Lesson 3 – Assumptions of the Income Approach (The Income Approach to Value)
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In Lesson 2, we discussed some of the basic principles applicable to the income capitalization approach. When emulating what an informed buyer and seller would do in an open market, appraisers must also consider some basic assumptions those buyers (investors) will consider in making an investment.
In this lesson, we will discuss those assumptions. There are three basic assumptions that are associated with income-producing properties. These assumptions are:
- Value is a Function of Income
- Investors will Estimate the Duration, Quantity, and Quality of the Future Income
- Future Income is Less Valuable than Present Income
If any one of these three assumptions cannot be made about the property being appraised, then the income approach to value should not be used.
Value is a Function of Income
People purchase income-producing property for the income it will return on their investment. It follows then that the value estimate of a property is based on the potential income that the property can produce. To apply the income approach, the property being appraised must be of a type that is commonly bought and sold based on its income stream.
The income a property generates may come from many sources, such as property rents, royalties, amenities, roof rents from billboards, and ground rents from cell towers. The estimate of future income may be based on either an actual or a hypothetical income stream. Rents are, in effect, sales prices for short-term rights to use property. Appraisers apply these short-term sales prices in the income approach to obtain value indicators, which are estimates of the present worth of the sum of all these expected future short-term sales prices. This sum of income may involve a terminating period or go on into perpetuity.
The benefits a property will provide over time must be expressed in terms of money, so the income approach to value is best when used with a type of property that is bought and sold based on its expected income stream such as commercial, industrial, and multi-family properties. These types of properties are typically developed and purchased for the income they provide and are frequently leased to tenants in competitive markets. Although single-family residential properties may also be leased, they are generally purchased to provide their owners with amenity benefits (a place to live) rather than monetary benefits. Consequently, it is often difficult to apply the income approach to single-family residences.
If the income approach is used to value property that provides both monetary and amenity benefits, care should be exercised in converting amenity benefits into value. If the capitalization rate reflects the amenity benefit, a question arises whether the amount of the amenity benefit reflected in the rate equals the amenity benefit in the subject property. For example, a farm may be both a production unit returning monetary benefits and a living unit returning amenity benefits. Because the appraiser is often unable to impute an income to the amenities from the living unit, the capitalization rate is derived from market data that is based only upon the income derived from the farm as a production unit. The capitalization rate will consequently be lower than it would have been had it been possible to impute an income to the amenities and sum the income from both benefits (i.e., monetary and amenity) to obtain a more accurate measure of the true monetary return. Capitalization rates that include both monetary and amenity elements should be used for properties that have amenities similar to those of the properties from which the respective rates were derived.
Again, investors purchase income-producing properties for the income (future benefits) the properties will yield (produce); it is the income the real estate generates, not income that the business generates that appraisers consider. For example, a retail store operated by the property owner involves at least two activities. One is the ownership of the real and tangible personal property, and the other is the business of selling merchandise at the property. It is necessary to determine what portion of the operation's expected future earnings is attributable to the ownership of the taxable property. If the earnings of the business (after deductions for operating expenses) are capitalized into an indicator of value, the appraiser should be aware that the indicator might contain the value of nontaxable intangible assets and rights. The value of such assets and rights must not be reflected in the value of the taxable property. However, taxable property may be assessed and valued by assuming the presence of intangible assets, or rights necessary to put the taxable property to beneficial and productive use.
Lastly, when valuing a property, appraisers consider not only the Highest and Best Use of the parcel As if Improved (with the existing structure and use), but appraisers also consider the Highest and Best Use of a property As if Vacant. Consideration of As if Vacant assists the appraiser in determining whether the existing improvement or use of a parcel is yielding the highest income the property has the potential to generate. For example, if a single-story automotive repair shop has been operating in the heart of a downtown financial district for decades, the Highest and Best Use As if Vacant for that parcel may be an office building, a multi-story parking garage, a retail/restaurant business, or a combination of businesses.
This concept – that the value of a property is directly related to the income it will generate during the period of ownership, which may be the economic lifetime of the property or may be a lesser period – cannot be stressed enough. If there is no relationship between income and value, the income approach is of no use in the valuation of that property.
Investors will Estimate the Duration, Quantity, and Quality of the Future Income
This second assumption is related to the first, that value is a function of income. Investors recognize that value is a function of income, and, in determining a price for a property, will need to know how much income they will receive, how long they will receive that income (the timing of the income flows), and the risk involved that they will (or will not) received that income.
Potential buyers (investors) of an income-producing property will generally make several determinations before investing a sum of money into a property. They will estimate the quantity, quality, and duration of the future income.
The income approach assumes that the investor in real property will estimate the duration of the income stream and its risk, or likelihood of receipt, when selecting a capitalization rate to value the property.
Duration refers to the probable period over which the property can be expected to produce the estimated income. For land, the estimated duration of the income stream is usually in perpetuity, but improvements have limited lives. The estimate of the remaining economic life of an improvement (that period of time over which the property will earn a net income above the rent imputable to the land alone) is an important consideration in the income approach. Average life tables have been developed as general guides to estimating remaining economic life. However, a careful study of the structural soundness of the improvements, the degree of functional obsolescence, and the economic and social trends in the neighborhood and community should serve as the primary basis for this estimate.
Quantity of income refers to the amount of income (rent) per year the investors can receive.
Quality of income is the amount of risk that is associated with the investment. The risk of an income stream refers to its certainty; that is, how likely it is that the investor will receive the income. The greater the uncertainty of the income, the greater the risk; consequently, the income should be capitalized using a higher capitalization rate. Not all investments are subject to the same level of risk, and as such, not all income streams should be capitalized at the same rate.
Future Income is Less Valuable than Present Income
The third assumption of the income approach is that future income is less valuable than present income. The concept of present value is essential to understanding the income approach to value; it provides that the sum of the present worth of the future income payments is always less than the undiscounted sum of these future payments.
This concept is one of the most important in valuation. Because investors prefer immediate returns to future returns, they "discount" future returns, or reduce their value, when analyzing investments. Because of the time value of money, this is true even if no risk is involved. A rational investor would not pay $1,000 today for the certain right to receive $1,000 one year from now because they could earn interest on the $1,000 during the year, with the result that the total value would accumulate (at the risk-free rate of interest) to an amount greater than $1,000 at the end of the year. To the rational investor, a certain payment of $1,000 a year from today is worth something less than $1,000 today, with the amount of the discount determined by the risk-free rate of interest.
An illustration of this concept is can be found in any lottery – how many winners take payment in graduated installments, and how many, instead, chose the cash value of their jackpot prize – how many would rather have the money now. An old English proverb goes, “A bird in the hand is worth two in the bush.”
The present value is the amount which, when compounded periodically (usually annually) at a given rate, will accumulate to the future amount. For example, $1,000 due one year from today has a present value of $909.09 if the annual interest rate is 10 percent ($909.09 x 1.10 = $1,000).
The process of discounting a series of annuity payments, or any future payment, in order to obtain the present value of this income, is the basic theoretical underpinning of income capitalization. This concept and the use of factors to convert annuities into value by using the compound interest tables was discussed in the mandatory Time Value of Money – Six Functions of a Dollar Self-Paced Online Learning Session the participant was required to successfully complete prior to starting this learning session. It will be reviewed in the next lesson, Lesson 4, Time Value of Money.
The lesson you just read discussed the three basic assumptions of the income approach to value. These assumptions, and the mathematics we will discuss later in this self-paced online learning session, are very similar to methods used in the analysis and valuation of other financial instruments and transactions, such as bond and securities pricing. The next lesson provides a summary of the time value of money and explains each function of the compound interest and annuity tables that are used by an appraiser in the income approach to value.
Note: Before proceeding on to the next lesson, be sure to complete the exercises for this lesson.