Lesson 7 Exercises – Processing the Income Stream (The Income Approach to Value)

Appraisal Training: Self-Paced Online Learning Session

Check Your Knowledge

Open All Solutions Close All Solutions
  1. The total amount of income that could be produced by real estate is referred to as:
    1. Cash flow
    2. Net operating income
    3. Gross income
    4. Effective gross income

c. Gross income

Explanation: Gross income is the amount of gross receipts if all available income is collected; it assumes no vacancies or collection losses.

  1. What rent should the appraiser use in making a gross income estimate on a free-and-clear, no lease valuation?
    1. Contract rent
    2. Economic (market) rent
    3. Excess rent
    4. Surplus rent

b. Economic (market) rent

Explanation: Because a lease interest is not being valued, the market rent should be used to estimate income. By using market rent (the typical rent found in comparable properties) instead of the actual rent of the property, the appraiser will be estimating the value to a typical investor, or market value.

  1. How is the income from renting garage space in an apartment building complex handled by an appraiser?
    1. It would be included as "other income" in calculating gross income
    2. It would be ignored because the income from a garage is derived from personal property
    3. It would be deducted from net operating income
    4. It would be used to reduce the operating expenses

a. It would be included as "other income" in calculating gross income

Explanation: Income from renting a garage space is an example of "other income" that would normally be included in the calculation of gross income, because the garage is part of the apartment complex.

  1. Which of the following statements BEST describes how much of an adjustment an appraiser should make for vacancy allowance in a property?
    1. 5 percent of gross income
    2. 1 percent for each year the property has been rented
    3. Somewhere between 5 percent and 10 percent
    4. The amount will vary with each property

d. The amount will vary with each property

Explanation: There is no absolute number or adjustment that can be used for vacancy allowance. One of the responsibilities of the appraiser in analyzing the market is to estimate what the specific number should be for the subject property.

  1. To estimate effective gross income, which of the following items are required?
    1. Gross income and operating expenses
    2. Gross income and vacancy and collection loss
    3. Gross income, operating expenses, and debt service
    4. Gross income and property taxes

b. Gross income and vacancy and collection loss

Explanation: By definition, effective gross income is equal to gross income less vacancy and collection loss.

  1. Which of the following expenses is NOT considered by an appraiser in estimating the net operating income of a particular property?
    1. Property insurance
    2. Mortgage payments
    3. Property management fees
    4. Upkeep and maintenance

b. Mortgage payments

Explanation: Mortgage (debt) payments are not part of the calculation to estimate net operating income. The remaining three choices are all subtracted from effective gross income to estimate net operating income.

  1. When appraising income-producing property, the appraiser often needs to estimate the replacement allowance. When doing so, the appraiser should avoid duplication with certain items that may already have been included in which of the following expense categories?
    1. Fixed expenses
    2. Repair and maintenance
    3. Property management fees insurance and taxation escrow accounts
    4. Insurance and taxation escrow accounts

b. Repair and maintenance

Explanation: The appraiser needs to analyze all expenses carefully when using the income approach to value. One reason is to make sure that certain items are not being either counted twice or eliminated completely. One area where careful attention should be given concerns replacement allowances, which could have mistakenly been placed in a repair and maintenance category.

  1. In the context of real estate operating expenses, what is meant by the term fixed expenses?
    1. Expenses that never change
    2. Expenses that are fixed for the holding period
    3. Expenses that do not vary with the level of occupancy
    4. Expenses that are guaranteed by the seller

c. Expenses that do not vary with the level of occupancy

Explanation: The distinction between fixed and variable expenses is based on whether or not the expense varies with the level of occupancy. For example, property taxes are considered a fixed operating expense because they will not change if occupancy (vacancy) changes. However, they are not necessarily constant over a holding period and certainly not forever.

  1. Which of the following items is an example of an outlay that might be included in a reserve for replacements?
    1. Building replacement at the end of its economic life
    2. Roof replacement when it is worn out
    3. Allowance for painting
    4. Refinancing fees

b. Roof replacement when it is worn out

Explanation: Reserves are intended for long-lived items that must be replaced before the end of the economic life of the property. An example would be the replacement of a worn-out roof. "a." is replacing the entire building at the end of its remaining economic life; "b." is replacing the roof when it, the roof, is worn out, but before the building has reached the end of its economic life, so that it, the building, can continue to produce income.

  1. What term would apply to a lease that requires the lessor to pay all operating expenses associated with the real estate?
    1. Index lease
    2. Gross lease
    3. Net lease
    4. Pass through lease

b. Gross lease

Explanation: If the lessor has to pay the expenses, it is a gross lease. If the lessee (tenant) pays the expenses, it is a net lease. The term pass through is sometimes used to refer to passing through expenses to a tenant.

  1. Estimate the annual gross income of the subject property based upon the following data:

    Neighborhood: All stores are 100 feet in depth; and, except for front footage, all of the stores are similar in age, quality, condition, and other units of comparability. The neighborhood has averaged 5 percent vacancy and collection losses over the last five years.

    Subject Property: The subject property has 50 feet of frontage. The building was leased four years ago for $1,000 per month. The term of the lease is ten years.

    Comparable Properties (Rental Data):
    1. The store has 40 feet of frontage and was recently leased for a five-year period. The agreed upon rent is $1,200 per month.
    2. This store with 50 feet of frontage that was recently rented for a guaranteed $1,200 per month. In addition to the guaranteed rent, the tenant agrees to pay 6 percent of all gross sales over $30,000 per month. Gross sales for the last five years have averaged $35,000 per month. The term of the lease is five years.
    3. This store has 160 feet of frontage. The contract rent is $3,000 per month. The lease was written five years ago and has 20 years remaining on it. The tenant has partitioned the building into four separate stores of equal size. These are subleased as follows:
      1. $1,300 per month; month to month rental agreement.
      2. $1,200 per month; five-year lease signed one year ago.
      3. $1,000 per month; five-year lease signed four years ago.
      4. $1,100 per month; ten-year lease signed six months ago.

The subject's rental income is old. Three comparables, 1, 2, and 3B, provide the best evidence of current market rents. 3, 3C, and 3D, are old and/or long term leases, and not good indicators current market rents – for property tax appraisal purposes, we're usually after a fee simple absolute value, "free and clear" of any restrictions.

Parcel Gross Income Front Footage Price per Front Feet Square Footage Price per Square Feet Remarks
Subject $1,000 50 $20.00 5,000 20¢ Old Lease; 10 Years
1 $1,200 40 $30.00 4,000 30¢ Recent Lease; 5 Years
2 $1,500 50 $30.00 5,000 30¢ Recent Lease; 5 Years
3 $3,000 160 $18.75 16,000 18¾¢ Old Lease; Larger; 25 Years
A $1,300 40 $32.50 4,000 32½¢ Month to Month
B $1,200 40 $30.00 4,000 30¢ One Year Old Lease; 5 Years
C $1,000 40 $25.00 4,000 25¢ Old Lease; 5 Years
D $1,100 40 $27.50 4,000 27½¢ 10 Year Lease

Gross Income: 50 F.F. x $30.00/F.F. = $1,500 x 12 months = $18,000

  1. Determine the Net Income Before Recapture [NIBR] for a duplex renting for $850 each side. The tenant pays the utilities only. The owner pays $50/mo. for water, sewer, and garbage for the building, insurance is $700 per year; taxes are based on a $175,000 value with a 1% tax rate; and maintenance is $70/mo. each side. Both units have been occupied for several years; it is appropriate to make no adjustment for vacancies and collection losses.

Gross Income (GI) : $850 x 2 units x 12 months
$20,400
No vacancy allowance
$0
Effective Gross Income [EffGI]
$20,400
Water/sewer/garbage: $50 x 12 months
-
$600
Insurance
-
$700
Maintenance: $70 x 2 units x 12 months
-
$1,680
Net Income Before deducting Recapture & Taxes (NIBT)
=
$17,420
Property Taxes (PT): $175,000 x 1%
-
$1,750
Net Income Before Recapture (NIBR)
=
$15,670
  1. Determine the Net Income Before deducting for Recapture [NIBR] for a 40,000 sq. ft. warehouse that rents for $0.35 per sq. ft. / mo. The insurance cost is $0.11 per sq. ft./year; maintenance costs and reserves for replacement is $0.40 per year; water and sewer cost is $150/mo.; garbage cost is $200/mo.; and taxes are based on a value of $1,500,000, with a tax rate of 1%. Vacancies and collection losses are 7%.

Gross Income (GI): 40,000 x $0.35 x 12
$168,000
Vacancy & Collection Loss (V&CL): $168,000 x 7%
-
$11,760
Effective Gross Income (EGI)
=
$156,240
Insurance: 40,000 x $0.11
-
$4,400
Maintenance and reserves: 40,000 x $0.40
-
$16,000
Water/sewer/garbage: $350 x 12
-
$4,200
Net Income Before deducting Recapture & Taxes (NIBT)
=
$131,640
Property Taxes (PT): $1,500,000 x 1%
-
$15,000
Net Income Before Recapture (NIBR)
=
$116,640
  1. Determine the Net Income Before deducting for Recapture [NIBR] for a 60,000 sq. ft. office building that rents for $1.85 sq. ft. / mo. The expenses are as follows: vacancy 7%; insurance $10,800; management 7% of effective gross income; maintenance $28,800; utilities $108,000, janitorial $43,200; and property taxes based on a value of $9,000,000 with a rate of 1%.

Gross Income (GI): 60,000 x $1.85 x 12
$1,332,000
Vacancy & Collection Loss (V&CL): $1,332,000 x 7%
-
$93,240
Effective Gross Income (EGI)
=
$1,238,760
Insurance
-
$10,800
Management: $1,238,760 x 7%
-
$86,713
Maintenance
-
$28,800
Utilities
-
$108,000
Janitorial
-
$43,200
Net Income Before deducting Recapture and Taxes (NIBT)
=
$961,247
Property Taxes (PT): $9,000,000 x 1%
-
$90,000
Net Income Before Recapture (NIBR)
=
$871,247
  1. Determine the Net Income Before deducting for Recapture [NIBR] for a 30,000 sq. ft. retail store that rents for $0.70 sq. ft. / mo. on a net rent to the owner. Vacancy and collection loss are estimated at 3.5%. The only expenses to the owner are a 1% management cost and a pro rata share on the vacant area that amounts to $700/mo.

Gross Income (GI) = 30,000 x $0.70 x 12
=
$252,000
Vacancy & Collection Loss (V&CL) = $252,000 x 3.5%
-
$8,820
Effective Gross Income (EGI)
=
$243,180
Management = $243,180 x 1%
-
$2,432
Expenses = $700 x 12
-
$8,400
Net Income Before deducting Recapture (NIBR)
=
$232,348

Rent is net to the owner; therefore, the owner passes through all operating expenses, including property taxes, to the tenant. Even though it is a "net" lease, it is appropriate to deduct for V&CL, if vacancies and/or collections losses are typical in the market. Note that the Net Income Before deducting Recapture is the same net income level as Net Operating Income [NOI] – two names, but the same level of net income -- annual net income after all operating expenses, including ad valorem property taxes are subtracted from the effective gross income.

  1. Using the actual income statement provided, determine the Net Income Before deducting Recapture [NIBR] for an apartment complex with eight 2-bedroom units renting for $650 per unit. The market vacancy and collection loss is 5%. The building manager has supplied you with a statement of income and expenses for the past year. This statement, prepared by his accountant, shows actual dollars received and spent.

    Income and Expense Statement

    • Actual Rents Received$ 58,000
    • Expenses45,356
      • Corporate Franchise Tax$8,700
      • Depreciation8,000
      • Insurance1,800
      • Interest on Mortgage5,000
      • Manager's Salary2,166
      • Miscellaneous Repairs2,500
      • Real Estate Property Taxes9,000
      • Reserve for Replacement1,190
      • Scheduled Maintenance3,600
      • Utilities3,400
    • Net Annual Profit$ 12,644

Effective Gross Income (EGI)
$58,000
Property Management
-
$2,166
Property Insurance
-
$1,800
Maintenance
-
$3,600
Repairs
-
$2,500
Utilities
-
$3,400
Reserve for Replacement
-
$1,190
Net Income Before deducting Recapture and Taxes (NIBT)
=
$43,344
Property Taxes (PT)
-
$9,000
Net Income Before Recapture (NIBR)
=
$34,344

Notice that in exercise above, the income did not begin with gross income instead the income stream was processed using effective gross income. As discussed in the lesson, effective gross income is the amount of income that remains after deducting vacancy and collection loss. The actual rents received are the effective gross income of the property. Since we have the effective gross income of the property, we do not need to deduct for vacancy and collection losses. In addition, the expenses also require analysis: corporate franchise tax, depreciation, and mortgage interest are excluded from the definition of gross outgo and, therefore, are not deducted as operating expenses.

  1. (1) Using the property's actual Income and Expense Statement below for this year, process the gross income to the actual Net Income Before deducting for Recapture AND property Taxes [NIBT]. (2) Would this be the same NIBT you would use to value the property; if not, what would you use?

    The owner of a 25-year-old apartment building has supplied you with this statement of income and expenses for the past year. The statement, prepared by his accountant, shows actual dollars received and spent. The building contains 15 units, of which eight are studio apartments that rent for $300 per month; five are one bedroom units at $360 per month; and two are three-bedroom units at $540 per month. The rental schedule is well in line with other apartments in the neighborhood. A 5 percent vacancy and collection loss factor is reasonable for the area. The cost to replace the building today is $540,000.

    Income and Expense Statement

    • Actual Rents Received$ 57,520
    • Expenses:42,744
      • Supplies$ 660
      • Roof Repair1,000
      • Water1,000
      • Corporation Franchise Tax2,000
      • Janitor's Salary3,000
      • Miscellaneous Repairs3,130
      • Insurance (3-year Premium)3,600
      • Manager's Salarty3,600
      • Electricity3,700
      • Real Estate Property Taxes4,136
      • Interest on Mortgage4,548
      • Gas6,200
      • Depreciation8,000
    • Net Annual Profit$ 14,776
    Miscellaneous repairs included exterior painting and some interior painting and decorating. Similar properties indicate a 25 percent ratio of allowable expenses to effective gross income.

Part 1: Compute NIBT
Actual Effective Gross Income (EGI)
$57,520
Actual Allowable Operating Expenses (OE)
Supplies
$660
Roof Repair
$1,000
Water
$1,000
Janitor's Salary
$3,000
Miscellaneous Repairs
$3,130
Insurance ($3,600/3 Years)
$1,200
Manager's Salary
$3,600
Electricity
$3,700
Gas
$6,200
-
$23,490
Actual Net Income Before deducting Recapture and Taxes (NIBT)
=
$34,030

Part 2: Would you use NIBT from Part I to value the property?

You would not use the NIBT that was calculated in part I because it was based on actual income and expenses for the property. For purposing of deriving value, we use market rents and expenses. If the income was being processed for valuation purposes, the income would be processed as follows:

Gross Income:

  • 8 units x $300 x 12 months$ 28,800
  • 5 units x $360 x 12 months$ 21,600
  • 2 units x $540 x 12 months$ 12,960
  • $63,360
Potential Gross Income (PGI)
$63,360
Vacancy & Collection Loss (V&CL) = $63,360 x 5%
-
$3,168
Effective Gross Income (EGI)
=
$60,192
Operating Expenses (OE) = $60,192 x 25%
-
$15,048
Net Income Before deducting Recapture & Taxes (NIBT)
=
$45,144

(Note in this case the gross income was based on the properties actual rent schedule – that was because it was representative of market – the situation explained that the rent schedule is well in line with other apartments in the neighborhood.)