Income Approach

In real estate appraisal, there are

three (3) basic approaches for
valuing property:

1 – Market Data Approach or “Sales

Comparison” 2 – Cost approach
3 -- Income approach
Valuation Approach #3 - The
Income Approach
Concept

In this approach, the current value is

dependent on the expected future
income that can be derived from
owning the property. The principles of
Substitution and Anticipation are in
play.
Therefore, the income approach is
particularly suitable for income-
earning property. The estimate of
future income should not be
speculative. It must be based on
actual or historical values, either as
experienced by the Subject property
itself or from comparables.
In general, income-earning properties
consist of buildings and
improvements used in a business.
However, certain kinds of land, such
as farms with high-value crops, can
also be considered as income-earning
properties.
Steps involved in translating the
net income projection into a
value indication

Make a thorough study of the

property’s potential gross income;

Allow for reasonable deductions –

vacancy rates, collection losses, etc.
and compute the
Effective Gross Income or EGI.

Subtract the operating expenses to

derive the “Net Operating Income”
or NOI;
Assuming the NOI to be a constant
future stream, apply a capitalization
rate to determine current value;

Alternatively, assuming the NOI to be

variable and its will end after a
determinable period, then compute
the current value by using a
discounted cash flow method (DCF).
Two capitalization methods:

Method 1 - Direct capitalization :

Value = NOI / cap rate
Method 2 - Discounted Cash Flow
: Value = NPV of annual flows +
reversion value

Estimating NOI:

From annual gross income,

deduct vacancy % to reach
effective gross income, EGI.
Estimate operating expenses and
deduct from EGI to arrive at NOI.
Note: NOI does not consider
depreciation, interest of loans
and taxes.
The Concept of “Discounting”

Discounting is a financial concept

which converts a future value into a
present value using a specified or
selected interest rate. Discounting is
merely the reverse of
“compounding.” It answers the
question:

“What is the equivalent present value

of a future amount given an interest
rate and duration?”
The interest rate used in the
computation is called the “Discount
rate”. In the income approach, it is
also called the “Overall Capitalization
Rate” or “Cap Rate” for short. The
cap rate itself may have multiple
components – a risk-free interest rate
and a recapture rate.
Discounting Formulas:

Single value discount factor:

PV = FV / f1 = FV /(1+r)^n f1 =
(1+r)^n; 1/f1 is the single sum
discount factor SDF
Where: PV = present value
FV = future value
r = the interest rate
n = number of periods
Example:
What’s the present value of P 10M to
be received 10 years from now if
interest rate is 10%?

Solution: r = 10%, n = 10 years.

f1 = (1.1)^10 = 2.59 SDF = 1/f1=
.3855
PV = 10M x .3855 = P 3.855 M
Multiple income stream discount
factor if term is fixed or limited:

PV = RV (f2/f1); f2 = (f1-
1)/r = [(1+r)-1]/r
or : PV = RV [(1+r)^n-1] Thus, the
discount factor MDF = [(1+r)^n-1]
r(1+r)^n r(1+r)^n
Where: PV = present value
RV = a constant recurring value in
the future (the income stream) r =
the interest rate (also the cap rate)
Example:
What is the present value of P1M
received annually for next 10 years if
the interest rate is 10%?

Solution: MDF = (1.1)^10-1 /

(.1)(1.1^10)= 6.144;
PV = P1M x 6.144 = Php
6,144,000.
The simplified Cap Rate Method

The first method in the Income

Approach is just to use the
assumption of a non-ending constant
future income stream. This is the
estimated “NOI”.
Thus, PV (Present Value) = NOI / cap
rate
Example:
An office building which is 5 years old
has been rented out with a total
gross rental of P20M
annually. Assuming that the average
vacancy rate is 10% and the total
annual operating costs has been P5M,
what is the value of the building if the
cap rate is 10%?
Solution:
Gross Income = P 20M Less
Vacancy 10% ( 2M) EGI =
P 18M
Less operating cost ( 5M)
NOI = P13M

Current Value = P13M / .10 = P 130M

(Note debt burden and taxes are not

considered in the NOI.)
The DCF Method

Discounted cash flow is more

sophisticated. It assumes that the
annual income stream will end after a
determinable period. Then the
building will have a reversionary
value or an estimated value that it
can be sold for at the future time.
Example:

An office building which is 5 years old

has been rented out with a total
gross rental of P20M annually.
Assuming that the average vacancy
rate is 10% and the total annual
operating costs has been P5M, what
is the value of the building if the cap
rate is 12%. Assume that the current
leases will end in 10 years and the
Owner intends to sell the building on
the 10th year at an estimated future
value of P150M. The 10-year single
sum discount rate SDF is 0.3855 and
the multi-sum discount rate MDF is
6.144.
Solution

Present value of future single sum

PV1 = SDF x P150M = 0.3855 x
P150M = P 58M

Present value of future multiple sums

PV2 = MDF x NOI = 6.144 x P13M =
P80M

Discounted cash flows

Value = PV1 +PV2 = P58M +P80M =
P138M
(Of course, the solution was
facilitated because the applicable
rates are given. In a real life
situation, the Appraiser must be
familiar with computing discount
rates.)
How to estimate a cap rate:

A cap rate can often be a judgment

call of the investor. It is the desired
rate which satisfies the investor’s
goals. As a bare minimum, the cap
rate must include the prevailing “cost
of money” or the opportunity rate
(what a depositor can get from a safe
investment) plus a recapture rate for
the portion of the property which
depreciates (such as the building).
Land alone will have a cap rate
equivalent to market interest rate. It
needs no recapture. At the end of the
investment period, land still
maintains its original value plus a
potential appreciation.

Buildings are wasting assets. At the

end of the investment period, its
value is expected to be lower due to
obsolescence.
For example, an Investor may look at it like this –

1) Risk-free rate of long term bonds 4%

2) Desired recapture rate of capital 6%
3) Risk premium 4%
4) Other factors (debt service) 2%
Overall cap rate = 16 %
Special Methods in the Income
Approach - Land and Building
Residuals

Residual Methods –
computational methods of
extracting the values of either
land or improvements from future
income and expenses.

Categories: Land Residual and

Building Residual.
Land Residual Method:

1. In this technique, the value of the

building is readily given.
2. Compute the NOI.
3. Subtract a portion to be allocated
to the building by adopting an
overall rate and multiplying the
said rate to the given value of the
building.
4. The balance is the income to be
allocated to the land.
5. Capitalize this by multiplying it
with the interest rate only.
6. Add back the building value to
yield value of the property.
Building Residual Method:

1. This is the reverse. Here, the

value of the land is known or
given.
2. Compute the NOI.
4.Allocate a portion of it attributable
to land by multiplying land value by
the interest rate only.
5.Subtract from NOI to yield portion
attributable to the building.
6.Capitalize portion attributable to
building by dividing it by the Overall
Rate.