Lesson 7 – Processing the Income Stream (The Income Approach to Value)

The processing of the income stream is actually two distinct and separate operations. One operation is the processing of the income stream in order to derive multipliers or rates from a particular property. The other operation is the processing of the income stream in order to value a particular property. Processing the income stream to various levels means subtracting amounts from the total income (gross income) that a property is expected to produce. The level to which an income stream is processed depends on the type of multiplier or rate that is being derived or the type of multiplier or rate that is being used to convert an income stream into an indicator of value.

The steps in processing an income stream are the same whether processing to derive multipliers and rates or calculating an estimated value for the property. The steps in processing an income stream are as follows:

Gross Income

Gross Income [GI] is the total annual income attributable to the property at full occupancy, before allowing for Vacancy and Collection Loss, and before deducting for normal Operating Expenses. It includes income from rent and other sources that a property would normally be expected to generate under normal management practices. Non-operating income is the income that an owner receives from sources other than operating the property, such as income from earnings on deposits in financial institutions, or investments.

Potential Gross Income [PGI] is the total annual income attributable to the property, assuming prudent management, at full occupancy, if available for rent on the open market, as indicated by the prevailing rental rates for comparable properties under similar terms and conditions. In other words, it is gross market income or gross economic income – it is the gross income that the market would expect the property to earn. It is the income before allowing for Vacancy and Collection Loss, and before deducting for normal Operating Expenses. It includes income from rent and other sources that a property would normally be expected to generate under normal management practices.

Anticipated Gross Income [Ant GI] is the total annual income referred to in Property Tax Rule (8) (g) (1), for the development of the market derived capitalization rate. When deriving multipliers or rates from recently sold comparable properties, it is the total income the buyer of a comparable sold property anticipated when the property was purchased — when the appraiser confirms the sales price with the buyer, the income (and expenses) anticipated by the buyer should also be confirmed; the buyer's purchase price should be based on the buyer's assumptions about the characteristics of the income stream, including the quality, quantity, and duration of the income. Anticipated incomes will be used starting in Lessons 9 and 11, when we derive Multipliers and OverAll Rates.

Rule 8(c) refers to gross income as "gross return." Gross return is defined as "any money or money's worth which the property will yield over and above vacancy and collection losses, including ordinary income, return of capital, and the total proceeds from sales of all or part of the property." Gross income is forecast on an annual basis.

With most income-producing properties, gross income is primarily in the form of rent. When valuing property for tax purposes, the relevant rent is market, or economic, rent. Market Rent is the rent a property would command, assuming prudent management, if placed for rent on the market as of the appraisal date. It is the rental rate prevailing in the market for comparable properties. Market rent is typically estimated using recently negotiated rents for the subject and comparable properties.

Gross Rent is the total rent a property would produce if 100 percent occupied at market rent.

A rental rate is applied to a spatial unit in order to calculate the rental amount. Rental units of comparison may vary depending on the conventions of a given market. When estimating market rent, rental units of comparison should be applied consistently to the subject and comparable properties. Different types of units of measure include (but are not limited to) rent per square foot of gross building area, rent per square foot of net leasable area, rent per room in a hotel, and rent per apartment unit.

In addition to rental income, some properties generate income from sources other than rent. Depending on the property type, non-rental income may include income from laundry facilities, parking, rental of storage spaces, billboard income, and cellular tower space. In most cases, the unit to be valued (i.e., the appraisal unit) is the real property only. In general, it is the culmination of all income that the typical investor in the market place would consider.

Gross income is usually expressed as an annual number. Therefore, if you have monthly rent information, you should multiply those monthly rents by 12 to derive the annual rent.

Vacancy and Collection Loss [V&CL]

Effective Gross Income [EGI]

Operating Expenses

Allowable expenses are also contingent on the type of lease. Depending on the terms of the lease, the tenant may directly pay certain operating expenses or reimburse the landlord for certain operating expenses paid by the landlord. Operating expenses paid or reimbursed by the tenant should not be deducted from rental income when estimating the income to be capitalized. Below are lease definitions according to The Dictionary of Real Estate Appraisal, Third Edition (Dictionary); however, each lease may contain stipulated expenses. Therefore, regardless of the type of lease reported, an appraiser should confirm which specific expenses are the responsibility of the landlord and which are the responsibility of the tenant.

Expenses may be expressed as a line item expense (as described above) or as a percentage of the effective gross income. If the operating expenses for a particular property are not known, an operating expense ratio can be used to derive the market expenses. The Operating Expense Ratio (OER) is the ratio between the total operating expenses and the effective gross income. The OER shows the percentage of a property's income that is being used to pay maintenance and operational expenses. OERs may be obtained from the market place such as from property managers or brokers familiar with the area. Typical market operating expenses can also be found in published local market resources from entities such as The Institute of Real Estate Management (IREM©) for apartment expenses and The Building Owners and Managers Association International (BOMA©) for office expenses.

Net Income Before deducting Recapture and Property Taxes

Property Taxes (PT)

Net Income Before deducting Recapture

Determine the Net Income Before Recapture for an apartment complex given the following information. The apartment complex has ten 1-bedroom units renting for $1,200 per unit. Its vacancy and collection loss is 5%, and its operating expense ratio is 28%. The property taxes are based on a value of $1,152,000, and the tax rate is one percent.

SOLUTION: As demonstrated in Examples 7-1 through 7-5, in order to calculate net income before recapture you will process the income stream using the following steps:

Determine the Net Income Before Recapture for a 25,000 sq. ft. commercial property that rents for $19 per sq. ft. per year. The vacancy and collection loss is 5%. The property has the following expenses:

• Property management at $0.90 per sq. ft.
• Property insurance at $0.34 per sq. ft.
• Maintenance and repair at $1.40 per sq. ft.
• Utilities at $1.96 per sq. ft.
• Replacement allowance at $25,000 at 1/20
• Property taxes at $45,000 per year

SOLUTION: Net Income Before Recapture is calculated by processing the income stream using the following steps:

Allowance for Recapture

As discussed in Lesson 6, an investor will anticipate that the income stream will provide for a return OF their investment. Return OF the investment is the recovery of invested capital, usually through income payments and/or the reversion. The return OF the investment is frequently referred to as the recapture of the investment, or capital recapture. Allowance for recapture can be accounted for in a variety of methods: sinking fund recapture, straight-line recapture, or sale of the property. However it is calculated, the allowance for recapture is deducted from the Net Income Before Recapture (NIBR) to arrive at the net income.

Net Income (Yield Income)

As discussed in Lesson 6, an investor will anticipate a profit or yield on the investment in the property, a return ON the investment. The return ON the investment is the additional amount received as compensation after the investor's capital is recaptured (represented by net income or yield income). The net income is what is left of the income stream after the recapture of the investment is removed.

When the income approach is used, the appraiser processes the income to a level from which an income multiplier or capitalization rate can be derived, or to a level from which the income is capitalized into an estimate of value. "Processing" the income means subtracting out amounts of outgo (expenses, etc.) from the total gross income that a property is expected to produce. The amount of income subtracted depends on whether the appraiser is: (1) deriving a capitalization rate or (2) capitalizing an income stream into an estimate of value using a capitalization rate. In addition, the type of income for extracting multipliers or rates from a property sale is different from the type of income used to value a property. These differences are addressed in the following sections.

The anticipated income, that is, the income that is anticipated by the purchaser/investor of a particular property, is used to derive income multipliers and rates. The investor decides to purchase property based on their anticipated income, expenses, and recapture. Appraisers use this direct relationship to derive multipliers and rates. The income is processed using the investors anticipated income, anticipated expenses, anticipated property taxes, and anticipated recapture.

The steps used in processing the income to derive income multipliers and rates are as follows:

Where:

As mentioned on page 2 in the discussion of anticipated gross income, the income and expenses anticipated by the buyer should be confirmed at the time the appraiser confirms the terms of the purchase with the buyer. Commonly, the anticipated income stream, vacancy and collection loss, and expenses are based on information provided in the income statements of the property from prior years. In general, past income statements provide investors (and loan creditors) with information to predict the anticipated gross income and future cash flows that a particular property may yield. Investors can use these predictions when considering the prospective return of their investment; likewise, these predictions could help loan creditors estimate the probability or safety of their investment. In summary, past income statements can help indicate the risk associated with the investment. Notably, the success and expenses of the past does not necessarily resemble what the future income statement may be, particularly with new management; however, some important trends may be depicted in the prior income statement that may be a reasonable indicator as to the property's income-producing promise. When looking at an income statement, an investor will consider such things as what major property adjustments were made, how the introduction of new technology may impact income and expenses, and how past income and expenses affect the income statement overall.

In Lesson 9, we will discuss more about multipliers and provide examples on how to derive them and how to apply them to value a property. In this lesson we are focusing on the steps to process an income stream and to introduce you to calculating Net Income Before deducting for Recapture [NIBR]; NIBR is also known as the Net Operating Income [NOI].

In valuing a property, the individual investor's anticipated income is no longer an item of importance. Instead, the market income, as exhibited by the various investors' actions within the market place, is used to derive an opinion of value for property tax purposes. The income is processed using market income, market indicated vacancy and collection losses, and market indicated operating expenses.

Market income, or market rent, is the amount of rental income that could be expected from a property of comparable assets, with typical terms and conditions, if it were available for rent on the open market. Typically, the rents are derived from recently negotiated contracts of comparable properties, which is similar to the method used in the Sale Comparison Approach.

Market operating expenses are the periodic expenditures necessary to maintain the real property and continue production of the effective gross income. The estimate of market operating expenses assumes prudent and competent management. Rule 8 refers to operating expenses as "gross outgo."

The steps in processing the income stream to value a property are as follows:

Property taxes and recapture, which are operating expenses, cannot be deducted when valuing property for ad valorem property taxation purposes, because they are dependent on the value of the property. Allowances for property taxes and recapture of the investment are reflected in the income multiplier and capitalization rate.

Demonstration of Processing Gross Income Based on Comparables

DEMONSTRATION 7-3: Estimating Gross Income Based on Comparables

In this demonstration, we will show you how to estimate gross income for a property being appraised (the subject property) based on information for comparable properties. Because we are deriving a value for the property, the gross income used is based on the market income.

The subject property is an office building that has 5000 square feet. The building was leased five years ago for $1,000 per month; the term of the lease is ten years.

Comparable one has 4500 square feet. The building was recently leased for a five-year period. The agreed upon rent is $2,250 per month.

Comparable two has 5000 square feet. The building was recently leased for a five-year period. The agreed upon rent is $2,500 per month.

Comparable three has 5500 square feet. The building was recently leased for a ten-year period. The agreed upon rent is $2,475 per month.

SOLUTION: The subject property's rental income is not current, it is 5 years old. The three comparable properties provide the best evidence of current market rents.

As shown in Example 7-1 of this lesson, the gross income is computed by multiplying the office building's area, 5,000 square feet, by the price per square foot determined from the most comparable of the three sales. That figure is then multiplied by 12 to annualize the income. In this case, if we determine that comparables 1 and 2 are comparable to the subject (they are both recent, short term, leases), we would calculate the gross income as follows:

5000 S.F. x $0.50 per S.F. = $2,500 per month x 12 months = $30,000 per year

DEMONSTRATION 7-4: Estimating Gross Income Based on Comparables

In this demonstration, we will show you how to estimate gross income for a property being appraised (the subject property) based on information for comparable properties. Because we are deriving a value for the property, the gross income used is based on the market income.

The subject property has 500 feet of front footage. The building was leased five years ago for $1,000 per month. The term of the lease is ten years.

Comparable one has 450 feet of front footage. The building was recently leased for a five-year period. The agreed upon rent is $2,250 per month.

Comparable two has 550 feet of front footage. The building was recently leased for a five-year period. The agreed upon rent is $2,475 per month.

Comparable three has 1500 feet of front footage. The building was leased five years ago for $2,250 per month. The term of the lease is ten years. The tenant has partitioned the building into three separate stores of equal size. These are subleased as follows:

• $2,625 per month, month-to-month rental agreement
• $2,375 per month, five-year lease signed six months ago
• $2,250 per month, ten-year lease signed one year ago

SOLUTION: The subject property's rental income is not current, it is 5 years old. The subject's rental income is old. The three comparable properties provide the best evidence of current market rents.

The gross income is computed by multiplying the number of units by the price per unit. That figure is then multiplied by 12 to annualize the income. In this case, if we determine that second unit of comparable three (3B above) is the most comparable to the subject, we would calculate the gross income as follows:

500 F.F. x $4.75 per F.F. = $2,375 per month x 12 months = $28,500 per year

The lesson you just studied explained how to process the income stream when deriving rates and multipliers and how to process the income stream to estimate value. There are several important concepts you should take away from this lesson:

• The journey from Gross Income to Net Income is always the same. There may be different starting places, for instance, Potential Gross Income or Effective Gross Income; there may be different destinations – maybe Gross Income is the destination, or maybe you're looking for Effective Gross Income, Net Operating Income, or some Net Income. But the route, from gross return, through allowable gross outgo, to net return, is the same.
• The income and expenses anticipated by the buyer are used when developing a multiplier or rate from a comparable sale – the appraiser is attempting to determine the relationship, in the buyer's mind, for that sale, between the income anticipated will be received after the purchase, and the value indicated by the sales price.
• Economic (market) income and expenses are usually used when valuing property for ad valorem property taxation purposes — that is, for market value.
• The "actual" income may be the anticipated income; the "actual" income may be the market (economic) income; anticipated and market income may be the same. Or not. Anticipated income and expenses come from discussions with the buyer or the buyer's broker of other representative; economic income is determined from properties comparable to the subject that the appraiser finds in the market place.
• Allowable expenses include any expenditures, and annual allowances for future expenses, necessary to maintain the flow of income to the property. Some expenses are not allowable when using the methods and techniques of capitalization discussed in this Self-Paced Online Learning Session – non-allowable expenses include amortization, depreciation, depletion charges, debt retirement, property taxes, and corporation income and franchise taxes

The next lesson will discuss methods of converting an income stream into value.

Before proceeding to the next lesson, please complete the check your knowledge exercises for this lesson. Print the exercises and work them all before reviewing solutions. If you answer any of the check your knowledge questions incorrectly, please review that portion of the lesson before proceeding to the next lesson.