2. Overview of the Income Approach
• Introduction
o The income approach is a method of appraising property
based on the property’s anticipated future income.
• Application of the Income Approach
o The income approach is most useful when appraising
properties whose ability to produce income is considered by
potential investors.
o The income approach depends on a property’s income: real
or potential.
• Limitations of the Income Approach
o The income approach has limited usefulness when current
rental data and operating statements are not available.
o The income approach requires current market data for
rentals of like properties as well as careful analysis of the
operating statements.
3. Overview of the Income Approach (continued)
• Converting Income to Value
o The basic methods are direct capitalization, and discounted
cash flow analysis (or yield capitalization).
Estimating Income
• Introduction
o Income is estimated both as gross income (total income
before deducting expenses) and as net operating income
(income received after expenses have been deducted).
• Potential Gross Income
o Potential gross income (PGI) is the maximum income a
property could generate.
o Questions an Appraiser Must Consider
What is the likelihood this property will continue to generate
that same amount of income into the near future?
Can the income be increased?
If so, by how much?
If not, why not?
4. Estimating Income
• Potential Gross Income
o A rental survey is an analysis of competitive rents.
o A rent concession is a discount given to induce a
tenant to rent.
• Effective Gross Income
o Effective gross income (EGI) is the property’s income
after deducting vacancy and collection losses from the
estimate of projected potential gross income (PGI).
o Vacancy loss is the amount of income lost due to
vacant units in a property.
o Collection loss represents an amount due to bad debts
or losses attributed to slow pay.
o EGI = PGI – Vacancy and Collection Loss
5. Estimating Income (continued)
• Net Operating Income
o Net operating income (NOI) is the income remaining
after the operating expenses are deducted from the
effective gross income.
o NOI = EGI – Operating Expenses
o Operating Expenses
Operating expenses are those expenses necessary to
maintain the property and to help ensure the continued
production of income.
• They include, but are not limited to, items such as property
management, insurance, property taxes, utilities, and
maintenance.
Fixed expenses are ongoing expenses not affected by
vacancy, such as property taxes, insurance premiums, and
licenses.
6. Estimating Income (continued)
• Net Operating Income
o Operating Expenses
Variable expenses are operating expenses that vary based
upon numerous criteria such as the level of occupancy,
the income a property generates, and the amount of
services provided by the owner to the tenants.
Replacement reserves are funds set aside to replace
short-lived components of the property, such as
carpeting, painting, roofing, or mechanical equipment.
o Excluded Expenses
Operating statements prepared by accountants for
accounting or tax purposes typically include all the
expenditures an owner makes for a property, even those
that are not operating expenses.
7. Direct Capitalization
• Direct Capitalization – Income Multipliers
o An income multiplier is a number that, when multiplied by
the income, gives an indicator of value.
o Gross Rent Multipliers
The gross rent multiplier (GRM) is the relationship (ratio)
between the sales price (value) and gross rent (annual or
monthly) for residential properties.
GRM = V0 / Gross Monthly Rent
V0 = Gross Rent x GRM
o Effective Gross Income Multipliers
The effective gross income multiplier (EGIM) is the
relationship (ratio) between sales price (value) and the annual
effective gross income from income producing properties.
EGIM = V0 / EGI
V0 = EGI x EGIM
8. Direct Capitalization (continued)
• Direct Capitalization – Cap Rates
o The capitalization rate (R0) is a ratio reflecting the
relationship between the net operating income a
property generates and its value.
o Deriving Capitalization Rates
The quality and quantity of data available to an appraiser
determines which technique is most appropriate.
Market Extracted Cap Rates
• When determine a capitalization rate using comparable
sales, an appraiser analyzes the relationship between the
sales prices of competing properties in the subject’s market
and the yearly net operating incomes generated by those
properties.
9. Direct Capitalization (continued)
• Direct Capitalization – Cap Rates
o Deriving Capitalization Rates
Band of Investment Method to Develop Cap Rates
• The band of investment method determines the capitalization
rate based on the two primary sources of funds used to
purchase a property—equity funds and debt funds.
• The amount a buyer invests into a property is called equity
capital and the amount borrowed by the buyer to purchase a
property is called debt capital.
• The mortgage constant is the ratio of the loan amount
(principal) to the annual sum of the individual loan payments.
• The equity cap rate reflects the anticipated return on a
percentage basis to the investor who owns the property and is
typically reflective of the first year of the investment.
• Weighted Debt Rate = Debt Percentage × Mortgage Constant
• Weighted Equity Rate = Equity Percentage × Equity Cap Rate
• Overall Cap Rate = Debt Rate + Equity Rate
10. Direct Capitalization (continued)
• Direct Capitalization – Cap Rates
o Residual Techniques
A residual technique is a method of estimating the value of a
building or land, given the value of one and the rate of
return.
Building Residual Technique
• The value of the total property may be estimated, by using the
building residual technique if the land value is known (or easily
estimated).
Land Residual Technique
• The value of the total property may be estimated by using the
land residual technique if both the total net operating income
for a property and the value of the building are known.
• This method also assumes an appraiser has obtained
information regarding cap rates for both the land and for the
building.
11. Direct Capitalization (continued)
• Yield Capitalization
o Yield capitalization, also known as discounted cash flow
analysis, is a method in which the value of future benefits is
discounted to a present value.
o Reversion is the lump sum amount the investor expects to
receive upon sale of a property at some future point in time
(return of investment).
o The process when the periodic future income flows and the
reversion are converted into a present value estimate is called
discounting.
o The discount rate is the yield rate to the investor and assumes a
satisfactory return on and return of investment to the investor.
o Steps to Perform for Yield Capitalization
Project the holding period of the investment.
Estimate and forecast all the future cash flows associated with the
investment.
Identify an appropriate discount rate.
Convert the future benefits into a present value estimate for the
property.
12. Direct Capitalization (continued)
• Yield Capitalization
o Six Functions of One Dollar
Three Overall Ways to Look at Money
• The future worth (amount) can be calculated based upon
compounding.
• The present worth (amount) of money may be calculated
through discounting.
• The amount of equal payments to retire a debt or to
accumulate a specific amount of money may also be
analyzed.
Column 1, Future Value of $1
• This column is used to calculate the future worth of a
present amount assuming the amount invested draws
interest at the rate stated at the top of the chart.
13. Direct Capitalization (continued)
• Yield Capitalization
o Six Functions of One Dollar
Column 2, Future Value of $1 per Period
• This column is used to calculate the future value if regular additions of
$1.00 are made every year and the interest stays constant during the
investment period.
Column 3, Sinking Fund Factor
• This column will tell the investor how much must be invested each year
to accumulate to a specific amount at the end of the stated period.
Column 4, Present Value of $1
• This column is used to calculate the present value of a future amount.
Column 5, Present Value of an Annuity of $1 per Period
• This column is much like Column 4, but instead of one future lump
payment, it is used to discount future cash flows into a present worth.
Column 6, Installment to Amortize $1
• This column is often used to identify the size of regular payments
(annually in this case) required to pay off a debt over a specified period.
14. Direct Capitalization (continued)
• Yield Capitalization
o Annuities
An annuity is regular payment of a predetermined amount.
For any income producing property, there is the
expectation that tenants will pay rent at regular intervals,
usually monthly, to the property owner.
When discounting, the present value of an annuity is
always assumed to be less than the sum total of all the
cash flows during the period of the annuity.
This procedure is tied to the premise that benefits
received today are worth more than benefits received in
the future.
