Lesson 5 – Definition of the Income Approach and Property Tax Rule 8 (The Income Approach to Value)

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Now that you have reviewed the basic principles and assumptions associated with the income approach, we will discuss the definition of the income approach to value and Property Tax Rule 8 (Rule 8) as to its directives on the use of the income approach. This lesson discusses the following:

  • Definition of the Income Approach to Value
  • Property Tax Rule 8

The income approach to value is a set of procedures through which a value indication is derived for an income-producing property by converting the future cash benefits from the property into an estimate of property value. The income approach is also called the capitalization approach because capitalization is the process of converting an expected income into an indicator of value. Any method that converts an income stream into an indicated property value can be considered an income approach to value.

What is an income-producing property?

An income-producing property is any property, real or personal, that produces an income stream. The most common types of income-producing properties are office, retail, industrial, and apartments. Other income-producing properties include motels, hotels, service stations, nursing homes, factories, and agricultural land. Leased equipment, such as copy machines and automobiles, also produce income streams, and can be considered income-producing property.

What is an income stream?

An income stream is a single payment or flow of payments or benefits from an investment or property. The income stream can be converted into an indication of value by using income multipliers, income factors, and capitalization rates.

What are future cash benefits?

Future cash benefits may be in the form of cash flows or as a reversion. A reversion is a lump sum that an investor receives at the termination of an investment.

The BOE is required to prescribe rules and regulations to govern assessors and local boards of equalization; these rules govern assessors when assessing, county boards of equalization and assessment appeals boards when equalizing, and the State Board of Equalization (BOE), including all divisions of the property taxes department. These rules are adopted to clarify statutes relating to assessment principles and procedures, such as those in Division 1, Property Taxation, of the Revenue and Taxation Code. The BOE's property tax rules are codified in Title 18, Public Revenues, of the California Code of Regulations.

Property Tax Rule 8 prescribes the conditions under which the income approach may be applied in the valuation of property for ad valorem property tax purposes. A summary of the subdivisions is provided below. Please refer to the complete Rule 8.

Subdivision (a) specifies that:
The income approach to value is used in conjunction with other approaches when the property under appraisal is typically purchased in anticipation of a money income and either has an established income stream or can be attributed a real or hypothetical income stream by comparison with other properties. It is the preferred approach for the appraisal of land when reliable sales data for comparable properties are not available. It is the preferred approach for the appraisal of improved real properties and personal properties when reliable sales data are not available and the cost approaches are unreliable because the reproducible property has suffered considerable physical depreciation, functional obsolescence or economic obsolescence, is a substantial over- or underimprovement, is misplaced, or is subject to legal restrictions on income that are unrelated to cost.

Subdivision (b) states that in using the income approach, “… an appraiser values an income property by computing the present worth of a future income stream.”

Subdivision (b)(1) provides for the reversion of land or salvage value (scrap value) of improvements.

Subdivision (b)(2) provides for the residual techniques (land residual or building residual). The residual techniques will be discussed in Lesson 14.

Subdivision (b)(3) provides that income may be “projected as a level perpetual flow.” Land income is usually projected as a level perpetual flow.

Subdivision (c) establishes that the amount to be capitalized is the net return that a reasonably well-informed owner and reasonably well informed buyers may anticipate that the taxable property, as it exists on the valuation date, will yield, considering prudent management and subject to such legally enforceable restrictions as such persons may foresee as of that date. It states, in part:

Net return, in this context, is the difference between gross return and gross outgo. Gross return means any money or money's worth which the property will yield over and above vacancy and collection losses, including ordinary income, return of capital, and the total proceeds from sales of all or part of the property. Gross outgo means any outlay of money or money's worth, including current expenses and capital expenditures (or annual allowances therefor) required to develop and maintain the estimated income. Gross outgo does not include amortization, depreciation, or depletion charges, debt retirement, interest on funds invested in the property, or rents and royalties payable by the assessee for use of the property. Property taxes, corporation net income taxes, and corporation franchise taxes measured by net income are also excluded from gross outgo.

Similar to the sales comparison approach, where the appraiser considers what are typical, or fair market, sales, the appraiser using the income approach analyzes typical or fair market rents, income, and expenses. Notably, the last sentence states that property taxes are excluded. This is because you need to know the value before you can determine the taxes and that is what the appraiser is determining.

Subdivision (d) states that,
In valuing property encumbered by a lease, the net income to be capitalized is the amount the property would yield were it not so encumbered, whether this amount exceeds or falls short of the contract rent and whether the lessor or the lessee has agreed to pay the property tax. Thus, the estimate of economic rent for income-producing property must be made without regard to actual lease arrangements that may exist, including rent levels and property tax payment considerations, since the valuation objective is the market value of the unencumbered and unrestricted fee simple interest.

Subdivision (e) recommends using income from property rental rather than from business operation, since income derived from business operation is more likely to be influenced by managerial skills and may arise in part from nontaxable property or other sources. If income from business operation must be considered, sufficient income must be excluded to provide a return to working capital, any other nontaxable intangible assets and rights, and unpaid or underpaid management.

Subdivision (f) requires the inclusion of a property tax component, where applicable, equal to the estimated future ad valorem portion of the tax rate for the area times the assessment ratio, in the capitalization rate for all property tax appraisals. (Under some types of leases, the tenant assumes all expenses of operating the property, including property taxes. If the income to be capitalized is income estimated under such a lease, it may not be necessary to add a property tax component to the capitalization rate.)

Subdivision (g) provides the following two methods of developing a capitalization rate for property tax appraisals:

(1) By comparing the net incomes that could reasonably have been anticipated from recently sold comparable properties with their sales prices, adjusted, if necessary, to cash equivalents (the market-derived rate).

(2) By deriving a weighted average of the capitalization rates for debt and for equity capital appropriate to the California money markets (the band-of-investment method) and adding increments for expenses that are excluded from outgo because they are based on the value that is being sought or the income that is being capitalized.

Note For the second method, (2), it may not always be appropriate to add increments for excluded expenses.

By comparing the net incomes with the sale prices for several comparable properties, the appraiser determines the ratio of net income to adjusted selling price of comparable sales, and develops a range of overall or yield rates. Subdivision (g)(1) states, regarding the market-derived rate, “This method of deriving a capitalization rate is preferred when the required sales prices and incomes are available.” In the method described in subdivision (g)(2), the appraiser derives a weighted average of current rates for debt and equity capital (subject to the inclusion of a property tax component). Methods of developing rates will be discussed starting in Lesson 11.

Subdivision (h) provides that income may be capitalized by the use of gross income, gross rent, or gross production multipliers, derived by comparing sales prices of closely comparable properties with their gross income, gross rent, or gross production. The derivation and use of multipliers will be discussed in Lesson 9.

Finally, subdivision (i) excludes open space land, as defined in Revenue and Taxation Code section 421, from the provisions of Rule 8, and states that not all provisions of Rule 8 apply to taxable possessory interests.

The lesson you just read discussed the definition of the income approach to value and Property Tax Rule 8. The next lesson will explain the characteristics of the Income Stream.

Note: Before proceeding on to the next lesson, be sure to complete the exercises for this lesson.