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The Income Approach
• Based on the anticipation principle
• The buyer will outlay a capital sum now for the benefit to be derived from the future ownership of the property
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Types of Income Property
• Multiple-family residential
• Commercial buildings • Industrial properties
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The Income Approach
• Two common methods adopted in :
– Direct Capitalisation
– Discounted Cash Flow (DCF)
Direct Capitalisation
The process of converting an income estimate into a value estimate
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I = Net Operating Income
R = Capitalisation I
Direct Capitalisation
• Definition
– Direct Capitalisation Translates
Income into its Capital Equivalent
• Income Characteristics – Quality
– Quantity – Duration
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Direct Capitalisation
• Adopts a constant income stream • Assumes regular income
• Assumes that it lasts in perpetuity
Example of Direct Capitalisation Approach
A rental flat produces a net operating income of 10,000 pa, the market capitalisation rate for this type of property is at 5.0%, what is the market value of the rental flat?
$10,000/0.05 = $200,000
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Direct Capitalisation
1 Determine effective gross income
2 Determine operating expenses (exclude debt servicing and depreciation)
3 Determine net operating income (NOI)
4 Analyse the capitalisation rate
5 Apply capitalisation rate to subject property
The Capitalisation Rate
Cap rates will vary according to:
• Relative risk (Quantity, quality and durability of income stream)
• Degree of marketability (Location, size)
• Age and condition of building (Operating
expenses and capital expenditure)
• Growth expectancy
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Methods of Estimating Cap Rates
– Direct comparison – Band of Investment – Summation
Market Rent
‘…market rent for any tenancy shall be the rent that, without regard to the personal circumstances of the landlord or the tenant, a willing landlord might reasonably expect to receive and a willing tenant might reasonably expect to pay for the tenancy, taking into consideration the general level of rents (other than income-related rents within the meaning of section 2(1) of the Public and Community Housing Management Act 1992) for comparable tenancies of comparable premises in the locality or in similar localities and such other matters as the Tribunal considers relevant.’ Residential Tenancies Act 1986
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Contract Rent
Rent being paid under some form of contract that is binding on both owners and tenants
Such rental agreements range from simple oral contracts to
complex leases
A lease form where the tenant pays a base rent (net rent) direct to the landlord and assumes direct responsibility for paying the rates, building insurance, body corporate levy, and other normal building operating expenses
Source: http://www.wellingtonwarehouses.co.nz/terminology.htm
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Gross Lease
A lease form where the tenant pays one rent (a gross rent) and the landlord assumes responsibility for paying rates, building insurance, body corporate levy, and other normal building operating expenses
Source: http://www.wellingtonwarehouses.co.nz/terminology.htm
Contract Rent vs Market Rent
– Types of tenancies
• Month to Month • Short-term Lease • Long-term Lease
– Common Lease Types • Straight
• Percentage
• Combinations
– Type of rent in leases • Minimum rent
– Responsibility for expenses
• Landlord • Tenant
Operating Expenses
Include Property-Related Expenses
• Current Operating Expenses • Projected Expenditures
• The Value of Owners Efforts
Exclude Owner-Related Expenses, such as: • Loan and Interest Payments
• Income Taxes
• Depreciation
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Operating Expense Categories
– Variable Expenses
– Fixed Expenses
– Reserves for Replacement
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An Owner’s Operating Statement
Risk and Return
• A basic underlying concept. The higher the risk means the return should be higher, otherwise why else invest?
• On the other had the lower the return should indicate lower risk
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Client comment…
• We are getting a 13% return which is much higher than the banks so the property must be very valuable…….
How is the income approach applicable in a residential context?
• Home and income properties
• Blocks of investment flats
• Kāinga Ora (Housing NZ) Leased properties
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The “home and income” property
Home and income means a standard dwelling with attached additional accommodation
The best way to value is by reference to other comparable home and income properties
The main house and additional unit may be on separate titles but more often they will be on one title
Valuer beware….
• Sometimes the additional unit may not have a permit. Try your best to find out. Be careful……
• Different Councils have different rules
• “Minor household unit” is a term used in some district plans to describe a unit that is less than 60 square metres
• The income approach is more likely to be used as a check method
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Blocks of units
• Sausage block type developments
• May be multiple or single title
Kāinga Ora leased housing
https://kaingaora.govt.nz/tenants-and- communities/our-tenants/
Changes to the Residential Tenancies Act – August 2019
Tenancy reviews for public housing tenants
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Discounted Cash Flow
Discounts the property’s future income streams and its reversionary (or residual) value back to a present value
Discounted Cash Flow
• To complete a DCF analysis we require the following estimates:
– Holding period of the investment – Income streams
– Residual property value
– Discount rate
• Find the present value of net cash flows
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Estimating, Measuring and Discounting Cash Flows
• TheUseofCashFlowsinValuations • EstimatingCashFlows
• Measuring Cash Flow from Periodic Income • Even Cash Flow
• Uneven Cash Flow
• Income Projections
• MeasuringCashFlowfromSaleProceeds – Estimating the Future Sale Price
• DiscountingCashFlows 29
Discount Formula
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Example of DCF
Rent per week
Rent increase
Annual increase in costs
Net sale price (yr 5 end)
Expenses (rates, insurance, repairs and maintenance)
Management fees (% of rental income)
Discount rate
Gross rent
Effective gross
Management
Net operating income
Net sale price
Total annual cashflow
Net present value
Comparison with Direct Capitalisation Approach
• Cap rate is not measured the investor’s rate of return
• DCF method
– Capture the changes of future cash flows
– Risk adjusted discount rates as required from capital market
• Cap rate method could be problematic in practice
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Income Approach in Practice
• Applicability of direct capitalisation and/or DCF’s
• When to use and when not to use
• DCF valuations should line up with available
market evidence
• Perform a risk analysis under the DCF approach
Income capitalisation is the process of translating income into value. By selecting capitalisation rates that reflect the types and amounts of return sought in the real estate investment market, the valuer completes the link between income and value.
The market value of amounts to be received in the future must always be reduced or discounted to their present values in some way to recognize the time value of money.
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Paragraph 40
• Application of the income approach
Paragraph 50
• Detail on application of the DCF method
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