Lesson 12 – Valuation of Property Using Overall Rates (The Income Approach to Value)
Appraisal Training: Self-Paced Online Learning Session
Open All Close AllLesson 8 discussed valuation of property using income multipliers, and Lesson 9 discussed the derivation of OverAll rates. This lesson serves as an introduction to the valuation of property using overall rates, and discusses the following:
- Overview of the Valuation Process and the Methods of Capitalization
- Use of Overall Rates
- Direct Capitalization of Land and of Improved Properties
Property Valuation
After the appropriate sales and income data has been collected, analyzed, and processed to derive income multipliers and capitalization rates from comparable properties, this information can be used to appraise property. The derived multipliers and rates are used with the appropriate level of market income to find an indication of value of the subject property.
When valuing property, the individual investor's anticipated income is no longer an item of importance. Instead, market income is used to value income-producing properties. Market rent is the amount of rental income that could be expected from a property if it were available for rent on the open market. Appraisers estimate the market rent for the subject property using the prevailing open market rental rates for comparable properties with typical terms and conditions. Typically, the rents are derived from recently negotiated rents of similar properties.
After vacancy and collection losses are subtracted, allowable expenses are deducted. Allowable expenses are those expenses that are typical operating expenses of comparable properties. Adjustments are made for any physical differences or other characteristics that the subject property experiences that are different from the comparable properties. The degree of comparability between a comparable property and the subject property determine what adjustments are necessary.
Ad valorem property taxes (property taxes based on property value) cannot be deducted as an expense when valuing property since this would presume that the value of property being appraised is already known. Instead, a property tax component is added to the overall capitalization rate.
When valuing property using a gross income multiplier, the income stream is processed to the level of economic potential gross income. When valuing property using an overall capitalization rate, the income stream is processed to the level of economic net income before recapture and property taxes. The steps used in processing the income stream to value a property are as follows:
The future income can be converted to a present value indicator by either direct capitalization or yield capitalization. This lesson discusses direct capitalization. Lesson 13 discusses yield, and subsequent lessons will discuss indirect capitalization using the residual and property reversion techniques.
Direct Capitalization
Direct capitalization is a method used to convert an estimate of a single year's income expectancy, or an annual average of several years' income expectancies, into an indication of value in one direct step. The conversion is done by either multiplying the income estimate by an appropriate multiplier (as we did in Lesson 8) or by dividing the income estimate by an appropriate capitalization rate. No distinction is made between return OF and return ON an investment. The income rates used in direct capitalization include the overall rate (OAR or Ro) and the land capitalization rate (RL).
Overall Rates
Just as in using income multipliers, the use of overall rates requires that the comparable properties be as similar as possible to the subject property. However, because the income stream has been refined by deducting vacancy and collection losses and operating expenses from the gross income, it is no longer necessary for some units of comparison to be closely comparable (for instance, vacancy rate and expense ratio). Remaining economic life, property use, shape of the income stream, land-improvement ratio, and other items must still be closely comparable.
The formula for valuing property using an overall rate is to divide the market net operating income (NIBR) by the capitalization rate to arrive at an indicated total property value. However, since property taxes cannot be deducted as an operating expense in arriving at the income to be capitalized, the income that is capitalized must be the market net income before recapture and taxes (NIBR&T). The capitalization rate is the sum of the OAR, derived from sales of comparable properties or the band‑the‑investment, and the effective tax rate (ETR).
EXAMPLE 12-1:
Sales of closely comparable properties indicate individual OARs that range from 9.5 to 10.5 percent. The typical OAR is 10 percent. The effective tax rate is 1.1 percent of the enrolled taxable value. Vacancy and collection losses indicate that a 3 percent allowance to the potential gross income would be proper. Operating expenses, including management, is 25 percent of the effective gross income. Based on the market OAR, the market value of the subject apartment complex is calculated as follows:
Land Capitalization Rates
Land is a non-wasting asset and in theory does not depreciate. The shape of the income stream is considered as constant perpetual. Because land is a non-wasting asset, there is no need to include an allowance for recapture in the capitalization rate. The income to be capitalized is the net income before taxes (NIBT). The capitalization rate is the yield rate (Yo) plus an effective tax rate (ETR). The formula for capitalizing land income would be as follows:
EXAMPLE 12-2:
A vacant parcel of land is subject to reappraisal because of a change in ownership. Similar parcels indicate that the subject property should be capable of producing a net income before an allowance for property taxes of $30,000 per year. Data on file in the assessor's office indicates that a proper yield rate for the subject is 8.25 percent. The effective tax rate is 1 percent. Assuming a constant perpetual income stream, the land income can be directly capitalized as follows:
Summary
The lesson you just read explained how to value property using overall rates.
Note: Before proceeding on to the next lesson, be sure to complete the exercises for this lesson.