cash flow = NOI - Debt service
= Before tax cash flow
Loan cash flow = Monthly payment x 12


= Purchase price - Loan

Equity cap rate

= BTCF ÷ Equity
= Re (equity dividend rate)

Loan cap rate

= Loan cash flow ÷ loan
= Rm (Loan constant)

Loan-to-value ratio

= Loan amount ÷ Price
= m (Mortgage-equity cap rate)
= m x Rm + (1−m) x Re

Recall one-year total yield example:

Total yield = Cap rate + Appreciation rate
=> Cap rate = Total yield - Appreciation rat

Selecting Among Different Cap Rate Estimates

Direct extraction is preferred, but needs three or more comparables with good information
Choice ultimately depends on quality of data available for each type of estimate
Reconciliation made by weighting

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