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Flashcards in Income Approach Deck (13)
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1
Q

Let’s look at the third of the three approaches, the income approach (aka income capitalization approach).

If you’re working solely in residential real estate, you won’t see appraisers using this approach very often. That’s because the income approach appraises real estate based on its income – it converts the income of a property into an estimate of its value.

Appraisers generally use this method for commercial buildings like shopping centers, office buildings, and large apartment buildings. This approach involves basing value on the amount of income the investment property could produce. (An investment is the purchase of an asset with the intention of profiting from it in the future.)

Investments of All Sizes
While gleaming high-rise buildings might be your picture of what an investment property looks like, realize that they can come in all shapes and sizes and be used in various capacities.

That said, if they have the potential of producing an income stream or profit, they are investment properties. Here’s a chart showing four main categories of investment properties.

Commercial, industrial, residential, and agricultural properties identified as types of investment property.

Image description
Principal of Anticipation
What would an approach to value be without a solid economic principle to back it up?

The income approach is supported by the principle of anticipation. This is the idea that the present value of a property is affected by the anticipated income or utility that a property will give its property owner.

Income Approach Pros and Cons
Like the other two approaches to calculating value, the income approach has its pluses and its minuses.

Pros
It’s the only approach to valuation that gives investors a picture of a building’s profitability. While the other two approaches are used for finding what a property might sell for, the income approach shows how much money the property might produce each month. While investors eventually want to sell their investment properties for a profit, their real interest lies in the monthly income that a property can produce.

Gotta get those passive investment dollars!

Cons
The biggest problem with the income approach is that the information needed to use it can be hard to find. If you could access every property’s full financial records, it would be great. Unfortunately, the information a potential buyer can get is usually much more limited. Additionally, determining the correct cap rate can be difficult for inexperienced investors. We’ll talk more about that in a bit.

The income approach only works with investment properties, so another limitation of this approach is that it is not suitable to use for properties homeowners are looking to live in.

Working With Investors
Working with investor buyers is a great career path for an agent, whether it’s as part of a big team working with a corporation or a single agent working with individual investors. It can be a lucrative niche, and one that doesn’t involve quite as much squishy buyer/seller feelings maintenance. But it does require a special skill set.

Using the tools that make up the income approach (like finding NOI, GRM, GIM, and cap rate) will be part of your day-to-day work.

A

Income Approach

2
Q

The income approach determines an investment property’s value based on its return. It does this by dividing its net operating income by the capitalization rate of the property.

Let’s define some terms:

Net operating income (NOI) is a property’s annual income that remains after paying its operating expenses.

Operating expenses are the occasional or continuous expenses required for the operation of an income-producing property. Examples include the salary of the building staff or maintenance costs.

Capitalization rate (cap rate) is a rate of return that calculates the percentage of expected annual income earned over a property’s value. It’s the present value for expected future income earned.

The IRV Formula
But wait a second! If you don’t know the value of the property, how can you possibly know what cap rate to use?

I promise we’ll get to that in a bit, Anthony. For now, just know that you use the IRV formula to get the value of the rental property:

Net operating income (I) ÷ Capitalization rate (R) = Value (V)

Sometimes, cap rates and NOI figures are contained in a property’s published listing documentation. Other times, only the sales price is.

EXAMPLE
The net operating income of a subject rental property is $20,000 and the average capitalization rate of the three comparable properties is 10%. The appraiser can appraise the value of the subject rental property by filling in the value formula as follows:

Net operating income (I) ÷ Capitalization rate (R) = Value (V)

$20,000 ÷ 0.1 = V

$200,000 = V

The value of the rental property is $200,000.

A

Income Approach Formula

3
Q

Using the income approach requires a bit of mental dexterity. You need to know the NOI to perform the income approach calculation. But before you can know the NOI, you need to understand all three common income calculations done in real estate investment:

Potential gross income (PGI)

Effective gross income (EGI)

Net operation income (NOI)

Potential Gross Income
The most simple calculation is potential gross income (PGI). That is because PGI is the amount of income the property would bring in if it was at 100% occupancy (all units rented out).

All you have to do is add up all the possible rents and BAM, you’ve got yourself the potential gross income.

Effective Gross Income
But, as you can probably guess, most properties are not running at 100% occupancy at all times. Most buildings have at least some income loss caused by vacancies and unpaid rent.

If you subtract the income loss from the PGI, you get the effective gross income (EGI). That’s the total annual income that a property actually produces. It does not account for any operating expenses.

Because not all units are yielding rent at a given time, the EGI almost always is smaller than the PGI.

Net Operating Income
There is an important factor that EGI doesn’t take into account, and that’s operating expenses*.

So, in order to have an even more accurate account of how much money a property brings in, you can subtract a property’s operating expenses from its EGI. When you do that, the number you get is the net operating income (NOI).

Because NOI takes into account both income loss and operating expenses, it is the most accurate representation of how much money a property actually brings in.

*Note: Debt obligation on account of the property owner is not considered an operating expense.

How to Calculate Value With the Income Approach
Understanding what we’ve just covered, you can calculate value via the income approach in five steps:

Find the property’s potential gross income (PGI).

Determine (or estimate) the property’s effective gross income (EGI).

Estimate the net operating income (NOI).

Choose a cap rate based on market data.

Apply the cap rate using the IRV formula to find the value.

Okay, with that, it’s time to dig a bit deeper into each component of these steps.

A

Income Calculations

4
Q

Let’s go over each of the income types again, this time with examples.

Potential gross income (PGI) is the total rental income a property would receive if the property was 100% leased.

In other words, potential gross income is the best-case scenario for a property’s rental income. (Unfortunately for investment property owners, very rarely will a building experience 100% occupancy.)

Potential gross income is calculated by adding both the contract rents from leased spaces/units and the projected rent from currently vacant spaces/units.

You might also see PGI referred to as gross potential rental (GPR) or gross potential rent income (GPRI).

Note: PGI does not account for any expenses or any vacancy costs.

Calculating the PGI
So, the formula for PGI looks like this:

Contract rent + Projected rent = PGI

Contract rent: The Baxter Building has 100 housing units. Of those 100 units, 75 housing units have lease agreements signed for the upcoming year for a combined promised rental income of $1,800,000.

Projected rent: If the Baxter Building’s remaining 25 units were occupied as well at the annual market rate of $24,000, that would bring in an additional $600,000.

$1,800,000 + $600,000 = $2,400,000

Final Answer: The potential gross income of the Baxter Building is $2,400,000.

A

Potential Gross Income

5
Q

Effective gross income is the estimated total annual income that a property produces. Effective gross income does not account for any expenses; it only accounts for the total income produced by a property.

The EGI paints a more realistic picture of how much income a property actually generates. It takes into account the cost of unrented units and tenants who are behind on their rent. EGI also includes any additional non-rental income the building generates, like parking fees, vending machines, laundry machines, or other miscellaneous charges.

Why it’s important: Investors want to know a property’s EGI so they can estimate how much income that property might actually produce for them.

Before you can go calculating EGI, you need the following information:

Potential gross income

Vacancy cost

Other income

You already learned how to calculate the potential gross income, but what about the other two?

Vacancy Cost
Vacancy cost* represents the loss a property receives due to vacancies or collections. Let’s define these terms:

Vacancies: Units not occupied

Collections: Tenants who fail to pay

*Vacancy cost is the preferred term rather than vacancy and collections cost because it’s shorter and snappier, but just know that the collections will be included in any discussion or formula involving the vacancy cost.

Finding the Vacancy Rate
The vacancy percentage is one of those numbers that it would be super helpful to know, but you will rarely be given access to when you’re performing this kind of valuation. Instead, you might be able to look at historical data for the building or use an average for the type of building in your area.

It might seem weird to calculate vacancy by percentage. If a seven-unit building has a 1% vacancy rate, how would that work? An apartment can’t be partially vacant, right? It’s important to remember that the vacancy rate is really telling you what percentage of the PGI (or expected annual income) is not being realized. That could mean losing one month’s rent because a unit took a while to find a tenant, for example.

Baxter Building’s Vacancy Cost
For the purposes of teaching you about vacancy cost, let’s say that we pored over the Baxter Building’s operating statements for the past five years. We discover that the vacancy rate for the past five years has consistently been at 4%.

Feeling confident that this vacancy rate is a trend that will continue, we decide to use 4% to solve for our vacancy cost. (From our earlier exercise, we already know that the building’s PGI is $2,400,000.)

So, here’s the formula and how we apply it:

Vacancy percentage (%) x PGI = Vacancy cost

0.04 x $2,400,000 = $96,000

Final Answer: The vacancy cost of the Baxter Building is $96,000.

Other Income
You may be wondering what I meant by other income. Well, buildings can make money in more ways than just rent payments.

A building might make additional money through their laundry machines, application fees, or by renting out event space. There are many different ways that a building can obtain other income. Because EGI calculates exactly how much money a property actually makes, it requires that all income streams be taken into account.

For example, the Baxter Building brings in an additional $50,000 annually, mainly by charging tenants $10 to do a load of laundry.

Solving for EGI
To solve for EGI, you just have to add up a property’s income and then subtract the vacancy cost. So, the formula looks like this:

PGI + Other income - Vacancy cost = EGI

If we plug in the numbers from the Baxter Building, the formula becomes:

$2,400,000 + $50,000 - $96,000 = $2,354,000

Final Answer: The EGI for the Baxter Building is $2,354,000.

A

Effective Gross Income

6
Q

Let’s look at another scenario for an additional opportunity to practice some EGI math.

Bienvenidos a Saguaro Towers
Saguaro Towers is a 20-unit apartment building with a PGI of $315,000. Based on local market data, Saguaro Towers can expect a 4% vacancy rate. Additionally, the building generates $4,500 a year in other income through the use of its premium shaded parking spaces.

Let’s find the EGI.

Step 1: Find the vacancy cost
Remember our vacancy cost formula:

Vacancy percentage (%) x PGI = Vacancy cost

So if we plug in our numbers, we get:

0.04 x $315,000 = $12,600

Answer: Saguaro Towers has a vacancy cost of $12,600.

Step 2: Find the EGI
Remember our EGI formula:

PGI + Other income - Vacancy cost = EGI

So with our numbers, we get:

$315,000 + $4,500 - $12,600 = $306,900

Final Answer: The EGI of the Saguaro Towers is $306,900.

A

EGI Scenario: Saguaro Towers

7
Q

While EGI helps investors project the realistic income that an investment property may create for them, effective gross income does not account for expenses.

To help account for expenses, let’s turn now to net operating income (NOI). And don’t worry, what we learned about effective gross income will be super helpful for calculating NOI.

What Counts as an Operating Expense?
Properties have many different kinds of expenses, but when trying to identify a property’s net operating income, we are only discussing operating expenses. For the purposes of net operating income, investors care about the direct costs of a property versus its direct income.

What counts as an operating expense is not particularly intuitive. For example, operating expenses generally do not include:

Debt service (like mortgage payments, for example)

Replacement reserves (money held in savings to make necessary repairs and replacements)

It’s About the Day-to-Day
While paying the mortgage every month is definitely a critical expense for investors, that cost is not usually included in the operating expenses. Operating expenses are the day-to-day costs of running the building. So, debt service and replacement reserves are not typically included in that number.

You will, however, find that different people calculate operating expenses differently. If you get into investment real estate, you’ll learn what is included in that number in your area.

The most important thing here is that you’re consistent about including the same things every time when you’re comparing buildings.

Baxter Building Update: More Investor Questions
After solving for the effective gross income of the Baxter Building, our prospective investors were content with the estimated income they would receive as property owners of the building. However, the investors were not completely sold on purchasing the property. They wanted to know more!

Effective gross income gave the prospective buyers a great estimate of the income that a property might produce for the buyers, but EGI did not account for any expenses. The prospective buyers were concerned that the property’s expenses might outweigh its income.

Baxter Building Update: NOI to the Rescue
The investors turned to another real estate metric: net operating income (NOI).

Net operating income is a property’s annual income that remains after paying its operating costs. Net operating income shows property owners and potential buyers the profit that a property produces.

Net Operating Income: The Heart of the Issue
Net operating income cuts to the heart of the issue for many potential investors: “How much money can this property produce for me?”

Let’s consider the following two investment properties:

Investment Property A: $30,000,000 in income; $35,000,000 in operating expenses

Investment Property B: $15,000,000 in income; $10,000,000 in operating expenses

Even though Property A produces more income than Property B, Property A actually loses $5,000,000 after accounting for its operating expenses. Property B’s income is lower than Property A, but since it has lower expenses, Property B nets a profit of $5,000,000 after accounting for operating expenses. Much better!

NOI: The Equation
How does one solve for net operating income? Here’s the formula!

EGI - Operating expenses = NOI

The Baxter Building: Solving for NOI
To solve for net operating income of the Baxter Building, you’ll need to know the following information:

The EGI of the Baxter Building is $2,354,000.

Baxter Building’s expenses are:

$125,000 in property management fees

$150,000 in property repairs

$134,000 in property taxes

$110,000 in property insurance

Step 1: Add up all the operating expenses
As you can see, there are a few different operating expenses that need to be accounted for. So first, add them all up to find the total operating expense of the building.

$125,000 + $150,000 + $134,000 + $110,000 = $519,000

Answer: $519,000

Step 2: Subtract the operating expenses from the EGI
Next, you’ll just need to subtract the operating expenses from the EGI, and just like that, you’ve got yourself the NOI.

EGI - Operating expenses = NOI

$2,354,000 - $519,000 = $1,835,000

Final answer: The Baxter Building’s NOI is $1,835,000.

A

Net Operating Income

8
Q

While EGI helps investors project the realistic income that an investment property may create for them, effective gross income does not account for expenses.

To help account for expenses, let’s turn now to net operating income (NOI). And don’t worry, what we learned about effective gross income will be super helpful for calculating NOI.

What Counts as an Operating Expense?
Properties have many different kinds of expenses, but when trying to identify a property’s net operating income, we are only discussing operating expenses. For the purposes of net operating income, investors care about the direct costs of a property versus its direct income.

What counts as an operating expense is not particularly intuitive. For example, operating expenses generally do not include:

Debt service (like mortgage payments, for example)

Replacement reserves (money held in savings to make necessary repairs and replacements)

It’s About the Day-to-Day
While paying the mortgage every month is definitely a critical expense for investors, that cost is not usually included in the operating expenses. Operating expenses are the day-to-day costs of running the building. So, debt service and replacement reserves are not typically included in that number.

You will, however, find that different people calculate operating expenses differently. If you get into investment real estate, you’ll learn what is included in that number in your area.

The most important thing here is that you’re consistent about including the same things every time when you’re comparing buildings.

Baxter Building Update: More Investor Questions
After solving for the effective gross income of the Baxter Building, our prospective investors were content with the estimated income they would receive as property owners of the building. However, the investors were not completely sold on purchasing the property. They wanted to know more!

Effective gross income gave the prospective buyers a great estimate of the income that a property might produce for the buyers, but EGI did not account for any expenses. The prospective buyers were concerned that the property’s expenses might outweigh its income.

Baxter Building Update: NOI to the Rescue
The investors turned to another real estate metric: net operating income (NOI).

Net operating income is a property’s annual income that remains after paying its operating costs. Net operating income shows property owners and potential buyers the profit that a property produces.

Net Operating Income: The Heart of the Issue
Net operating income cuts to the heart of the issue for many potential investors: “How much money can this property produce for me?”

Let’s consider the following two investment properties:

Investment Property A: $30,000,000 in income; $35,000,000 in operating expenses

Investment Property B: $15,000,000 in income; $10,000,000 in operating expenses

Even though Property A produces more income than Property B, Property A actually loses $5,000,000 after accounting for its operating expenses. Property B’s income is lower than Property A, but since it has lower expenses, Property B nets a profit of $5,000,000 after accounting for operating expenses. Much better!

NOI: The Equation
How does one solve for net operating income? Here’s the formula!

EGI - Operating expenses = NOI

The Baxter Building: Solving for NOI
To solve for net operating income of the Baxter Building, you’ll need to know the following information:

The EGI of the Baxter Building is $2,354,000.

Baxter Building’s expenses are:

$125,000 in property management fees

$150,000 in property repairs

$134,000 in property taxes

$110,000 in property insurance

Step 1: Add up all the operating expenses
As you can see, there are a few different operating expenses that need to be accounted for. So first, add them all up to find the total operating expense of the building.

$125,000 + $150,000 + $134,000 + $110,000 = $519,000

Answer: $519,000

Step 2: Subtract the operating expenses from the EGI
Next, you’ll just need to subtract the operating expenses from the EGI, and just like that, you’ve got yourself the NOI.

EGI - Operating expenses = NOI

$2,354,000 - $519,000 = $1,835,000

Final answer: The Baxter Building’s NOI is $1,835,000.

A

Net Operating Income

9
Q

Let’s dive a little deeper into the topic of operating expenses because they can be categorized into two different types of expenses:

Fixed expenses: predictable expenses; they are traditionally consistent every year

Variable expenses: expenses that vary based on occupancy rates

Fixed Expenses = Predictable Costs
Fixed expenses generally do not vary as a result of a property’s occupancy rate. They are property expenses that are consistently the same, year after year. Here are some examples of fixed expenses:

Property taxes

Property insurance

Landscaping fees

Variable Expenses = Fluctuating Costs
Variable expenses are expenses that vary from year to year, and they are expenses that commonly fluctuate in response to a property’s occupancy rate.

Here are some examples of variable expenses:

Property repairs

Property management payroll

Utilities

Depends on Occupancy
One way to consider variable expenses is by asking the question: What type of expense might vary depending on the occupancy rate?

If a building has a lower occupancy rate, it will probably have fewer repairs. (Fewer units occupied means fewer tenants potentially breaking their appliances.)

If a building has a higher occupancy rate, the property owner will probably need to increase the property management staff.

An array of carpenter’s tools on a work desk.

Replacement Reserves vs. Maintenance
I told you that replacement reserves are not generally considered an operating expense, but then included property repairs as an example of a variable expense. I’m not trying to be contradictory, Anthony, I promise!

Replacement reserves are used for capital expenditures, or big, one-time upgrades or repairs. Capital expenditures are things like:

Replacing the roof

Adding a pool

Upgrading a building’s wiring

Property Repairs
Property repairs are things that are more like ongoing maintenance. Do you see the theme? Operating costs should feel like day-to-day expenses while things excluded from operating costs are big, one-time expenses.

From the perspective of a homeowner, imagine the difference between a repair you could pay for from your regular monthly salary vs. something you would have to save up to pay for.

Examples of property repairs include:

Fixing a leaky faucet

Repairing a broken window

Unstopping a stopped-up toilet

The difference between property repairs and replacement reserve items ultimately comes down to how they are classified for tax purposes. Different investors will classify them differently. You just need to understand the conceptual difference for now.

A

Operating Expenses: Two Types

10
Q

Time for some more NOI deep diving, Anthony.

Net operating income is one of the metrics most used by investors to evaluate real estate properties. It’s often used by investors to directly compare potential investment properties.

EXAMPLE
Property A has a net operating income of $400,000.

Property B has a net operating income of $200,000.

Property C has a net operating income of $500,000.

Well, I guess Property C is the best option.
– Hypothetical Investor

Because of its importance, there is often much debate about which variables should be accounted for in a net operating income figure.

The Line
From time to time, you’ll hear the phrases “above the line” or “below the line” in discussions about real estate metrics. The line that people are referring to is the “net operating income” line. And this “above or below the line” distinction is important to real estate investors wanting to ensure that they are comparing apples to apples.

Let’s look at a scenario to illustrate the importance of this concept.

Two cardboard houses, both white, identical except one house has a red roof

Scenario: How ‘Bout Them Apples to Apples?
Matthew is considering the purchase of two rental houses. He’s really interested in each property’s net operating income, so he asked each property owner for their NOI. Here’s what they told him.

Property A has a net operating income of $5,000,000.

Property B has a net operating income of $2,000,000.

It sounds like Property A is probably the best choice for Matthew, right?

Apples to Bananas Is More Like It
After investigating the actuals of both properties, Matthew found that the two properties used different variables to solve for their net operating incomes! 🙀

Property A deducted day-to-day expenses (operating expenses) from its effective gross income to solve for NOI.

Property B deducted all expenses from its effective gross income to solve for NOI. These expenses included mortgage payments, replacement reserves, etc.

Apples to bananas make a tasty mixed-fruit salad, but it’s not what you want when trying to compare NOI!

Recalculating NOI
To ensure that he was comparing the properties fairly, Matthew recalculated the net operating income of the properties. This time, however, he only subtracted operating expenses from both properties.

Property A still had a net operating income of $5,000,000.

Property B now had a net operating income of $6,000,000.

Matthew now had valid real estate metrics to use in comparing the two properties.

Less important: It’s not necessarily important which expenses one includes when calculating net operating income or any other real estate metric.

More important: When comparing investment properties, it’s of utmost importance that the same methods are used for comparison. Do not assume that how one property solved for net operating income is the same as how another property solved for net operating income.

A

Above and Below the Line

11
Q

The GNB building had $25,000,000 in operating expenses last year. Here’s how to work the math.

Step 1: Identify the operating expenses
To solve for operating expenses, we just need to add day-to-day expenses. We do not need to add mortgage payments or replacement reserves as they are not to be counted for day-to-day operating expenses.

Remember, this was our list of expenses:

$5,000,000 in property management fees ✅

$10,000,000 in property repairs ✅

$8,000,000 in property taxes ✅

$2,000,000 in property insurance ✅

$7,000,000 in mortgage payments ❌

$3,000,000 in replacement reserves ❌

Answer: We should include the property management fees, repairs, taxes, and insurance in the operating expenses.

Possible Error: You might have added mortgage payments or replacement reserves. Don’t! They are “below the line” and not to be included when calculating net operating income.

Step 2: Add them up
We just add all of the included expenses to get the operating expenses, like so:

$5,000,000 + $10,000,000 + $8,000,000 + $2,000,000 = $25,000,000

Final Answer: The GNB Building has $25,000,000 in operating expenses.

A

GNB Building: Operating Expenses

12
Q

So, now that we have the NOI, the other part of the equation to find the value of the property is the cap rate.

By way of refresher, the capitalization rate is a rate of return that calculates the percentage of expected annual income earned over a property’s value.

It’s the present value for expected future income earned.

Cap rates are written as percentages. It might look like 4.5% or 3.7%. That number is the percentage of the value that an investor can expect to be returned to them in a given year.

For example, if an investor buys a commercial property for $100,000 and makes $10,000 a year in NOI, then that property has a cap rate of 10%. Essentially, the investor would make their money back in 10 years (although it wouldn’t play out that simply, as there are many other factors involved in investing).

How Are Cap Rates Determined?
While the value of a property and its NOI are unique to a property, its cap rate is not. Cap rates are determined by external factors and are estimates about a property’s potential income compared to its value.

Different markets and different property types have different cap rates. In downtown areas, cap rates are usually lower. In lower-income areas, cap rates are usually higher.

An Art and a Science
The more accurate the cap rate the appraiser assigns is, the more accurate the resulting valuation will be. So choosing the right cap rate is pretty important. However, it’s one of those things that you have to learn by doing. It takes experience and up-to-date market data. The better a person knows the market they’re working in, the better they’re likely to be at assigning a cap rate.

Solving for Cap Rate
Cap rates are one of the most common metrics used in commercial real estate. And sometimes an investor might have the value and NOI of the property but want to figure out the cap rate.

To solve for capitalization rate, we use the formula below:

Net operating income ÷ Property value = Cap rate

The Baxter Building’s Cap Rate
Okay, Anthony, let’s return to the Baxter Building to learn how to solve for cap rate. Here is the information you’ll need:

From previous work, we know that the Baxter Building’s net operating income is $1,835,000.

We are now told that Baxter Building is currently listed at $20,388,888, so we will use that as the value of the building.

Step 1: Divide the NOI by the property value
It’s pretty simple. You just have to divide the two numbers.

$1,835,000 ÷ $20,388,888 = 0.09 (rounded)

Answer: 0.09

Step 2: Convert the decimal to a percentage
By dividing the property’s net operating income by its property value and then converting that result into a percentage, we were able to identify the Baxter Building’s cap rate.

Final answer: The Baxter Building’s cap rate is 9%.

A

Meet Your Cap Rate

13
Q

A chapter that long needs a summary. Am I right, Anthony?

Let’s do a quick review of some of the important terms, concepts, and principles you learned.

Key Terms
Here are the key terms you encountered. Say hello to your old friends:

capitalization rate
a rate of return that calculates the percentage of expected annual income earned over a property’s value; the present value for expected future income earned

correlation
the process in which an appraiser weighs the relevance of each approach to value for the subject property in order to come up with a final value estimate

effective gross income (EGI)
the total annual income that a property produces; does not account for any expenses

gross rent multiplier (GRM)
the ratio of the price of investment property to its annual rental income before considering expenses like taxes and insurance, etc.

income capitalization approach
method of estimating the value of a property by applying a rate of return to the net income it produces

investment
the purchase of an asset with the intention of profiting from it in the future

net operating income (NOI)
a property’s annual income that remains after paying its operating expenses

operating expenses
occasional or continuous expenses required for the operation of an income-producing property

potential gross income (PGI)
the total rental income a property would receive if the property was 100% leased

Key Concepts & Principles
Here are the concepts and principles you’ll want to master from this chapter:

Calculating Value With the Income Approach
You can calculate value via the income approach in five steps:

Find the property’s potential gross income (PGI).

Determine (or estimate) the property’s effective gross income (EGI).

Estimate the net operating income (NOI).

Choose a cap rate based on market data.

Apply the cap rate using the IRV formula to find the value.

GRM and GIM
The income approach is the best way to value large or expensive investment properties. But for smaller properties that can produce income but don’t necessarily have to (like a single-family or multi-family rental) there are two simpler methods that an investor can use.

They don’t take into account vacancies or operating expenses, so the picture they paint is much more limited. However, they can be useful, especially when comparing one property to another.

They are:

Gross rent multiplier (GRM)

Gross income multiplier (GIM)

The Value Approaches
Here’s an at-a-glance summary of which value approaches work best for which kinds of properties.

A table which shows the three value approaches: sales comparison, income capitalization, and cost. Includes formulas and likely uses.

Image description
Correlating Approaches: aka Reconciliation
An appraiser can potentially use all three approaches to value when appraising a property. Those three approaches will probably give the appraiser three different values. The appraiser needs to reconcile those three values into one final estimate of value.

Weighing Approaches
To come up with a final value estimate, the appraiser will weigh the relevance of each approach to value for the subject property. (The combined relevance weighting should equal 100%.)

Here’s an example of how that might look when evaluating one property in three ways:

The math for the final estimate, showing the indicated value, weight, and weighted value for each of the approaches (sales comparison, cost, and income)

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Formulas to Know:
Potential Gross Income
Contract rent + Projected rent = PGI

Vacancy Cost
Vacancy percentage (%) x PGI = Vacancy cost

Effective Gross Income
PGI + Other income - Vacancy cost = EGI

Net Operating Income
EGI - Operating expenses = NOI

IRV
Net operating income (I) ÷ Capitalization rate (R) = Value (V)

Cap Rate
Net operating income ÷ Property value = Cap rate

Gross Rent Multiplier
Property price ÷ Annual rent income = GRM

Gross Income Multiplier
Property price ÷ (Annual rent income + Annual other income) = GIM

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Chapter Summary