imcome approach

Chapter Four: Income Approach

Introduction to Income Capitalization Approach

• The income capitalization approach, often referred to simply as the income approach, is one of three approaches to appraising real estate.
• It is primarily used for commercial properties such as shopping centers, office buildings, and large apartment buildings, rather than in residential real estate.
• This method involves appraising real estate based on the income it generates, thus converting projected or actual income into a value estimate.
• Investment Definition: An investment is described as the purchase of an asset with the intent of profiting from it in the future.
• This approach is grounded in the principle of anticipation which suggests that the present value of a property is influenced by anticipated future income or utility it will provide to its owner.

Case Study: Baxter Building

• The chapter will use the Baxter Building, an apartment building located in Springfield, as a focal point for examples of valuation methods.
• Baxter Building Overview:
    - 35 stories tall.
    - Currently listed for sale after unfortunate events affecting the property.
    - Attracting interest from local investors who intend to evaluate its potential value.

Income Approach Formula

• The value of an investment property is estimated through the formula:
  $ext{Value} (v) = \frac{ ext{Net Operating Income} (I)}{ ext{Capitalization Rate} (r)}$

Key Terms

• Net Operating Income (NOI): The annual income of a property after deducting operating expenses.
    - Operating Expenses: Occasional or ongoing costs necessary for the operation of an income-generating property.
    - Examples include staff salaries and maintenance costs.
• Capitalization Rate (Cap Rate): A percentage that represents the expected rate of return over a property’s value, calculating how much income an investor can expect based on the property's value.

IRV Formula

• The IRV formula is split into three steps:
    1. Estimate the Net Operating Income.
    2. Determine the Capitalization Rate.
    3. Use the IRV formula to compute the property value.

Example Problem Using the IRV Formula

1. If the Baxter Building has a Net Operating Income of $20,000 and the average cap rate of 10%:
      - Calculation:
   $ext{Value} = \frac{20,000}{0.1} = 200,000$
      - Result: The estimated value of the rental property is $200,000.

Income Calculations Breakdown

• Understanding common calculations is crucial for employing the income approach:
    1. Potential Gross Income (PGI): The total possible income if all units were rented at full occupancy.
       - Calculation:
  $ext{PGI} = ext{Contract Rent} + ext{Projected Rent}$
    2. Effective Gross Income (EGI): Represents total annual income after accounting for vacancies.
       - Calculation involves determining the vacancy cost.
    3. Net Operating Income (NOI): Actual income remaining after paying operating expenses.
       - Calculation:
  $ext{NOI} = ext{EGI} - ext{Operating Expenses}$

Detailed Calculations of Income Types

• Potential Gross Income (PGI):
    - This is calculated by summing all expected rents from all units:
    - For the Baxter Building:
      - Contract Rent: $1,800,000$ (from 75 leased units).
      - Projected Rent for remaining units: $600,000$ (25 units).
      - Total PGI: $2,400,000$.

• Effective Gross Income (EGI) Calculation:
    - Accounts for the loss of income from vacancies:
    - Using a 4% vacancy cost from a PGI of $2,400,000$ yields:
      - $0.04 imes 2,400,000 = 96,000$ (vacancy cost).
      - Other income: $50,000$ (from sources like laundry).
      - EGI Calculation:
  $ext{EGI} = ext{PGI} + ext{Other Income} - ext{Vacancy Cost}$
      - Result: EGI = $2,354,000$.

• Net Operating Income (NOI) Calculation:
    - To find NOI, subtract operating expenses from EGI:
    - Total Operating Expenses for Baxter Building:
      - Property Management Fees: $125,000$
      - Property Repairs: $150,000$
      - Property Taxes: $134,000$
      - Property Insurance: $110,000$
      - Total Operating Expenses: $519,000$.
    - Final Calculation:
      - $ext{NOI} = ext{EGI} - ext{Operating Expenses}$
      - Result: NOI = $1,835,000$.

Summary of Income Types

• Potential Gross Income (PGI): Total income at full occupancy.
• Effective Gross Income (EGI): Total income after accounting for vacancies.
• Net Operating Income (NOI): Income left after operating expenses are deducted.

Capitalization Rate and its Determination

• To determine the cap rate, we use the formula:
  $ext{Cap Rate} = \frac{ ext{NOI}}{ ext{Property Value}}$
• The cap rate conveys the expected return based on property value and is usually expressed as a percentage.
• Example Calculation for Baxter Building:
    - Given:
      - NOI: $1,835,000$
      - Property Value: $20,388,888$
    - Calculation:
      - $ext{Cap Rate} = \frac{1,835,000}{20,388,888} = 0.09$ which converts to 9%.

Finding the Value of the Baxter Building

• Ultimately, using the equation from earlier:
  $ext{Value} = \frac{NOI}{ ext{Cap Rate}}$
    - Using values established:
    - $ext{Value} = \frac{1,835,000}{0.09} = 20,388,889$
• Result: The appraised value of the Baxter Building is $20,388,889.

Importance of Memorizing IRV Formula

• The IRV formula is essential for real estate valuation using the income approach.
• Important to remember for ASIBL tests and state licensing exams.

Additional Method: Gross Rent and Income Multipliers

Gross Rent Multiplier (GRM)

• GRM is a ratio that compares the price of an investment property to its annual rental income (before expenses).
    - Calculation:
  $ext{GRM} = \frac{ ext{Property Price}}{ ext{Annual Rent}}$
    - Example:
      - Selling price: $200,000$; Monthly Rent: $1,200$
      - Annual Rent Calculation: $1,200 imes 12 = 14,400$
      - GRM Calculation: $\frac{200,000}{14,400} ext{ gives } 13.89$.

Gross Income Multiplier (GIM)

• GIM expands on GRM by including income from other sources beyond rent (e.g., parking fees).
• Calculation:
    - Total Income includes rent and additional sources.
    - Example:
      - Total Income Calculated: $1,300$ (rent + additional income)
      - Annual Total Income: $1,300 imes 12 = 15,600$
      - GIM Calculation: $\frac{200,000}{15,600} ext{ gives } 12.82$.

Conclusion

• Familiarity with the income approach and its calculations is critical for investment appraisal and assessing property values accurately. Understanding PGI, EGI, and NOI as well as calculations for cap rates using the IRV formula is vital for any aspiring real estate professional.