Real Estate Appraisal

Engr. Gian Carlo Bero, REB, REA, ECE

INCOME APPROACH

Direct Capitaliza�on
General Working Formula:
𝑁𝑁𝑁𝑁𝑁𝑁
Value =
𝑟𝑟

INCOME APPROACH
• Under the income capitaliza�on approach, the value of a property is related to the income it
can produce.
• Its underlying principle is Principle of An�cipa�on which states that value of any property is the
present worth of future benefits; the �me value of money by reducing or discoun�ng future
income to its present worth
• The process requires an accurate es�ma�on of income and expenses and the selec�on of a
capitaliza�on rate and capitaliza�on technique by which net income is processed into value.
• The primary advantage of the income capitaliza�on approach is that it approximates the
thinking of the typical investor, who is interested in the return on, as well as the return of, an
investment in income-producing real estate.
• The disadvantages of the income capitaliza�on approach is that a complex set of rela�onships
must be developed and these complexi�es tend to confuse non-appraisers.

Basic Steps in Income Approach

1. Es�mate the annual gross income the property is capable of producing
2. Es�mate typical vacancy and collec�on losses
3. Subtract rent losses from gross income to arrive at the effec�ve gross income
4. Es�mate annual expenses and subtract them from the effec�ve gross income to determine the
net income (or net opera�ng income)
5. Analyze comparable investments to arrive at a capitaliza�on rate and method appropriate for
the subject property
6. Divide the net opera�ng income by the capitaliza�on rate to obtain the capitalized value

HOW TO DETERMINE THE NET OPERATING INCOME (NOI)

Rent - – is the major source of income from most investment real estate

Market Rent - also known as Economic Rent

- an estimate of a property’s rent poten�al
- it is what an investor can expect to receive in rental income if the subject is currently available for a
new tenant
- must consider not only present rents paid by tenants but also past rents and rents currently paid for
comparable proper�es in the area

Historical Rent - rent paid in past years

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Scheduled Rent - also known as Contract Rent
- rent currently being paid by agreement between tenant and landlord

Sources of Data for Scheduled Rent

• Lessee – the person or company ren�ng or leasing the property
• Lessor – the owner of the property
• Property Manager – the one who maintains the property
• Real Estate Brokers/ Salespersons

Other Income
• Laundry Machines
• Vending Machines
• Parking Area Rentals
• Etc

Poten�al Gross Income (PGI) - a property’s total poten�al income from all sources during a specified
period of �me, normally a year

Effec�ve Gross Income (EGI) - total poten�al income from all sources less allowance for vacancy/ bad
debts (usually around 5-10%)

Opera�ng Expenses (OpEx)

- costs incurred to maintain the property and to con�nue the income stream

Classification of Operating Expenses:

• Variable Expenses - out of pocket costs for management, salaries, benefits, fuel, u�lity
servces, repairs and maintenance, etc, required to operate the property. Variable expenses
tend to vary with occupancy
• Fixed Expenses – costs that are more or less permanent regardless of occupancy. Ex. real
estate taxes, insurance for fire, the� and hazards
• Reserves for Replacement and Allowances – allowances for replacement of building parts
that have short life expectancy such as aircon, roofing, etc.

Accoun�ng versus Appraisal

Opera�ng expenses for appraisal purposes do not include expenditures that are beyond the
direct opera�on of an income-producing property.
1. Financing costs.
The focus of a market value opinion is the property's produc�vity-its NOI.
2. Income tax payments.
Income taxes relate to the owner, not the property.
3. Deprecia�on charges on buildings or other improvements.
The process of capitaliza�on automa�cally provides for the recovery of the investment.
4. Capital improvements.
the payments for capital improvements are not treated as opera�ng expenses but are taken
from the replacement reserve monies.

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 RECONSTRUCTING THE OPERATING STATEMENT

ACCOUNTANT’S FIGURES
Gross Income (Rent) P560,000.00
Allowance for Vacancies and Bad Debts ---
Effec�ve Gross Income ---
Opera�ng Expenses
Salaries and wages 60,005.00
Employees’ Benefits 5,190.00
Electricity 9,001,20
Gas 30,146.00
Water 4,001.00
Pain�ng and decora�ng 10,000.00
Supplies 5,255.60
Repairs 20,243.00
Management 30,000.00
Legal and accoun�ng fees 8,000.00
Miscellaneous expenses 4,000.00
Insurance (three-year policy) 15,000.00
Real estate taxes 51,000.00
Reserves
Roof replacement ---
Plumbing and electrical ---
Payments on air condi�oners 12,000.00
Principal on mortgage 15,000.00
Interest on mortgage 100,000.00
Deprecia�on-building 80,000.00
Total Expenses 458,843.80
Net Income 101,156.20

APPRAISER’S ADJUSTED ESTIMATE

Gross Income (Rent) P587,000.00
Allowance for Vacancies and Bad Debts 29,000.00
Effec�ve Gross Income 558,000.00
Opera�ng Expenses
Salaries and wages 60,000.00
Employees’ Benefits 5,000.00
Electricity 9,000,00
Gas 30,000.00
Water 4,000.00
Pain�ng and decora�ng 10,000.00
Supplies 5,00.00
Repairs 20,000.00
Management 30,000.00
Legal and accoun�ng fees 8,000.00
Miscellaneous expenses 4,000.00
Insurance (yearly policy) 5,000.00
Real estate taxes 51,000.00
Reserves
Roof replacement 5,000.00
Plumbing and electrical 10,000.00
Payments on air condi�oners ---
Principal on mortgage ---
Interest on mortgage ---
Deprecia�on-building ---
Total Expenses 256,000.00
Net Income 302,000.00

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[EXERCISE] In the list below, which are NOT an expense from an appraiser’s point of view?
Gas and Electricity
Deprecia�on on building
Water
Real Estate taxes
Building Insurance
Income Tax
Supplies
Payments on air condi�oners
Janitor’s salary
Management fees
Maintenance and repairs
Legal and accoun�ng fees
Principal and interest on mortgage
Adver�sing
Paint and decora�ng
Deprecia�on on equipment
Value of janitor’s apartment (rent free)
Water and sewer tax
Salaries and wages of employees
Reserves for Replacement
Payments on Stoves and Refrigerators

OPERATING STATEMENT RATIOS

Opera�ng Expense Ra�o - The ra�o of the total opera�ng expenses to effec�ve gross income
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
OpEx Ra�o =
𝐸𝐸𝐸𝐸𝐸𝐸

Net Income Ra�o - The ra�o of the net opera�ng income to effec�ve gross income
𝑁𝑁𝑁𝑁𝑁𝑁
NOI Ra�o =
𝐸𝐸𝐸𝐸𝐸𝐸

Break-Even Ra�o - The ra�o of funds (before taxes) flowing out of the property to funds coming in
- The ra�o of opera�ng expenses plus annual debt service to poten�al gross income
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂+𝐴𝐴𝐴𝐴𝐴𝐴
Break-Even Ra�o =
𝑃𝑃𝑃𝑃𝑃𝑃

By comparing the various ra�os for proper�es comparable to the one being appraised, the appraiser can
learn what kind of return is expected in the marketplace for proper�es producing that level of income.

Ra�os are par�cularly useful tools when they either confirm that a property's income and expenses are
in line with those of other proper�es or indicate an abnormality that warrants further inves�ga�on.

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 DETERMINING THE NOI
Net Opera�ng Income (NOI)
- is calculated by deduc�ng the opera�ng expenses of owning a property from its effec�ve gross income

Poten�al Gross Income

Less: Allowance for Vacancies and Collection Losses
Effec�ve Gross Income

Less: Operating Expenses

NET OPERATING INCOME

Example 1:
What is the poten�al gross yearly income of 30 apartment units that has 20 units two-bedrooms earning
at P17,500 each per month and 10 units one-bedroom ren�ng for P4,500 each per month, whereby 14
two-bedroom units and 8 one-bedroom units were occupied?
Solu�on:
PGI = (1BR)(1BR Rent)(12) + (2BR)(2BR Rent)(12)
PGI = (10)(4500)(12) + (20)(17500)(12)
PGI = 540,000 + 4,200,000
PGI = 4,740,000 per year

Example 2:
A 100-unit apartment complex includes 70 one-bedroom and 30 two-bedroom units that are rented out
for Php7,000.00 and Php15,000.00 respec�vely. The apartment complex has vacancy rate of 8%, a
miscellaneous income Php45,000.00 per year and an annual opera�ng expense of Php600,000.00.
Compute the effec�ve gross income of the apartment complex.
Solu�on:
EGI = (1BR)(1BR Rent)(12)(0.92) + (2BR)(2BR Rent)(12) (0.92) + Misc Income
EGI = (70)(7000)(12)(0.92) + (30)(15,000)(12)(0.92) +
45,000
EGI = 5,409,600 + 4,968,000 + 45,000
EGI = 10,422,600

Example 3:
An office building which is 7 years old has been rented out with a total annual gross rental of P15M.
Average vacancy rate is 12% and the total annual opera�ng costs has been P3.5M. What is the Net
Opera�ng Income of the building?
Solu�on:
NOI = EGI – OpEx
EGI = PGI – Vacancy
EGI = 15M – (0.12)(15M)
EGI = 13.2M
NOI = 13.2M – 3.5M
NOI = 9.7M

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 HOW TO DETERMINE THE CAPITALIZATION RATE

DETERMINING THE CAP RATE

Capitaliza�on Rate
• also known as Overall Capitaliza�on rate
• It is the rela�onship between the annual net opera�ng income of a property and its value (or the
ra�o of net income to value)
• theore�cally it comprises both return on investment and return of investment but the
propor�ons are usually unknown

Interest Rate
• It is the rate of return on invested capital (return on investment)
• synonymous with yield rate and discount rate;
• does not include provision for return of investment capital

Recapture Rate
• rate at which invested funds are being returned to the investor (return of investment)

Example 4:
An investor paid P50,000,000 for a building that earns a net income of P5,000,000 a year. What is the
capitaliza�on rate of the investment?
Solu�on:
𝑁𝑁𝑁𝑁𝑁𝑁
Value =
𝒓𝒓
NOI
r=
V
5,000,000
r=
50,000,000
r = 10%

BUILDING A CAP RATE

Thru Comparable Sales

Comparable Selling Price NOI Cap Rate

A 1,360,000 148,000 10.88%
B 940,000 110,000 11.70%
C 1,270,000 150,000 11.81%
D 1,105,000 126,000 11.40%
E 1,500,000 320,000 21.30%
Notes:
1. Comparable E’s capitaliza�on rate appears out of line compared with the other four
comparables. Therefore, E’s cap rate will be disregarded.
2. Average capitaliza�on rate using the remaining four comparables is 11.45%

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SAMPLE PROBLEMS

Example 5:
A vacant lot is rented for a car display for P24,000 a month. The interest rate applicable to this type of
property is 8%. Compute the value of the property by the income approach
Solu�on:
𝑁𝑁𝑁𝑁𝑁𝑁
V=
𝑟𝑟
24000 ∗12
V=
0.08
V = 3600000

Example 6:
If comparable A was sold for 4,865,000, the PGI is 851,060, the EGI is 750,000, and the opera�ng
expenses are 255,000, what is the overall capitaliza�on rate?
Solu�on:
𝑁𝑁𝑁𝑁𝑁𝑁
V=
𝑟𝑟
𝑁𝑁𝑁𝑁𝑁𝑁
r=
𝑉𝑉
750,000-255,000
r=
4,865,000
r = 0.1017

GROSS INCOME MULTIPLIER (GIM) / GROSS RENT MULTIPLIER (GRM)

GIM / GRM THEORY

• The rela�onship between sales and rental prices can be expressed in a ra�o which is the GIM or
GRM
• GIM/GRM Theory: Rental prices and sales prices generally react to the same market influences.
They tend to move in the same direc�on and in the same propor�on

Gross Income Mul�plier (GIM)

• usually used in commercial and industrial proper�es where annual income from all sources are
considered
• usually uses gross annual income
• Also known as poten�al gross income mul�plier

Gross Rent Mul�plier (GRM)

• applicable to single-family residences which usually produce only rental income.
• usually uses gross monthly rental income

Example 7:
A commercial property was sold a month ago for P90,000,000. The annual gross income is P10,000,000.
What is the GIM for the property?
Solu�on:
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉
GIM =
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
90,000,000
GIM =
10,000,000
GIM = 9
DETERMINATION OF VALUE USING GIM

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Thru Comparable Sales

Comparable Selling Price Annual Gross Income GIM

1 4,000,000 400,000 10
2 4,500,000 500,000 9
3 3,610,000 380,000 9.5
4 4,675,000 550,000 8.5
5 4,275,000 450,000 9.5
Subject ??? 420,000 Average: 9.3

Notes:
1. Average GIM using the five comparables is 9.3
2. Subject property value can be computed by using the formula V = (Annual Gross Income)(GIM)
3. V = 420,000 (9.3) = 3,906,000

Please do not distribute this learning material | Engr. Gian Carlo Bero, REB, REA, ECE | 09175980215