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THE INCOME APPROACH

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THE INCOME APPROACH

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THE INCOME APPROACH

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  1. Chapter 13 THE INCOME APPROACH

  2. CHAPTER TERMS AND CONCEPTS • Income property • Intangible benefit • Lease term • Market rent • Minimum or base rent • Net income ratio • Net operating income • Operating expense ratio • Operating expenses • Operating statement • Overage rent • Percentage lease Amenities Capital recovery Capitalization Capitalization rate Contract rent CPI lease Direct capitalization Effective gross income Excess rent Fixed expenses Gross income Gross income multiplier (GIM)

  3. CHAPTER TERMS AND CONCEPTS Potential gross income Present worth of future benefits Recapture Rent roll Reserves for replacements Return of investment Return on investment Step-up (or “graduated”) lease Straight (or “flat”) lease Tangible benefit Variable expenses

  4. LEARNING OUTCOMES Distinguish between the tangible and intangible benefits of property ownership. Name the six steps in the income approach to value. Explain the use of gross income multipliers in the income approach. Define the terms contract rent and market rent as used in appraisals. Name the three main categories of expenses and give examples of items in each. Outline the procedure used for reconstructing the owner’s operating statement.

  5. Types of Income Property 1. Multiple-family residential, including large and small apartment buildings. 2. Commercial buildings, including stores, offices, medical offices, convalescent hospitals, hotel and motel properties, and shopping centers. 3. Industrial properties, such as warehouses and factories.

  6. MOTIVES AND BENEFITS OF PROPERTY OWNERSHIP • Intangible Benefits • Pride of ownership • Sense of security • Personal opportunity • Tangible Benefits • Return on investment • Return of investment

  7. CHARLEY’S SAVING ACCOUNT Hi Charley! Here’s your $36 annual check! We give 6% • How Much is in Charley’s Savings Account? • Amount on Deposit? • $216 • $600 • $360 • $6,000

  8. Capitalization • the process of converting an income estimate into a value estimate.

  9. IRV FOR VALUE • The Value Formula • Key • Horizontal line indicates division • Vertical line indicates multiplication • Formulas • Value = I/R • Rate = I/V • Income = R X V

  10. BASIC STEPS: INCOME APPROACH • Estimate the Annual Gross Income • Estimate Vacancy and Other Losses • Subtract to Get Effective Gross Income • Subtract Operating Expenses to Get Net Operating Income • Arrive at a “Cap” Rate and Method • Divide Net Operating Income by Capitalization Rate

  11. Analysis of GIM • Gross Income Multipliers • GIM = Price ÷ Gross Income • Price Gross Income GIM • $300,000 $30,000 10.0 • $250,000 $30,000 8.3 • $200,000 $30,000 6.7 • Effect of Expense Ratios

  12. Analysis of GIM • GIM Varies with: • Location • Intangible Amenities • Number of Units • Expense Ratio • Size of Units • Services Included

  13. MARKET RENT • Market Rent Defined • Potential gross rent • Assumes no encumbrances • Assumes efficient management • Measures all the property rights • Overage Rent • Excess Rent • Responsibility for Expenses • Landlord • Tenant • Shared

  14. Contract Rent • rent being paid under some form of contract that is binding on both owners and tenants. Such rental agreements range from simple oral contracts to complex leases that are beyond the scope of this book.

  15. CONTRACT VS. MARKET RENT • Types of tenancies • Month to Month • Short-term Lease • Long-term Lease • Common Lease Types • Straight • Step Up • Percentage • Combinations

  16. OPERATING EXPENSES • What to Include: • Include Property-Related Expenses • Current Operating Expenses • Projected Expenditures • The Value of Owners Efforts • Exclude Owner-Related Expenses, such as: • Loan and Interest Payments • Income Taxes • Depreciation

  17. OPERATING EXPENSES CATEGORIES • Operating Expense Categories • Variable Expenses • Fixed Expenses • Reserves for Replacement

  18. INCOME AND EXPENSE RATIOS • Income and Expense Ratios • The Net Income Ratio = NOI ÷ EGI • The Operating Expense Ratio = Operating Expenses ÷ EGI • NOI = Net Operating Income • EGI = Effective Gross Income

  19. An Owner’s Operating Statement

  20. A Reconstructed Operating Statement

  21. SUMMARY An overview of the income approach as it applies to various types of residential income, commercial, and industrial properties was also included. The income approach can either analyze the income year-by-year, or by emphasizing one year. Income property appraisals require an estimate of income and expenses for the property. A knowledge of typical expense ratios assists in the reconstruction of operating expense statements.