# Chapter 38. Appraising Income Property INTRODUCTION

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1 Chapter 38 Appraising Income Property INTRODUCTION The income appraisal approach estimates the current market value for a real property by projecting and analyzing the income that the property could generate. Income-earning properties include single-family homes, duplexes, apartment buildings, shopping centers, freestanding retail stores, office buildings and warehouse and industrial buildings. The appraiser converts the projected income of the property into an estimate of market value. The formula for doing so is derived from the valuation of fixed income securities such as long term corporate and government bonds: Value = Income / capitalization rate. The definitions of the elements of the formula are: (a) (b) Income = a periodic income payment received by the owner of the asset after deducting operating expenses of the property and Capitalization rate = an income rate that converts income into value. As applied to real estate appraisal, this equation simply states the following relationship: the value of the income-generating real property is equal to the periodic (net) income (usually annual) generated by the property divided by a capitalization rate (cap rate) appropriate for the market in which the property will trade, the period of time when it will trade, and the risk associated with this type of property. If a parcel of real estate generates an income payment of \$10,000 per year and the appraiser estimates a capitalization rate of 10 percent per year, the value of the real property is \$10,000 divided by 0.1 equals \$100,000. ANALYSIS OF REVENUE An appraisal of income property starts with projecting the income that the property will generate as that income would be projected by qualified buyers in that market at that time. An appraisal of current market value relies on the current prevailing rents in the market and the amount of space that the property can offer to prospective tenants. The appraiser uses three income definitions in an income property appraisal. These three income concepts are: (1) potential gross income, (2) effective gross income, and (3) net operating income. These three income concepts rely on an understanding of: (a) (b) (c) market rent and contract rent; vacancy and collection losses; and operating expenses. POTENTIAL GROSS INCOME

2 Potential gross income is the total number of dollars that the income-producing property could generate if the property obtained the prevailing market rent for each unit of space in the property plus any other income generating activities of the property. Understanding two different rent concepts, contract rent and market rent, is critical to understanding potential gross income. Contract rent is the rent that the tenant actually pays to the property owner under by the lease contract. In contrast, market rent is the rent the property owner would receive if a tenant paid the current rent prevailing in the market. The value of a fee simple estate is based on the market rents at the time of valuation. The value of a leased fee estate is based on the contract rents for occupied space, plus market rents on vacant space to be occupied, less an adjustment for a rent-up period and expenses. The property's potential gross income is the total of the rents for each of the rentable units in the property plus income from miscellaneous sources. Market rent and contract rent need not be the same. The current market rent can be greater than, equal to, or less than the contract rent based upon a lease that is one, two, or even ten years old. At the time of the original lease, the economic circumstances in the market were more than likely different from the current economic climate. To determine a property's potential gross income, the appraiser first identifies all rentable space in that structure. The appraiser prices this space, whether it is the number of apartment units or the floor area in square feet, at the prevailing market rent rate for similar space in competitive properties. In addition to the rentable space, the appraiser must identify any other sources of potential income such as parking fees, vending machine revenue, and laundry room receipts. In developing the market rent rate, the appraiser must analyze the difference between the effective market rent and the asking or quoted rents. Commercial tenants rarely pay the asking rents because owners give various concessions to these tenants. The magnitude of these rent concessions increases as the amount of vacant space in the market increases. Rent concessions may take the following forms: (a) (b) (c) (d) (e) (f) periods when the tenant does not owe rent; funds for the decoration or the finishing of the tenant s space (tenant improvement allowances), free parking spaces; assistance with the tenant's moving costs; assistance with space planning expenses; and funds to buy out the tenant's obligation in an existing lease. EFFECTIVE GROSS INCOME Effective gross income is an estimate of the subject property's maximum incomeearning potential, given current and future effective market rent conditions, reduced by an allowance for vacancies and collection losses. When the appraiser is considering the earning potential of an income property, he or she recognizes that some space in that structure may be vacant for some period and that all the rent due may not be collected. This situation could occur even if the property is fully occupied at the time by reliable and financially stable tenants. To establish effective gross income projections, the appraiser must reduce potential gross income to reflect the vacancy levels the property will experience and the inability to collect all the rent

3 earned. The result of this reduction for vacancy and collection losses is effective gross income. ANALYSIS OF OPERATING EXPENSES The operating expenses of an income-producing property are the total cash payments that are necessary to generate effective gross income. The important phrase in this definition is "necessary to generate effective gross income." As operating expenses of the property, the appraiser considers only expenditures that are necessary for the operation of the property; therefore, expenditures associated with the owner's personal needs or the operation of another property do not count. For example, the owner's income taxes are not an operating expense; depreciation claimed for income tax purposes is not an operating expense; nor are payments on mortgages secured by the property operating expenses. The three operating expense categories are variable expenses, fixed expenses, and reserves for replacement. Variable expenses include cash outlays that change with the level of occupancy in the structure including the following: (a) (b) (c) (d) (e) (f) (g) management fees for rent collection, tenant selection, property marketing, and other administrative work; payroll and personnel expenses such as salaries, social security contributions, unemployment insurance, and all other fringe benefits provided by the property owner to the employees; utility expenses paid by the owner for electricity, natural gas, heating oil, water, sewer service, and trash collection; maintenance and repair expenses; leasing commissions; supplies and materials expenses for items to make the property habitable and clean such as light bulbs, rug cleaning solutions, floor wax, and paint; and grounds care expenses to maintain improvements other than the main building such as parking lots, access roads, sidewalks, the lawn and the landscaping, the swimming pool, tennis courts, and patios. The second operating expense category, fixed expenses, does not vary with the level of occupancy of the building. Consequently, they remain relatively constant whether the property is fully occupied or entirely vacant. The two most important fixed expenditures are (a) real property taxes and special assessments and (b) property insurance for hazards such as fire, theft, and vandalism, and liability insurance. The third category of operating expense is a reserve for replacement of short-lived items such as appliances and carpets in an apartment unit, heating and cooling equipment, elevators, escalators, light fixtures, revolving doors, and plumbing fixtures. The economic life of these fixtures is much shorter than the economic life of the structural components of the building, and every five or ten years the owner will find it necessary to replace them. Therefore, the owner may need to create a reserve of funds to cover the outlay to replace these items as they wear out. NET OPERATING INCOME (NOI)

4 Net operating income is effective gross income minus total operating expenses. The importance of net operating income (NOI) to the appraiser is simple to understand. NOI is the numerator in the valuation formula discussed above. The appraiser divides NOI by a capitalization rate to obtain an estimate of the property's current market value. THE DIRECT CAPITALIZATION METHOD Direct capitalization is the process of converting net operating income into an estimate of market value. The appraiser estimates the property's net operating income. Then the appraiser derives the appropriate capitalization rate by using one of two procedures: (a) derivation from the property market or (b) derivation from the financial market. in the recent past and obtains both their sales prices and net operating incomes. As an ex was \$35,000 at the time of sale. In this case, the overall rate of capitalization is NOI Sa investment properties, the appraiser can use the overall rate of capitalization from such m available. Moreover, if the properties are not similar, the appraiser will have to make a si In order for the overall capitalization rate extracted from the market to be accurate and u negotiations as might be true in the case of a transaction between parties th If these elements of comparability do not exist in the current market, the overall capitalization ra benefit monetarily from investing in real estate: lenders and buyers (equity investors). M investment differ. In the vast majority of cases, buyers require some borrowed money an of loan to value and the interest rate) plus the equity investor's expectation of return is im example, in a given market, purchasers of income-producing real estate may obtain 70 pe expect a 16% annual income return on their investment in equity. Using that information (a) DERIVATION OF THE CAP RATE FROM PROPERTY MARKET DATA - To derive the overall rat then loses its validity and its applicability. (1) physical characteristics of the improvements and the site; (2) neighborhood and locational characteristics; (3) financing involved in the purchase; (4) terms of sale and market conditions prevailing at the time of the sale; (5) income streams that represent the same timing, risk, and stability; (6) buyer and seller motivations underlying the transaction; and (7) arm's length transactions surrounding the sale. The term "arm's length" rep the capitalization rate. (b) THE BAND OF INVESTMENT CAPITALIATION RATE - This method of developing a capitaliza technique in its simplest formulation. Rate = (L/SP)(R M ) + (E/SP)(R E ) L/SP = the ratio of the loan to the sales price (70% or 0.7) R M = the annual payment rate on borrowed funds (10% or 0.10) including both in E/SP = the ratio of funds that the buyer pays as a down payment (the equity) to the R E = the expected buyer's expected rate of income return on the investment in th

5 (c) Given the assumed payment rates and portions, the calculation of the capitalization rate is THE VALUE ESTIMATE FROM DIRECT CAPITALIZATION - After the appraiser calculates the property market or by the band-of-investment technique, he or she can divide NOI by R to property is \$322,034. The next step is to round the estimate to reflect the appraiser s jud the estimate. In this situation, while some appraisers would round to the nearest thousan thousand figure and thereby present the client with the value estimate of \$320,000. AN EXAMPLE OF DIRECT CAPITALIZATION Exhibit A displays the relevant information for a property that has 12 apartment units that will sell in a market that has \$800 per month market rent and an 8% vacancy rate. An investor has requested an appraisal to help set an offering price. The historic operating expenses for the past few years are obtained from the owner or the property owner. These operating expenses need to be reconstructed which means that they are evaluated for necessity. Are the stated expenses necessary to operate the property? The data for the property might have included income taxes, depreciation as per the IRS and mortgage interest rates ; these expenses are not necessary to operate the property so they are removed from the list of necessary operating expenses. The reconstructed operating expenses are then evaluated for their applicability to the future. If property taxes for the last 3 years averaged \$16,500 will this level exist in the near future? Over the last few days the investor discovered that the local jurisdiction must build a new school and a prison and a new public safety facility (fire station or police station). Would \$18,000 be a more relevant estimate for property tax over the next few years?

6 From the data provided in Exhibit A the appraiser generates the cash flow statement in Exhibit B. PGI is \$115,200 (\$800 per month times 12 months times 12 apartments). EGI is PGI les the vacancy loss of \$9,216 due to the market vacancy rate of 8%. Total Operating Expenses are \$40,419 so NOI is \$65,565. The Cap Rate is calculated from a sales comparison approach of the property market in which the subject property will sell using the procedure presented in the previous discussion. It is 9.20% or, in decimal terms, The market value estimate is NOI of \$65,565 divided by = \$712,664 rounded to \$713,000. THE GROSS INCOME OR RENT MULTIPLIER TECHNIQUE The gross income multiplier (GIM) or gross rent multiplier (GRM) technique is another form of direct capitalization to estimate the market value of income-earning property that attempts to model actual investor behavior, usually for smaller properties. The term "gross income multiplier" (GIM) usually refers to annual gross income while the term "gross rent multiplier" (GRM) usually refers to monthly gross income. Sometimes appraisers will use the term "gross monthly rent multiplier" (GMRM) for clarity. In any event, the multiplier converts a gross income measure such as rent into an estimate of market value. To apply the GIM or the GRM, the appraiser draws a judgment, based on his market research, that investors in income-earning properties act upon financial self-interest and have good information about the real estate market. The appraiser makes a second judgment that the sales prices of recently sold comparable properties adequately reflect the investors' judgments about the future NOI of those properties. Inherent in this second judgment is the idea that the sales prices paid for these comparable properties adequately reflect future trends in operating expenses and vacancy rates as well as future trends in the market value of the rentable space being provided by those structures. On the basis of these judgments,

7 the appraiser obtains an estimate for the gross rent or gross income multiplier by dividing the sales price of each of the comparable properties by the monthly or annual gross rent. By developing GRM s or GIM s for several comparable properties that have sold recently, the appraiser establishes a range for the current multiplier. If the appraiser chooses comparables carefully, the several gross rent or income multipliers should be approximately the same or reasonably close to each other. This small level of deviation more than likely reflects differences in age, condition, special features, room size, and/or location of the property. For this reason the appraiser does not adjust gross rent or income multipliers. The appraiser selects from the group of properties a comparable property that is most like the subject property and uses its GRM or GIM to estimate the market value of the subject. The gross multipliers of the other comparable properties serve as a check on the accuracy of the market, in other words, on the consistency of the different investors' judgments about the market value of the similar properties. As an example of the use of the gross rent multiplier technique, an appraiser selects several comparable properties and finds GRM s for these properties to be in the range of 90 to 95. The most comparable property has a GRM of The appraiser estimates that market rent is \$ per unit for each of 12 apartments in the structure. The market value estimate then is GRM times the market rent or 91.5 times \$425/month times 12 apartments which equals \$466,650. The appraiser must recognize limitations when using the gross income or rent multiplier. Since the gross income multiplier relates the appraiser's estimate of market value to a gross income concept, that is, to potential gross income or to effective gross income rather than to net operating income, its use is only valid for certain types of property. The properties used for comparison must exhibit a high degree of uniformity among their operating expense ratios, and this uniformity must be present among the whole set of comparable properties and the subject property itself. Without uniformity in operating expense ratios, the gross income estimate cannot reflect comparability in net operating income among the properties and the subject property. If this uniformity among operating expense ratios exists, the appraiser can assume comparability among the net operating incomes of the comparable properties and the subject property. Despite the limitations of the technique, the gross income or rent multiplier is very appealing because of its simplicity. By obtaining estimates of gross income multipliers from the comparable properties, checking to be sure that the divergence among these estimates is not excessively large, and identifying the comparable property most like the subject property, the appraiser can reliably estimate current market value. YIELD CAPITALIZATION The second class of techniques available to the appraiser to estimate current market value uses the NOI estimates for a number of years into the future and the net proceeds from the anticipated future sale of the property to estimate market value. This technique is more complex than direct capitalization technique which is only an initial year analysis. A complete discussion of this technique is beyond the scope of this guide because it involves time value of money considerations and investment analysis concepts. A complete presentation of yield capitalization is available in any appraisal text that discusses income property valuation.

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