This document discusses methods for estimating the income and expenses of a real estate property to determine its value. It describes how to calculate potential gross income, vacancy and credit losses to determine effective gross income. Operating expenses like management, taxes, insurance and reserves are then subtracted to get net operating income. This income can be capitalized using market rates or discounted in a cash flow analysis to estimate the property's worth. The document provides an example analysis that values the property at $80,000 using direct capitalization and $103,000 using discounted cash flow.

1. MBA 590
Real Estate Analysis
! College
of Business Alfaisal
UNIVERSITY

2. Chapter 8
Income Approach

3. Estimating Income
and Expenses
Reconstructing
Adding
Subtract

4. Net Operating Income
Income
Less: expenses
= Net Operating Income
(NOI)

5. Net Operating Income
more details
can be complex

6. Estimating Income
and Expenses
usually different than
the owner’s statements

7. Potential Gross Income
If the property was
100% occupied at
market rent

8. Two loss deductions
vacancy loss
credit loss

9. Vacancy Loss
no tenant
no Income

10. Credit Loss
tenant
not paying rent

11. Effective Gross Income
potential gross income
less: vacancy loss
less: credit loss

12. Abbreviations
PGI
less: CVL
EGI

13. Gross Income
Potential Gross Income
(PGI)
10,000
Less: Vacancy Loss 4% 400
Less: Credit Loss 4% 400
8% 800 !
Effective Gross Income
(EGI) 9,200

14. Operating Expenses
reimbursable
non-reimbursable

15. Operating Expenses
management
property taxes
insurance
utilities
reserves for replacements
maintenance
other

16. Management
Must recognize even if
owner operated
4% to 10% of EFI

17. Reserves for
Replacements
Prudent management
will build a fund to
replace long-lived items

18. Differences
Owner Reconstructed
Management 0 300
Property Taxes 500 500
Insurance 1,000 1,000
Utilities 300 300
Reserves for Replacements 0 500
Maintenance 100 100
Total Operating Expenses 1,900 2,700

19. Reconstructed Operating Statement
Potential Gross Income 10,000 100%
Less: Credit and Vacancy
800 8%
Loss
Effective Gross Income 9,200 92%
Operating Expenses
Management 300 3%
Property Taxes 500 5%
Insurance 1,000 11%
Utilities 300 3%
Reserves for
500 5%
Replacements
Maintenance 100 1%
Total Operating Expenses 2,700 29%
Net Operating Income 6,500 71%

20. What is the property
worth?

21. Two Methods
Direct Capitalization
Discounted Cash Flow

22. Direct Capitalization
Convert an annual
income into a value
with a
capitalization rate

23. IRV
Income = Rate x Value
Rate = Income ÷ Value
Value = Income ÷ Rate

24. Getting Rates
Market
Built Up

25. Market
Sales Analysis

26. Rates
Sale Price 1,000,000
Net Operating
Income 75,000
Multiplier Rate 13.33 Years to Recover
Investment
Capitalization
Rate 7.50% Yield on
Investment

27. Why are rates different?
Risk Factors
change in market
management
liquidity

28. Built Up
Risk Free Rate
US.Treasury Bond
1.5%
Management 3.0%
Illiquidity 3.0%
Volatility 2.0%
Capitalization Rate 9.5%

29. Net Operating Income 6,500
Rate Value
5% 130,000
6% 108,333
7% 92,857
8% 81,250
9% 72,222
10% 65,000
11% 59,091
12% 54,167
What is
the
property
worth?

30. Selecting a rate
quality and quantity
stabilized
volatility
judgment

31. Sales Comparison
calculate rate
adjust for differences
weigh
apply rate

32. Rates
Sale 1 Sale 2 Sale 3
Sale Price 750,000 5,500,000 287,000
Net Operating Income 60,000 721,000 12,000
Multiplier 12.50 7.63 23.92
Capitalization Rate 8.00% 13.11% 4.18%
Comparability Similar Inferior Superior
Adjustment 0.00% -5.00% 5.00%
Adjusted Rate 8.00% 8.11% 9.18%
Average 8.43%

33. Weighted Rates
Sale 1 Sale 2 Sale 3 Average
Adjusted
Capitalization Rate 8.00% 8.11% 9.18% 8.43%
Weighting 70% 20% 10% 100%
Weighted 5.60% 1.62% 0.92% 8.14%

34. Indication
Net Operating Income 6,500
Capitalization Rate 8.14%
Indicated Value 79,853
Rounded To 80,000

35. Discounted Cash Flow
DCF
Present value of all
future benefits

36. Discounted Cash Flow
DCF
Return on capital
Return of capital

37. Discounted Cash Flow
DCF
1. Estimate amount of NOI for each period
2. Select a discount rate
3. Calculate PV factor for each period
4. Apply the PV factor to each cash flow
5. Add up the present value of all cash flows

38. the present is worth
more than the future
!
the future is worth less
than the present

39. time is money
!
money is time

40. compensated to wait
!
patience is rewarded

41. time value of money
!
money value is relative
to time

42. Assumptions
money value is relative
to time

43. Assumptions
time value of money
!
money is worth
different based on the
time

44. Finance
Time and Risk
how long
how much

45. Number
of periods
(1 + rate)
(1 + r)N

46. Key Formulas
r = rate
N = number of periods
Compounding
Future Value or FV
multiplying
(1+r)N
Discounting
Present Value or PV
dividing
1
(1+r)N

47. Tomorrow
One Year
Ten Years

48. Discount the future
!
Today is worth
more than
tomorrow

49. Grow
in the
Future
Today
One year
Ten Years

50. Compounding
Grow by a percentage
each year,
not a fixed amount

51. Compounding
The process of finding
the future value of a
present sum of money
!
multiplying

52. Discounting
The process of finding
the present value of a
future sum of money
!
dividing

53. compounding is the
inverse of discounting
discounting is the
inverse of compounding

54. DCF of the NOI
Discount Rate 7%
1 2 3 4 5 Total
NOI 6,200 6,500 6,800 7,200 7,500 34,200
PV Factor 0.9346 0.8734 0.8163 0.7629 0.7130 0.8147
Present Value 5,794 5,677 5,551 5,493 5,347 27,863

55. Reversion
return of your capital
resale

56. Reversion
Net Operating Income 7,500
Capitalization Rate 8.14%
Indicated Value 92,138
PV Factor 0.8147
Present Value of the
75,064
Reversion

57. DCF
Face
Value
Present
Value
Net Operating Income 34,200 27,863
Reversion 92,138 75,064
Summary 126,338 102,927
Rounded To: 103,000

58. Income Approach
Direct Capitalization 80,000
Discounted Cash Flow 103,000