Real Estate Appraiser Guidelines - Part 7x - 2/9/2004 - Expert Real Estate Advice

Real Estate Appraiser Guidelines - Part 7

INCOME (CAPITALIZATION) APPROACH 

The income approach is concerned with the present worth of future benefits (the income stream) which may be derived from a property. This method is important in the valuation of income-producing property, although it can rarely be relied on as the only approach. An important consideration in this approach is the net income which a fully informed person using good management can expect to receive during the remaining useful life of the improvement. An alternative, using gross income and the Gross Rent Multiplier (GRM) is explained later in this chapter. 
 
The process of calculating the present worth of a property on the basis of its capacity to continue to produce an income stream is called capitalization. The capitalization approach is based primarily on the appraisal concepts of comparison, substitution and anticipation. 
 
Appraiser’s and Owner’s Viewpoints A real estate professional will understand that there are several differences in the owner’s and appraiser’s viewpoints on income property.  

An owner purchases income property as an investment, based on personal desires and tax position. The owner frequently views the investment as equity in a financed property. “Equity” is the owner’s down payment or the difference between the loan amount and the value or price of the property. The owner calculates the payments on the loan as an expense of owning the property, and deducts from income tax the interest paid on the loan and the “book” depreciation from the purchase price or cost basis. The owner can deduct only actual expenses, not reserves for future expenses, and can compute gross income only from income actually collected (or owed), not just projected. The owner looks for a profitable resale or exchange at a higher price or favorable tax position. In most cases, the appraiser will ignore these personal considerations.  

The appraiser reconstructs expense and income into amounts the well-informed investor would anticipate, without specific regard for personal equity, spendable income, or tax consequences. Using methods outlined below, an appraiser analyzes an income property to ascertain its value to the market generally, i.e., the Fair Market Value. 
 
Capitalization 
Capitalization is the mathematical process of estimating the present value of income property based on the amount of anticipated annual net income it will produce. Capitalization converts the future income stream into an indication of present worth of property. There are several methods of capitalizing net income. Our discussion will deal with the direct method. 
 
There are four types of capitalization (cap) rates used in the appraisal process: 

> The interest rate is the rate of return on invested capital. It is the same as the yield rate or risk rate. It does not include any provision for the return of investment capital. 
> The recapture rate is the rate at which invested funds are being returned to the owner. 
> The capitalization rate is derived from the interest rate and the recapture rate. 
> The overall rate is derived from the relationship between net income and value for the total property and theoretically provides in one rate for both return on, and recapture of, the capital investment. The overall cap rate is an income rate. Any interest in income producing property can be valued using this rate but appraisers apply it most commonly to fee simple estates. 
 
Capitalization rates may be estimated by several methods: 

> market or sales data; 
> band of investment (uses a weighted average rate by combining a rate for mortgage loan money and a rate for investor’s equity); or > summation (has very limited use - involves building up a “safe” interest rate based on various risk/investment factors).  
Of course, the market or sales data method involves an appraiser’s systematic comparison of recent sales of similar properties.

The appraiser analyzes each comparison property’s sales price, rents, expenses, net income and cap rate, makes needed adjustments and selects an appropriate indicated overall cap rate for the property being appraised. This rate represents both the return on and the return of the investment. To ensure reliability of the selected rate, the appraiser uses judgment and experience to make certain the comparables and the subject property have similar age, physical, location, income, expense and risk characteristics.  

Capitalization rate formula. The capitalization rate is a combination of the interest rate (return on the investment) and the recapture rate (return on the investment in improvements). If only the land produces income, the cap rate and interest rate are the same. However, when improvements contribute to the income production, a provision must be made for recapture of the value of the improvements before the end of their economic life. Land has no limited economic life; it will never wear out and thus will always be able to produce income. The building is a wasting asset and cannot be used indefinitely. 
 
The most common method of providing for recapture of the investment in the improvements is the “straight line” method, with the building value recaptured in equal annual installments. The recapture rate is computed by dividing the remaining economic life of the improvements into 100%. Thus, the annual recapture rate for a building with an estimated remaining economic life of 40 years is 2.5% (100% ÷ 40). If the remaining economic life is 25 years, the recapture rate is 4%.  

To find the indicated value of income property, divide the net annual income by the capitalization rate: 

Net Annual Income ÷ Capitalization Rate = Property Value 
or
I ÷ R = V 
 
If any two factors in this formula are known, the third can be obtained. 
I = R x V 
and
R = I ÷ V 
 
INCOME APPROACH PROCESS 

The main steps to calculate value by capitalizing income are: 

> Determine the net annual income; 
> Select the appropriate cap rate by market comparisons; and Capitalize the income (divide the net annual income by the cap rate). 
 
Determining Net Annual Income 
The procedures for determining net annual income are: 

> Estimate potential gross income the property is capable of producing. 
> Deduct from potential gross income an annual allowance for vacancy factor and rent collection loss. The remainder is called “effective” gross income or adjusted gross income. 
> Deduct from adjusted gross income the estimated probable future annual expenses of operation (fixed expenses, variable expenses, reserves for replacements for building components or short-lived items) to obtain the net income of the investment property. 
 
Income and expenses. The potential gross income used is the expected future income. In many cases, the immediate past or current income may be an indicator of future income. However, reliance solely upon past or current income is incorrect. The income to use is the one which the purchaser and seller anticipate over the remaining productive life of the improvement, as adjusted for foreseeable economic changes. 
 
Income estimates. The gross income estimate for an income property is the potential or anticipated gross income from all sources (market rents, services, parking space fees and rentals, and coin-operated equipment, etc.). Gross income is estimated as of the date of the appraisal. Contract rent is the actual, or contracted, rent received from the property. Market rent is the rent the property should bring in the open market at the date of appraisal. Rents and vacancy factors and collection losses are based on current market rent data. The appraiser uses his/her judgment of the area in arriving at an allowance for vacancy and collection losses. 
 
Rent data is obtained from the subject property’s rent schedule and the appraiser’s review of rents from similar recent sales in the area. Individual apartments or units of the comparables are compared with the subject property, using square footage, number of bedrooms, or similar items of comparison. It is assumed management for all properties is adequate. Cost of deferred maintenance or repairs is an adjustment item.  

Market rent schedules and expenses are usually maintained on a monthly basis. Both must be converted to an annual basis. 
 
Expenses must be realistic. The operating expenses (all expenditures necessary to produce income) are to be deducted from the effective gross income to find the net operating income expected from the property. The appraiser must use caution in extracting expense information from owner’s operating statement as some items included on the operating statement, such as principal and interest payments on mortgages and depreciation allowance for income tax purposes, must be disregarded by the appraiser as not being allowable expense items.  

These non-allowables may include entertainment expenses and other items of personal expense, and capital improvement expenditures. Since most operating statements are prepared by accountants for tax and accounting purposes, appraisers usually must reconstruct them to properly forecast annual expenses. 
 
Expenses are generally classified as being one of the following: 

> Fixed expenses. These are incurred annually with relatively little change from year to year. They are to be paid whether the property is fully occupied or not. These items include taxes, insurance, licenses and permits. 
> Variable expenses. These expenses are incurred continually in order to maintain and give service to the property. They are variable depending upon the extent of occupancy and include items such as utilities, management fees, security, costs of administration, maintenance and repairs for structures, grounds and parking area maintenance, contracted services (e.g., rubbish removal) and payroll. 
> Reserves for replacements. This is an annual allowance for replacing worn out equipment and building components, such as stoves, carpets, draperies, roof covering. 
 
Selecting the Cap Rate 
The appraiser selects an appropriate overall capitalization rate (“present worth” factor) after market analysis of similar properties.

This rate provides for return of invested capital plus a return on the investment).  

The rate is dependent upon the return which investors will actually demand before they will be attracted by such an investment. The greater the risk of losing the investment, the higher will be the accompanying rate as determined in the market for such properties.

By analyzing market prices, the rate can be approximated at any given time. 
 
A variation of only 1 percent may make a substantial difference in the capitalized value of the income. 
 
For example, based on an annual net income of $30,000, and a capitalization rate of 6 percent, the capitalized property valuation would be $500,000 (income ÷ rate). Capitalizing this same income at a rate of 7 percent would result in a value of only $428,500 (rounded). 
 
Capitalizing Net Annual Operating Income 
The final step after having determined the net annual income and the capitalization rate is to capitalize the income. This may be merely the mathematical calculation of dividing the income by the rate if the income is considered to be in perpetuity. For example, the valuation of property which has an assumed perpetual annual net income of $30,000 and a capitalization rate of 5 percent is $600,000. The lower the rate, the greater the valuation, and the greater the assumed security of the investment. So ­called annuity tables are used in capitalizing incomes for fixed periods of varying duration. 
 
As stated earlier, an important element in all capitalization rates is provision for a return of the investment on the improvements to the property during their remaining economic life. This may be called an amortization of such investments. It may be provided for by straight-line depreciation, which recovers a definite sum every year for the period of years estimated to be the economic life of the improvement, at the end of which time the cost of improvement will be accrued. It may also be provided for by other methods, such as establishing “sinking funds” or a declining balance depreciation. These are more technical procedures which are used by professional appraisers. 

INCOME APPROACH APPLIED 

Using procedures just discussed, here are two examples for finding estimated value using the income approach. 
1. How much should an investor pay for a 10 unit apartment house, 24 years old, estimated fair market rent per unit being $500 per month. Indicated vacancy factor is 7%. Acceptable cap rate is 8 percent. Fixed expenses are: taxes of $3,200 and insurance of $860. Operating expenses are: management - $3,960; utilities - $1200; waste removal - $600; reserves for replacement - $1,700. 

2. A small commercial building has rental income of $27,650 annually and suffers vacancy/collection losses of 5%. Expenses include: taxes $3,780; utilities $850; roof reserve $1,500; insurance $1,100; maintenance $2,000; repainting and fixture reserve $500; and management $2,000. The appraiser finds similar properties have cap rates ranging from 8.75% to 9.37%. Based on this market data the appraiser selects an indicated overall capitalization rate for the subject property of 9%. Using the Income Approach, what is the indicated value of the property? 

RESIDUAL TECHNIQUES 

Suppose vacant land returns net income of $6000 a year and the applicable interest rate for this type of real property is 7 percent. Using the income method, the property has a value of $85,715 ($6,000 ÷ .07). 
 
However, income from improved property is the result of the contribution of both land and buildings. The buildings have limited economic life and their value must be recaptured over their remaining economic life. Income attributable to land is deemed perpetual. 
 
There are three methods to capitalize income from improved property. They are each a “residual technique” because capitalization is applied to the residual (leftover or unknown) net income attributable to the property as a whole, to the building, or to the land. The appropriate technique would be selected based on market data. The same net income figure applies in all three methods.  

Property Residual Technique 
This is the simplest method of capitalizing the net income from improved property because the property is valued as a single unit (used when the value of neither land nor improvements can be estimated independently). The property’s total net income is capitalized directly at an overall rate developed from the market data, comparing similar income producing properties which are also similar in the way net income is estimated.  

Example. The net income generated from real property is $32,000 annually and the overall cap rate selected from the market data approach is 9%. What is the value of the property? 

> Income ÷ Rate = Value
> $32,000 ÷ .09 = Value
> Value = $355,556 
 
Building Residual Technique 
If the value of the land is known and the value of the building is unknown, the property’s value may be determined by the building residual technique. This technique allocates the net income of the property to both land and building. The procedure is:

1. Multiply the known land value by the applicable interest (i.e., return) rate on the land to determine the income attributable to land only. 
2. Deduct income to the land from total net income to determine the balance (“residue”) of the net income which represents the portion of the income attributable to/earned by the building.
3. Capitalize the building’s income at the overall cap rate (interest rate plus recapture rate) to derive the value of the building. 
4. Add the capitalized value of the building to the land value to arrive at the value of the whole property. 
 
Example. An appraiser estimates that a 60 unit apartment building has an estimated remaining economic life of 25 years. The annual net income of the property is forecast at $216,000. On the basis of several comparables, an appraiser estimates that the land value is $60,000 and the applicable rate of interest for this type of investment property is 8%. What is the indicated value of the property by the income approach? 

Land Residual Technique 

If the building value is known and the land value is unknown and cannot be determined separately, the value of the property as a whole may be estimated by using the land residual technique. The land residual technique is similar to the building residual technique except that the appraiser must first find the income attributable to the improvements and the residue (balance) of the income is then attributable to the land. The procedure is: 

1. Multiply the known improvement value by the applicable building capitalization rate (interest rate plus recapture rate) to determine the income attributable to the building only. 
2. Deduct income to the building from the total net income to determine the residue (balance) of the net income attributable to/earned by the land. 
3. Capitalize the land’s income at the interest rate only (since it is not necessary to recapture the permanent land value) to derive the value of the land. 
4. Add the capitalized value of the land to the building value to arrive at the value of the whole property by the land residual technique. 
 
Example.  Same facts as the building residual technique example above. 

Finding the Overall Cap Rate - Example 

A property sells for $250,000. Building value is $190,000. Remaining economic life is 25 years. Annual net income from building is $28,000. What is the interest rate for the building? What is the overall cap rate? 

YIELD CAPITALIZATION ANALYSIS 

Now preferred over the residual techniques discussed above, yield capitalization analysis is a method of converting economic benefits of ownership into present value by discounting each anticipated benefit at an appropriate yield rate, or by developing an overall capitalization rate that explicitly reflects the required yield rate and anticipated changes in income and/or value, if any. The yield rate is a rate of return on capital. This method simulates typical investor assumptions by using formulas that calculate the present value of future economic benefits based on specified rate of return requirements. 
 
The future economic benefits that are typically considered in this analysis are periodic cash flows and reversion. The procedure used to convert these future economic benefits into present value is called discounting, and the required rate of return (or yield rate) is referred to as the discount rate. The discounting procedure is based on the assumption that the investor will receive an adequate rate of return on the investment, plus return of the capital invested. Unlike direct capitalization using market-extracted rates, the method and timing of the returns on and of capital are explicit in yield capitalization analysis. This valuation method can be used to value the fee simple interest in a property, or any property interest for which all future economic benefits can be estimated. 
 
The most common form of yield capitalization analysis is called discounted cash flow analysis. In this valuation technique, each anticipated future economic benefit of ownership of the property or property interest being valued must be estimated. Next, each benefit is discounted to present value using a discount rate that reflects the risk associated with the characteristics of the investment. This rate cannot be extracted directly from sales (as can an overall capitalization rate), but must be based on market attitudes and expectations for rates of return for similar assets. Yield rates inherently include a safe, risk-free rate, along with premiums to compensate the investor for the added risk, illiquidity, and burden of management associated with the specific investment. The safe rate included in the yield rate includes an inflationary expectation for the anticipated term of the investment. The discounting process can be performed using formulas and factors obtained from financial tables, or by using financial calculators or personal computers. 
 
The following discounted cash flow analysis example summarizes the application of yield capitalization analysis to a simple real estate problem. The property to be appraised is expected to produce a first-year net operating income of $100,000, which is expected to increase at 3 percent per year over a seven-year holding period. At the end of the holding period, it is anticipated that the property can be sold for $1,000,000 net of sales expenses. The appropriate yield rate for this investment is concluded to be 13 percent. The following table shows the anticipated cash flows, along with the present value factors and the calculated present value of each year’s cash flow.

TOTAL PRESENT VALUE: $902,339; rounded to $900,000. 

(The present value factors in this analysis were calculated using a financial calculator, but could have been obtained from a set of financial tables.)