Chapter 3

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Chapter 3

Income and Expense Analysis

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Chapter Objectives

• Upon completion of this chapter, the participant will be able to:– Recognize critical information related to the appraiser’s

lease analysis– Recall recognized methods and techniques for

estimating and applying market level rent as a component of the appraiser’s value analysis

– Estimate, from analysis of market data, various losses and operating expenses associated with income-producing properties

– Identify the method and use of expense and income ratios

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Key Terms

• Collection Loss

• Estate for Years

• Net Income Ratio (NIR)

• Operating Expense Ratio (OER)

• Periodic Tenancy

• Reconstructed Operating Income Statement

• Rent Roll

• Rent Survey

• Vacancy Rate

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Lease Analysis

• Level of analysis is determined by scope of work:– Amount of agreed-upon rent– Term of lease (e.g., month-to-month, one year)– Provisions for rent or terms to change– Beginning and ending date– Personal property included– Expenses paid by landlord/tenant– Other services/amenities provided by landlord

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Analyzing Lease Documents

• Easier for smaller residential income properties than those with a large number of units

• Leases are not standard and can vary in style, format, and content

• Not all of the content will be meaningful to the appraiser– Some portions are of special interest

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Analyzing Lease Documentscontinued

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Analyzing Lease Documents

• Month-to-month agreements are referred to in many areas as a periodic tenancy– When the rent is paid for that month (or some

other period of time), the lease automatically renews until the rent is due at the beginning of the next period

• When the lease agreement is for a specified period of time (e.g., 6 months or 1 year), the agreement creates a leasehold estate known in some areas as estate for years or a term tenancy

continued

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Rent Roll

• Briefly details the unit information, lease terms, and contract rent, as well as the effective date of the leases that are in place for the property– Can be compiled by the client or property owner

as an alternative to presenting each individual lease

– Could be created as a summary of the lease terms and information by the appraiser after he examines individual lease documents

– Appraiser might develop a rent roll based upon an interview with the client or property owner

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Rent Roll Example

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Estimating Market Level Rent

• Determining an applicable market level rate of rent for subject property is the core of the appraiser’s income analysis for any income-producing property

• If data is plentiful and relevant, this will be relatively simple

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Rent Surveys

• A compilation of the rents being generated, and often rent history, in a particular market for a particular property type

• Should include properties that share similar:– Locational desirability– Physical characteristics– Lease terms and conditions

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Rent Survey Example

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Adjusting Rent Data

• Some physical differences can be observed for which a dollar amount could be assigned for the possible adjustments

• The scope of work might require the appraiser to further analyze different elements of market appeal

– Knowledge of market and market participants will assist the appraiser with this recognition

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Deriving Rent AdjustmentsExample 1

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Deriving Rent AdjustmentsExample 2

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Applying Rent Adjustments

Bedroom--$50 per month

Central Air-Conditioning--$25 per month

Covered Parking--$50 per month

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Estimating Vacancy and Collection Losses

• Losses due to vacancy and collection are usually based on a percentage of the PGI

• The percentage applied is derived from information obtained through:– The property owner– Analysis of leases or rent roll– Market data of other similar properties

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Deriving a Vacancy Rate

• Vacancy Rate: A percentage rate for all units comprised of the total number of unrented days divided by the total number of rentable days in a year– Should always reflect market level

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Deriving a Vacancy Rate Example

Subject’s Vacancy Rate:

28 Days ÷ 1,460 Days (365 x 4 units) = 1.92% (Vacancy Rate)

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Deriving a Vacancy Rate Example

• The subject property owner’s estimation of vacancy is not representative of market level

• Since the subject has four units, market level vacancy rates would fall somewhere between 2.38% and 2.51%

• If the subject’s PGI was $36,000 ($750 x 4 units x 12 months) and a vacancy rate of 2.50% was determined to be appropriate for the subject, the vacancy loss would be $900

$36,000 x 2.50% (0.025) = $900

continued

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Treatment of Collection Losses

• Collection (or credit) loss: An amount stated as a percent or a dollar amount reflecting the risk anticipated for nonpayment of rent by tenants

• Appropriate when the market supports that there is evidence in the market for its use– Can be derived from surveys similar to that

which was performed to derive a market vacancy rate

• When warranted, it is applied to PGI in the same manner as the percentage for vacancy loss

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Expense Analysis

• Market level operating expenses must be estimated when scope of work includes the analysis of NOI

• Data ideally provided by, or through an interview with the property owner

• Appraiser will typically develop a reconstructed operating income statement:– A statement prepared by the appraiser that

reflects anticipated net operating income (NOI)

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Expense Analysis Example

• See extensive example on pages 33-35

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Operating Income Analysis

• Extensive analysis is common for larger multi-family properties

• A specific form reporting the reconstructed operating income statement is most often a client requirement for 2- to 4-unit residential properties when appraisal is to be used in a mortgage finance transaction

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Reconstructed Operating Income Statement

• Next step after estimating market level rent/income, as well as market level expenses

• The net operating income concluded in this analysis represents a one-year projection for the property

• See Example on page 36

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Expense and Income Ratios

• Types of ratios:– Operating Expense Ratio (OER)– Net Income Ratio (NIR)

• Regardless of which the appraiser chooses, the comparison should be consistent (e.g., comparing the OER for the subject to the OER from the market)

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Operating Expense Ratio (OER)

• The ratio of total operating expenses to effective gross income, expressed as a percentage

Total Operating Expenses

÷Effective GrossIncome

OER=

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Operating Expense Ratio (OER) Example

• The subjects total operating expenses = $17,008• The subject’s effective gross income = $35,100. • Thus, the OER for the subject is 48.46%

$17,008 ÷ $35,100 = 0.4846 or 48.46%

Subject’s OER is reasonable and bracketed within the data

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Net Income Ratio (NIR)

• The ratio of net operating income to effective gross income, expressed as a percentage

Net Operating Income

Effective Gross Income

NIR÷ =

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Net Income Ratio (NIR) Example

• The subject’s indicated NOI = $18,092• The subject’s effective gross income =$35,100• Thus, the NIR for the subject is 51.54%.

$18,092 ÷ $35,100 = 0.5154 or 51.54%

Subject’s NIR appears reasonable and is bracketed within the data

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Chapter 3 Quiz

1. A three-unit apartment building had two units vacant for ten days each during the past year with the third unit being vacant for 17 days. What is the annual vacancy rate indicated by the data?

a. 2.41%b. 3.14%c. 3.38%d. 3.97%

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Chapter 3 Quiz

2. In a market value assignment, the contract rent of the subject should be

a. the basis of the appraiser’s analysis for owner-occupied units.

b. discussed in the appraisal report at the appropriate level of detail.

c. disregarded, since it never reflects market level.

d. used as EGI in every income analysis.

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Chapter 3 Quiz

3. When an amenity common to the market is provided by the subject property’s landlord per the terms of the lease, the cost of the amenity must be included when developing

a. debt service.b. effective gross income.c. market level operating expenses.d. rent surveys.

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Chapter 3 Quiz

4. Analysis of a two-unit property includes developing appropriate replacement reserves for the subject property. Rounded to the nearest dollar, what should be the total annual replacement reserve for the property?

a. $3,667

b. $4,487

c. $5,852

d. $6,187

ItemYears

RemainingEstimated

Cost

Carpet 3 $3,800

HVAC 10 $7,200

Appliances 4 $6,000

Roof 12 $12,000

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Chapter 3 Quiz

5. Which is a factor used in the appraiser’s analysis that represents the ratio of total operating expenses and effective gross income?

a. EGI

b. NIR

c. NOI

d. OER

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Chapter 3 Quiz

6. If a four-unit apartment building with a PGI of $950 per unit had a total vacancy of 63 days during the year, what was the EGI?

a. $40,380

b. $41,570

c. $43,630

d. $45,790

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Chapter 3 Quiz

7. Using these adjustments, what is the indicated adjusted rent to be applied to the subject?

Bedroom—$75

Central A/C—$50

Covered Parking—$25

a. $1,050

b. $1,200

c. $1,250

d. $1,275

Subject Unit

Comparable Unit #1

Comparable Unit #2

Contract Rent (Monthly)

__ $1,225 $1,075

Bedrooms 3 3 2

Central A/C Yes Yes No

Covered Parking

None Yes None

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Chapter 3 Quiz

8. Which item would NOT be considered an operating expense?

a. accounting expense for property

b. commission payment to property manager

c. landscape maintenance

d. mortgage payment

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Chapter 3 Quiz

9. Rounded to the nearest dollar, if the EGI for a three-unit property is $22,560, what is the NOI if the net income ratio is 46.57%?

a. $10,506

b. $11,731

c. $12,337

d. $13,639

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Chapter 3 Quiz

10. For the purpose of analysis, the appraiser gathers the subject’s income and expense data from the property owner to assist in developing a

a. reconstructed operating income statement.

b. rent adjustment.

c. rent survey.

d. vacancy loss.