Chapter 8 Valuation Using the Income Approach

1. Chapter 8Valuation Using the Income Approach Real Estate FIN 331 Fall 2014

2. The Income Approach to Appraisal • Rationale: Value = present value of future income • Income capitalization: converting future income into a present value • The present value is a function of the capitalization rate • The capitalization rate reflects investor requirements for return on investments • ROIs are adjusted for riskiness of investment • Two Approaches To Income Valuation • Direct capitalization using a single overall cap rate • Discount all expected future cash flows (CFs) at a discount rate

3. The Income Approach to Appraisal • Direct capitalization • 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 • Discounted cash flow (DCF) • Project net CFs for a standard holding period (say, 10 years). • Discount all expected future CFs at required return (IRR) • DCF valuation models require: • Estimate of typical buyer’s expected holding period • Estimates of net (annual) CFs over expected holding period, including net income from expected sale of property • Appraiser to select discount rate (required IRR)

4. Rental Property Operating Statement PGI Potential Gross Income - VC Vacancy & Collection Losses + MI Miscellaneous Income = EGI Effective Gross Income • OE Operating Expenses - CAPX Capital Expenses = NOI Net Operating Income

5. Estimating Net Operating Income • Potential gross income (PGI) • Rental income assuming 100% occupancy • Sometimes referred to as potential gross revenue (PGR) • Should forecast of PGI be based on contract rent (signed leases) or current market rents? • 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

6. Estimating Net Operating Income • 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 • Miscellaneous income • Garage rentals & parking fees • Laundry & vending machines • Clubhouse rentals

7. Estimating Net Operating Income • 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 • OE do not include: mortgage payments, tax depreciation, capital expenditures

8. Estimating Net Operating Income • Net Operating Income equals Effective Gross Income minus Operating Expenses • 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 (net cash flow)

9. Estimating Net Operating Income • Sources Of Industry Expense Data • Institute of Real Estate Management www.irem.org • Building Owners and Managers Association www.boma.org • International Council OF Shopping Centers www.icsc.org • Urban Land Institute www.uli.org

10. First Income Valuation Method: Direct Capitalization • Basic Value Equation: V = NOI ÷Ro • Where: Ro is a capitalization rate NOT a discount rate • A Cap Rate is defined simply as: Net Operating Income1 ÷ Sale Price • See Exhibit 8-5 for an example of how cap rates are estimated • Note that the NOI is the expected or anticipated first year net operating income

11. First Income Valuation Method: Direct Capitalization • 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 and comparable properties • Assumes market rents are paid • Best used for properties with short-term leases (apartments & rental houses)

12. First Income Valuation Method: Direct Capitalization • Problems with Valuation by Direct Capitalization • Inadequate data on comparable sales due to: • Above- or below-market leases • Differing length of leases and rent escalations • Comparable vs. subject • Differing distributions of operating expenses between landlord and tenant • Differing prices between institutional and private investors for similar properties • Result: Discounted cash flow (DCF) analysis can be preferable

13. Terminal Cash Flow Analysis • Selling an income property at the end of the investment horizon • Sales Price (SP) • - Selling Expenses (SE) • = Net Sale Proceeds (NSP) • Year N cash flows = rental income + NSP • Value analysis best handled using the PV methodology. (see Example 8-3 page 207) PV = SCFn / Cap rate for all n =1 to N

14. Appraisal Work Requires Analytical and People Skills • Developed a network of data contacts • Collect, read, interpret, and organize data and reports • Be skilled in data analysis and report production • Be able to meet tight deadlines

15. Homework Assignment • Key terms: Capital Expenditures, Direct capitalization, effective gross income, effective gross income multiplier, capitalization rate, natural vacancy rate, net operating income, operating expenses • Study Questions: 1, 4 - part a, 5, 6, 8 (Some calculations are required for 4a, 5, & 6.)