THE INCOME APPROACH

Chapter 13

CHAPTER TERMS AND CONCEPTS

Amenities

Capital recovery

Capitalization

Capitalization rate

Contract rent

CPI lease

Direct capitalization

Effective gross income

Excess rent

Fixed expenses

Gross income

Gross income multiplier (GIM)

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Income property

Intangible benefit

Lease term

Market rent

Minimum or base rent

Net income ratio

Net operating income

Operating expense ratio

Operating expenses

Operating statement

Overage rent

Percentage lease

CHAPTER TERMS AND CONCEPTS

Potential gross income

Present worth of future benefits

Recapture

Rent roll

Reserves for replacements

Return of investment

Return on investment

Step-up (or “graduated”) lease

Straight (or “flat”) lease

Tangible benefit

Variable expenses

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LEARNING OUTCOMES

1. Distinguish between the tangible and intangible benefits of property ownership.

2. Name the six steps in the income approach to value.

3. Explain the use of gross income multipliers in the income approach.

4. Define the terms contract rent and market rent as used in appraisals.

5. Name the three main categories of expenses and give examples of items in each.

6. Outline the procedure used for reconstructing the owner’s operating statement.

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Types of Income Property

1. Multiple-family residential, including large and small apartment buildings.

2. Commercial buildings, including stores, offices, medical offices, convalescent hospitals, hotel and motel properties, and shopping centers.

3. Industrial properties, such as warehouses and factories.

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MOTIVES AND BENEFITS OF PROPERTY OWNERSHIP

Intangible Benefits

Pride of ownership

Sense of security

Personal opportunity

Tangible Benefits

Return on investment

Return of investment

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CHARLEY’S SAVING ACCOUNT

How Much is in Charley’s Savings Account?

Amount on Deposit?

$216

$600

$360

$6,000

We give 6%Hi Charley! Here’s your $36 annual check!

Capitalization

• the process of converting an income estimate into a value estimate.

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IRV FOR VALUE

The Value Formula

Key Horizontal line indicates division Vertical line indicates multiplication

Formulas Value = I/R Rate = I/V Income = R X V

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BASIC STEPS: INCOME APPROACH

• Estimate the Annual Gross Income

• Estimate Vacancy and Other Losses

• Subtract to Get Effective Gross Income

• Subtract Operating Expenses to Get Net Operating Income

• Arrive at a “Cap” Rate and Method

• Divide Net Operating Income by Capitalization Rate

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Analysis of GIM

Gross % Net Cap    

Income Expenses Income Rate Price GIM

$30,000 40.00% $18,000 6% $300,000 10

$30,000 50.00% $15,000 6% $250,000 8.3

$30,000 60.00% $12,000 6% $200,000 6.7

Gross Income Multipliers

GIM = Price ÷ Gross Income

Price Gross Income GIM

$300,000 $30,000 10.0

$250,000 $30,000 8.3

$200,000 $30,000 6.7

Effect of Expense Ratios

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Analysis of GIM

GIM Varies with: Location Intangible Amenities Number of Units Expense Ratio Size of Units Services Included

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MARKET RENT

Market Rent Defined Potential gross rent Assumes no encumbrances Assumes efficient management Measures all the property rights

o Overage Rento Excess Rent

Responsibility for Expenseso Landlordo Tenanto Shared

Contract Rent

• rent being paid under some form of contract that is binding on both owners and tenants. Such rental agreements range from simple oral contracts to complex leases that are beyond the scope of this book.

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Types of tenancieso Month to Montho Short-term Leaseo Long-term Lease

Common Lease Typeso Straighto Step Upo Percentage o Combinations

CONTRACT VS. MARKET RENT

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OPERATING EXPENSES

What to Include: Include Property-Related Expenseso Current Operating Expenseso Projected Expenditureso The Value of Owners Efforts

Exclude Owner-Related Expenses, such as:o Loan and Interest Paymentso Income Taxeso Depreciation

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OPERATING EXPENSES CATEGORIES

Operating Expense Categories Variable Expenses Fixed Expenses Reserves for Replacement

INCOME AND EXPENSE RATIOS

Income and Expense Ratios

The Net Income Ratio = NOI ÷ EGI

The Operating Expense Ratio = Operating Expenses ÷ EGIo NOI = Net Operating Incomeo EGI = Effective Gross Income

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An Owner’s Operating Statement

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A Reconstructed Operating Statement

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SUMMARY

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An overview of the income approach as it applies to various types of residential income, commercial, and industrial properties was also included. The income approach can either analyze the income year-by-year, or by emphasizing one year. Income property appraisals require an estimate of income and expenses for the property. A knowledge of typical expense ratios assists in the reconstruction of operating expense statements.