8. MARKET VALUATION AND APPRAISAL: Valuation Using the Income Approach

This chapter focuses on the third approach to market valuation—the income approach. The income approach includes the valuation of income-producing properties by discounted cash flow (DCF) analysis, direct capitalization, and effective gross income multiples (EGIMs). The mechanics of DCF analysis are the same whether the analysis is used for the purpose of making investment decisions or for valuation. For valuation purposes, however, the viewpoint is different; consequently, the data employed may differ from those used in investment analysis for the same property. To estimate the market value of a property using DCF analysis, an appraiser must use market-derived data. Thus, for appraisal purposes, market data are the inputs, and an estimate of market value is the output. Direct capitalization involves dividing projected net operating income over the next 12 months by a capitalization rate to estimate market value. The income and cap rate could be for any interest in real estate: the fee simple interest, leased fee interest, leasehold inter- est, land only, or building only. The only requirement is that the cap rate is obtained for whatever interest produces the income. In most situations, the value of the fee simple inter- est in a property is estimated, so the relevant income is net operating income (NOI) and the relevant cap rate is an overall cap rate (Ro). Once an Ro is selected, it is used to convert an annual income estimate into an estimate of current market value. In straightforward appraisal situations, direct capitalization can be more accurate and reliable than DCF anal- ysis because the appraiser can rely on the decisions of other investors represented in the sale prices and incomes of comparable properties. It is not necessary to explicitly estimate cash flows over an expected holding period. The sales comparison and cost approach to market valuation should also be applied when reliable data are available. However, these approaches to commercial property valu- ation are usually not considered as reliable as the income approach and are usually weighted less in the final estimate of market value of income-producing properties.

Explain the difference between direct capitalization and discounted cash flow (DCF) models of property valuation.

• Direct Capitalization estimates value by applying a capitalization rate to a single year’s expected net operating income (NOI).

  • It assumes a constant stream of income and a stable market.

  • Formula:

    V=NOI1RV=RNOI1​​

  • Used when future cash flows are expected to be stable.

• Discounted Cash Flow (DCF) involves forecasting multiple years of net cash flows and the reversion (sale) at the end of the holding period, then discounting all these cash flows to present value.

  • More flexible and accurate for complex or changing properties.

The direct capitalization method relies on the ratio of a property’s single-year NOI to its value, while the DCF method discounts a series of expected cash flows and a reversion value to the present

Distinguish between operating expenses and capital expenditures.

• Operating Expenses: Regular, recurring costs necessary to keep the property functional and competitive.

  • Examples: utilities, maintenance, property taxes, insurance.

• Capital Expenditures (CapEx): Costs for replacing or improving assets that extend the life or add value to the property.

  • Examples: new roof, HVAC replacement, structural repairs.

Operating expenses keep the property operating and competitive... Capital expenditures replace worn-out components and add value beyond the current year

Explain the general relationship between discount rates and capitalization rates.

• The capitalization rate is generally lower than the discount rate, because cap rates reflect the net income return without considering future growth in income or a lump-sum reversion.

• Cap rate is typically:

  Cap Rate=Discount Rate−Growth Rate of NOICap Rate=Discount Rate−Growth Rate of NOI

“The capitalization rate is related to the discount rate, adjusted for expected growth in income... A higher expected growth results in a lower cap rate relative to the discount rate

Calculate the overall capitalization rate by direct market extraction given appropriate data.

Formula:

R = NOI1 divided by Sale Price

Example:
If a property sold for $2,000,000 and had a NOI of $140,000,

R=140,000/2,000,000=0.07 or 7%

Cap rates are extracted from comparable property sales by dividing the first-year NOI by the sale price

Describe an effective gross income multiplier (EGIM) approach to valuation and demonstrate its use, given appropriate data.

• EGIM is calculated by:

  EGIM=Sale Price/ EGI

• To estimate value:

  Value=Subject’s EGI × Market EGIM

Example:
If similar properties sell for 6.5× their EGI, and the subject property has EGI = $100,000, then:

Value=100,000×6.5=650,000Value=100,000×6.5=650,000

The EGIM method works best when operating expenses are similar across comparables and the subject property

Develop a five-year net cash flow forecast (pro forma), including the expected cash flows from sale, given appropriate data.

A 5-year pro forma includes:

• NOI for each year: Projected rent – operating expenses

• Net Sale Proceeds in Year 5:

  Reversion Value = NOI6 / Terminal Cap Rate

  Then subtract selling costs (e.g., 6%).

Structure:

Year	NOI
1	$100,000
2	$103,000
3	$106,090
4	$109,273
5	$112,551
Sale Proceeds (NOI6/Cap)	$117,178 / 0.07 = $1,673,971

The investor forecasts annual net cash flows and a reversion value, based on market cap rates and anticipated growth

Estimate an indicated market value by DCF analysis.

Steps:

1. Forecast annual net cash flows (NOI minus CapEx and leasing costs).

2. Estimate reversion value at the end of holding period.

3. Discount all cash flows to present using an appropriate discount rate.

Formula:

Value=∑NCFt/(1+r)t + Reversion(1+r)n

Example (simplified):
Years 1–5: $100,000 annually
Reversion: $1,500,000
Discount rate = 8%

PV of NOI=∑100,000/(1.08) t≈399,271

PV of Reversion=1,500,000/(1.08)^5≈1,020,337

Total Value=399,271+1,020,337=1,419,608

DCF valuation combines multi-year forecasts with a reversion estimate, discounted to present using an investor’s required return

If a commercial property is performing well, what other parties, in

addition to the owner(s), also benefit from this performance?

When a commercial asset is performing well, there is sufficient cash being generated to both service the debt (i.e., make the mortgage payment) and pay all state and federal income taxes. So, both the lender and the income tax collector(s) benefit from good property performance.

List three important ways in which DCF valuation models differ from

direct capitalization models.

Direct capitalization models require an estimate of income for one year. DCF models require estimates of net cash flows over the entire expected holding period. In addition, the cash flow forecast must include the net cash flow expected to be produced by the sale of the property at the end of the expected holding period. Finally, the appraiser must select the appropriate investment yield (required return) at which to discount all future cash flows.

What is “stabilized” net income? Why must the appraiser base her cash flow forecasts on what she believes the typical market partici- pant is expecting?

The appraiser is generally tasked with estimating market value. Thus, it is the expectations of the market that are relevant, not the appraiser’s personal opinion about where the market is heading. Stabilized income means under current market conditions, but adjusted to reflect market rents (not contract rents), “normal” vacancy and collection losses (not current if they are higher than normal), and normal operating expenses and capital expenditures. For example, some- times an investor feels the current owner is not managing the property well in that rents are lower than the market will bear and expenses are higher than they need be. In putting together the reconstructed operating statement, the appraiser values the property under the assumption that the owner will quickly stabilize the property (i.e., bring revenues and expenses to market levels).

Distinguish between contract rent and market rent.

Contract rent is the actual rent being paid under the terms of the lease(s). A listing of these contract rental rates is some- times called the property’s “rent roll.” Market rent is the income the property is capable of producing if leased at current market rates.

How is an operating expense distinguishable from a capital

expenditure?

Operating expenses include the ordinary and necessary expenditures associated with operating an income producing property. They keep the property competitive in its mar ket, but they do not prolong the useful life of the asset or increase its market value. In contrast, capital expenditures are replacements, alterations, or additions significant enough to prolong life and increase value.

If capital expenditures are subtracted from revenues in the calcula-

tion of NOI, is this an above-line or a below-line treatment?

When capital expenditures are subtracted (i.e., taken out) in the calculation of NOI, this is referred to as an “above-line” treatment of capital expenditures.

Assume the estimated first-year NOI of the subject property is $400,000. Also assume that data from the sale of comparable prop- erties indicates the appropriate cap rate is 9 percent. What is the indicated value of the subject property?

The indicated value is $4,444,444 ($400,000 / 0.09).

If new information suggests that rents in a market are going to increase at a faster rate than what had been projected, what will happen to the cap rates that appraisers abstract from this market after this new information becomes known to market participants?

f new information suggests that rents are going to increase at a faster rate, but yo (the required total rate of return) has not changed, then capitalization rates will fall because Ro = yo – g. Said differently, if a larger portion of the required total return is going to come in the form of future rent growth and price appreciation, then a smaller portion of the total return needs to be obtained from the current cash flow.

If an appraiser concludes that the rents of a subject property will grow faster than the rents of comparable properties, how would the appraiser adjust for this when reconciling the EGIMs abstracted from the comparable sales? How would this adjustment affect the esti- mate of value for the subject?

If the appraiser believes that the subject’s rents will grow faster than the rents of the comparable properties, then an investor can justify paying a higher price per dollar of cur- rent rental income. Thus, the appraiser should adjust upward the EGIM abstracted from the market, which would imply a higher estimated value for the subject property.

Explain why DCF analysis, as commonly used in market valuation, is

really a combination of DCF and direct capitalization.

DCF analysis requires an estimate of the value of the property at the end of the assumed holding period. The most common method used to estimate the market value of the property at the end of, say, 10 years, is to capitalize the NOI estimate in year 11 into an end-of-year 10 value. Thus, DCF is a combination of DCF analysis and direct capitalization.