Income Approach Flashcards
What is Einstein’s “Rule of 72”?
“Rule of 72” - How long does it take to double your money at a given interest rate?
Step 1: Determine the interest rate to be examined. Let’s use 6% for our example.
Step 2: Divide the number 72 by 6%.
72 [ENTER] 6 [÷] Display reads: 12
At 6% interest you will double your money invested in 12 years. Unfortunately, your investments or bank deposits that are earning a lower amount of interest – 2%, say – would take 36 years, and at 1% interest it would take 72 years to double your money.
Difference between Direct and Yield Capitalization
In Direct Capitalization, a single year’s Potential Gross Income is assumed to be indicative of its value.
In Yield Capitalization, it is assumed the value is reflected in the present value of a stream of future cash flows resulting from future Potential Gross Incomes.
Income Formula
PGI Potential Gross Income
-V&CL - Vacancy and Collection Losses
______ __________________________________
EGI Effective Gross Income
-TOE - Total Operating Expenses (fixed, variable, replacement reserves)
______ _____________________________________
NOI Net Operating Income
If the appraiser bases the income and calculations on existing leases, the ownership interest appraised can be classified as “______________.” If the appraiser bases the income and calculations on market rents, the appraised interest is “___________________.”
If the appraiser bases the income and calculations on existing leases, the ownership interest appraised can be classified as “leased fee.” If the appraiser bases the income and calculations on market rents, the appraised interest is “fee simple.”
six-step appraisal process:
six-step appraisal process first.
Definition of the Problem
Scope of Work
Data Collection and Analysis
Application of the Approaches to Value
Reconciliation of Value Indications and Final Opinion of Value
Report of Defined Value Opinions
Equity Residual Technique
Know Data:
- Mortgage
- Mortgage annual payments
- Annual net operating income
- Equity cap rate
What is property value?
NOI - Annual Debt Service (Mortgage Payment) = ** Residual Income to Equity**
Residual Income to Equity/Equity Cap Rate = Available Equity
Available Equity + Mortgage = ** Property Value**
Mortgage Residual Technique
Know Data
-Available equity
- Annual net operating income
- equity cap rate
- mortgage cap rate
What is property value?
Available Equity * Equity cap rate = Residual Income to Equity
NOI - Residual Income to Equity = Mortgage Payment
Mortgage Payment / Mortgage cap rate = Mortgage value
Available Equity + Mortgage = Property Value
Mortgage capitalization rate (RM):
The mortgage capitalization rate that is the ratio of the first-year debt payment divided by the beginning loan balance. In some instances, the ratio may be calculated using one month’s payment, but typically it is the total of the loan payment for an entire year. Also referred to as a mortgage loan constant.
For example, a $100,000 loan has terms of 10 percent interest, monthly payments, and a 20-year term. Monthly payments equal $965.02. How do you calculate the mortgage capitalization rate?
RM = ($965.02 x 12) / $100,000 = 0.116, or 11.6%”
Monthly payments * 12 = Annual Payment
Annual Payment/Original Loan Amount = Mortgage Capitalization Rate
RM = ($965.02 x 12) / $100,000 = 0.116, or 11.6%”
Band of Investment
Mortgage-equity formula:
The weighted average of the mortgage capitalization rate (mortgage constant) and equity capitalization rate (equity dividend rate) results in an estimate of the overall capitalization rate for the property (RO = M x RM + (1 – M) x RE).
For example: A property being appraised can be financed with a 75% loan. The loan has a 15-year term with monthly payments at 9 percent interest (indicated mortgage capitalization rate of 0.1217). Comparable sales indicate an equity capitalization rate of 10 percent. The overall capitalization rate can be estimated as follows:
RO = (0.75 x 0.1217) + (0.25 x 0.10) = 0.116
Band of Investment
Land-building formula:
Land-building formula: The weighted average of the land capitalization rate and the building capitalization rate results in an estimate of the overall capitalization rate for the property (RO = L x RL + B x RB).
For example, comparable sales indicate that the land capitalization rate is 0.09, the building capitalization rate is 0.14, and the land-to-value ratio is 30 percent. The indicated overall capitalization rate can be calculated as follows:
RO = (0.30 x 0.09) + (0.70 x 0.14) = 0.125)”
Debt coverage ratio (DCR):
The ratio of annual net operating income (NOI) divided by the annual debt service. Lenders usually specify a minimum DCR (e.g., 1.2) that they require the property to meet during the first year of a loan term.
For example, if a property is estimated to have an NOI of $12,000 for a given year and debt service (principle and interest) during that year is $10,000, then the DCR is $12,000/$10,000, or 1.2. ”
Debt coverage ratio formula: A method of developing the overall capitalization rate
Debt coverage ratio formula: A method of developing the overall capitalization rate by multiplying the debt coverage ratio by the mortgage capitalization rate and the loan-to-value ratio for the property (RO = DCR x RM x M). See also band of investment technique.
For example, a property can be purchased with a 75% loan. The loan has a 15-year term with monthly payments at 9 percent interest (indicated mortgage capitalization rate of 0.1217). The lender requires a debt coverage ratio of 1.2. The overall capitalization rate can be estimated as follows:
RO = 1.2 x 0.1217 x 0.75 = 0.1095 [implied cap rate for property]
This method views the valuation problem from the point of view of the lender only. There is an implied equity dividend in the analysis. If the implied equity dividend reflects the requirement of a typical investor, this method may be used to estimate the overall rate for a market value appraisal.”
The Debt Coverage Ratio formula has the nickname of ”underwriter method” for obvious reasons. Because it is applicable when the implied equity dividend reflects the requirement of a typical investor, there are often occasions when this method would not be appropriate. It is important to note that the implied cap rate may or may not be the actual cap rate derived from other methods. It is only a check by the lender/underwriter on the “reasonableness” of the cap rate selected in an appraisal.
Finding Overall Rate (RO) via Effective Gross Income Multipliers
This is a hybrid method that involves the net income ratio and the Effective Gross Income Multiplier.
Effective Gross Income is Potential Gross Income less the Vacancy and Collection Losses:
PGI – V&CL = EGI
The Net Income Ratio (NIR) is the Net Operating Income (NOI) divided by the effective gross income (EGI):
NOI / EGI = NIR
The Effective Gross Income Multiplier (EGIM) is then the Sales Price (aka: value) divided by the Effective Gross Income:
V / EGI = EGIM
To develop an Overall Rate (RO) divide the Net Income Ratio (NIR) by the Effective Gross Income Ratio (EGIM):
NIR ÷ EGIM = RO
The Net Income Ratio is …
The Net Income Ratio (NIR) is the Net Operating Income (NOI) divided by the effective gross income (EGI):
NOI / EGI = NIR
The Effective Gross Income Multiplier is …
The Effective Gross Income Multiplier (EGIM) is then the Sales Price (aka: value) divided by the Effective Gross Income:
V / EGI = EGIM
Overall Rate (RO) utilizing Net Income Ratio by the Effective Gross Income:
NIR ÷ EGIM = RO
or
(NOI/EGI) / (Value/EGI) = NOI/Value = Ro
DCF techniques can be applied in the valuation or analysis of:
DCF techniques can be applied in the valuation or analysis of:
-proposed construction
-land development
-condominium development or conversion
-rehabilitation development
-income-producing real estate of various types.
DCF analysis has become a requirement of many real property clients and intended users. These users of appraisal services favor the inclusion of DCF analysis as a management tool in projecting cash flow and return expectations, capital requirements, refinancing opportunities, and timing of future property dispositions.
Yield Capitalization vs. Discounted Cash Flow
Yield Capitalization. Discounted Cash Flow analysis is under the umbrella of Yield Capitalization, but there is so much more involved that we will not only continue to discuss Discounted Cash Flow analysis, but also include other related procedures and methodologies
C
C Mortgage Coefficient
CF
CF Cash Flow
i
I
i Interest Rate
I Income
IB
IB Building Income
IE
IE Equity Income
IL
IL Land Income
ILF
ILF Leased Fee Income
ILH
ILH Leasehold Income
IM
IM Mortgage Income
IO
IO Net Operating Income
IRR
IRR Internal Rate of Return
J
J “J” Factor
K
K “K” Factor
M
M Loan-to-value ratio
MIRR
MIRR Modified Internal Rate of Return
n
n Number of periods
NPV
NPV Net Present Value
When estimating interest rates in net present value calculations, the rates used are typically:
Current rates
If the investment required for two different properties is different, the Net Present Values will differ even if all other factors are alike.
P
P Percentage of Loan Paid Off
R
R Capitalization Rate
RB
RB Building Capitalization Rate
RE
RE Equity Capitalization Rate
RL
RL Land Capitalization Rate
RM
RM Mortgage Capitalization Rate (constant)
RO
RO Overall Capitalization Rate
V
V Value
VB
VB Building Value
VE
VE Equity Value
VL
VL Land Value
VLF
VLF Leased Fee Value
VLH
VLH Leasehold Value
VM
VM Mortgage Value
VO
VO Overall Value
Y
Y Yield Rate
YE
Y E Equity Yield Rate
YET
YET Equity Yield Rate After Tax
YLF
YLF Yield to Leased Fee
YLH
YLH Yield to Leasehold
YM
YM Mortgage Yield Rate
YO
YO Overall Yield Rate (AKA: Property Yield Rate)
YOT
YOT Overall Property Yield Rate After Tax
Δ
Δ - Percent of change
ΔE
ΔE Percent of change in equity
ΔI
Δ percent of change in income
ΔO
ΔO percent of change in overall property value
1/Sn
1/Sn Present value factor
an
an▯ Present value of an amount per period
1/Sn▯
1/Sn▯ Sinking Fund Factor
Sn
Sn Future value of an amount
Sn▯
Sn▯ Future value of an amount per period
1/an▯
1/an▯ Partial payment factor
The premise used for valuing the income stream of a wasting asset is:
Hoskold
The K-factor is an income adjustment used to convert a stream of income changing at a constant ratio into its
Level equivalent
An algebraic formula used to calculate an overall rate that is based on mortgage equity analysis concept and allows for cash flow forecasts, including the impact of financing, is the:
Ellwood formula
In the Akerson format the non-algebrais formula is similar to:
The Band of Investment Method for determing a cap rate.
An alternative way of writing the Ellwood formula is:
Akerson format
The Ellwood “formula is applicable only to properties with stable or stabilized income streams and to properties with income streams expected to change according to the:
J-factor pattern or K-factor pattern
The premise used for valuing the income stream of a wasting asset is:
Hoskold
An income adjustment or stabilization factor formerly used to convert a stream of income changing at a constant ratio into its stable or level equivalent is the:
K factor
The Hoskold premise was designed to value the income stream of a/an
Wasting asset
The K-factor is an income adjustment used to convert a stream of income changing at a constant ratio into its
Level equivalent
An assumption that the present value of an income stream is based on a single discount rate is the definition of which of the following?
Inwood premise
A method of estimating property value by discounting all expected future cash flows refers to:
Yield Capitalization
An income adjustment or stabilization factor formerly used to convert a stream of income changing on a curvilinear basis into its level equivalent is the:
J factor
The Hoskold premise assumes that a portion of the net operating income is:
Reinvested at a safe rate
A wasting asset
A wasting asset is an item that has a limited life span and irreversibly declines in value over time. Examples include depreciating fixed assets such as vehicles and machinery and securities with time decay, like options, which continually lose time value after purchase.
A method of estimating property value by discounting all expected future cash flows refers to:
Yield Capitalization
Basic steps of Yield Capitalization:
Yield Capitalization, the basic steps are to:
1) Estimate a holding period
2) Determine estimated cash flows
3) Estimate a reversion
4) Select a yield rate
5) Calculate the present value of the cash flows and reversion
Direct Capitalization vs Yield Capitalization
In Direct Capitalization, the concern was using a single year’s cash flow to reflect a stabilized income or estimate of stabilized income.
In Yield Capitalization, the cash flow forecast addresses a series of years’ cash flows, over the holding period. These cash flows most often are based on rental income from income producing properties. Even when a specific site improvement is owner-occupied and not currently experiencing rental income, the appraiser can extract from projected market rents that would reflect typical investor attitudes.
The difference between the present value of all positive cash flows and the present value of negative cash flows is referred to as:
Net Present Value
When the initial out-go is divided into the present value of the in-flows, the result is called the:
Profitability index
A Profitability Index of -1 means that the investment:
Fails to meet the profitability goals
The number of animals that can feed in an area without damaging other vegetation is known as:
Grazing capacity
Transferable development rights are often used to:
Preserve historic sites or buildings
Preserve agricultural land
The contributory value of merchantable timber as it stands on timberlands is:
Stumpage value
Which is a consideration in valuing timberland?
Quality
Species
Obstacles
Rights purchased or acquired through condemnation that allow aircraft to fly at low elevations are called:
Avigation easements
As a general rule, in the appraiser’s day-to-day practice, the real property rights being appraised are:
Surface rights
An area of public or private rangeland that is grazed as a single entity defines:
Grazing unit
In valuing mineral rights, which approach is sometimes considered unreliable?
Income Approach
The agency that sets standards for various trees is called the:
U. S. Forestry Service
Consideration of annual production, costs of extraction, and environmental issues apply to the valuation of:
Mineral rights
Comparable sales of airspace would more likely be found
In dense urban areas
Factors such as consumptive use and amounts that can be diverted relate to the appraisal of:
Water rights
The coal mining process that causes surface subsidence is:
Long wall
One method for determining the value of air rights is:
Before-and-after
A before-and-after method involves two values (before rights and after rights) with the difference between the values being the value of the rights. This method can be a very reliable indicator of value for what type of rights?
Intangible
Water
Life estate
Investment
Water
A logical flow to a narrative appraisal report is:
Introduction, Problem Identification, Presentation of Data, Analyses and Conclusions
When an appraiser performs a feasibility study and comparable sales are scarce, what is a common alternative?
Subdivision Analysis
External obsolescence can be measured by
- Capitalizing income loss due to the negative influence
- Comparison sales of similar properties which are and are not subject to the same negative influence
The commonality of the J Factor and the K Factor is that they both
Solve problems with increasing/decreasing income flows
If an appraiser analyzes the demand in a local area relative to a national benchmark, that is:
BPI - buying power index
The buying power index (BPI) relates to
Demand and ability
The K-factor is used to convert a stream of income that changes….
at a constant ratio into a level payment equivalent.
Prior to 1987, short term capital gains were treated as ordinary income but long term capital gains were not taxed. After 1987,
Both are taxed as ordinary income
When the appraiser identifies taxable profit, it is called:
Capital Gain
One of the methods of measuring external obsolescence is by:
Capitalizing the income loss due to the negative influence
The statement, “capitalization rate and yield rate are interchangeable” is:
False. A cap rate uses one year’s data and a yield rate uses income streams for many years.
The difference between economic and locational obsolescence is:
Economic impacts areas and locational impacts a site
Ordinary Annuity vs. Annuity Due
Ordinary Annuity vs. Annuity Due
An ordinary annuity is when a payment is made at the end of a period. An annuity due is when a payment is due at the beginning of a period.
An appraiser who takes an assignment beyond his level of competency, and does not take the necessary steps to become competent, will likely produce a:
- Non-credible value opinion
- A misleading report
- A poorly-documented value opinion
- All of these
All of these
Although the Income Approach can have different elements, depending on the property type, there are some basic expectations which are universal to the Income Approach. Which of the following would NOT be one of those universal expectations?
- Credible data
- Accurate calculations
- Absolute accuracy in estimating replacement reserves
- Properly developed and supported rates
Absolute accuracy in estimating replacement reserves
Commonly challenging assignment types include all of the following EXCEPT:
- Car washes
- Restaurants
- Hotels
- Office buildings
Office buildings
Federal financial institution regulatory agencies identified several violations related to the development of the Income Approach. Which of the following was NOT identified as an issue with the Income Approach?
- Failing to address market trends
- Failing to estimate the effective age
- Using non-market based time constraints
- Failing to report appropriate deductions and discounts for tract development appraisal
Failing to estimate the effective age
The subject of an appraisal review assignment can be:
- All or part of an appraisal report
- The workfile
- Either or both of these
Either or both of these
A reviewer believes the original appraiser’s capitalization rate of 9.5% is inappropriate, and changes it to 10.5%, which results in the reviewer’s own opinion of value. What does USPAP state about the reviewer’s obligations when reporting this opinion of value?
- She may report her own value opinion within her review report
- She must prepare a separate appraisal report which complies with Standard 2
- If she provides an oral report, she does not have to comply with USPAP
- This situation does not result in the reviewer developing her own opinion of value
She may report her own value opinion within her review report
Which of these statements in a review report would indicate that the reviewer did NOT develop her own opinion of value?
- I concur with the value conclusion
- I do not agree with the value
- The value conclusion is adequately supported
- In my opinion, the value is too high
The value conclusion is adequately supported
