Income approach
Encyclopedia
The Income Approach is one of three major groups of methodologies, called valuation approaches, used by appraisers. It is particularly common in commercial real estate appraisal
and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or business valuation
.
While there are quite a few acceptable methods under the rubric of the income approach, most of these methods fall into three categories: direct capitalization, discounted cash flow, and gross income multiplier.
(CAP rate). For income-producing real estate, the NOI is the net income of the real estate (but not the business interest) plus any interest expense and non-cash items (e.g. -- depreciation) minus a reserve for replacement. The CAP rate may be determined in one of several ways, including market extraction, band-of-investments, or a built-up method. When appraising complex property, or property which has a risk-adjustment due to unusual factors (e.g. -- contamination), a risk-adjusted cap rate is appropriate. An implicit assumption in direct capitalization is that the cash flow is a perpetuity and the cap rate is a constant. If either cash flows or risk levels are expected to change, then direct capitalization fails and a discounted cash flow method must be used.
In UK practice, Net Income is capitalised by use of market-derived yields. If the property is rack-rent
ed then the All Risks Yield will be used. However, if the passing rent differs from the Estimated Rental Value (ERV), then either the Term & Reversion, Layer or Equivalent Yield methods will be employed. In essence, these entail discounting the different income streams - that of the current or passing rent and that of the reversion to the full rental value - at different adjusted yields.
However, capitalization rate inherently includes the investment-specific risk premium. Each investor may have a different view of risk and, therefore, arrive at a different capitalization rate for a given investment. The relationship becomes clear when the capitalization rate is derived from the discount rate using the build-up cost of capital model. The two are identical whenever the earnings growth rate equals 0.
estimation in finance. However, appraisers often mistakenly use a market-derived cap rate and NOI as substitutes for the discount rate and/or the annual cash flow. The Cap rate equals the discount rate plus-or-minus a factor for anticipated growth. The NOI may be used if market value is the goal, but if investment value is the goal, then some other measure of cash flow is appropriate.
of the University of Reading
(and ultimately based on earlier work by Wood and Greaves). The RICS have encouraged use of the method in appropriate circumstances. The Short-cut DCF is an adaptation to property valuation of the DCF method, which is widely used in finance.
In the Short-cut DCF, the passing rent, which is constant (in nominal or real terms) for the duration of the rent period, is discounted at an appropriate rate of return
(possibly derived by reference to the risk-free rate of return obtained on government bonds, to which is added an allowance for risk and an allowance for the illiquidity of property assets). The reversion is discounted at the market-derived All Risks Yield (ARY), which correctly implies growth in the reversionary income stream. The reversionary income is the current Estimated Rental Value (ERV) inflated by an appropriate annual growth factor (or CAGR - Compound Annual Growth Rate). The crux of the Crosby-Wood model, and that which sets it apart from the customary DCF, is that the growth factor is derived by means of formula, as a function of the rate of return and the All Risks Yield. For example, if the rate of return is 10% per annum, the ARY is 8% per annum and rent is reviewed annually, then the growth factor will be 2%. (This simple subtraction only works when rent is reviewed annually - in all other situations the growth factor is derived by use of the Crosby formula.) Thus the Short-cut DCF produces a mathematically consistent valuation.
Real estate appraisal
Real estate appraisal, property valuation or land valuation is the process of valuing real property. The value usually sought is the property's Market Value. Appraisals are needed because compared to, say, corporate stock, real estate transactions occur very infrequently...
and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or business valuation
Business valuation
Business valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business...
.
While there are quite a few acceptable methods under the rubric of the income approach, most of these methods fall into three categories: direct capitalization, discounted cash flow, and gross income multiplier.
Direct Capitalization
This is simply the quotient of dividing the annual net operating income (NOI) by the appropriate capitalization rateCapitalization rate
Capitalization rate is the ratio between the net operating income produced by an asset and its capital cost or alternatively its current market value...
(CAP rate). For income-producing real estate, the NOI is the net income of the real estate (but not the business interest) plus any interest expense and non-cash items (e.g. -- depreciation) minus a reserve for replacement. The CAP rate may be determined in one of several ways, including market extraction, band-of-investments, or a built-up method. When appraising complex property, or property which has a risk-adjustment due to unusual factors (e.g. -- contamination), a risk-adjusted cap rate is appropriate. An implicit assumption in direct capitalization is that the cash flow is a perpetuity and the cap rate is a constant. If either cash flows or risk levels are expected to change, then direct capitalization fails and a discounted cash flow method must be used.
In UK practice, Net Income is capitalised by use of market-derived yields. If the property is rack-rent
Rack-rent
Rack-rent denotes two different concepts:# an excessive or extortionate rent, or# the full rent of a property, including both land and improvements if it were subject to an immediate open-market rental review...
ed then the All Risks Yield will be used. However, if the passing rent differs from the Estimated Rental Value (ERV), then either the Term & Reversion, Layer or Equivalent Yield methods will be employed. In essence, these entail discounting the different income streams - that of the current or passing rent and that of the reversion to the full rental value - at different adjusted yields.
However, capitalization rate inherently includes the investment-specific risk premium. Each investor may have a different view of risk and, therefore, arrive at a different capitalization rate for a given investment. The relationship becomes clear when the capitalization rate is derived from the discount rate using the build-up cost of capital model. The two are identical whenever the earnings growth rate equals 0.
Discounted Cash Flow
The DCF model is analogous to a net present valueNet present value
In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
estimation in finance. However, appraisers often mistakenly use a market-derived cap rate and NOI as substitutes for the discount rate and/or the annual cash flow. The Cap rate equals the discount rate plus-or-minus a factor for anticipated growth. The NOI may be used if market value is the goal, but if investment value is the goal, then some other measure of cash flow is appropriate.
Gross Rent Multipler
The GRM is simply the ratio of the monthly (or annual) rent divided into the selling price. If several similar properties have sold in the market recently, then the GRM can be computed for those and applied to the anticipated monthly rent for the subject property. GRM is useful for rental houses, duplexes, and simple commercial properties when used as a supplement to other more well developed methods.Short-cut DCF
The Short-cut DCF method is based on a model developed by Professor Neil CrosbyNeil Crosby
Neil Crosby is an influential academic valuer, Professor of Real Estate at the University of Reading. He has heavily influenced UK property valuation practice through a series of journal publications in the late 1980s and early 1990s, which dealt with questions of investment property valuation...
of the University of Reading
University of Reading
The University of Reading is a university in the English town of Reading, Berkshire. The University was established in 1892 as University College, Reading and received its Royal Charter in 1926. It is based on several campuses in, and around, the town of Reading.The University has a long tradition...
(and ultimately based on earlier work by Wood and Greaves). The RICS have encouraged use of the method in appropriate circumstances. The Short-cut DCF is an adaptation to property valuation of the DCF method, which is widely used in finance.
In the Short-cut DCF, the passing rent, which is constant (in nominal or real terms) for the duration of the rent period, is discounted at an appropriate rate of return
Rate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or...
(possibly derived by reference to the risk-free rate of return obtained on government bonds, to which is added an allowance for risk and an allowance for the illiquidity of property assets). The reversion is discounted at the market-derived All Risks Yield (ARY), which correctly implies growth in the reversionary income stream. The reversionary income is the current Estimated Rental Value (ERV) inflated by an appropriate annual growth factor (or CAGR - Compound Annual Growth Rate). The crux of the Crosby-Wood model, and that which sets it apart from the customary DCF, is that the growth factor is derived by means of formula, as a function of the rate of return and the All Risks Yield. For example, if the rate of return is 10% per annum, the ARY is 8% per annum and rent is reviewed annually, then the growth factor will be 2%. (This simple subtraction only works when rent is reviewed annually - in all other situations the growth factor is derived by use of the Crosby formula.) Thus the Short-cut DCF produces a mathematically consistent valuation.
Further reading
- Baum, A. and Mackmin, D. (1989) The Income Approach to Property Valuation (Third Edition), Routledge, London.
- Baum, A. and Crosby, N. (1988) Property Investment Appraisal (Second Edition), Routledge, London.
- Havard, T. (2004) Investment Property Valuation Today, Estates Gazette, London.
- The Appraisal of Real Estate (12th Edition), The Appraisal Institute, Chicago.
- Kilpatrick, John A., (2007) Valuation of Brownfields, Chapter 29 in Brownfield Law and Practice (Lexis-Nexis Matthew Bender)