THE INCOME APPROACH, sometimes called the income capitalization approach, is a method of estimating value based on money you expect to receive in the future. This method works best for standard income properties that are fully rented and have been producing income for some time. These are sometimes called “stabilized” income properties.
The income approach may not be that reliable for owner-occupied real estate, because owners don’t pay rent. Also, the income approach may be less reliable for vacant, unique, unusual or mixed-use properties.
Vacation rentals and single family residences can produce substantial rental income. However, this income may not have any relation to the value of the real estate because buyers purchase these properties for private residential use rather than investment. Also, many rural properties have something called “excess land,” or more land than is needed to support the income-producing use. Therefore, the income approach may not be that helpful in estimating the value of these types of properties.
Commercial Sales Data
In urban areas, real estate information services such as Comps Inc. research commercial real estate sales and sell this information to appraisers, investors and other real estate professionals.
In non-urban areas, real estate agents have the major responsibility for collecting and entering accurate and consistent income and expense data into the local multiple listing service (MLS). Without this data it’s hard for buyers, sellers and appraisers to estimate commercial real estate value. When sellers fail to fully disclose income and expense data this can mislead buyers, cause them to overpay, and lead to business failures and loan defaults.
The best time to collect income and expense data is when a seller lists his or her property. This is when they are the most cooperative and motivated. After the sale, the buyer or seller is much less inclined to release this information.
The following are some descriptions of important terms and concepts used in analyzing income property.
Reconstructed Operating Statement
A reconstructed operating statement is a simple spreadsheet that lists the anticipated first year income and expenses for commercial real estate. It is a useful tool for evaluating income property. A thorough operating statement includes such things as vacancy and collection losses, replacement reserves and management expenses. However, it does not include the owner’s income taxes and mortgage payments, which are based more on the owner’s circumstances than the real estate.
Market Rent
Market rent is the rental income that a property would most probably command in the open market. The best way to estimate market rent is to look at current rents paid for comparable space.
In rural areas and small towns, comparable rental space is rarely identical to the property being evaluated, and may need some adjustments. Landlords will normally charge more rent for properties with higher vehicle or pedestrian traffic. More off-street parking may mean higher rent, and ground floor rents are usually higher than second floor rents. Small spaces usually pay more rent per square foot than large spaces. Smart landlords often charge less than market rent for stable long-term tenants, thus avoiding a lot of expenses associated with vacancy and turnover.
Leases
A lease is a written document that transfers the rights to use and occupy real estate from the owner to a tenant for a specified period of time in exchange for rent. The period of time the lease is in effect is called the term. Many residential leases operate on a month-to month basis, but commercial leases usually have a term of one or more years.
In a “gross” lease, the landlord pays all or most of the property’s operating expenses and real estate taxes. In a “net” lease, the tenant pays all the operating expenses in addition to the rent. A “triple net” lease requires the tenant to pay all utilities and operating expenses in addition to rent, including the owner’s real estate taxes.
An “index” lease calls for periodic rent adjustments based on some economic index, usually the regional Consumer Price Index. Restaurants often have “percentage” leases, where all or a portion of the rent is based on a percentage of gross sales.
Tenants with a “flat” or “level payment” lease pay the same rent throughout the lease term. Tenants with “graduated” or “step-up” and “step-down” leases pay different levels of rent at certain points during the term of the lease.
Leasehold and Leased Fee Interests
It’s important to examine any leases carefully, because they may grant certain property rights to the tenant and lower the value for the owner.
Tenants with long-term leases who pay below market rent may have a type of property right called a “leasehold interest,” which lowers the value of the owner’s “leased fee” interest. The tenant’s leasehold interest plus the owner’s leased fee interest equals the market value of the real estate.
Leases may also include options to buy the property, the right to sublet and the right to sell the lease to another party. These tenant rights may also reduce the owner’s leased fee portion of the property value.
Measuring Rentable Floor Area
Since most leases are based on a certain amount of rent per square foot, it’s important to measure commercial floor area correctly and consistently.
Commercial floor area is measured differently than residential floor area. Residential gross living area is normally calculated by measuring the exterior dimensions of the house less non-livable areas such as garages and storage spaces. Commercial floor area normally includes the interior square footage, including interior walls. However, It does not include common areas shared with other tenants such as stairways and lobbies, or major utilities such as elevators and ventilation shafts.
In 1966, the Building Owners and Managers Association published new, upgraded standard for measuring office buildings, originally developed in 1915. For more information, contact BOMA at 202-408-2662, or visit their web site at www.boma.org.
Gross Scheduled Rents
Gross scheduled rents are the total income due under all existing leases. This may or not be the same as the asking rent for unrented space. The owner’s asking price could be too high, which could be why the space is vacant.
Other Income
Other income is any other real estate-related income apart from rent, such as parking fees.
Potential Gross Income (PGI)
Potential gross income is the total income attributable to the real estate at 100 percent occupancy, before any expenses are deducted. This should include gross scheduled rents, the estimated market rent for any unrented spaces, and any other real estate-related income.
Be careful about including asking rents for unrented spaces. These could be considerably higher than actual market rents. If this type of rental space is oversupplied in the current real estate market, it may remain vacant regardless of the rent.
Vacancy and Collection Loss
Few income properties are 100 percent rented and collect all their gross scheduled rents. Some percentage of PGI should be deducted for these losses, depending on what is typical for this type of property under current market conditions.
Effective Gross Income (EGI)
Effective gross income is what is left after an allowance has been deducted for vacancy and collection losses.
Fixed Expenses
Fixed expenses don’t vary with occupancy. They have to be paid whether or not you have tenants. Fixed expenses generally include restate taxes and building insurance.
Since the 1978 passage of Proposition 13 (the Jarvis-Gann Initiative), annual real estate taxes in California are limited to one percent of the assessed value, plus a small amount to service the bonded indebtedness of local districts. When the law took effect, all properties were assessed at their 1976 value. The assessed value can trend upward at a maximum rate of two percent annually. The only things that trigger a reassessment are transfers of ownership and major new construction. When either of these occurs, the property is reassessed.
Building insurance is almost impossible to calculate without an actual estimate from an insurance agent. Generally, older buildings pay higher insurance than newer buildings. Certain occupancy types (restaurants, nightclubs, etc.) pay higher rates due to higher risks.
Management is usually a fixed expense, because the fee is often tied to potential gross income, whether or not the space is rented. Management expenses should be included in the operating statement, even if the property owner is the manager.
Variable Expenses
Variable expenses normally change with the level of occupancy. These include utilities, repair and maintenance, and reserves for replacement.
The best indications of future utility expenses are the previous bills. But the type of building can give you some clues about future expenses. For example, older, poorly insulated buildings usually have high heating expenses. Flat roofs may tend to leak more than pitched roofs.
Repair and maintenance costs include the normal expense of keeping things in working order. Owners sometimes postpone major repair jobs, so it’s important to get a professional building inspection to reveal any deferred maintenance.
Few building owners actually put money aside for repair and replacement reserves. However, this is a legitimate annual expense to consider when evaluating income property. Professional inspections can reveal the need for major work, such as roof replacements, heating and air conditioning system upgrades, and major plumbing and electrical jobs.
Leasing Costs
Leasing costs include tenant improvements and leasing commissions. These are normally associated with large commercial properties where the owner makes substantial improvements for new tenants and pays commissions to agents for negotiating and securing leases. The owner usually compensates for these costs by charging higher rents over the term of the lease.
For small commercial properties, the tenant is usually responsible for making improvements and the owner does not normally use an agent to secure tenants.
Net Operating Income (NOI)
Net operating income is the anticipated first year income which remains after all operating expenses have been deducted from the effective gross income. NOI should not include any expenses for debt service or income taxes, which are more related to the owner than the real estate.
Cash Flow
Cash flow, sometimes called “pre tax cash flow,” is the net operating income minus the debt service (mortgage payments). “After tax cash flow” is the income left over after income taxes have been paid. Properties that produce a positive cash flow are said to ”pay for themselves.” However, even properties that produce a negative cash can be good long-term investments if they appreciate in value over time.
Operating Expense Ratio (OER)
The operating expense ratio is the total operating expenses divided by the effective gross income.
Experienced real estate professionals can recognize appropriate expense ratios for different types of properties. Also, national organizations such as the Institute for Real Estate Management and the Building Owners and Managers Association (BOMA) conduct nationwide studies and publish these ratios. However, the most useful numbers are derived from the local real estate market.
Net Operating Income Ratio
The net operating income ratio is the simply the complement of the operating expense ratio (100 percent minus the operating expense ratio). You can also calculate this ratio by dividing NOI by EGI.
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Chet Boddy, Real Estate Appraisal, Sales and Consulting
43300 LR Airport Road, #59, Little River, CA 95456
707-937-4011, office
707-937-4818, fax
chet@chetboddy.com
Copyright © 2002 Chet Boddy, All Rights Reserved
Chet Boddy is a Certified General Real Estate Appraiser, Realtor and real estate consultant who has lived on the Mendocino Coast since 1976. Look for this and other real estate columns on Chet’s web site at www.chetboddy.com
