Valuation Using the
Income Approach
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Rationale:
Value = present value of anticipated income
Often called “income capitalization”
Capitalize: to convert future income into a present value
Note: All of the discussion in this chapter refers to existing
properties. Development is discussed in Chapter 23
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1. Direct capitalization (with an “overall” cap rate)
2. Discount all expected future cash flows (CFs) at
discount rate (“DCF”)
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1. Direct capitalization (with an “overall” cap rate)
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
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2. Discounted cash flow (DCF)
Project net CFs for a standard holding period (say, 10 yrs)
Discount all expected future CFs at required return (IRR)
Appraiser trying to think like a typical investor!
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DCF valuation models require:
1. estimate of typical buyer’s expected holding period
2. estimates of net (annual) CFs over expected holding
period, including net income from expected sale of
property
3. appraiser to select discount rate (required IRR)
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Exhibit 8-1
Sometimes referred to as a “reconstructed” operating
statement
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Exhibit 8-2
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Potential gross income:
Rental income assuming 100% occupancy
Sometimes referred to as potential gross revenue (PGR)
Important issue:
Should forecast of PGI be based on contract rent (signed
leases) or current market rents?
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First Floor
1,000 sq. ft. suites: 2 x $1,800 x 12 mos. = $43,200
2,000 sq. ft. suite: 1 x $3,600 x 12 mos. = $43,200
Second Floor
800 sq. ft. suites: 5 x $1,560 x 12 mos. = $93,600
Potential Gross Income = $180,000
Note: Estimating first-year contract rent is not usually
this easy!
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Example: Survey of rental rates for other second-
floor offices in market:
Implications: 2nd floor rents in Centre Point average $1.95 /month/sf
($93,600/12/5/800); this is consistent with current market rates of $1.94
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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
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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
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Miscellaneous income
Garage rentals & parking fees
Laundry & vending machines
Clubhouse rentals
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Potential gross income (PGI) $180,000
− Vacancy & collection loss (VC) 18,000 (@10%)
+ Miscellaneous income (MI) 0
= Effective gross income (EGI) $162,000
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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
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Do not include:
Mortgage payments
Tax depreciation
Capital expenditures
Leasing commissions
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CAPX: Non-recurring expenditures that increase
value of structure/prolong its useful life:
Roof replacement
Additions
HVAC Replacement
Resurfacing of parking areas
Tax motivation for classifying a cash expenditure
as an OE (versus CAPX)
if possible?
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Most appraisers Above Line
treat CAPX as EGI
“above line” - OE
expense (see - CAPX
Exhibit 8-4). = NOI
Institutional Below Line
investors usually EGI
treat CAPX as - OE
“below line” = NOI
expense. - CAPX
= Net Cash Flow
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Exhibit 8-4
10% of
PGI
40% of
Above-line EGI
treatment
of CAPX 5% of EGI
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Institute of Real Estate Management (IREM):
www.irem.org
Detailed information on apartments, offices, shopping
centers, federally assisted housing and condominiums, co-
ops, planned communities.
Building Owners and Managers Association (BOMA):
www.boma.org
Large office buildings
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International Council of Shopping Centers (ICSC):
www.icsc.org
Urban Land Institute (ULI): www.uli.org
Local market participants
Other pro formas you have seen
Market knowledge is key!!
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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
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NOI1
Basic value equation: V
Ro
Warning!!!!!!!
Ro is a “cap” rate
Ro is NOT a discount rate!!!!
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1. Obtain estimates of cap rates, Ro,, from
market using “direct market extraction”
NOI1 From the sale of a
Ro comparable property
Selling Pr ice
2. Divide subject’s NOI1 by a weighted average of
the Ros abstracted from the market to obtain an
estimate of value for the subject property
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Step 1: Extract Ro from the market
Note: We have assumed each is equally comparable to subject
From where do you obtain comparable NOIs and sales prices?
Non-disclosure states: Alaska, Idaho, Indiana, Kansas, Louisiana, Maine, Mississippi, Missouri, Montana, New Mexico,
North Dakota, Texas, Utah, Wyoming
Defining the “market” for comparable selection is critically important
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2. Compute estimated market value, using
expected first year NOI (i.e., next 12 months):
$89,100
Value $1,060,714
0.084
Which we round to $1,061,00
Value $89,100 x 11.905 $1,060,735
Which we round to $1,061,00
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Situs Real Estate Research Corporation’s Real
Estate Report: www.rerc.com
RealtyRates.com: www.realtyrates.com
Grubb & Ellis: www.grubb-ellis.com
Newmark Nigh Frank: (www.ngkf.com)
CoStar (www.costar.com)
UF Bergstrom Real Estate Center’s Survey of
Emerging Market Conditions: (www.realestate.ufl.edu)
Other appraisers & market participants
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Direct capitalization only uses first year NOI, but
Ro reflects all future cash flows:
Why? Because transaction prices of the comparables
reflect the value of future cash flows
In turn, the cap rates extracted from these sale
transactions do so as well
Point?
Direct capitalization IS
forward looking?
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Cap Rate Levels
10.0
Red: CBD office
9.0
8.0
Cap Rate (%)
Green: Regional malls
7.0 These are cap rates on high
quality properties
6.0
5.0
Apartments
4.0
1996Q3
1997Q2
1998Q1
1998Q4
1999Q3
2000Q2
2001Q1
2001Q4
2002Q3
2003Q2
2004Q1
2004Q4
2005Q3
2006Q2
2007Q1
2007Q4
2008Q3
2009Q2
2010Q1
2010Q4
2011Q3
2012Q2
2013Q1
2013Q4
2014Q3
2015Q2
2016Q1
2016Q4
Cap rates are obtained from the Real Estate Research Corporation’s Real Estate Report, which publishes results from
RERC’s quarterly Real Estate Investment Survey. The Real Estate Report summarizes the expected rates of return,
property selection criteria, and investment outlook of a sample of institutional investors and managers throughout the
U.S. The property level cap rates displayed above are aggregated across all metropolitan markets.
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Assume the following first-year cash flows for Centre
Point:
Purchase price: $1,056,,000
NOI: $89,100
Sale Price at the end of year 1: $1,077,120 ($21,120 increase)
Costs of sale at end of year 1: $0.00
89,100 21,120
1st year return 10.44%
1,056,000
89,100 21,120
1.056,000 1,056,000
0.0844 0.0200
= cap rate + appreciation rate
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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 & comparable properties
Assumes market rents are paid
Best used for properties with short-term leases
(apartments & rental houses)
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Exhibit 8-6
Indicated value = 6.49 x EGI
of subject
= 6.49 x 162,000
= 1,051,380 rounded to $1,051,000
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Inadequate data on comparable sales due to:
Above- or below-market leases
Differing length of leases & rent escalations
Comparable vs. subject
Differing distributions of operating expenses between
landlord and tenant
Differing prices between institutional & private
investors for similar properties
Result: Discounted cash flow (DCF) analysis can be
preferable
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Very simple lease structure!
Exhibit 8-7
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Very simple lease structure!
Exhibit 8-7
Sale price at end of Year 5 = NOI6 ÷ Rt = $103,291/0.0875
= $1,180,469
Where Rt is a terminal or “going-out” cap rate, slightly
higher than Ro Required
assumption
Sale price (SP) $1,180,469
− Selling expenses (SE) 47,219 @ 4%
= Net sale proceeds (NSP) $1,133,250
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Exhibit 8-8
From Exhibit 8-7
Discount rate presumed to reflect required yield (IRR) in market for
unlevered investments of similar risk
For surveys of unlevered yields, see RERC www.rerc.com
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Exhibit 8-9
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Is direct capitalization using Ro superior to valuation
by DCF?
Fewer explicit assumptions and forecasts are required
What implicit assumption are you making?
NOI1
Ro
Selling Pr ice
Develop Collect, read,
network interpret, and
of data organize data
contacts and reports
Be skilled in
data analysis Fight time
and report deadlines
production
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Problem: Cannot estimate cap rates without actual
comparable sales
Solution 1: Since income-producing RE has both
equity & debt financing, think of cap rate as a wtd.
average of equity cap rate & mortgage cap rate
Equity cash flow = NOI – Debt service
= Before tax cash flow
= BTCF
Loan cash flow = Monthly payment x 12
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Equity = Purchase price – Loan
Equity cap rate = BTCF ÷ Equity
= Re (equity dividend rate)
Loan cap rate = Loan cash flow ÷ loan
= Rm (Loan constant)
Loan-to-value ratio = Loan amount ÷ Price
= m (Mortgage-equity cap rate)
= m x Rm + (1−m) x Re
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Equity dividend rate (from market) = 10.0%
Typical mortgage loan cap rate = 8.0%
Typical loan-to-value ratio = 75%
Mortgage-equity cap rate:
R = 0.75 x 0.08 + (1 − 0.75) x 0.10
= 0.085 or 8.5%
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Recall one-year total yield example:
Total yield = Cap rate + Appreciation rate
=> Cap rate = Total yield – Appreciation rate
Assume required total yield is 11.75%
Assume expected appreciation rate of 2.0%
=> cap rate = 11.75% – 2.0%
= 9.75%
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Direct extraction is preferred, but needs three or
more comparable sales with good information
Choice ultimately depends on quality of data
available for each type of estimate
Reconciliation made by weighting
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End of Chapter 8
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