Valuation Using The Income Approach

Chapter 8:
Valuation Using the

Income Approach
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The Income Approach to Appraisal
 Rationale:
 Value = present value of anticipated income
 Often called “income capitalization”
 Capitalize: to convert future income into a present value
 Note: All of the discussion in this chapter refers to existing

properties. Development is discussed in Chapter 23
Two Approaches to Income Valuation
1. Direct capitalization (with an “overall” cap rate)

2. Discount all expected future cash flows (CFs) at
discount rate (“DCF”)
1. Direct capitalization (with an “overall” cap rate)

 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
2. Discounted cash flow (DCF)

 Project net CFs for a standard holding period (say, 10 yrs)
 Discount all expected future CFs at required return (IRR)
 Appraiser trying to think like a typical investor!
How Does DCF Differ from Direct
Capitalization?
 DCF valuation models require:
1. estimate of typical buyer’s expected holding period
2. estimates of net (annual) CFs over expected holding
period, including net income from expected sale of
property
3. appraiser to select discount rate (required IRR)
Estimating Net Operating Income
Exhibit 8-1
Sometimes referred to as a “reconstructed” operating

statement
Example: Centre Point Office Building
Exhibit 8-2
Potential Gross Income (PGI)
 Potential gross income:

 Rental income assuming 100% occupancy
 Sometimes referred to as potential gross revenue (PGR)
 Important issue:
 Should forecast of PGI be based on contract rent (signed
leases) or current market rents?
Potential Gross Income: Centre
Point Office Building
First Floor
1,000 sq. ft. suites: 2 x $1,800 x 12 mos. = $43,200
2,000 sq. ft. suite: 1 x $3,600 x 12 mos. = $43,200
Second Floor
800 sq. ft. suites: 5 x $1,560 x 12 mos. = $93,600
Potential Gross Income = $180,000
Note: Estimating first-year contract rent is not usually

this easy!
Using Rent Comparables to Estimate
Rental Rates (Exhibit 8-3)
 Example: Survey of rental rates for other second-floor offices
in market:
Implications: 2nd floor rents in Centre Point average $1.95 /month/sf

($93,600/12/5/800); this is consistent with current market rates of $1.94
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
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
Effective Gross Income
 Miscellaneous income
 Garage rentals & parking fees
 Laundry & vending machines
 Clubhouse rentals
Effective Gross Income: Centre
Point
Potential gross income (PGI) $180,000

− Vacancy & collection loss (VC) 18,000 (@10%)
+ Miscellaneous income (MI) 0
= Effective gross income (EGI) $162,000
Operating Expenses
 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
Operating Expenses
 Do not include:
 Mortgage payments
 Tax depreciation
 Capital expenditures
 Leasing commissions
Capital Expenditures (CAPX)
 CAPX: Non-recurring expenditures that increase

value of structure/prolong its useful life:
 Roof replacement
 Additions
 HVAC Replacement
 Resurfacing of parking areas
 Tax motivation for classifying a cash expenditure
as an OE (versus CAPX)
if possible?
Special Problem in Income Property
Analysis: CAPX
Above Line
Most appraisers treat
CAPX as “above line” EGI
expense (see Exhibit - OE
8-4). - CAPX
= NOI
Institutional Below Line

investors usually EGI
treat CAPX as - OE
“below line” = NOI
expense. - CAPX
= Net Cash Flow
Reconstructed Operating Statement
Exhibit 8-4
10% of PGI
40% of EGI
Above-line
treatment
of CAPX 5% of EGI
Sources of Industry Expense Data
 Institute of Real Estate Management (IREM):

www.irem.org
 Detailed information on apartments, offices, shopping
centers, federally assisted housing and condominiums, co-
ops, planned communities.
 Building Owners and Managers Association (BOMA):
www.boma.org
 Large office buildings
Sources of Industry Expense Data
 International Council of Shopping Centers (ICSC):

www.icsc.org
 Urban Land Institute (ULI): www.uli.org
 Local market participants
 Other pro formas you have seen
 Market knowledge is key!!
Net Operating Income
 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
First Income Valuation Method:
Direct Capitalization
NOI1
Basic value equation: V
Ro
Warning!!!!!!!
Ro is a “cap” rate
Ro is NOT a discount rate!!!!
Steps in Direct Capitalization
1. Obtain estimates of cap rates, Ro,, from

market using “direct market extraction”
NOI1 From the sale of a

Ro  comparable property
Selling Pr ice
2. Divide subject’s NOI1 by a weighted average of

the Ros abstracted from the market to obtain an
estimate of value for the subject property
Direct Capitalization: Centre
Step 1: Extract Ro from the market
Note: We have assumed each is equally comparable to subject

From where do you obtain comparable NOIs and sales prices?
Non-disclosure states: Alaska, Idaho, Indiana, Kansas, Louisiana, Maine, Mississippi, Missouri, Montana, New Mexico,
North Dakota, Texas, Utah, Wyoming
Defining the “market” for comparable selection is critically

important
Direct Capitalization: Centre
2. Compute estimated market value, using
expected first year NOI (i.e., next 12 months):
$89,100
Value   $1,060,714
0.084
Which we round to $1,061,00
Value  $89,100 x 11 .905  $1,060,735

Which we round to $1,061,00
Other Sources of Cap Rates
 Situs Real Estate Research Corporation’s Real

Estate Report: www.rerc.com
 RealtyRates.com: www.realtyrates.com
 Grubb & Ellis: www.grubb-ellis.com
 Newmark Nigh Frank: (www.ngkf.com)
 CoStar (www.costar.com)
 UF Bergstrom Real Estate Center’s Survey of
Emerging Market Conditions: (
www.realestate.ufl.edu)
 Other appraisers & market participants
Important Point About Cap Rates
 Direct capitalization only uses first year NOI, but

Ro reflects all future cash flows:
 Why? Because transaction prices of the comparables
reflect the value of future cash flows
 In turn, the cap rates extracted from these sale
transactions do so as well
Point?
Direct capitalization IS
forward looking?
U.S. Cap Rates for 3 Property Types Since
1996:Q1
Cap Rate Levels
10.0
Red: CBD office

9.0
8.0
Cap Rate (%)
Green: Regional malls

7.0 These are cap rates on high
quality properties
6.0
5.0
Apartments
4.0
2000Q2
2001Q1
2003Q2
2009Q2
2010Q1
2010Q4
1996Q3
1997Q2
1998Q1
1998Q4
1999Q3
2001Q4
2002Q3
2004Q1
2004Q4
2005Q3
2006Q2
2007Q1
2007Q4
2008Q3
2011Q3
2012Q2
2013Q1
2013Q4
2014Q3
2015Q2
2016Q1
2016Q4
Cap rates are obtained from the Real Estate Research Corporation’s Real Estate Report, which publishes results from
RERC’s quarterly Real Estate Investment Survey. The Real Estate Report summarizes the expected rates of return,
property selection criteria, and investment outlook of a sample of institutional investors and managers throughout the
U.S. The property level cap rates displayed above are aggregated across all metropolitan markets.
Understanding Cap Rates
 Assume the following first-year cash flows for Centre

Point:
 Purchase price: $1,056,,000
 NOI: $89,100
 Sale Price at the end of year 1: $1,077,120 ($21,120 increase)
 Costs of sale at end of year 1: $0.00
89,100  21,120
1st year return   10.44%
1,056,000
89,100 21,120
 
1.056,000 1,056,000
 0.0844  0.0200
= cap rate + appreciation rate
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 & comparable properties
 Assumes market rents are paid
 Best used for properties with short-term leases
(apartments & rental houses)
Effective Gross Rent Multiplier Example
Exhibit 8-6
Indicated value = 6.49 x EGI

of subject
= 6.49 x 162,000
= 1,051,380 rounded to $1,051,000
Problems with Valuation by Direct
Capitalization
 Inadequate data on comparable sales due to:
 Above- or below-market leases
 Differing length of leases & rent escalations
 Comparable vs. subject
 Differing distributions of operating expenses between
landlord and tenant
 Differing prices between institutional & private
investors for similar properties
 Result: Discounted cash flow (DCF) analysis can be
preferable
DCF Example: Centre Point
Very simple lease structure!
Exhibit 8-7
DCF Example: Centre Point
Very simple lease structure!
Exhibit 8-7
Sale price at end of Year 5 = NOI6 ÷ Rt = $103,291/0.0875

= $1,180,469
Where Rt is a terminal or “going-out” cap rate, slightly
Required
higher than Ro assumption
Sale price (SP) $1,180,469
− Selling expenses (SE) 47,219 @ 4%
= Net sale proceeds (NSP) $1,133,250
Valuation of the Unlevered Cash Flows:
Centre Point
Exhibit 8-8
From Exhibit 8-7
Discount rate presumed to reflect required yield (IRR) in market for

unlevered investments of similar risk
For surveys of unlevered yields, see RERC www.rerc.com
Reconciliation of Value Indicators
Exhibit 8-9
So…What’s Better?
 Is direct capitalization using Ro superior to

valuation by DCF?
 Fewer explicit assumptions and forecasts are required
 What implicit assumption are you making?
NOI1
Ro 
Selling Pr ice
Work of Appraiser Requires Analytical
AND People Skills
Develop Collect, read,

network interpret, and
of data organize data
contacts and reports
Be skilled in
data analysis Fight time
and report deadlines
production
Appendix: Other Methods of
Estimating Cap Rates
Alternate Methods of Estimating Cap
Rates: Mortgage-Equity Rate
 Problem: Cannot estimate cap rates without actual
comparable sales
 Solution 1: Since income-producing RE has both
equity & debt financing, think of cap rate as a wtd.
average of equity cap rate & mortgage cap rate
 Equity cash flow = NOI – Debt service
= Before tax cash flow
= BTCF
 Loan cash flow = Monthly payment x 12
Mortgage-Equity Rate (continued)
 Equity = 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
Mortgage-Equity Cap Rate: Example
 Equity dividend rate (from market) = 10.0%

 Typical mortgage loan cap rate = 8.0%
 Typical loan-to-value ratio = 75%
 Mortgage-equity cap rate:
R = 0.75 x 0.08 + (1 − 0.75) x 0.10
= 0.085 or 8.5%
Constant Growth Cap Rate
 Recall one-year total yield example:

Total yield = Cap rate + Appreciation rate
=> Cap rate = Total yield – Appreciation rate
 Assume required total yield is 11.75%
 Assume expected appreciation rate of 2.0%
=> cap rate = 11.75% – 2.0%
= 9.75%
Selecting Among Different Cap Rate
Estimates
 Direct extraction is preferred, but needs three or
more comparable sales with good information
 Choice ultimately depends on quality of data
available for each type of estimate
 Reconciliation made by weighting
End of Chapter 8

Valuation Using The Income Approach

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Valuation Using The Income Approach

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Chapter 8:

Valuation Using the

 Note: All of the discussion in this chapter refers to existing

1. Direct capitalization (with an “overall” cap rate)

1. Direct capitalization (with an “overall” cap rate)

2. Discounted cash flow (DCF)

 Appraiser trying to think like a typical investor!

Sometimes referred to as a “reconstructed” operating

 Potential gross income:

Note: Estimating first-year contract rent is not usually

Implications: 2nd floor rents in Centre Point average $1.95 /month/sf

 Straight lease: “level” lease payments

 VC-vacancy & collection loss is based on:

Potential gross income (PGI) $180,000

 CAPX: Non-recurring expenditures that increase

Institutional Below Line

 Institute of Real Estate Management (IREM):

 International Council of Shopping Centers (ICSC):

 Market knowledge is key!!

 NOI is property's "dividend“

1. Obtain estimates of cap rates, Ro,, from

NOI1 From the sale of a

2. Divide subject’s NOI1 by a weighted average of

Note: We have assumed each is equally comparable to subject

Defining the “market” for comparable selection is critically

Value  $89,100 x 11 .905  $1,060,735

 Situs Real Estate Research Corporation’s Real

 Direct capitalization only uses first year NOI, but

Red: CBD office

Green: Regional malls

 Assume the following first-year cash flows for Centre

 EGIM = sale price ÷ effective gross income

Indicated value = 6.49 x EGI

Sale price at end of Year 5 = NOI6 ÷ Rt = $103,291/0.0875

Discount rate presumed to reflect required yield (IRR) in market for

 Is direct capitalization using Ro superior to

Develop Collect, read,

 Equity = Purchase price – Loan

 Equity dividend rate (from market) = 10.0%

 Recall one-year total yield example:

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