1. 2 8/21/2015 1 Chapter 2 Income Concepts

2. 2 8/21/2015 2 Chapter Objectives Upon completion of this chapter, the participant will be able to: –Contrast the concepts of income versus rent –Identify the measures of income and benefits which will be used in the appraiser’s income analysis –Classify the different types of operating expenses –Recognize specific income factors and rates of return and their key elements –Distinguish the identifying characteristics of leasehold and leased fee interests

3. 2 8/21/2015 3 Key Terms Contract Rent Debt Service Deficit Rent Effective Gross Income (EGI) Excess Rent Fixed Expenses Gross Income Multiplier (GIM) Gross Rent Multiplier (GRM) Leased Fee Interest Leasehold Interest

4. 2 8/21/2015 4 Key Terms Market Rent Net Operating Income (NOI) Operating Expenses Overall Capitalization Rate Overall Yield Rate Potential Gross Income (PGI) Reserves for Replacement Reversionary Benefit Variable Expenses continued

5. 2 8/21/2015 5 Income vs. Rent In some cases, a property’s rent may be its income There may be other types of income aside from rent –Examples: income from parking, garage, or storage spaces, vending machines, etc. Two types of rent we will discuss: –Contract Rent –Market Rent

6. 2 8/21/2015 6 Contract Rent What tenant is actually paying in rent, as stated in the terms of the lease May or may not reflect what a typical: –Lessor would expect –Lessee would pay Appraiser must determine if rent being generated actually reflect that which would be typical in that marketplace

7. 2 8/21/2015 7 Market Rent What the property could rent for in the open market if currently vacant and available –Also referred to as economic rent When market rent exceeds contract rent, the difference is called deficit rent –Lessee has advantage When contract rent exceeds market rent, the difference is known as excess rent –Lessor has advantage

8. 2 8/21/2015 8 Measures of Income and Benefits Potential Gross Income (PGI) Effective Gross Income (EGI) Net Operating Income (NOI) Reversionary Benefit

9. 2 8/21/2015 9 Potential Gross Income (PGI) The income that could be produced by a property in an ideal situation, with no vacancy or collection losses In most cases, based on an annual amount

10. 2 8/21/2015 10 Effective Gross Income The potential gross income, less vacancy and collection losses The formula for EGI is: PGI - Vacancy and Collection Losses = EGI

11. 2 8/21/2015 11 Net Operating Income The income after expenses. Do not confuse NOI with cash flow The formula for NOI is: PGI - Vacancy and Collection Losses = EGI – Operating Expenses = NOI Like PGI and EGI, most commonly expressed in annual terms

12. 2 8/21/2015 12 Reversionary Benefit Typically a sum, often stated in a dollar amount, that a property owner will receive when or if he sells the property at the end of the investment term

13. 2 8/21/2015 13 Operating Expenses Day-to-day costs of running a building, like repairs and maintenance, but not including debt service or depreciation –Debt Service: The amount of funds required to make periodic payments of principal and interest to the lender Considered on an annual basis when income is analyzed at an annual level

14. 2 8/21/2015 14 Operating Expenses Typically, operating expenses are categorized as: –Fixed expenses –Variable expenses –Reserves for replacement continued

15. 2 8/21/2015 15 Fixed Expenses Ongoing expenses that do not vary based on occupancy levels: –Real estate taxes –Insurance –Services contracted at a level rate for, perhaps, a year at a time (e.g., refuse collection) –Cost of a security light for a parking area where the expense is a reoccurring flat fee

16. 2 8/21/2015 16 Variable Expenses Operating expenses necessary to the property, but dependent on the property’s occupancy level: –Maintenance, repairs, and utilities to units furnished by lessor –Management fees (often expressed as a percent) Legal and accounting fees that are charged on a non-consistent basis might be variable expenses, as well as other miscellaneous expenses

17. 2 8/21/2015 17 Reserves for Replacement Refers to an amount of money set aside for future replacement of major items –Sometimes just called reserves Most often applied as an annual dollar amount (sometimes as a percentage)

18. 2 8/21/2015 18 Rent and Income Multipliers Multiplier: A factor derived by dividing the sale price, or sometimes value, of a comparable property by its gross income, or in some cases, rent –Not a percentage Derived using this formula: Sale Price (or Value) ÷ Gross Income (or Rent)

19. 2 8/21/2015 19 Rent and Income Multipliers Two types of multipliers can be applied: –Gross rent multipliers –Gross income multipliers continued

20. 2 8/21/2015 20 Gross Rent Multipliers (GRMs) A factor derived from comparable rental data, which is then used to develop an opinion of value of the subject property –Used when the property has income that is derived only from rental of living units Most commonly derived on a monthly basis –GMRM (gross monthly rent multiplier) emphasizes the factor is expressed as monthly

21. 2 8/21/2015 21 Gross Income Multipliers (GIMs) A factor that takes into account income derived from all sources of a property Commonly derived from and applied to annual income Could be based on PGI or EGI –Resulting multiplier could therefore be a potential gross income multiplier (PGIM) or an effective gross income multiplier (EGIM)

22. 2 8/21/2015 22 Rates of Return Overall Capitalization Rate –An income rate Yield Rate –Reflects the anticipation of all future benefit returns

23. 2 8/21/2015 23 Overall Capitalization Rate Used to interpret a property’s single year net operating income to the property’s value using direct capitalization M x R M + (1-M) x R E = R O Formula in which the rate, stated as a percent, is extracted for application in direct capitalization (known as IVR): (Net Operating) Income ÷ Value = Rate

24. 2 8/21/2015 24 Overall Yield Rate Considers a series of annual figures over the entire investment period as well as reversion Use of yield capitalization in most residential appraising is not common

25. 2 8/21/2015 25 Type of Value in the Assignment Type of value prompts appraiser to utilize valuation methods that will produce the most credible result –Also alerts appraiser of transaction characteristics to look for when choosing comparable data Types of value typically requested: –Market value of fee simple estate (most common) –Investment value –Value in use

26. 2 8/21/2015 26 Leasehold and Leased Fee Interests Scope of work may include valuing only leasehold or leased fee interest, or the leasehold or leased fee estate Income techniques most likely used to value these interests –GRM technique is the most simple and common Sales comparison approach is of little value unless comparable sales can be located

27. 2 8/21/2015 27 Leasehold and Leased Fee Interests When contract rent is less than market rent, an advantage to the lessee occurs and creates a positive leasehold When contract rent is more than market rent, an advantage to the lessor occurs and creates a negative leasehold Leasehold interest: Defined by the amount of rent that is less than market rent (amount of difference between contract and market rent) Leased fee interest: Defined by the amount of contract rent over and above market rent continued

28. 2 8/21/2015 28 Leasehold and Leased Fee Interests continued

29. 2 8/21/2015 29 Positive Leasehold Example Property’s contract rent = $1,200 per month Appraiser determines property should have a market rent of $1,350 per month Appraiser selects a GRM of 110 $1,350 x 110 = $148,500 $1,200 x 110 = $132,000 $148,500 – $132,000 = $16,500 Therefore, the value of the leasehold interest is $16,500, the amount of the advantage to the lessee, in dollars

30. 2 8/21/2015 30 Negative Leasehold Example Property contract rent = $1,500 per month Appraiser determines property should have a market rent of $1,250 per month Appraiser selects a GRM of 95 $1,250 x 95 = $118,750 $1,500 x 95 = $142,500 $118,750 - $142,500 = - $23,750 (stated as a negative — negative leasehold) Therefore, the value of the leased fee interest is $23,750, the amount of the advantage to the lessor, in dollars

31. 2 8/21/2015 31 Chapter 2 Quiz 1. The potential gross income for a property less any vacancy and collection losses is known as ______________ income. effective gross

32. 2 8/21/2015 32 Chapter 2 Quiz 2. The net proceeds, if and when a property is sold, are known as a _____________ benefit. reversionary

33. 2 8/21/2015 33 Chapter 2 Quiz 3. A type of expense that could be associated with the occupancy level of a property is known as a __________ expense. variable

34. 2 8/21/2015 34 Chapter 2 Quiz 4. A _____ is an appropriate factor to be used in developing the income approach when the property generates income from sources in addition to rent from the living units. GIM

35. 2 8/21/2015 35 Chapter 2 Quiz 5. When the contract rent of a property is greater than market rent, a ______ ___ interest results. Leased fee

36. 2 8/21/2015 36 Chapter 2 Quiz 6. An overall capitalization rate is used to interpret a series of annual net income figures over the entire investment period. TRUEFALSE

37. 2 8/21/2015 37 Chapter 2 Quiz 7. Regardless of the type of value identified in an assignment, market rent is used in the appraiser’s income analysis. TRUEFALSE

38. 2 8/21/2015 38 Chapter 2 Quiz 8. Debt service is not included in the analysis of operating expenses when determining net operating income. TRUEFALSE

39. 2 8/21/2015 39 Chapter 2 Quiz 9. For an appraisal in which investment value is specified, the appraiser’s value opinion is based upon an income or level of return reflecting the investor’s specific criteria. TRUEFALSE

40. 2 8/21/2015 40 Chapter 2 Quiz 10. A positive leasehold is created when contract rent is greater than market rent. TRUEFALSE