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Income Approach
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MBA 590 Real Estate Analysis
! College of BusinessAlfaisal
UNIVERSITY
Chapter 8
Income Approach
Estimating Income and Expenses
Reconstructing Adding
Subtract
Net Operating Income
Income Less: expenses
= Net Operating Income (NOI)
Net Operating Income
more details can be complex
Estimating Income and Expenses
usually different than the owner’s statements
Potential Gross Income
If the property was 100% occupied at
market rent
Two loss deductions
vacancy loss credit loss
Vacancy Loss
no tenant no Income
Credit Loss
tenant not paying rent
Effective Gross Income
potential gross income less: vacancy loss less: credit loss
Abbreviations
PGI less: CVL
EGI
Gross IncomePotential Gross Income (PGI)
10,000
Less: Vacancy Loss 4% 400
Less: Credit Loss 4% 400
8% 800 !
Effective Gross Income (EGI)
9,200
Operating Expenses
reimbursable non-reimbursable
Operating Expensesmanagement
property taxes insurance utilities
reserves for replacements maintenance
other
Management
Must recognize even if owner operated 4% to 10% of EFI
Reserves for Replacements
Prudent management will build a fund to
replace long-lived items
DifferencesOwner Reconstructed
Management 0 300
Property Taxes 500 500
Insurance 1,000 1,000
Utilities 300 300
Reserves for Replacements 0 500
Maintenance 100 100
Total Operating Expenses 1,900 2,700
Potential Gross Income 10,000 100%Less: Credit and Vacancy Loss
800 8%Effective Gross Income 9,200 92%Operating Expenses Management 300 3% Property Taxes 500 5% Insurance 1,000 11% Utilities 300 3% Reserves for Replacements
500 5% Maintenance 100 1%Total Operating Expenses 2,700 29%Net Operating Income 6,500 71%
Reconstructed Operating Statement
What is the property worth?
Two Methods
Direct Capitalization
Discounted Cash Flow
Direct Capitalization
Convert an annual income into a value
with a capitalization rate
IRV
Income = Rate x Value Rate = Income ÷ Value Value = Income ÷ Rate
Getting Rates
Market Built Up
Market
Sales Analysis
Sale Price 1,000,000
Net Operating Income 75,000
Multiplier Rate 13.33 Years to Recover Investment
Capitalization Rate 7.50% Yield on
Investment
Rates
Why are rates different?
Risk Factors change in market
management liquidity
Built UpRisk Free Rate US.Treasury Bond
1.5%
Management 3.0%
Illiquidity 3.0%
Volatility 2.0%
Capitalization Rate 9.5%
Net Operating Income 6,500
Rate Value
5% 130,000
6% 108,333
7% 92,857
8% 81,250
9% 72,222
10% 65,000
11% 59,091
12% 54,167
What is the
property worth?
Selecting a ratequality and quantity
stabilized volatility judgment
Sales Comparisoncalculate rate
adjust for differences weigh
apply rate
Sale 1 Sale 2 Sale 3Sale Price 750,000 5,500,000 287,000
Net Operating Income 60,000 721,000 12,000
Multiplier 12.50 7.63 23.92
Capitalization Rate 8.00% 13.11% 4.18%
Comparability Similar Inferior Superior
Adjustment 0.00% -5.00% 5.00%
Adjusted Rate 8.00% 8.11% 9.18%
Average 8.43%
Rates
Sale 1 Sale 2 Sale 3 Average
Adjusted Capitalization Rate 8.00% 8.11% 9.18% 8.43%
Weighting 70% 20% 10% 100%
Weighted 5.60% 1.62% 0.92% 8.14%
Weighted Rates
IndicationNet Operating Income 6,500
Capitalization Rate 8.14%
Indicated Value 79,853
Rounded To 80,000
Discounted Cash Flow DCF
Present value of all future benefits
Discounted Cash Flow DCF
Return on capital Return of capital
Discounted Cash Flow DCF
1. Estimate amount of NOI for each period 2. Select a discount rate 3. Calculate PV factor for each period 4. Apply the PV factor to each cash flow 5. Add up the present value of all cash flows
the present is worth more than the future
!
the future is worth less than the present
time is money !
money is time
compensated to wait !
patience is rewarded
time value of money !
money value is relative to time
Assumptions
money value is relative to time
Assumptions
time value of money !
money is worth different based on the
time
Finance
Time and Risk how long how much
(1 + rate)Number
of periods
(1 + r)N
Key Formulas
(1+r)N
r = rate N = number of periods
Compounding Future Value or FV multiplying
Discounting Present Value or PV dividing
(1+r)N1
Tomorrow
One Year
Ten Years
Discount the future !
Today is worth more than tomorrow
Grow in the Future
Today
One year
Ten Years
Grow by a percentage each year,
not a fixed amount
Compounding
Compounding
The process of finding the future value of a
present sum of money !
multiplying
Discounting
The process of finding the present value of a future sum of money
!
dividing
compounding is the inverse of discounting
discounting is the inverse of compounding
Discount Rate 7%
1 2 3 4 5 Total
NOI 6,200 6,500 6,800 7,200 7,500 34,200
PV Factor 0.9346 0.8734 0.8163 0.7629 0.7130 0.8147
Present Value 5,794 5,677 5,551 5,493 5,347 27,863
DCF of the NOI
Reversion
return of your capital resale
ReversionNet Operating Income 7,500
Capitalization Rate 8.14%
Indicated Value 92,138
PV Factor 0.8147
Present Value of the Reversion
75,064
DCFFace Value
Present Value
Net Operating Income 34,200 27,863
Reversion 92,138 75,064
Summary 126,338 102,927
Rounded To: 103,000
Income Approach
Direct Capitalization 80,000
Discounted Cash Flow 103,000
