2 8/21/2015 1 Chapter 2 Income Concepts. 2 8/21/2015 2 Chapter Objectives Upon completion of this chapter, the participant will be able to: –Contrast.

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Chapter 2

Income Concepts

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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

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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

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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

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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

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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

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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

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Measures of Income and Benefits

• Potential Gross Income (PGI)

• Effective Gross Income (EGI)

• Net Operating Income (NOI)

• Reversionary Benefit

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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

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Effective Gross Income

• The potential gross income, less vacancy and collection losses

• The formula for EGI is:

PGI - Vacancy and Collection Losses = EGI

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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

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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

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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

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Operating Expenses

• Typically, operating expenses are categorized as:

– Fixed expenses– Variable expenses– Reserves for replacement

continued

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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

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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

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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)

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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)

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Rent and Income Multipliers

• Two types of multipliers can be applied:– Gross rent multipliers– Gross income multipliers

continued

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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

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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)

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Rates of Return

• Overall Capitalization Rate– An income rate

• Yield Rate– Reflects the anticipation of all future

benefit returns

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Overall Capitalization Rate

• Used to interpret a property’s single year net operating income to the property’s value using direct capitalization

M x RM + (1-M) x RE = RO

• Formula in which the rate, stated as a percent, is extracted for application in direct capitalization (known as IVR):

(Net Operating) Income ÷ Value = Rate

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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

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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

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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

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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

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Leasehold and Leased Fee Interestscontinued

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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

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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

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Chapter 2 Quiz

1. The potential gross income for a property less any vacancy and collection losses is known as ______________ income.effective gross

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Chapter 2 Quiz

2. The net proceeds, if and when a property is sold, are known as a _____________ benefit.reversionary

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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

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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

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Chapter 2 Quiz

5. When the contract rent of a property is greater than market rent, a ______ ___ interest results.Leased fee

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Chapter 2 Quiz

6. An overall capitalization rate is used to interpret a series of annual net income figures over the entire investment period.

TRUE FALSE

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Chapter 2 Quiz

7. Regardless of the type of value identified in an assignment, market rent is used in the appraiser’s income analysis.

TRUE FALSE

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Chapter 2 Quiz

8. Debt service is not included in the analysis of operating expenses when determining net operating income.

TRUE FALSE

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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.

TRUE FALSE

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Chapter 2 Quiz

10. A positive leasehold is created when contract rent is greater than market rent.

TRUE FALSE