Ch. 23 THE INCOME OR INVESTMENT APPROACH OF APPRAISAL

INTRODUCTION

-The income or investment approach of appraisal is most frequently applied to the valuation of income-producing properties.

-The purchase price of these properties is regarded as an invested lump sum from which a return is received through rents paid by tenants, the owner’s use and occupation, or a combination of the two.

-the benefits received through the owner’s use and occupation can be measured by the potential rental value of the premises; that is, the amount the owner could receive if they chose to rent the premises.

- focuses on rental income from the property

-The “return” realized on the investment in real property is not necessarily the actual rent received

- If the property is subject to real property taxes, insurance, heating, or other operating expenses that are paid for by the landlord, the net operating income is the measure of return used by the appraiser.

-2 technques: the direct capitalization technique and the discounted cash flow technique.

The steps involved in appraising a revenue producing property (using the income approach of appraisal and the direct capitalization technique)

1. calculating the amount of annual net operating income the property produces;

2. estimating the return or yield expected in the market on investments of this type; and

3. determining the price (market value) that would be paid at the appropriate yield as estimated in step 2, for the right to receive the net operating income as calculated in step 1. This final step is carried out by capitalizing the net operating income.

ESTABLISHING NET OPERATING INCOME

-Whether the appraiser is examining existing rents in the subject property or estimating the rent for vacant or owner-occupied property, they must apply the current contract rents observed in the market place in their analysis.

-they must use a yield rate derived from analyzing recent sales and net operating incomes of properties that are comparable to the subject property.

-The comparable properties used to derive the yield should possess the same risk as the subject property.

-more appropriate and accurate for properties that produce rental income

Gross potential revenue

+ Other income

- Vacancy and bad debt allowance (also called "vacancy and collection loss allowance)

= Gross realized revenue (also called "effective gross income")

- Operating expenses (paid by landlord)

= Net operating income

Gross Potential Revenue

-estimated using actual current rents paid on similar properties

-considering the class of building involved

- Comparisons of rental levels must be made between buildings similar in floor area of accommodation, amount and standard of equipment and fittings, standard of finish, quality of management, location, view, and class of tenant.

-allowance may be made to adjust for dissimilar characteristics.

-the terms of the lease must be taken into account

- leasing inducements are not considered an operating expense.

-The appraiser’s concept of rental value should be based on assumptions consistent with typical market leasing terms.

Other Income

- If the rental schedule includes garage rentals with the respective suite rentals of the tenants, the garage rents should be deducted and shown separately,

-may also be an entry for laundry income

Vacancy and Bad Debt Allowance

-also known as vacancy and collection loss

-allowance is not an operating expense

-is an allowance for reductions in gross potential revenue attributable to vacancies, tenant turnover, and nonpayment of rent or other income

-Gross potential revenue are the potential rents earned if the building has 100% occupancy, while gross realized revenue is the amount of money actually received by way of rents on the units actually rented.

=> the gross realized revenue is derived from total gross rentals but is modified by vacancy and bad debt allowances.

Gross potential revenue (per annum)

- Vacancy and bad debt allowance (2%)

= Gross realized revenue

-The vacancy allowance should be determined by the long-term vacancy rates in the area; that is, the vacancies in comparable buildings modified, if necessary, by expected future trends

-the allowance for vacancy is a percentage of gross potential revenue;

Operating Expenses - Fixed

Fixed expenses are those that must be paid regardless of the level of occupancy and use of the property. These include:

• real property taxes: paid annually to the taxing authority; can be estimated by obtaining the assessment on the land and completed building, and the tax rates. Normally, the detailed appraisal report would compare the subject’s assessment to that of comparable properties to verify whether the subject’s assessment appears equitable and that its level of property taxes are fair and comparable to similar properties in the market.

• insurance policies: one or more insurance contracts may be used to insure against fire, rent loss through damage or explosion, water escape, and public liability

Operating Expenses - Variable

their amounts will vary based upon the nature of the occupancy of the property and the amount of lease activity required to maintain full occupancy. These include:

-Management: professional service charge covering the general supervision of the building, collection of rents, payment of operating expenses, and maintenance of proper accounts; usually between 3% and 5% of the gross income collected; may or may not include leasing commissions; Where management work is done by the owner, an appropriate fee should be estimated.

-Utility charges: the cost of water, sewer, gas, electricity, heating, and air conditioning.

-Maintenance and Repairs: repairs to the electrical, plumbing, heating, and air-conditioning installations; Less frequent repairs will be required to the building structure, roof, walls and floors; painting and decorating internally and externally; Specialty services, such as elevator maintenance; cyclical repairs: repairs that are done on a periodic basis; If repairs are immediately required at the time of appraisal, their cost should be deducted as a lump sum from the property’s final value

-Replacement reserves or allowances: provides for the periodic replacement of building components that wear out more rapidly than the building itself and must be replaced during the building’s economic life.

-Cleaning or janitorial: This may be done under the heading of maintenance, but can be a significant cost for certain types of properties such as office buildings.

-Grounds and Parking Area Maintenance: : includes the cost of cutting and maintaining the lawns, flower beds, trees, shrubbery, etc; cost to maintain fencing and parking areas; cleaning of the grounds; snow removal

-Wages: covers the cost of building employees but excludes the cost of professional management that is listed separately; also includes unemployment insurance, workers’ compensation, etc; gardeners and extra cleaning staff.

-Garbage removal

-Decorating expenses

-Miscellaneous expenses

Lease Considerations

- Commercial leases can be written on a gross or net basis.

-On a gross lease, the owner or the lessor pays all operating costs; The rental rate charged to the tenant is a base rent amount plus a contribution to these expenses, this “gross rent” remains constant for the term of the lease.

-When it is used for commercial properties, it often includes escalation clauses that can at least partially protect the lessor from rising expenses.

- An “escalator clause” allows the landlord to recover any increases in the cost of an expense over a stated base, and is generally found in industrial and commercial leases

-A net lease is where the tenant pays a base rent plus their pro rata share of the operating expenses such as property taxes, utilities, heating, repairs and maintenance etc.

-“single net” where the tenant pays a base rent and a portion of the operating expenses

-“triple net” where the tenant pays all operating expenses but the landlord is responsible for structural repairs

-“absolute net” where the tenant pays a base rent plus all expenses including structural maintenance and repairs.

-The net lease is more common than the gross lease for commercial properties.

-In calculating rentable area, only the space rented to a tenant for their exclusive use is included

Items Omitted in Calculating Net Operating Income

-The major omissions include depreciation, capital cost allowance, income tax and debt repayments.

-because they are specific to the individual owner or investor.

-As the appraiser is estimating market value, not value to the owner, they cannot consider any items that vary according to an owner’s individual circumstances.

1. Depreciation: measures the loss of value that occurs even though repair and maintenance work has been carried on.
   -The life of a building depends on its economic durability, not its physical durability.
   -The economic life of many buildings is so long that the amount of depreciation taken each year is not an important element in the estimation of value.
   - There is no objective method of estimating the future economic life of a building and any estimate made must be based on subjective opinion
   -If depreciation is attributed to buildings, it could be argued that appreciation should be attributed to the value of the site.
   -In examining similar buildings, there is no way to determine if, or how, depreciation enters into the calculation of value by the vendor and purchaser.

2. Income Tax
   -since the rate at which individuals are taxed varies and, broadly speaking, all investments are liable to income tax on the same basis,

3. Capital cost allowance: refers to the depreciation of assets, claimed for income tax purposes

4. Debt service: Each project or property will have its own unique financing package.

Equity Yield

-the total property value less all mortgage debts.

-The net operating income represents a return on the entire value of the property, before financing is considered; net operating income is not a return on the equity portion of the property’s value.

-Mortgage debt is only considered in cases where the property is financed at a contract rate that differs from current mortgage rates.

-If a purchaser wishes to calculate their potential equity yield, they will have to consider their own financing arrangements and income tax situation. The appraiser does not include these items in their attempt to estimate market value.