3rd Approach: Income Approach

• Based on the present value of the rights to future income • Assumes the income generated by a will determine the property value • Used for valuing any income-producing property such as: buildings Shopping centers Office buildings Shopping mall Single family income-producing residential

Capitalization rate: • Rate of return appropriate to the risk and liquidity of the investment • Determined by comparing the relationship of net operating income to the sales prices of similar properties • Annual rate • The model doesn’t consider the cost of borrowing money in expenses, so the investor must increase their preferred return (cap rate) by the cost of borrowing money • Example: an investor can earn 4% from a regular savings account, so the investor requests an 8 % return from the that he purchased, and will pay 5% to borrow the money - thus requiring a 13% cap rate (8% + 5%) from his investment. • Arbitrary amount - considers the risk of the investment

Annual potential gross income - Vacancy and rent loss = Effective gross income - Operating expenses = Net operating income ÷

Value (sales price)

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Income approach “The Income Ap proach is one of three major groups of methodologies, called valuation approaches, used by appraisers. It is particularly common in commercial and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or business valuation.

While there are quite a few acceptable methods under the rubric of the income approach, most of these methods fall into three categories: direct capitalization, discounted cash flow, and gross income multiplier.

Direct Capitalization This is simply the product of dividing the annual net operating income (NOI) by the appropriate capitalization rate (CAP rate). For income producing real estate, the NOI is the net income of the real estate (but not the business interest) plus any interest expense and non-cash items (e.g. -- depreciation) minus a reserve for replacement.

Capitalization rate inherently includes the investment-specific risk premium. Each investor may have a different view of risk and, therefore, arrive at a different capitalization rate for a given investment.

Discounted Cash Flow The DCF model is analogous to a net present value estimation in finance. However, appraisers often mistakenly use a market-derived cap rate and NOI as substitutes for the discount rate and/or the annual cash flow. The Cap rate equals the discount rate plus-or-minus a factor for anticipated growth. The NOI may be used if market value is the goal, but if investment value is the goal, then some other measure of cash flow is appropriate.

Gross Rent Multipler The GRM is simply the ratio of the monthly (or annual) rent divided into the selling price. If several similar properties have sold in the market recently, then the GRM can be computed for those and applied to the anticipated monthly rent for the subject property. GRM is useful for rental , duplexes, and simple commercial properties when used as a supplement to other more well developed methods.38

38 http://en.wikipedia.org/wiki/Income_approach Accessed June 26, 2010. ABC Real Estate School 3st ed National Workbook August 2010 Page 179

Calculating Income Approach: II. Estimate the annual potential gross income • All income the property could generate from all sources • Includes rent and other potential sources such as vending machines, parking fees, etc. • Based on future predictions of income - may not reflect current market rates • Number of units times rent per month times 12 months per year III. Subtract the Vacancy and rent loss • Based on the appraiser’s experience • Could be a percentage or actual figure IV. You now have effective gross income • Annual potential gross income - vacancy and rent loss V. Subtract the Operating expenses • Always include management costs • Do not include mortgage payments and debt service • Could be a percentage or actual figure • If percentage - usually percentage of effective gross income unless the problem says differently VI. You are left with Net operating income (NOI) • The amount remaining after all expenses have been met • Effective gross income - operating expenses = net operating income • The interest earned on the investment VII. Divide the NOI by the Capitalization (cap) rate to find value A. Compare the relationship of net operating income to the sales prices of similar properties that have sold in the current market B. As the rate decreases - value increases C. As the rate increa s es - value decreases

Example to Calculate Cap rate: Sally wants to make a 7% return on her investment. She has to borrow the money to invest and will need to pay interest of 7% on the money to her lender. She is counting on being able to sell the property for the same price as the purchase price. How much will Sally probably require? Answer: 14% (7% + 7%)

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Income Approach Example Annual Potential Gross Income: 5 units @ $1,300 per month x 12 months = 78,000 10 units @ $2,000 per month x 12 months = 240,000 Marquee rent 15 units @ $50 per month x 12 months = 9,000 Total income: 327,000 Vacancy and Rent Loss: Vacancy: 327,000 X .05 = 16,350 Bad debts: $500 Total vacancy and bad debts: 16,850 Effective Gross Income: Total: 327,000 - 16,850 = 310,150 Operating Expenses: Real Estate Taxes: 36,000 Insurance: 500 Utilities: 2,200 Management: 4,000 Accounting: 3,200 Advertising: 800 Upkeep: 1,200 Gardening: 900Total Expenses: 48,800 Net Operating Income: Total Net Income: 310,150 - 48,800 = 261,350 Value: 261,350 / capitalization rate of 12% =$2,177,917

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Income Approach (Either memorize these or learn 1 and substitute a math problem to find the others – something like 6/3 = 2)

Income/Rate = Value

Income/Value = Rate

Value X Rate = Income

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