ch 8; pt 1: Valuation Using the Income Approach

Valuation Using the Income Approach

Introduction

• Focus on the Income Approach to property valuation.

• Main topics covered:

  • Direct Capitalization vs. Discounted Cash Flow.

  • Estimating Net Operating Income (NOI).

  • Methodologies for valuation via direct capitalization and discounted cash flow.

  • Other approaches to valuation.

  • Reconciliation of values obtained through various methods.

  • Valuing partial and other interests in properties.

  • Additional methods of estimating capitalization rates (cap rates).

  • Sample computational problems for practice.

The Income Approach to Appraisal

• Rationale:

  • Value equals the present value of anticipated income. This methodology is often referred to as "income capitalization."

  • Capitalize: This refers to the conversion of future income into present value.

• Note: All discussions in this chapter refer to existing properties. Development scenarios will be introduced in Chapter 23.

Approaches to Income Valuation

1. Direct Capitalization:

   • Involves using an "overall" cap rate.

   • Value is determined based on projected first-year net income (NOI).

   • The cap rate (or multiple) is derived from sales of comparable properties.

   • Conceptually similar to valuing a stock with a price-to-earnings ratio.

2. Discounted Cash Flow (DCF):

   • Requires projecting expected future cash flows over a defined holding period, e.g., 10 years.

   • All future cash flows are discounted at the internal rate of return (IRR).

   • The appraiser strategically mirrors a typical investor's decision-making process.

Comparison of DCF and Direct Capitalization

• DCF Requirements:

  • An estimate of the typical buyer's expected holding period.

  • Projections of net (annual) cash flows during the expected holding period, including anticipated sale proceeds.

  • The selection of an appropriate discount rate (required IRR).

Estimating Net Operating Income (NOI)

• Formula:

  • $\text{NOI} = \text{EGI} - \text{OE} - \text{CAPX}$,
    where:

  • PGI: Potential Gross Income

  • VC: Vacancy and Collection Loss

  • MI: Miscellaneous Income

  • EGI: Effective Gross Income

  • OE: Operating Expenses

  • CAPX: Capital Expenditures

• Pro Forma: A reconstructed operating statement that serves as a template for future earnings assessments.

Types of Leases

• Commercial Real Estate Lease Types:

  • Straight Lease: Consistent, level payments.

  • Step-up Lease: Scheduled increases in rent over time.

  • Indexed Lease: Rent adjusted based on inflation metrics, such as the consumer price index.

  • Percentage Lease: Rent calculated as a percentage of tenant sales.

Example: Centre Point Office Building

• Description:

  • Comprises eight office suites (three on the first floor and five on the second).

• Contract Rents:

  • Two 1,000-sq.-ft. suites at $1,800/month.

  • One 2,000-sq.-ft. suite at $3,600/month.

  • Five second-floor suites at $1,560/month.

• Annual Market Rent Increase: Assumed at 3% per year.

• Vacancy/Collection Losses: Estimated at 10% of total rents collected.

• Operating Expenses: Fixed at 40% of EGI.

• Capital Expenditures: Allocated at 5% of EGI.

• Expected Holding Period: 5 years, with considerations for lease expirations during this timeframe.

Potential Gross Income (PGI)

• Definition: The maximum theoretical rental income at full occupancy.

• Formula:

  • $\text{PGI} = \text{Total Contract Rent} + \text{Projected Rent from Vacant Spaces}$

Effective Gross Income (EGI) Calculation

• Centre Point Example:

  • $\text{PGI} = 180,000$

  • \text{VC} = 18,000 ext{ (10%)}

  • $\text{MI} = 0$

  • $\text{EGI} = 180,000 - 18,000 + 0 = 162,000$

Operating Expenses

1. Types of Operating Expenses:

   • Fixed Expenses: Costs such as hazard insurance and local property taxes that do not fluctuate with occupancy.

   • Variable Expenses: Costs like utilities and maintenance that may vary with occupancy levels.

2. Exclusions: Mortgage payments, tax depreciation, capital expenditures, and leasing commissions are not included.

Capital Expenditures (CAPX)

• Definition: One-time expenses that enhance property value or prolong its useful life.

• Examples of CAPX:

  • Roof Replacement: Essential for maintenance and protection of the structure.

  • HVAC Replacement: Ensures comfortable climate conditions and energy efficiency.

  • Parking Resurfacing: Provides necessary upkeep of external facilities.

Treatment of Capital Expenditures in Analysis

• Above Line Treatment:

  • Structure: EGI − OE − CAPX = NOI

• Below Line Treatment:

  • Structure: EGI − OE = NOI − CAPX (reflects net cash flow).

First-Year Pro Forma Example

• Financial Breakdown:

  • PGI: $180,000

  • Vacancy Loss: $18,000

  • EGI: $162,000

  • Total Operating Expenses Breakdown:

  • Fixed Expenses Total: $25,100

  • Variable Expenses Total: $39,700

  • Overall Operating Expenses: $64,800

  • Reserves for CAPX: $8,100

  • Net Operating Income (NOI): $89,100

Sources of Industry Expense Data

1. Institute of Real Estate Management (IREM):

   • Provides info on various property types including apartments, shopping centers, and condos.

2. Building Owners and Managers Association (BOMA):

   • Focus on large office buildings.

3. International Council of Shopping Centers (ICSC)

4. Local Market Participants

5. Market Knowledge: Recognized as essential for accurate valuation.

Net Operating Income (NOI)

• Definition: NOI serves as a property's "dividend."

• Importance: It determines the property's value and must be adequate to service mortgage debt and provide a reasonable return to equity investors.

• Note: Differentiate between NOI and NCF (Net Cash Flow) when estimating returns and values.

Study Question Example and Solution

• Question: Prepare a reconstructed operating statement for a property with 10 rental units renting for $550 each, considering a 5% vacancy loss and annual operating expenses as historical data.

• Solution:

  • PGI: $10 imes 550 imes 12 = 66,000$

  • Vacancy Loss: $66,000 imes 0.05 = 3,300$

  • EGI: $66,000 - 3,300 = 62,700$

  • Operating Expenses Summed: Totaling approximately $20,000.

  • Net Operating Income: $62,700 - 20,000 - 2,800 ext{ (CAPX)} = 39,900$.

Valuation Using Direct Capitalization

• Basic Equation: $\text{Value} = \text{NOI} / R<em>0$, where $R</em>0$ is the cap rate.

• Important Note: Cap rates differ fundamentally from discount rates.

Steps in Direct Capitalization

1. Obtain cap rate estimates from real market data through direct market extraction from comparable properties.

2. Average the cap rates obtained to develop a weighted average.

3. Use the subject property’s NOI in conjunction with the weighted average to estimate value.

Example from Centre Point Office Building

1. Extraction of Cap Rates:

   • Example calculations:

     • Comparable A: $\frac{80,000}{919,540} = 0.087$

     • Comparable B: $\frac{114,000}{1,390,244} = 0.082$

     • Comparable C: $\frac{100,000}{1,250,000} = 0.080$

     • Comparable D: $\frac{72,000}{808,989} = 0.089$

     • Comparable E: $\frac{90,000}{1,097,561} = 0.082$

   • Average Cap Rate Calculated: 0.084 and the adjusted value based on multiples computed as $M<em>0 = \frac{1}{R</em>0}$.

2. Estimated Market Value Calculation: Derived from the expected first year NOI rounded to $1,061,000.