Income Approach

2 Income Approach
 The income approach is a method to measure the present value of a
property’s expected future returns.
 The principle in estimating the value of income property is the
anticipation of future benefits.
 The Principle of Anticipation: This principle states that income
capitalization methods, techniques, and procedures try to take the
anticipation of future benefits to account and estimate their present
value.
 This may involve either forecasting the anticipated future income or
estimating the capitalization rate which implicitly shows the
anticipated pattern of change in income over time.

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3 Income Approach
 The income approach also called income capitalization, converts
future benefits of property ownership into an indication of present
worth(market value).
 Present worth, which is the result of capitalizing net income, is the
amount a prudent investor would be willing to pay now for the right
to receive the future income stream.
 Operating companies with profitable operations, like a retail business,
a restaurant, or a manufacturing company, are best suited for this
valuation approach. Your business value is determined by estimating
the net income you expect to make through some future point and
then recalculating that cash flow in terms of today’s dollar values (also
known as the present value).
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4 Income Approach
The income approach has two methods
1. Direct Capitalization Method (DCM)
2. Discounted Cash flow Method (DCF)

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5 Income Approach
1. Direct Capitalization Method (DCM)
 Direct capitalization considers only one year’s income expectancy
and then converts income into value via rate or factor.
 A capitalization rate is a measure of return on investment.
 One of the benefits of direct capitalization is that it provides a way
to get a quick estimate.

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6 DCM
Steps for Direct Capitalization Method
1. Research the income and expense data of the subject property and
comparable properties.
2. Estimate the potential gross income of the subject property by
summing the rental income and other potential income (miscellaneous
income such as parking fees, laundry, and vending receipts are
added to the potential).
3. Estimate vacancy and collection loss (due to vacancies, tenant
turnover, and nonpayment of rent).

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7 Steps for Direct Capitalization Method
4. Calculates an effective gross income (EGI) for the property by
deducting the vacancy and collection loss from the annual potential gross
income.
5. Estimate the total operating expenses (TOE) of the subject property
by adding fixed expenses, variable expenses, and replacement
allowance.
 Fixed expenses are operating expenses that generally don’t vary
with occupancy and which prudent management will pay whether the
property is occupied or vacant whereas variable expenses vary with
occupancy or the extent of services provided.

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8 Steps for Direct Capitalization Method
Replacement allowance represents an allowance that provides for the
periodic replacement of building components that wear out more
rapidly than the building itself and must be replaced during the
building’s economic life.
6. Estimate the annual Net Operating Income (NOI) of the subject
property by deducting TOE from EGI.
7. Estimate the capitalization rate from similar properties.
8. Capitalize the NOI by the capitalization rate to estimate the value of
the property.

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9 Cont…..
Estimating Potential Gross Income
• PGI is the total income attributable to a property before any
allowance for vacancy and collection loss and before
deductions for any operating expenses.
• Represents all of the rent that could possibly be collected for this
property.
• It is the total annual rental income the property would produce
assuming 100 percent occupancy and no collection losses.
• All the above data/rents are collected from comparable
properties, i.e., it is the market rent.

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10 Cont…..
 The two common practices of estimating Potential gross income are :
1. PGI = (No. of room units)*(monthly rent)*(12 months)
2. PGI = (amount of rentable space)*(rent per unit of space)
Note: It is important to distinguish the market rent and contract
rent, the analysis should be based on market rent.
Types of Rent
Historical Rent: Rent paid in past years
Contract Rent: Rent presently paid by agreement between the
user (tenant) and the owner.
Economic Rent: The rent that a property should command on the
open market at any given time.
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11 Cont…..
 Market Rent: this should be the amount that would result from a lease
negotiated on the open market between a willing lessor and a willing
lessee, both knowledgeable and free of influence from outside
sources.

Other
Historical Estimated Income, if
Rent Gross any
Income

Compara
Contract ble
Economic
Rent Properties
Rent
Rent
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12 Cont…..
Estimating market rental from comparable
Properties
 Making detailed inspection of the property to be valued;
 Taking measurement (NIA or GIA) of the property;
 Considering the lease agreement of the property (including lease
length, the pattern of rent review, repair and liability, restrictive user
clause, etc.);
 Assessing rental evidence;
 Analysis and adjustment of comparable property rents.
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 Adjustment of the rental value will be done by considering the following:
13

 Date of Valuation  Natural lighting

 Location  Type of construction
 Building design/Layout materials
of the building  Rent review pattern
 Shape  Length of lease
 Size  Repair & Insurance
 Presence of a road  Restrictive user clause,
network etc.
 Facilities
 Car parking
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14 Estimation of Vacancy and Collection Losses
Adjustment of the rental value will be done by considering the
following:
 Vacancy and collection loss is an allowance for reductions in potential
income due to vacancies, tenant turnover, any rental concessions, and
non-payment of rent or other income.
 A vacancy is a loss in potential income attributed to unoccupied
periods. This occurs during periods of tenant turnover, building
renovation, refurbishment, and sluggish economic conditions.
 It is expressed as a percentage of potential gross income.
Vacancy rates will vary depending on the age, condition, and quality of
the building as well as the location of the property.
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15 Estimation of Vacancy and Collection Losses
 As buildings age, vacancy rates generally increase because of
physical deterioration and functional and external obsolescence.
 Collection loss is the loss in potential income from nonpayment of
rent. It is expressed as a percentage of potential gross income.
 Collection loss is calculated by dividing the uncollected rent by the
total rent billed.
Allowance for vacancy and collection loss is based on typical
management because these rates can vary depending on management
style.
 A well-managed property may experience lower than typical loss.
 A poorly managed property may experience higher than typical loss.
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16 Estimation of Vacancy and Collection Losses
 The recent history of the subject and comparable properties is the
starting point for estimating vacancy and collection loss.
 The appraiser should also consider projected market conditions and
neighbourhood trends.
 Estimation of Effective Gross Income
 Effective gross income (EGI) = PGI - VCL
Where;
PGI = Potential Gross Income
VCL= Vacancy & collection loss

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17 Miscellaneous Income
Miscellaneous income may from several sources such as parking, vending
machines, and laundry services.
 EGI is the amount remaining after allowances for vacancy and
collection loss is subtracted from potential gross rent and
miscellaneous income is added.
 Estimation of Operating Expenses
 Operating expenses are expenditures necessary to maintain the
real property and continue the production of gross income.
 These operating expenses are the costs necessary to maintain the
property so it can continue to produce rental income.
 They are typically estimated on an annual basis.
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18 Miscellaneous Income
 The starting point for estimating operating expenses is often the
subject property’s recent history, this information should be checked
against recent data from comparable properties.
 Operating expenses can be estimated as a percentage of effective
gross income or potential gross income.

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19 Cont…
 Operating Expenses are generally divided into two categories:
 Allowable Expenses and;
 Non-Allowable Expenses.
 Allowable Expenses is operating expenses that may be ordinary
and regular expenditure necessary to keep a proper functioning
competitively.
 Allowable operating expenses include, but are not limited to,
 Fixed Expenses (property tax and insurance),
 Variable expenses (outlays for property management, leasing
expenses, maintenance and repair, utilities, etc.) and
 Replacement Allowance and Capital Expenditures.
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20 Proper Operating Expenses
 Heat/Utilities  Landscape Maintenance
 General Maintenance  Legal & Accounting
 Insurance  Management
 Trash Collection  Supplies
 Hardware & Supplies
 Snow Removal
 Advertising
 Salaries
 Exterior Repairs

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21 Cont…
 Reserves for replacement are funds for replacing short-lived items
that will not last for the remaining economic life of a building.
 Reserves for replacement items include:
I. Roof and floor covering
II. HAVC system
III. Water heaters
IV. Painting and Decorating; and
V. Kitchen Appliances
VI. Calculate the annual monetary charges for any specific item

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22 Cont…
 Non-Allowable Expenses are operating expenses that have nothing
to do with the property appraised such as Depreciation, Income taxes
and. debt payments (i.e., both the interest on debt and the retirement,
or repayment, of debt), Owner’s Business Expenses, Additions to
Buildings.
Fixed expenses or cost
 To an appraiser, fixed costs are those costs that will be incurred
regardless of the occupancy rate of the property.
 These costs would be incurred even if there were no tenants renting
space.
 Fixed costs include property taxes and casualty insurance.
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23 Cont…
 This includes:
 Property taxes: Property taxes are an "ad valorem" tax, meaning that they are a tax
that is based on value.
 Property Insurance: Owners of income properties need adequate insurance on the
property.
Variable expenses or Costs
 Variable costs are those costs which will be affected by the occupancy rate of the property.
 Variable costs includes:
 Property management:
 Utilities:
 Maintenance and repair:
 Grounds and parking area maintenance
 Replacement allowance:
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24 Cont…
 Variable costs include:
Property management:
Utilities:
Maintenance and repair:
Grounds and parking area maintenance
Replacement allowance:
Total operating expenses are the sum of fixed, and variable
expenses and the reserve for replacements.

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25 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

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26 Cont…
 Net Operating Income
NOI= EGI-TOE
Where;
 NOI is net operating income
 EGI is effective gross income
 TOE is the total operating expense.
 Once we determine NOI, the resultant "NOI" is capitalized by an
overall capitalization rate to derive value.

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27 Capitalization Rates
 A capitalization rate is a rate used for the conversion of net income
into value.
 It can be market extracted and compared to other investment
opportunities.
 The cap rate is determined by analyzing cap rates for sales
transactions of most similar comparable properties in the area to
the subject property.
 The appraiser needs to “reconcile” these rates by weighting them on
the basis of the differences between the comparable from the subject
property in terms of location, condition, amenities, income-earning
capacity, occupancy rate, etc.

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28 Capitalization Rates
 Any rate used to capitalize income. It reflects the relationship between
income and value. It is calculated by the IRV formula, in which:
 Rate = Income/Value
 Value = Income/Rate
 Income = Rate * Value
The capitalization rate of a particular property can be determined
according to the following formula:
 Cap Rate = Net Operating Income/ Sale Price

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29 Capitalization Rates
 The Capitalization Rate is a measure of return on investment.
The formula for the capitalization rate is:
Capitalization Rate =
(Expected Income from Property – Fixed Costs – Variable
Costs)/Property Value
Example 1
 If an apartment building has a sale price of Birr 15,000,000 and an
annual net operating income of Birr 360,000, then the cap rate is:
 Cap rate = 360,000/15,000,000 = 2.4%

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30 Capitalization Rates
Example 2
Let’s say Angelina buys a house to rent out for extra income. The house
costs $100,000. She borrows a 30-year mortgage at 5% to pay for it,
meaning her payments are 536 per month, her property taxes work out
to $165 a month, and the insurance on the place runs $60 a month, for a
total outlay of $761. She rents the house out for $1,000 a month.
Solution
We can calculate that Angelina’s capitalization rate for this property is:
Capitalization Rate = (($1,000 -$761)*12 months)/$100,000
Cap Rate = 2.87%

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31 Capitalization Rates
Example 3
Appraisers can quickly get a market multiplier from recently sold
property transactions. Consider two recently sold comparables, one with
a PGI of $300,000 and a sales price of $2.1 million and another PGI of
$225,000 and a sales price of $1.8 million. The first yields a PGIM of 7
($2,100,000/$300,000) while the second yields a PGIM of 8
($1,800,000/$225,000).
 So, the market average PGIM of 7.5 can be applied to a subject
property’s PGI estimate to provide a quick valuation.
 If a subject property’s expected PGI next year is %195,000, multiply
that by the market PGIM to estimate the subject value.
 Subject Value = $195,000 * 7.5 = $1,462,500
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32 Capitalization Rates
When only the value of the land or the value of the improvements is
known.
 The value of land may be known from a separate analysis using
comparable land sales data.
 From this analysis, suppose the land value is $350,000 with a 9%
land capitalization rate. Further, suppose the improvements alone
have a 10% capitalization rate.
 The portion of the property’s NOI that is generated by the land can
be calculated by multiplying the land value and land capitalization
rate. The remaining income is attributed to improvements.

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33 Capitalization Rates
NOI $350,000
Less return generated by land $31,500
The return generated by improvements $318,500
Direct Capitalization of improvements $318,500
Plus land Value $350,000
Total Subject Property Value $3,535,000

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34 Capitalization Rates
Exercise
Suppose that an apartment house that has a total number of units 25 is
rented with different rent. The apartment type, number of units, and their
respective rents are given below:
Determine the annual PGI.
Apartment Type No of Units Monthly Rent(birr)

2 – bedroom units 10 2,000

3 – bedroom units 10 3,450

4 – bedroom units 5 4,000

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35 Capitalization Rates
We can multiply the number of rooms by * (monthly rent) * (12 months)
Thus, the owner of the apartment collects 240,000 from 2-bedroom units,
414,000 from 3-bedroom units, and 240,000 from 4-bedroom units. The
total annual rental income of the property is birr 894,000.

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36 2. DCF Method
 DCF measures the direct economic benefits derived from ownership, in
the form of future cash inflows and outflows attributed to the
property, stated at their present value.
 Cash inflows are derived from income plus noncash expenses
(depreciation expense).
 Cash outflows arise from future operating and
general/administrative expenses, future capital expenditures, and
any required influxes of working capital necessary to support growth
and sales revenue.

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37 2. DCF Method
Considers the future cash flows for each year of the anticipated
holding period plus cash expected from the sale of the property at the
end of the holding period to discount to present value.
Steps involved:
1. Estimate future net cash flows
2. Estimate discount rate
3. Discount cash flows back to the present value using the discount rates
and the estimated future cash flows.

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38 Cont…
1. Estimating future net cash flows
 Operating net cash flows
 Residual value
2. Estimate discount rate:
 The discount rate is the minimum rate of return required by fund
providers
 The weighted average cost of capital (WACC) for companies Market
rate/yield for similar risk

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39 Cont…
Weighted Average Cost of Capital(WACC)
 If a company uses both debt and equity financing, the cost of capital
must include the cost of each, weighted to the proportion of each
(debt and equity) in the firm’s capital structure
WACC = (Wd x kd) (1-T) + (We x ke)
Where; Wd = proportion of long-term debt in the capital structure
We = proportion of equity in the capital structure
kd = cost of debt before tax
kd after-tax = loan interest * (1-T), ke = cost of equity
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40 Cont…
Cost of Equity
 It is the return that a company requires for an investment or
project, or the return that an individual requires for an equity
investment. Using the capital asset pricing model (CAPM):
Ke = KRF + i(KM – KRF) Where; Ke = Cost of equity
KRF = risk-free rate of return
i= beta coefficient for the business,
KM =expected market return, that is the return expected on the market
portfolio
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41 Cont…
CAPM Method
 The capital asset pricing model (CAPM) is one of the more widely
discussed and used developments in modern financial theory. William
F. Sharpe, Harry M. Markowitz, and Merton H. Miller originally
formulated the CAPM, to measure the cost of equity capital.
 This method also uses the concept of beta, defined as the measure of
the volatility of the subject investment’s return relative to the volatility
of returns in the marketplace as a whole.

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42 Cont…
Example 1
 Green rental lets an apartment for tenants. Green financed the investment by
70% by debt and 30% by equity. The prevailing market loan interest rate is
12% and the profit tax rate is 30%. The risk-free rate is assumed to be 7%
and the average market rate of return is 19%. The beta of the company is
estimated to be 1.2.
 Required: Determine WACC

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43 Cont…
Solution Ke = KRF + i(KM – KRF)
Given Ke = 0.214
Wd = 0.7, (I-T) = 70%, We * Ke = 0.3*0.214 = 0.0642
Kd = 12% WACC = (Wd x kd) (1-T) + (We x ke)
=(Wd * Kd)(I-T) = 0.0588 WACC = 0.0588+0.064
We = 0.3 WACC = 0.123
Ke =?
KRF = 7%, I = 1.2, KM = 19%

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44 Cont…

Value of Asset = present value of operating cash flows + present value

of residual value
𝑪𝑭 𝑹𝑽
VA = σ𝒏𝒕=𝟏 𝟏 + 𝒏
𝟏+𝒌 𝟏+𝒌
 Where, n = end of economic life of the asset
 K = WACC
 CF = annual operating cash flows
 RV = Residual Value

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45 Cont…
0 1 2 n

Value CF1 CF2 CFn

𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝟑 𝑪𝑭𝒏
Present Value = + + + ⋯+
𝟏+𝒌 𝟏 𝟏+𝒌 𝟐 𝟏+𝒌 𝟑 𝟏+𝒌 𝒏

𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝟑 𝑪𝑭𝒏

 DCF = + + + ⋯+
𝟏+𝒌 𝟏 𝟏+𝒌 𝟐 𝟏+𝒌 𝟑 𝟏+𝒌 𝒏

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46 Cont…

 DCF is the sum of all future discounted cash flows that the investment is
expected to produce. This is the fair value that we’re solving for.
 CF is the total cash flow for a given year. CF1 is for the first year, CF2
is for the second year, and so on.
 r is the discount rate in decimal form. This discount rate is basically the
target rate of return that you want on the investment.

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47 Cont…

Example 2
 Further assuming the previous example 1 for Green Rental. The
company is estimated to generate ETB 500,000 for the first 5 years,
ETB 600,000 for another 5 years, and ETB 750,000 for the last 5
years after which it expects to save the apartment for ETB 5,000,000.
 Required: Find the value of the apartment
 Example DCF Method
DCF Example..xlsx

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48 Cont…

 The subject property is expected to yield a PGI of $200,000 over the

next year and currently has a 5% vacancy rate. Operating expenses
are currently 45% of EGI, and that is expected to stay the same
during the holding period.
 Market rent is currently increasing at a rate of 3% per year. During
the second year, however, it is expected to only grow at a rate of 1%
before returning to the current 3% growth rate.
 The vacancy rate is expected to climb to 7% during the following two
years and then return to a stable 5%.
 The terminal/resell value is 1,319,909.
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49 Cont…
This cash flow statement is under the given market assumptions. What is
the PV of a building? (using 6 years)
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Market 1% 3% 3% 3% 3%
rent
PGI 200,000 202,000 208,060 214,302 220,731 227,353

Vacan. % 5 7 7 5 5 5

Vacancy 10,000 14,140 14,564 10,715 11,037 11,368

EGI 190,000 187,860 193,496 203,265 209,694 215,985

Ope. Expe 85,500 84,537 87,073 91,614 94,362 97,193

NOI 104,500 103,323 106,423 111,973 115,332 118,792

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50 Difference between Cap & Discount Rates
 Now we can compute the present value by discounting the future
cash flows back to the present using the investor’s required rate of
return of 12%.
 The cash flows are $104,500 in year 1, $103,323 in year 2,
$106,423 in year 3, $111,973 in year 4, and $ 1,435,241 (the
sum of NOI in year 5 and the expected resale value ) in year 5.

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51 Cont…

N 1 2 3 4 5 6

NOI 104,500 103,323 106,423 111,973 115,332 118,792

RV 1,319,909

Sum 104,501 103,325 106,426 111,977 115,337 1,438,707

PV 93,304 82,370.1 75,751.9 71,163.4 64445.3 $728,893.74 $1,116,928.91

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52 Difference between Cap & Discount Rates
 Discount and cap rates are used to convert some measure of
income into an estimate of value.
 The cap rate allows us to value a property based on a single
year’s NOI. So, if a property had an NOI of $80,000 and we
thought trade at an 8% cap rate, then we could estimate its
value at $1,000,000.
 The cap rate will be a misleading performance indicator.

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53 Difference between Cap & Discount Rates
 The discount rate, on the other hand, is the investor’s required
rate of return. The discount rate is used to discount future cash
flows back to the present to determine value and account’s for
all years in the holding period, not just a single year like the
cap rate.
 The DCF method is suitable for business owners who expect
their company to experience rapid or unpredictable growth in
the future years.

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54 Strengths Vs Weaknesses of Approaches to Value

Method Strength Weaknesses

Cost Good for special purpose assets Sometimes economic obsolescence

can be overstated
Good for new assets. Depreciation estimate is subjective

Market Most reliable indicator for individual Certain assets have no comparable
items with established markets. sales, and adjusting is subjective.
More accurate measure of Sales data is sometimes questionable
depreciation and not detailed, and buyer and seller
motivation is unknown
Income Recognizes income contribution to a Poor method if specific assets
business segregated.
Most accurate measurement of total Rates of return are subjective and
depreciation of all assets need to be combined with the
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business value
55 Question or Comment

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