CHAPTER 6

INCOME APPROACH TO VALUATION

 Valuation Method-income approach

 In the income capitalization approach,an appraiser

analyzes a property’s capacity to generate future
benefits and capitalizes the income in to an
indication of present value.
 The princciple of anticipation is fundamental to the
approach.
 All income capitalization methods,techniques,and
procedures attempt to consider anticipated future
benefits and estimate their present value.
 Basis for the income approach
 Income from rents and price appreciation
 Current value thus a function of
 Expected income stream

 From operating property

 From eventual resale
 Valuation
 Converting income forecast into value estimate
(capitalisation of income)
 Application, Assumption, and limitation

Application
 The income capitalization approach is most suitable income producing

properties such as,

 apartments
 Retail properties
 Office buildings
 Malls and other property types that generate regular income.
 It is preferred for land valuation when there is no reliable comparable
market data
 It is preferred when the use of cost approach is inappropriate, when the
reproducible property has suffered considerable physical depreciation,
functional or external obsolescence, is substantial over or under
improvement, is misplaced or subject to legal restriction on income that
are unrelated to cost
Application, Assumption, and limitation …

Assumption and limitation,

 The approach is limited when one of the assumption is

failed, the assumptions are,

A. Value is function of income:
 property value depends on the income that will yield.

B. Value depends on size, shape, duration and risk of the

income stream :
 how the size of the income changes over time
 Income stream my increase or decrease or may remain level over
time
 The risk is related to certainty
Application, Assumption, and limitation …

C. Future income is less valuable than present income

 Future income must be discounted to make it equivalent

to present income
Relation to appraisal principles
 The principle of anticipation is the fundamental for
income capitalization.

1. Principle of anticipation
2. Principle of supply and demand
3. Principle of substitution
Relation to appraisal principles …
Principle of anticipation
 This principle holds that the buyer of the property bases the

purchase on the expectation of benefits to be received in the future

The principle of supply and demand
 Important in estimating rates of return both income and rate of

return are determined in the market.

 If supply greater than demand, the vacancy rate will be increase and

if the demand greater than supply the vacancy rate will be decreased
Principle of substitution:
 holds that the estimate of market rent derived from comparable

rental property should reflect the same pattern of services as those

provided by the subject property.
 Processes of income Approach
 Summarised in 2 steps
– First step: estimate income
• Forecast revenue, expenses, resale value
 – Second step: convert income to value
• Direct capitalisation
• DCF valuation (yield capitalisation)
 Direct capitalisation

 Values based on ratio/multiple of expected first year

NOI
 Ratios and multipliers must come from comparable
sales
 Example: if similar properties are selling for 10
times their 1st year NOI, then subject property will
sell for 10 times its expected 1st year NOI
 Advantage and problem
Advantage
 Cap rates and multipliers come from market
indications of relationship between income and value,
i.e., comparable sales
Problem
 Using a year’s income estimate assumes expected

changes in income will be similar for comparable.

 Discounted Cash Flow (DCF)
 DCF valuation takes the value of an asset to be the
present value of the expected cash flows on the asset.
 Philosophical basis:
– Intrinsic value of an asset can be estimated from
its characteristics: cash flows, growth and risk.
 DCF contiued......
DCF valuation - inputs
 A holding period typical of potential investors

 Explicit forecasts of cash flows during the life of the

asset
 Rental rates
 Vacancy and collection rates
 Operating Expenses
 Cash flow from future selling price of the property
 The discount rate to apply to these cash flows to get
present value
Difference between the two methods

The main difference between the two method

is described as follows:
 Direct capitalisation you do only one year

forecast.
 DCF valuation you do a multi-year forecast.
 How to reach at NOI ?
Potential Gross Income (rent roll)
 Potential revenue if property were fully rented out

 Two ways to compute PGI:

1. PGI = (Nr of x-room units)*(monthly rent)*(12

months)
2. PGI = (amount of rentable space)*(rent per unit of
space)
 For expired leases, rent projections must be made

– Initial rent of subject property usually projected to grow at

inflation rate
 Contract or market rent?
Projections of PGI can be based on
– Contractual rent terms, or
– Market rents
 If space is covered by existing and long-term

leases, revenues are computed from the

contractual commitments (assuming financially
stable tenants).
 Cont.……………
 Use market rents for any space
- not covered by existing leases, or
- once existing leases expire.
 Market rent = the rental income that space would

most likely command on the open market as of the

date of appraisal.
 Vacancy and collection losses

 Vacancy allowance
– For properties with short-term leases,
 Vacancy can be calculated as a percentage of
PGI
 Cont.………………..
 Vacancy allowance
– Explicit forecast for each unit
– More appropriate for buildings with long-term leases
– Vacancies arise from time it takes for new tenant to
move in, stand-by unit for occupation during repairs
etc.
 Whatever method you use, check with typical vacancy

in local market for similar buildings.

 Subtracting vacancy allowance from PGI gives the

EGI (Effective Gross Income).

 Operating expenses
 Regularly occurring expense items associated with
current operation of the property
– Could be fixed, i.e. independent of occupancy levels
– Could be dependent on occupancy levels and hence
variable
 Fixed operating expenses:
 Property taxes
 Hazard Insurance
 Property security
 Variable operating expenses:
 Utilities
 Building and grounds maintenance and routine

 Repairs

 Property management (even if owner operated)

 Depreciation
 Note: depreciation is not included as an expense
– Property proforma is a CF statement and not an
accrual income statement in the standard accounting
sense
– The occurrence of depreciation shows up anyway in a
number of ways:
• Lower real rents over time
• Higher operating expenses
• Higher capital improvement expenses
• Lower resale value
 Capital expenditures
 It is a long term spending aimed at sustained
improvement of the physical quality of the property.
 Examples: AC system replacements, roof
replacements, adding a parking lot, new landscaping
etc
• Tenant improvements an important category of
such expenditures in buildings with long leases
 Alternate names- Replacement reserves, capital and

leasing costs etc.

 Net Operating Income (NOI)
 Net Operating Income
– Results from subtracting expenses from all the
revenues described earlier
– Most widely used indicator of net cash flow or
operating profit generation ability of an income
producing real estate asset
Constructing operating statement

Potential Gross Income (PGI) XXXXXX

Less vacancy and collection loss (VC) (XXXXX)

Equals Effective Gross Income (EGI) =XXXXX

Less Operating Expenses

Fixed expenses

Variable expenses

Total operating expenses (XXXXX)

Less capital improvement expenditure (XXXX)

Net operating Income (NOI) =XXXX

 Direct Capitalization
 Process of converting usually first year’s income
into a value estimate
– Divide income by an appropriate cap rate
– Multiply income by a multiplier
The basic formulas for direct capitalization are:
I =RxV R=I/V V=I/R
V=IxF I=V/F F=V/I
Where I is Income,R is capitalization rate,V is
value ,and F is factor.
 Potential Gross Income Multiplier (PGIM)
 It is the ratio between the sale price of a property and
its potential gross income.
PGIM=V/PGI
 Where does PGIM come from?

– Sales data of comparables similar wit respect to

• Physical, locational and financial attributes
• basis for calculating rents and expenses
 Implied assumption:

– Future expected annual income will be similar to first

year income
 Effective Gross Income Multiplier (EGIM)

 It is defiend as the ratio between the sale price (or value) of

a property and its effective gross income; a single year’s
EGI expectancy or annual average of several years EGI
expectancies.
EGIM=V/EGI
 The EGIM is similar extracted from comparable
 Primary difference between PGIM and EGIM is that EGIM
is applied to income after allowing for vacancy and credit
losses
 Advantage with EGI is To account for differences in
vacancy allowance between subject property and
 Net Income Multiplier (NIM)
 It is defined as the ratio between the sales price of a
peroperty and the first year’s net operating income
of the property.
NIM =Sales price /NOI
 NIM extracted from sales data of comparables

 Advantage

– Accounts for differences in expense and vacancy

tradition in appraisal is to use the reciprocal of the
NIM, the overall cap rate
 Overall capitalization Rate
 Cap rate is the reverse of the NIM.
Cap Rate=Ro=NOI/Sales price
 Published sources

– Databases, market reports

 Sales prices usually a matter of public record easy to obtain

– Comparable NOI’s not publicly available

•buyers/sellers source of revenue and expense information
• Must be adjusted by appraiser
 Cap rate is useful in capitalising first year NOI only, not

future NOI forecasts and it is not a discount rate.

 Discounted Cash Flow
DCF Process
 Generating a reconstructed operating statement for the asset

 Typical holding period is 10 years

 More practical to do 5-year forecasts

 Cash flow forecasting more difficult than it seems

•You need experienced hands to guide you in developing good

assumptions
Reversion Cash flows
 Second major part of eventual part of property value
– In a typical 10-year DCF valuation, salvage value accounts for
over a third of property value!!!
 Continued........
Salvage Value
 The best, most widely used method for forecasting

resale value
– Direct capitalisation of NOI at the end of the
holding period
– Example: for a 10-year DCF, project NOI for
11th year
– Divide by an assumed resale cap rate
– Gordon formula quite common in determining
exit yield
Estimating the Salvage Value

We can use a cap rate at the end of the holding period to

capitalize the first year NOI to the next owner. This cap
rate is known as the terminal cap rate or exit yield
Pro Forma Operating Statement which takes in to account the debt service and income
taxes.

 Potential Gross Income (PGI)

-Vacancy Loss & Collection Loss (VLC)
=Effective Gross Income (EGI)
- Operating Expense (OE)
=Net Operating Income (NOI)
-Debt service (DS)
=Before tax cash flow(BTCF)
-Income Tax (IT)
=After tax cash flow (ATCF)
Advantages of DCF Valuation
 Since DCF valuation is based upon an asset’s
fundamentals, it should be less exposed to market
moods and perceptions.
 If good investors buy businesses, rather than
stocks( eg. Bonds and shares), discounted cash
flow valuation is the right way to think about what
you are getting when you buy an asset.
Disadvantages of DCF Valuation

 Since it is an attempt to estimate intrinsic

value, it requires far more inputs and
information than other valuation approaches.
 These inputs and information are not only

noisy (and difficult to estimate), but can be

manipulated by the savvy / skillful and
knowledgeable analyst to provide the
conclusion he or she wants.
Thank you!!!