Income Approach - Explained

What is the Income Approach?

The Income Approach is one of the most common valuation methods employed to determine the value of an income-producing property. The Income Approach involves an analysis of the subject’s income stream and leases over a 12-month period. A survey of the rental market in the subject’s market area is conducted to determine whether the subject’s rents are below, at, or over what is typically commanded on the market. The subject’s income is subsequently calculated using actual rents or market rents (referred to as Potential Gross Income, or PGI). A market Vacancy & Collection rate is then applied to the subject to calculate its Effective Gross Income, or EGI. Operating expenses like taxes, insurance, utilities, and regular maintenance are deducted from the EGI to calculate the subject’s Net Operating Income (NOI). Market-derived capitalization rates are subsequently applied to the subject’s NOI, resulting in a value estimate. This approach is most appropriate for income-producing properties like apartment buildings, multi-tenant office buildings, and retail strips.

Some properties may have irregular income streams, in which case the Yield Income Approach is applied and a Discounted Cash Flow over the subject’s holding period is conducted.

How does an appraiser select comparable commercial rentals?

Appraisers use a variety of databases to find comparable rentals, including MLS, CoStar, and Crexi. Appraisers may also consider active listings on popular commercial real estate websites like LoopNet. In some instances, an Appraiser will also consider leases that they have readily available in their internal files -- provided that disclosure of the lease information does not violate confidentiality guidelines.

Ideally, leases with comparable terms are selected. There are three types of commercial leases:

Gross Leases, which require the tenant to pay a base rental fee over a specified term. The owner covers all other expenses, including utilities, real estate taxes, insurance, maintenance and repair, etc.

Modified Gross Leases, which require the tenant to pay a base rental fee, the cost of utilities, and reimbursements for common area maintenance (CAM). Under these agreements, the ownership is usually responsible for real estate taxes and insurance. These leases are often referred to as Single Net or Double Net Leases, depending on the number of expenses covered by the tenant.

Triple Net (NNN) Leases, which require the tenant to pay a base rental fee, the cost of utilities, maintenance, insurance, real estate taxes, and most other expenses associated with the real estate. These leases are typically long-term, with escalation clauses and sophisticated terms that have been extensively negotiated by the two parties.

It is notable that the terminology above is really only used to describe commercial leases. While a residential lease agreement for a 1-bedroom, 1-bathroom apartment with utilities paid by the tenant may meet the criteria for a Modified Gross lease, it is uncommon for them to be categorized in this manner.

Appraisers will also select comparable commercial rentals based on their overall comparability to the subject -- that is, how similar the rental is in regard to square footage, location, condition, and use.

How is the potential gross income (PGI) calculated for an income-producing property?

The Potential Gross Income (PGI) is the income generated by rents before any considerations for vacancy and operating expenses. It is often referred to as "gross income" or "gross revenue." In some instances, an Appraiser may determine that a property's rents are at market; the Appraiser then uses the actual rents to project the income-stream over a 12-month period, leading to an estimate of the PGI.

In many cases, a property may be encumbered below-market rents or a long-term below-market lease. An Appraiser may opt to project the rents at market rates, and deduct income loss over the lease term from the final value. See the example below:

An Appraiser is working on a property that generates $70,000 per year in PGI. Market rentals illustrate that the subject should be generating $80,000 per year in PGI. The subject is currently encumbered by a long-term lease for five more years. The Appraiser ultimately values the subject at $700,000 based on market rents, but deducts $50,000 ($10,000 in income loss from below market rents x 5 years) from the value to account for the below-market lease. The Appraiser ultimately arrives at a value of $650,000.

In rarer instances, a lease may be above-market. This usually leads the Appraiser to select a higher capitalization rate (discussed below) to reflect the greater risks and potential decrease in income after the above-market lease expires.

Why is vacancy and collection deducted from the PGI? How is this percentage derived?

The effective gross income (EGI) is the income after a market vacancy and collection rate is applied. A vacancy rate is applied to reflect what the typical investor could expect from purchasing an income-producing property. Even if a property is fully occupied, a typical investor would still consider vacancy as a possible risk -- especially if the property is occupied by a single tenant. The Vacancy & Collection Rate also reflects the reality that tenants do not always pay on time, which could have serious consequences for the property owner (late mortgage payments, late bill payments, etc.)

The Vacancy & Collection rate is typically derived from a variety of sources, including national and local surveys, interviews with local real estate brokers, and a property's historical vacancy rate.

How is the Net Operating Income (NOI) calculated?

After the Appraiser finds the EGI, they proceed to calculate the Net Operating Income (NOI). The NOI is the income produced by the property after all expenses are taken into consideration. Expenses may include real estate taxes, insurance, utilities, maintenance and repair, and management. The NOI is always calculated BEFORE debt service. Financing expenses are never deducted from the EGI.

Appraisers often use a mix of actual expenses and projected expenses to calculate the NOI, as some expenses are considered variable from year to year (e.g., maintenance.) Consider the example below:

PGI = $50,000
Vacancy & Collection = 5%
EGI = $47,500 ($50,000 - $2,500)
- Real Estate Taxes = $4,000
- Insurance = $2,000
- Water & Sewer = $1,000
- Management (Projected @ 5% of EGI) = $2,375
- Maintenance & Repairs (Projected @ 3% of EGI) = $1,425
- Replacement Reserves (2% of EGI) = $950
Total Expenses = $11,750
NOI = $35,750

You may be wondering: what are replacement reserves and why were they deducted from the EGI? Simply put, replacement reserves reflect the theoretical amount of capital an owner sets aside over the long-term to replace more short-lived property components, like a building's HVAC system or roof. Even if the ownership does not have an actual reserve -- ill advised! -- this expense is still deducted because a major repair will need to occur at some point. Replacement reserves can be projected higher or lower, depending on the age and lifespan of the short-lived components (e.g., a completely new building may be projected at 2% reserves, while an older building with a leaky roof may be projected at 4% reserves.)

What is a capitalization rate? How is income converted to value?

A capitalization rate reflects the overall rate of return that an investor can expect from their income-producing property. It is expressed as a percentage. A capitalization rate is derived using the following formula:

Cap Rate = NOI / Value

Example: 10% =$50,000 (NOI) / $500,000 (Value)

Appraisers use multiple sources to determine a market capitalization rate for a given property. Sources may include local sales of income-producing properties (generally considered the most reliable), local and national market surveys for a property type, the Band of Investment Technique, and interviews with market participants like real estate brokers.

After an Appraiser decides an appropriate capitalization rate, it can be used to determine a value with the following formula:

Value = NOI / Cap Rate

Example: NOI = $35,570 (from previous section)

Cap Rate = 8.00%, based on local sales

Value = $35,570 / 0.08

Value = $444,625 (rounded to nearest $10,000, or $440,000)

Factors that influence the Appraiser's selection of a capitalization rate may be lease terms, current mortgage interest rates, the quality of the tenant (e.g., a McDonalds vs. a local restaurant), and the condition and location of the property.