2.2 Appraisal - Income Approach to Valuation

What are the three appraisal methods used to solve for present value in real estate?

Sales comparison approach
- Past comp sales

Cost approach
- Current depreciated cost

Income approach
- Future capitalized cash flows

Income approach:
What is the rationale behind the income approach in real estate valuation?

The value of an income property is considered the present value of its anticipated future cash flows.

Income approach:
What is another term for the income approach in real estate appraisals?

Income capitalization

Income approach:
What does "income capitalization" mean

The process of converting future income into a lump sum present value of that future income.

Income approach:
What types of properties are valued using the income approach?

Income properties i.e. properties that generate income cash flows from operations, such as rents.

Types of income valuation:
What are the two types of income valuation methods in real estate?

- Discounted cash flow (DCF)
- Direct capitalization (DC)

Types of income valuation:
How does the discounted cash flow (DCF) method estimate present value?

Discounts multiple years' cash flows at a required return (a/k/a discount rate) to estimate present value

Types of income valuation:
How does the direct capitalization (DC) method estimate present value?

Applies a capitalization rate (cap rate) or multiplier (multiple) to a single year's cash flow to estimate present value

Types of income valuation:
What do both DCF and DC methods use to estimate the present value of a property?

Estimated future net cash flows from the property's operations (rents net of expenses) or disposition/sale (sales proceeds net of sales costs).

DCF:
What does the DCF method involve estimating in real estate valuation?

All future cash flows over the assumed holding period:
- Operating net cash flows from rents
- Terminal net cash flow from sale/disposition at the end of the holding period.

DCF:
What does the term "required return" represent in the DCF method?

The expected return on investments of similar risk, also known as the "opportunity cost."

DCF:
How does the DCF method solve for the present value of an investment?

Tells us the amount to pay today that would yield the required return on the investment given the estimated future cash flows
-> essentially valuing the investment in reverse.

DCF elements:
What are the key elements that need to be estimated in the DCF method?

- Expected holding period
- Net cash flows over the holding period from both operations and sale
- The required return (discount rate)

DCF elements:
What do net cash flows from the property include in the DCF method?

- Net operating income (NOI) from operations
- Net sales proceeds (NSP) from the sale.

DCF elements:
What is the objective of DCF valuation in real estate?

To determine the objective market value based on typical market participants, rather than the appraiser's subjective opinions.

What is the formula for estimating NOI?

Potential gross income (PGI)
- Vacancy and collection loss (VC)
+ Miscellaneous income (MI)
---------------------------------------
= Effective gross income (EGI)
- Operating expenses (OE)
- Capital expenditures (CAPEX)
---------------------------------------
= Net operating income (NOI)

Potential gross income:
What does "potential" in potential gross income (PGI) refer to?

Rental income assuming 100% occupancy.

Potential gross income:
When estimating PGI, what type of rent should be considered?

Current market rent, as it reflects future cash flow expectations.

Potential gross income:
Why might contract rent not be used when valuing PGI?

Contract rent represents past rental values agreed upon in previous leases, which may not reflect current or future market conditions.

Potential gross income:
When should contract rent be used for PGI estimation instead of market rent?

When long-term lease(s) prevent adjusting to market rents during the holding period, such as in long-term single-tenant properties (e.g., fast-food chains or Walgreens).

Potential gross income:
What is the general assumption about contract rents over the holding period?

Contract rents will increase to market rents unless restricted by long-term leases.

Effective gross income:
How is effective gross income (EGI) calculated from potential gross income (PGI)?

- Deduct vacancy and collection (VC) loss from PGI
- Add miscellaneous income (MI) if applicable.

Effective gross income:
What factors should be considered when estimating vacancy and collection (VC) loss?

- Historical experience of the subject property
- Vacancy rates of competing or similar properties in the market
- The "natural vacancy rate," which represents the expected vacancy in a stable market.

Effective gross income:
How does the "natural vacancy rate" differ for multi-tenant vs. single-tenant properties?

Multi-tenant properties typically have higher vacancy rates compared to single-tenant properties due to the likelihood of turnover.

Effective gross income:
What type of cash flows account for natural market vacancy?

Stabilized

Effective gross income:
What is miscellaneous income (MI) in the context of EGI calculation?

Income other than contracted rents
e.g. revenue from garage rentals, parking fees, laundry facilities, vending machines, etc.

Net operating income:
How is net operating income (NOI) calculated?

NOI = EGI - OE - CAPX

Net operating income:
What are operating expenses (OE) in the context of real estate?

Ordinary and regular expenses necessary to keep a property functioning properly
- costs for operating, maintaining, and repairing the property

Net operating income:
What should be considered when estimating operating expenses (OE)?

- The historical experience of the subject property
- The operating expenses of competing or similar properties in the market

Net operating income:
What are fixed operating expenses?

Expenses that do not vary with occupancy e.g. property taxes and insurance.

Net operating income:
What are variable operating expenses?

Expenses that vary with occupancy level e.g. utilities, supplies, maintenance, and repairs.

NOT STABILIZED

Net operating income:
Which expenses are not included or deducted when calculating NOI?

Loan payments (debt service) -> "levered" cash flows

Income taxes -> they are considered in after-tax analysis.

Depreciation (which is a non-cash expense that affects income taxes but not cash flows) -> only included/deducted in after-tax analysis

Net operating income:
What are capital expenditures (CAPX) in the context of calculating NOI?

Expenses that materially increase the property's value or extend its useful life e.g. replacements and improvements

Net operating income:
What types of expenses are considered CAPX?

- Additions or renovations (e.g., tenant improvements, or "TIs")
- Major replacements (e.g., roof, HVAC systems, parking lots)

Net operating income:
How is CAPX typically accounted for when estimating NOI?

Using a constant annual reserve for CAPX rather than actual yearly estimates (simplifies the process even though it may not reflect the exact timing of expenditures)

Net operating income:
Why is it important to consider CAPX separately from regular operating expenses?

Because CAPX involves significant improvements that enhance the property's long-term value or extend its useful life, unlike routine maintenance costs.

How do you estimate present value (PV)?

PV = discounted operating cash flows (NOI) + terminal cash flows (NSP)

Cash flows:
What are property-level cash flows in real estate?

- Cash flows generated by the property itself, before considering any financing (debt)
- Represented by NOI, which is like the income property's "dividend"
- It reflects the property's net income after deducting operating expenses
(similar to how a business calculates net income -> annual income - expenses = net income, available for dividends)

Cash flows:
What are investor-level cash flows in real estate?

- What remains after NOI i.e. includes the effect of financing (debt service) on the property
- The NOI must be sufficient to pay debt service (loan payments) and still provide a return to the investor.
- Leveraged returns (e.g., IRR and NPV) are calculated at this level by including debt.

Cash flows:
Why is NOI important at the property level?

It represents the income available for debt service and potential investor returns, like dividends in a business.

Cash flows dependent on leases:
What is straight/fixed rent?

Unchanging rents throughout the lease term

Cash flows dependent on leases:
What is step-up/graduated rent?

Rents with pre-determined increases at specific intervals during the lease term.

Cash flows dependent on leases:
What is indexed rent?

Rent tied to an inflation index (e.g. CPI)

Cash flows dependent on leases:
What is percentage rent?

Rent that includes a percentage of the tenant's sales, commonly used in retail leases.

Cash flows dependent on leases:
What is the difference between gross rent and triple net (NNN) rent?

Gross rent:
- The landlord pays all operating expenses (OE) and capital expenditures (CAPX)

Triple net (NNN) rent:
- The tenant pays all OE and CAPX

Cash flows dependent on leases:
What does each "N" in triple net (NNN) rent represent?

"N" (single net): Tenant pays property taxes.

"N" (double net): Tenant pays property taxes and property insurance.

"N" (triple net): Tenant pays property taxes, insurance, and all property operation, maintenance, repairs, and replacements (common area maintenance or "CAM").

Gross vs NNN rent:
What is the key difference in risk between gross rent and triple net (NNN) rent?

- Gross rent places more risk on the landlord
- NNN rent places more risk on the tenant by transferring responsibility for operating expenses (OE) and capital expenditures (CAPX) to the tenant

Gross vs NNN rent:
How does NNN rent reduce risk for investors and lenders?

Risk is reduced because NNN rent leads to more certain future cash flows
- More predictable cash flows and a more accurate valuation of the property today

Gross vs NNN rent:
How does NNN rent affect the tenant's risk?

Higher risk as they are responsible for paying operating expenses and CAPX -> usually compensated by lower rent

Gross vs NNN rent:
Why does more certain future cash flow reduce the risk of a valuation mistake today?

More predictable future cash flows provide a more reliable basis for estimating the property's current value, reducing the chance of over or under-valuing the property.

Gross vs NNN rent:
What type of rent structure is most common?

Most leases are a negotiated hybrid between gross and NNN rent, especially regarding capital expenditures (CAPX)

Direct capitalization:
What is capitalization in the context of real estate?

The process of converting future cash flows into a present value, which gives the estimated value of the property

Direct capitalization:
How does direct capitalization differ from DCF?

DCF:
- capitalizes all future cash flows over the holding period (including operating and terminal cash flows)

Direct capitalization:
- capitalizes only a single stabilized operating cash flow (NOI)

Direct capitalization:
What are stabilized operating cash flows?

Income (PGI/EGI) and expenses (OE/CAPX) under normal operating conditions

Direct capitalization:
What are the two direct capitalization methods?

- Capitalization rate (cap rate)
- Income multiplier (multiple)

Cap rate R₀:
What is R₀ in real estate valuation?

R₀ is the "going-in" capitalization rate used to estimate the value of a property today (V₀)
- It is applied to the first stabilized net operating income (NOI₁)
- It tells us how much income a property generates relative to its price

Cap rate R₀:
What is the difference between R₀ and Rₜ?

R₀ is the cap rate used to estimate the value today

Rₜ (the "terminal" cap rate) is used to estimate the terminal value (sales price, Vₜ) at the end of the holding period.

Cap rate R₀:
How is the cap rate (R₀) determined?

The cap rate is extracted from recent sales of comparable properties in the market

HOWEVER:
- Unlike the sales comparison method, it values future cash flows by applying a capitalization rate, not by comparing sales prices of similar properties

Cap rate R₀:
What kind of properties are used to extract the cap rate?

Comparable properties are of the same type or class (e.g., office, retail), but they do not have to be close substitutes in terms of location or other specific details.

Cap rate R₀:
How is the cap rate R₀ calculated?

R₀ = NOI₁ / V₀

Example: $10 NOI₁ and $100 value = 10% cap rate

Cap rate R₀:
How is property value (V₀) estimated using the cap rate?

V₀ = NOI₁ / R₀

Example: $10 NOI₁ and 10% cap rate = $100 value.

Cap rate R₀:
Is the cap rate (R₀) a measure of return?

No

The cap rate is not a measure of return like the required return (discount rate) or expected return (IRR) -> instead, cap rates are a PRODUCT of return

Cap rate R₀:
How are cap rates extracted from comparable properties?

Cap rates are extracted by comparing the NOI₁ of a comparable property to its sale price (V₀)

Cap rate (R₀) = NOI₁ of comp / Sale price of comp

This extracted cap rate is then applied as a SHORTCUT to a DCF to estimate the PV of the subject property.

Cap rate R₀:
Why aren't cap rates a measure of return?

Cap rates reflect the relationship between a single year's NOI and the property's value, but they do not account for all future cash flows like the required return (discount rate) or IRR. They simplify DCF analysis by focusing on stabilized NOI.

Cap rate R₀:
What are the steps in a cap rate valuation method?

1). Extract cap rates from recent sales of comparable properties:

R₀ = NOI₁ / Selling price of comp
*comps

2). Estimate the subject property's value by applying the extracted cap rate:

V₀ = NOI₁ / R₀
*subject

Cap rate R₀:
Step 1: Why do we use NOI and cap rate instead of just comparing sales prices?

- The cap rate method values cash flows rather than the physical property.
- Comps don't need to be close substitutes, just the same type or class of property.

Cap rate R₀:
Step 1: How to handle differences in comparables (comps) when calculating cap rates?

Weighting is used if comps vary in relevance.

Cap rate R₀:
Step 1: Where do we get NOI and sales price information for comps?

NOI: From property marketing info, deal participants, or estimating it based on available data.

Sales Price: Typically public information; details to be explored further.

Cap rate R₀:
Step 2: Why isn't the cap rate a measure of required return?

The cap rate (R₀) is a quick way to estimate the PV of multiple future cash flows based on one stabilized cash flow (NOI₁).
- It is derived from comparable properties' pricing, not as a direct calculation of the required or expected return (like the IRR).

Cap rate R₀:
Step 2: What is embedded in R₀:?

- Future operating and terminal cash flows
- Discount rate (required return)

-> these are already factored in indirectly

Income multiplier (EGIM):
What is the income multiplier in real estate valuation?

The income multiplier uses the first stabilized operating cash flow to estimate property value but expresses the value as a multiple (e.g., 10x) instead of a percentage (rate) of value.

Income multiplier (EGIM):
How does the income multiplier differ from the cap rate?

The income multiplier states cash flow as a multiple of value (e.g., 10x), while the cap rate expresses cash flow as a percentage of value (e.g., 10%).

Income multiplier (EGIM):
What are the steps in the income multiplier method?

1). Extract the multiplier from comparable properties (comps) using the reciprocal of the cap rate, but with effective gross income (EGI) instead of net operating income (NOI):

EGIM₀ = Selling Price / EGI₁

2). Estimate the subject's value by multiplying the subject's estimated EGI₁ by the extracted multiplier:

V₀ = EGI₁ × EGIM₀

Income multiplier (EGIM):
What makes the income multiplier simpler than the cap rate?

EGI does not require OE or CAPX

Income multiplier (EGIM):
Why is it critical for comps and the subject property to have similar OE/CAPX in the income multiplier approach?

Since the multiplier approach does not account for OE or CAPX, it assumes comps and the subject have similar operating expenses and capital expenditures for accuracy.

Income multiplier (EGIM):
How does the appraiser reconcile values in the income approach?

The appraiser reconciles indicated values across all methods to determine the final appraised value.
- Weighting within the income approach and across all three appraisal methods is acceptable.