Income Approach

Income approach

Based on the following economic principles

- Principle of anticipation states that the value of any property maybe

defined as the present worth of future benefits

- Principle of Agents of Production states that all production stems from

the use of four agents: labor, coordination, capital and land; these
agents are paid, in the order listed, from available income

- Principle of Contribution states that the value of each one of the four
agents of production is proportional to that part of the total income that it
contributes

- Principle of Highest and Best Use states that the highest and best use
of property is that use which produces the greatest income return to the
land and therefore develops the highest land value
2
Income approach

A process of converting income into value

Requires an accurate estimation of income and
expenses and the selection of a capitalization rate
and capitalization technique by which net income is
processed into value

3
Advantages/Disadvantages

Primary advantage
It approximates the thinking of the typical
investor, who is interested in peso return on and
return of an investment in income producing real
estate
Disadvantages
A complex set of relationships must be developed
Complexities of income capitalization tend to
confuse non appraisers

4
 Investment Criteria

Safety investment safety refers to the reliability of the

net income and assurance of getting the original
investment back without loss
Yield all other things being equal, the investment with
the highest yield is the most desirable; refers to the return
on the investment such as interest
Liquidity the ease with which an investment can be sold
is a factor in its value
Freedom from management burden investments that
require the lest attention and overall supervision are
usually the more attractive ones; real estate generally
requires considerably more management effort than
financial investments such as bonds and securities.
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 Investment Criteria

Prospects for appreciation when purchasers of either

corporate stocks or real estate can anticipate an increase
in the value of the investment, they are satisfied with
lower current earnings
Burden of property taxes ad valorem taxes decrease
the net income of investment property
Shelter from income taxes buyers will accept a lower
return for income that is sheltered from income tax
Size or denomination small investments tend to have
broader market appeal and greater liquidity than large
ones; i.e. Limited partnerships and syndications
6
 Investment Criteria

Hypothecation using an investment as security for a

loan provides a practical substitute for investment
liquidity; relative stability of real estate makes it superior
to many other types of investments in this respect
Leverage advantage in low equity results when property
yield is higher than the cost of loan money; a similar
leverage occurs when low equity is held on a highly
depreciable property, or property experiencing rapid
market appreciation

7
Motives and Benefits of Ownership

Tangible benefits
Return on investment (which is like interest)
Return of investment (allowing the investment funds to be
recovered)
Intangible benefits
Pride of ownership
Sense of security
Development and application of management skills

8
 Utility, Income and Value

Utility is one of the basic characteristics of value.

For any commodity to have value, it must have
usefulness
Everything else being equal, the greater the utility, the greater the
value
Income is defined as the annual money received or
as the return or flow of funds from an investment.
Examples: in case of savings, expense free earnings, dividends paid
on stocks; in terms of real estate investment, the net rent
Value is the present worth of future benefits
Can also be described as the relationship between the amount of net
income produced and the rate of return on required by the typical
investor
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Methods of Appraising Income Property

Income Capitalization Techniques

Direct capitalization technique - the most widely used and
simplest approach to apply. It is used when income is not
expected to vary significantly over time.
Building residual technique
Land residual technique
Equity residual technique

Yield Capitalization -requires explicit projects of income,

holding period, and property reversion and generally
considers the income streams for several years.

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Methods of Appraising Income Property (cont)

GrossRent (or Gross Income) Multiplier

commonly used as the income approach in the
appraisal of single family residential properties
A unit of comparison .
It helps the appraiser compare the subject property to the
sale properties by using an economic measurement of the
propertys usefulness the rent
Simply the ratio of the selling price to the gross income or
computed as sales price divided by gross income

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Gross income and gross rent multipliers

Substitute for a more elaborate income capitalization analysis

Expressed as
o Gross income multiplier (GIM) = Sales Price/Gross Income
o Gross rent multiplier (GRM) = Sales Price/Gross Rent
Illustration : A commercial property sold a month ago for
P11,000,000. The annual gross income is P1,250,000. What is
the GIM of the property?
P11,000,000/1,250,000 = 8.8, the GIM for this property

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 Deriving Gross Rent Multipliers

1. Make an adequate search for comparable sales.

At least 3 recent sales (or comparable offerings)
are desired. A larger sample is often preferred
2. Estimate the market rents for each comparable
as of the time of sale
3. Divide the selling price (adjusted for any unusual
terms) by the gross rent for each comparable
4. The result is called the gross rent (or income)
multiplier and is abbreviated GRM or GIM.

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 Selecting and Using Gross Rent Multipliers

1. Location and neighborhood

The buyers impression of risk relative to other investments and
prospects for value appreciation is influenced by the location
and neighborhood. Higher multipliers are associated with better
location
2. Intangible amenities
Multipliers are typically higher for property bought for owner-
occupancy or other notable intangible benefits, i.e. prestigious
address, a famous building
3. Income-expense ratio
Properties with lower operating expenses will normally sell for a
higher gross multiplier. Investors are interested in the net
income, not the gross income

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 Selecting and Using Gross Rent Multipliers

4. Number of units
The number of units tends to identify which investment market
the property would sell in; it also affects operating efficiency.
Very small complexes often sell at higher than average
multipliers because of the intangible amenities.
5. Size per unit
Buildings with small dwelling units can have higher operating
costs and often higher turnover rates; multipliers are often lower
than average
6. Services included
Utilities, furniture and other services provided by the landlord
increase operating costs relative to buildings where tenants pay
for them. Hence lower multipliers often result

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 Effect of Expenses on the Gross Rent
Multiplier

Capitalization
Annual Gross Rent Expenses Net Income Rate Price GRM
1,400,000.00 30.00% 980,000.00 7.00% 14,000,000.00 10.00
1,400,000.00 40.00% 840,000.00 7.00% 12,000,000.00 8.57
1,400,000.00 50.00% 700,000.00 7.00% 10,000,000.00 7.14

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 GRM Application

Application: Assume that you are appraising a 10-

unit, unfurnished apartment building with a
scheduled annual gross rent of Php2,725,000. A
rent survey suggests that the schedule agrees
with the prevailing market rents in the area.
Your comparable sales have been analyzed and
market rents established at the time of sale for each.
The results follow:

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 GRM Application

Number of Number of
Comparable Furnished Unfurnished Gross Rent
Number Units Units Price Scheduled Gross Multiplier
1 10 - 25,000,000.00 3,100,000.00 8.1
2 - 9 21,250,000.00 2,125,000.00 10.0
3 - 5 14,500,000.00 1,200,000.00 12.1
4 4 8 27,625,000.00 3,250,000.00 8.5
5 - 12 23,750,000.00 2,500,000.00 9.5

1) Assigning the most weight to Comparables 2 & 5 as most similar to the subject, a GRM of
9.75 is suggested for the appraisal
2) Comparables 1 & 4 were not stressed, since they involvred furnished units
3) Comparable 3 is not considered competitive with the subject, since it is a smaller project
that appeals to a different investor market

Value conclusion:
Annual gross 2,725,000.00 x 9.75 = 26,568,750.00

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 GIM Application

Illustration: GIM
Sale No. Market Value Annual Gross Income GIM
1 PHP 4,300,000.00 PHP 430,000.00 10.0
2 6,580,000.00 730,000.00 9.0
3 5,400,000.00 560,000.00 9.6
4 8,000,000.00 950,000.00 8.4
5 4,900,000.00 515,000.00 9.5
Subject ? 475,000.00 ?

Range: P475,000 x 8.4= P3,990,000

P475,000 x 10 = P4,750,000
Market value = P4,370,000

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 Income Capitalization Approach Definitions

Capitalization process of converting the net income of a

property into its equivalent capital value; recognizes a
principle known as time value of money.
Reflects the time value of money by reducing or discounting future
income to its present worth
Actual mathematics of discounting can be a direct capitalization, or
indirect, depending upon the capitalization techniques used

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 Income Capitalization Approach Definitions

Capitalization rate generally defined as a rate of return,

or percentage, used to convert income into its equivalent.
Such a rate directly or indirectly provides for a return on the
investment (interest), as well as a return of the investment (capital
recovery).
Reversion future or deferred return when an
investment is resold

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 Distinct Types of Rates

1. Interest rate rate of return of invested capital;

synonymous with yield rate and discount rate; does not
include provision for recapture of investment capital
2. Overall capitalization rate the relationship between net
income and value for the total property (or the ratio of net
income to value); theoretically allows for both return on
investment and recapture of investment capital, but the
proportions are usually unknown
3. Recapture rate rate at which invested funds are being
returned to the investor
4. Composite capitalization rate composed of interest rate
and recapture, in separately determined amounts and
known proportions
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 Methods of Estimating Rates

1. Direct Comparison Method generally the preferred

method; analyze recent sales of similar properties and in
each case divide the net income by the sales price (after
adjusting for nonmarket financing)
2. Band of Investment Method produces a capitalization
rate that is a weighted average
3. Summation Method calculated by combining or adding
up amounts for the separate theoretical elements that
help determine yield rates; also called a built-up rate

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 Building a capitalization rate

Basic components are the recapture rate and the interest rate
o Capital recapture return of the investment the right to get
back the purchase price at the end of the term of ownership and is
ordinarily expressed as an annual rate
o Interest rate also the discount rate, risk rate or return on rate
return on the investment - the investors profit on the money
used to purchase the property
Because land usually does not depreciate, its sales price at the
end of the investors period is considered adequate
compensation
Buildings depreciate, however, and the investor has an asset of
continually decreasing value. This anticipated future
depreciation is provided for in the recapture part of the cap
rate.
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 Building a capitalization rate Illustration

Construct an interest rate for a recently sold commercial

property with the following known facts: the selling price was
P18,705,000. The site value is P5,375,000 and the buildings
remaining economic life is 25 years. Total net operating income
is P2,451,000. What is the overall cap rate for the property?

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 Building a capitalization rate
Solution to Illustration

Computations
A Selling price Given 18,705,000.00
B Site value Given 5,375,000.00
C Building value A-B 13,330,000.00
Building estimated
D remaining life Given 25.00
E Recapture rate 1/D 0.04
NOI available for
F building recapture CxE 533,200.00
Total net operating
G income Given 2,451,000.00
H NOI available for site G-F 1,917,800.00
I Interest rate H/A 10.25%
J Overall cap rate I+E 14.25%

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 Building a capitalization rate Illustration

You are appraising an industrial building with an NOI of

P731,000. You have previously appraised or studied the
comparable properties listed below. Use all the information
you have on hand to find a suitable capitalization rate for the
subject, then the subjects value. Round your answer to the
nearest P1,000.
Property Selling Price Net operating income Capitalization rate
A 5,848,000.00 636,000.00 10.9%
B 4,042,000.00 473,000.00 11.7%
C 5,461,000.00 645,000.00 11.8%
D 4,752,000.00 542,000.00 11.4%
E 6,450,000.00 1,376,000.00 21.3%

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 Building a capitalization rate
Solution to Illustration

Property Selling Price Net operating income Capitalization rate

A 5,848,000.00 636,000.00 10.9%
B 4,042,000.00 473,000.00 11.7%
C 5,461,000.00 645,000.00 11.8%
D 4,752,000.00 542,000.00 11.4%
E 6,450,000.00 1,376,000.00 21.3%

The capitalization rate of property E appears out of line with the rest of the comparables and should be discarded

Range 6,722,000.00 731,000.00 10.9%

6,189,000.00 731,000.00 11.8%
6,455,500.00

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 Band of investment method
Mortgage and equity elements

Considers the financial components, or bands of debt and

equity capital required to support the investment.
Takes into account everyone who has a financial interest in the
real estate being appraised
Must take into account both the rate required by the lender and
the rate necessary for the equity investors desired pretax cash
flow
Mortgage constant rate required by the lender
Equity capitalization rate also cash on cash rate, cash flow
rate or equity dividend rate - required by the equity investor,
which is the ratio of the investors expected pretax cash flow to
the investments value

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 Band of investment method
Mortgage and equity elements Illustration

Assume a case in which a mortgage with a 15-year

amortization period covering 60% of the value of the property
can be obtained at 8% interest and the buyer requires a return
of 10% on the equity portion (the 40% of the value of the
property the buyer will invest). Using the band of investment
method, the overall rate could be developed as:

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 Band of investment method
Mortgage and equity elements
Solution to Illustration

Mortgage constant
Loan principal amount 5,000,000.00
Term of loan 15 years
Interest 8%
Monthly amortization PHP 47,782.60
Annual debt service PHP 573,391.22
Mortgage constant 11.5%

Percent of Property's Total

Value Return Required
Loan 60% 11.5% Mortgage constant 6.88%
Equity 40% 10.00% Equity cap rate 4.00%
Band of Investment 10.88%

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 Band of investment method
Mortgage and equity elements Illustration

Assuming the following data, what capitalization rate would

you use in appraising the subject property?
A 10-year mortgage covering 70% of property value can be
obtained from a bank at 8 %. The mortgage constant is .092.
Equity for this type of property requires a 12% return.

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 Band of investment method
Mortgage and equity elements
Solution to Illustration

Percent of Property's Total

Value Return Required
Loan 70% 9.2% Mortgage constant 6.44%
Equity 30% 12.00% Equity cap rate 3.60%
Band of Investment 10.04%

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 The Summation Method - Example

Safe rate +6.75% Weakness lies in the imprecise

Investment +2.00% and subjective methods
risk
available for rating the various
Lack of +1.25%
liquidity
investment features involved
Burden of +1.00%
management
Prospects for -2.00%
appreciation
Indicated 9.00%
interest rate

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Relationship of Capitalization Rate and Risk

High risk = high capitalization rate

Low risk = low capitalization rate
High risk = high capitalization rate = low value
Low risk = low capitalization rate = high value

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 Direct Capitalization Technique - Steps

Estimate an overall capitalization rate by one of

the 3 methods
Capitalization rate = net operating income/value

Capitalize the net income that is projected for

the subject property
Value = net operating income/capitalization rate

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 Direct Capitalization Technique - Example

Net operating income = Php6,000,000/

Divide by: overall capitalization
Rate, say 10%
Equals: Indicated Value Php60,000,000

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 Building Residual Technique

Used to capitalize income when there is reliable data to

support an accurate estimate of the land value, but the
building value is unknown.
Most useful when appraising older buildings, and the
sales data are inadequate to estimate overall rates for the
direct capitalization technique

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 Building Residual Technique - Steps

1. Estimate the interest rate and recapture rate

2. Calculate the amount of income needed to provide a
return on the land investment by multiplying the land
value times the selected interest rate. The resulting
income is sometimes referred to as the land charge
3. Subtract the land return from the total net operating
income to calculate the income that can be attributable
to the improvements
4. Capitalize the income to the improvements by using a
composite building capitalization rate that combines
both interest and recapture
5. Add the indicated value for the improvements to the
value indicated for the land to obtain the property value
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 Building Residual Technique - Example

Assume:

Net operating income Php2,550,000

Land value (estimated from land Php5,000,000

sales)
Interest rate (estimated from 7%
sales of leased land)

Recapture rate (estimated from 4%

the age and condition of the
subject)

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 Building Residual Technique
Solution to Example

Net income 2,550,000.00

Less: Return required on land
(Php5,000,000 x 0.07) 350,000.00
Equals Net income to improvements 2,200,000.00
Divided by: Composite rate
Interest rate 0.07
Plus: recapture rate 0.04
Equals: Composite ratw 0.11
Equals: Indicated improvement value 20,000,000.00
Plus: Land value 5,000,000.00
Equals: Property value 25,000,000.00

41
 Land Residual Technique

Useful when the building value can be reliably estimated,

but the land value is unknown
When the improvements are new or nearly new and are
also clearly the highest and best use of the land, the
value of the improvements is likely to equal their cost of
reproduction

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 Building Residual Technique - Steps

1. Calculate the interest rate and recapture rate

2. Add the two rates to calculate the composite building
capitalization rate
3. Estimate the value of the improvements by using their
reproduction or replacement cost less accrued
depreciation
4. Multiply the improvement value by the composite rate
calculated in Step 2. The result is known as the
building charge, or the income needed to provide the
desired return of, and return on, the building investment
5. Subtract the building charge from the net operating
income to calculate the net income that can be
attributable to the land
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 Building Residual Technique - Steps

6. Divide the net income available to the land by the

selected interest rate. The result is the indicated value
of the land
7. Add the estimated values for the land and building to
calculate the indicated value for the property

44
 Land Residual Technique - Example

Assume:
Net operating income Php1,750,000
Building cost new Php15,000,000
Interest rate (estimated from 6.5%
band of investment or summation
method)
Recapture rate (estimated from 2.5%
the age and condition of the
subject)

45
 Land Residual Technique
Solution to Example

Net income 1,750,000.00

Less: Income to building
Improvement value 15,000,000.00
Times: Composite rate
Interest rate 0.065
Plus: recapture rate 0.025
Equals: Composite rate 0.09
Equals: Income to building 1,350,000.00
Equals Income to land 400,000.00
Divide by: Interest rate 0.065
Equals: Land value 6,153,846.15
Plus: Improvement value 15,000,000.00
Equals: Property value 21,153,846.15
Rounded: 21,154,000.00

46
 Equity Residual Technique

Analyzes the cash flow from an investment.

Could also be described as the residual income to the
equity investment.
Can be used whenever financing terms are a major
influence upon market prices
When the equity residual technique is calculated using
the typical market financing terms and equity rates, it
results in an estimate of market value for the property
When calculated using unique financing rates (e.g. sellers
financing), the resulting value is properly described as
value as financed

47
 Equity Residual Technique - Steps

1. Subtract the annual loan payments from the net

operating income to estimate the annual cash flow to
the investor
2. Divide the equity cash flow, from Step 1, by the
estimated equity cash-on-cash rate (equity dividend
rate). The result is the indicated value of the equity.
3. Add the indicated value of the equity to the amount
owed on the mortgage. The result is the estimated
value of the property.

48
 Equity Residual Technique - Example

Assume:
Net operating income Php2,500,000
Loan amount Php15,000,000
Annual loan payments Php1,930,000

Equity cash-on-cash rate 7%

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 Equity Residual Technique
Solution to Example

Net income 2,500,000.00

Less: Loan payments 1,930,000.00
Equals: Equity cash flow 570,000.00
Divided by: Equity cash-on-cash rate 0.07
Equals: Indicated equity value 8,142,857.14
Plus: Loan amount 15,000,000.00
Equals: Total value estimate 23,142,857.14
Rounded: 23,143,000.00

50
 Yield Capitalization Technique

A method used to convert future benefits into present

value by discounting each future benefit at an appropriate
yield rate or by developing an overall rate that explicitly
reflects the investments income pattern, value change,
and yield rate
Should reflect market behavior
Called as yield capitalization because it analyzes whether
an investment property will produce the particular level of
profit or yield required

51
 Income Capitalization Approach Basic Steps

1. Estimate the annual gross income the property is capable of

producing
2. Estimate typical vacancy and collection losses
3. Subtract rent losses from gross income to arrive at the effective gross
income
4. Estimate annual expenses and subtract them from the effective gross
income to determine the net income (or net operating income)
5. Analyze comparable investments to arrive at a capitalization rate and
method appropriate for the subject property
6. Divide the net operating income by the capitalization rate to obtain the
capitalized value.

52
 Potential gross income

Propertys total potential income from all sources during a

specified period of time, usually a year
Illustration 1: You are appraising a six-unit residential property
and the only information available is the following yearly
income and expense data. List the income information in
statement form, then compute the estimated potential gross
income.
o Apartment rental income is P1,376,000. Outlay for janitorial
service is P116,000, with another P30,000 for supplies. Utilities are
P206,000 and maintenance and repairs amount to about P43,000.
Taxes are P116,000. Income from washers and dryers is P39,000.
Building depreciation is estimated at P108,000 per year. Rental
spaces in the adjacent parking lot bring in P43,000 per year.

53
 Potential gross income
Solution to Illustration

Potential Gross Income

Apartment rental income PHP 1,376,000.00
Income from washers and dryers 39,000.00
Rental spaces (parking) 43,000.00
1,458,000.00

54
 Effective Gross Income

Derived by totaling potential income from all sources, then

subtracting vacancy and collection losses
Appropriate rate to allow for anticipated vacancy and collection
losses is based on market conditions
Illustration : An eight-unit apartment building historically has 4%
vacancy rate and a 4% collection loss rate. A current survey of
the local market also supports these vacancy estimates. The
projected income for the building over the next year is
P1,995,000 market rent, P86,000 parking income, P56,000
from vending machine income and P34,000 income from
laundry facilities. What is the propertys effective gross
income?

55
 Effective Gross Income
Solution to Illustration

Potential Gross Income

Market rent PHP 1,995,000.00
Parking 86,000.00
Vending machines 56,000.00
Laundry facilities 34,000.00
2,171,000.00
Vacancy and collection losses
@8% of potential gross income (174,000.00)
Effective gross income PHP 1,997,000.00

56
Income capitalization approach Illustration

Using income and expense information in the

illustration, draw up an effective gross income
statement for the subject property. The effective gross
income will be based on the following vacancy and
rental losses: the apartment units are vacant for an
average of one week each year. There has also been a
total rental loss of 3% for each of the past three years.

57
Income capitalization approach Solution to
Illustration

Potential Gross Income

Apartment rental income PHP 1,376,000.00
Income from washers and dryers 39,000.00
Rental spaces (parking) 43,000.00
1,458,000.00
Vacancy and collection losses
@5% of potential gross income (73,000.00)
Effective gross income PHP 1,385,000.00

Computation of vacancy
6.00 units
52.00 weeks
Full occupancy 312.00
Vacancy 6.00 units/year
Vacancy allowance 1.9%
Say 2.0%
Collection losses 3%
Vacancy & collection losses
allowance 5.00%

58
 Net operating income

Calculated by deducting the operating expenses of owning a

property from its effective gross income
Operating expenses are the periodic expenditures needed to
maintain the property and continue the production of the
effective gross income
Customarily expressed in annual amount.
Expenses incurred depend on the property and the services
provided by the owner

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 Classification of operating expenses

Variable expenses
o Out of pocket costs incurred for management, wages and benefits
of building employees, fuel, utility services, decorating, repairs and
other items required to operate the property.
o Vary according to the occupancy level of the property
Fixed expenses
o Costs that more or less permanent and do not vary according to
occupancy, such as real estate taxes and insurance for fire, theft
and hazards
Reserves for replacement (capital expenditure)
o Allowances set up for replacement of building and equipment items
that have a relatively short life expectancy. For example, roof
replacements, elevators, etc.

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 Expenses for Appraisal Purposes

Operating expenses for appraisal purposes do not include

expenditures that are beyond the direct operation of an income
producing property
Four types of expenses that are not operating expenses of real
estate
o Financing costs property is appraised without considering
available or probable financing, except under the mortgage equity
capitalization method.
o Income tax payments Income taxes relate to the owner, not the
property

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Expenses for Appraisal Purposes (cont)

o Depreciation charges on buildings or other improvements annual

depreciation charge is an accounting method of recovering the cost
of an investment over a period of time. Process of capitalization
provides for the recovery of the investment
o Capital improvements payments are not treated as operating
expenses but are taken from the replacement reserve monies

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 Selected Financial Ratios

Operating Expense Ratio (OER) - ratio between the total

operating expenses and the effective gross income for an
income producing property.
Net Income Ratio - the ratio of the net operating income to
effective gross income
Break-even ratio (BER) - (Debt Service + Operating Expenses)
/ Gross Operating Income

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 Yield capitalization (Discounted cash flow
analysis)

Value estimates for a variety of ownership interests

maybe calculated by forecasting cash flows over a typical
holding period and discounting those cash flows to a
present value estimate using a typical discount rate
Discount rates used in this approach directly address the
expected profitability of the investment

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 Yield capitalization (Discounted cash flow
analysis) Illustration

(Fixed income and a fixed resale price) -12% DR

Year 1 2 3 4 5
Potential Gross Income
(PGI) 300,000.00 300,000.00 300,000.00 300,000.00 300,000.00
Less: vacancy & credit loss (18,000.00) (18,000.00) (18,000.00) (18,000.00) (18,000.00)
Effective gross income
(EGI) 282,000.00 282,000.00 282,000.00 282,000.00 282,000.00
Less: operatinmg
expenses (82,000.00) (82,000.00) (82,000.00) (82,000.00) (82,000.00)
Net operating income
(NOI) 200,000.00 200,000.00 200,000.00 200,000.00 200,000.00
Present value factor 0.892857 0.797194 0.711780 0.635518 0.567427
PV 178,571 159,439 142,356 127,104 113,485
Net sale proceeds 2,300,000.00
Value 720,955 1,305,082
2,026,037

65
 Yield capitalization (Discounted cash flow
analysis) Illustration

(Fixed income and a fixed resale price)

Short cut

Present value annuity

@12% Present value factor
200,000.00 x 3.604776 = 720,955
2,300,000.00 x 0.567427 = 1,305,082
Total present value 2,026,037

66
 Yield capitalization (Discounted cash flow
analysis) Illustration

(Variable income and a fixed resale price)

Year 1 2 3 4 5 6
Growth rate
(compounded annually) 4% 4% 4% 4% 4%
Potential Gross Income
(PGI) 300,000.00 312,000.00 324,480.00 337,459 350,958 364,996
Less: vacancy & credit loss (18,000) (18,720) (19,469) (20,248) (21,057) (21,900)
Effective gross income
(EGI) 282,000 293,280 305,011 317,212 329,900 343,096
Less: operatinmg
expenses (82,000.00) (85,024.00) (88,183.00) (94,580.00) (98,021.00) (101,616.00)
Net operating income
(NOI) 200,000 208,256 216,828 222,632 231,879 241,480
Present value factor 0.892857 0.797194 0.711780 0.635518 0.567427 0.477194
PV 178,571 166,020 154,334 141,486 131,574
Net sale proceeds 2,300,000.00
Value 771,987 1,305,082
2,077,069
67
 Yield capitalization (Discounted cash flow
analysis) Illustration

(Variable income and Resale based on a terminal capitalization

rate)
Year 1 2 3 4 5 6
Growth rate
(compounded annually) 4% 4% 4% 4% 4%
Potential Gross Income
(PGI) 300,000.00 312,000.00 324,480.00 337,459 350,958 364,996
Less: vacancy & credit loss (18,000) (18,720) (19,469) (20,248) (21,057) (21,900)
Effective gross income
(EGI) 282,000 293,280 305,011 317,212 329,900 343,096
Less: operatinmg
expenses (82,000.00) (85,024.00) (88,183.00) (94,580.00) (98,021.00) (101,616.00)
Net operating income
(NOI) 200,000 208,256 216,828 222,632 231,879 241,480
Present value factor 0.892857 0.797194 0.711780 0.635518 0.567427 0.477194
PV 178,571 166,020 154,334 141,486 131,574 115,233
Net sale proceeds 2,414,801
Value 771,987 1,370,223
2,142,210

Terminal capitalization
rate 10%
Discount rate 12%
68
 Workshop - Income approach

1. The ratio of the total operating expenses to effective gross

income is the (a) operating expense ratio (b) net income
ratio (c) effective gross income ratio (d) break-even ratio
2. The ratio of the net operating income to effective gross
income is the (a) operating expense ratio (b) net income
ratio (c) effective gross income ratio (d) break-even ratio
3. The ratio of the operating expenses plus annual debt service
to potential gross income is the - (a) operating expense ratio
(b) net income ratio (c) effective gross income ratio (d) break-
even ratio

69
 Workshop - Income approach

4. A building that has an effective gross income of P2,150,000

and total operating expenses of P430,000 has what
operating expense ratio? (a) .10 (b) .15 (c) .20 (d) .25
5. The building described in problem 4 has what net income
ratio? (a) .80 (b) .90 (c) 1 (d) 5

70
 Workshop - Income approach

6. In the building residual technique, the appraiser starts with an

assumption of
a) Replacement cost
b) Building value
c) Net capitalization
d) Land value
7. The cash on cash rate is the same as the
a) Yield capitalization rate
b) Equity dividend rate
c) Overall capitalization rate
d) Break even point

71
 Workshop - Income approach

8. Name the two component rates that are inherent in

every capitalization rate
9. Under which method are the recapture installments
lowest in the earlier years?
a) Annuity
b) Straight-line
10. Under which method are the recapture installments
highest?
a) Annuity
b) Straight-line
11. Of the two recapture approaches, which would yield (a) the
highest value? (b) the lowest value?
72
 Workshop - Income approach

12. Which recapture method suggests the greatest reduction in

risk? (a) annuity (b) straight-line
13. Using the following data, compute value by (a) the building
residual technique and (b) the land residual technique
Given: net operating income is P1,720,000; land value is
P2,150,000; 65% of the value of the property can be
borrowed at 11%, and equity capital for this type of
investment requires a 12% return; the buildings remaining
economic life is 25 years.

73
 Workshop - Income approach

14. In this problem, you will estimate the market value of a property
by the income capitalization approach.
You have been asked to appraise a one-storey commercial
building located in a small neighborhood shopping center.
The building is about 12 years old and is divided into four (4)
separate stores, all of equal size. Each store pays a yearly
rental of P450,000, which is well in line with comparable
properties analyzed.
The owner of the subject property lists the following items of
expense for the previous year: real estate taxes, P150,000;
insurance three-year policy, P120,000; repairs and
maintenance P120,000; mortgage payments P350,000;
legal and accounting fees, P25,000; miscellaneous expenses
P21,500. 74
 Workshop - Income approach

In addition to the above expense listing, you obtain the

following information:
Tenants pay for their own water, electricity and garbage removal
Repairs and maintenance should be based on 12% of effective
gross income
Miscellaneous expenses should be increased to 2% of potential
gross income
The records of property managers indicate that vacancy and
collection losses in the area run about 4%.
A new roof, costing P100,000 and having an average life of 20
years was installed last year
Recent sales in the area indicate that the land value of the
subject property should be estimated at P2,500,000.
You have determined from the banks in the area that 75% of the
value of the property can be borrowed at 11% interest, and equity
money for this type of investment requires a 13% return 75
 Workshop - Income approach

You have determined from the banks in the area that 75% of the
value of the property can be borrowed at 11% interest, and equity
money for this type of investment requires a 13% return
The building is 12 years old and appears to have depreciated
about one-third
On the basis of the information provided on the previous
pages, reconstruct the operating statement; determine the
capitalization rate and estimate the property value.

76
 Workshop - Income approach

15. You are appraising a commercial building earning an annual

NOI before recapture of P2,150,000. Based on supportable
information, the interest rate has been established at 15%.
Land value has been estimated at P4,300,000 and the
buildings remaining economic life at 25 years. Determine the
estimated value of the property in each case below.
a) The property has year-to-year tenants of average credit risk
b) The property is leased for the entire 25 years to a national
concern with an excellent credit rating.

77
 ANY
QUESTIONS???

78
THANK YOU

79