590 8
DESCRIPTION
Income ApproachTRANSCRIPT
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MBA 590 Real Estate Analysis
! College of BusinessAlfaisal
UNIVERSITY
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Chapter 8
Income Approach
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Estimating Income and Expenses
Reconstructing Adding
Subtract
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Net Operating Income
Income Less: expenses
= Net Operating Income (NOI)
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Net Operating Income
more details can be complex
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Estimating Income and Expenses
usually different than the owner’s statements
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Potential Gross Income
If the property was 100% occupied at
market rent
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Two loss deductions
vacancy loss credit loss
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Vacancy Loss
no tenant no Income
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Credit Loss
tenant not paying rent
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Effective Gross Income
potential gross income less: vacancy loss less: credit loss
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Abbreviations
PGI less: CVL
EGI
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Gross IncomePotential Gross Income (PGI)
10,000
Less: Vacancy Loss 4% 400
Less: Credit Loss 4% 400
8% 800 !
Effective Gross Income (EGI)
9,200
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Operating Expenses
reimbursable non-reimbursable
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Operating Expensesmanagement
property taxes insurance utilities
reserves for replacements maintenance
other
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Management
Must recognize even if owner operated 4% to 10% of EFI
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Reserves for Replacements
Prudent management will build a fund to
replace long-lived items
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DifferencesOwner Reconstructed
Management 0 300
Property Taxes 500 500
Insurance 1,000 1,000
Utilities 300 300
Reserves for Replacements 0 500
Maintenance 100 100
Total Operating Expenses 1,900 2,700
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Potential Gross Income 10,000 100%Less: Credit and Vacancy Loss
800 8%Effective Gross Income 9,200 92%Operating Expenses Management 300 3% Property Taxes 500 5% Insurance 1,000 11% Utilities 300 3% Reserves for Replacements
500 5% Maintenance 100 1%Total Operating Expenses 2,700 29%Net Operating Income 6,500 71%
Reconstructed Operating Statement
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What is the property worth?
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Two Methods
Direct Capitalization
Discounted Cash Flow
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Direct Capitalization
Convert an annual income into a value
with a capitalization rate
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IRV
Income = Rate x Value Rate = Income ÷ Value Value = Income ÷ Rate
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Getting Rates
Market Built Up
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Market
Sales Analysis
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Sale Price 1,000,000
Net Operating Income 75,000
Multiplier Rate 13.33 Years to Recover Investment
Capitalization Rate 7.50% Yield on
Investment
Rates
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Why are rates different?
Risk Factors change in market
management liquidity
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Built UpRisk Free Rate US.Treasury Bond
1.5%
Management 3.0%
Illiquidity 3.0%
Volatility 2.0%
Capitalization Rate 9.5%
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Net Operating Income 6,500
Rate Value
5% 130,000
6% 108,333
7% 92,857
8% 81,250
9% 72,222
10% 65,000
11% 59,091
12% 54,167
What is the
property worth?
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Selecting a ratequality and quantity
stabilized volatility judgment
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Sales Comparisoncalculate rate
adjust for differences weigh
apply rate
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Sale 1 Sale 2 Sale 3Sale Price 750,000 5,500,000 287,000
Net Operating Income 60,000 721,000 12,000
Multiplier 12.50 7.63 23.92
Capitalization Rate 8.00% 13.11% 4.18%
Comparability Similar Inferior Superior
Adjustment 0.00% -5.00% 5.00%
Adjusted Rate 8.00% 8.11% 9.18%
Average 8.43%
Rates
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Sale 1 Sale 2 Sale 3 Average
Adjusted Capitalization Rate 8.00% 8.11% 9.18% 8.43%
Weighting 70% 20% 10% 100%
Weighted 5.60% 1.62% 0.92% 8.14%
Weighted Rates
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IndicationNet Operating Income 6,500
Capitalization Rate 8.14%
Indicated Value 79,853
Rounded To 80,000
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Discounted Cash Flow DCF
Present value of all future benefits
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Discounted Cash Flow DCF
Return on capital Return of capital
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Discounted Cash Flow DCF
1. Estimate amount of NOI for each period 2. Select a discount rate 3. Calculate PV factor for each period 4. Apply the PV factor to each cash flow 5. Add up the present value of all cash flows
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the present is worth more than the future
!
the future is worth less than the present
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time is money !
money is time
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compensated to wait !
patience is rewarded
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time value of money !
money value is relative to time
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Assumptions
money value is relative to time
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Assumptions
time value of money !
money is worth different based on the
time
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Finance
Time and Risk how long how much
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(1 + rate)Number
of periods
(1 + r)N
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Key Formulas
(1+r)N
r = rate N = number of periods
Compounding Future Value or FV multiplying
Discounting Present Value or PV dividing
(1+r)N1
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Tomorrow
One Year
Ten Years
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Discount the future !
Today is worth more than tomorrow
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Grow in the Future
Today
One year
Ten Years
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Grow by a percentage each year,
not a fixed amount
Compounding
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Compounding
The process of finding the future value of a
present sum of money !
multiplying
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Discounting
The process of finding the present value of a future sum of money
!
dividing
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compounding is the inverse of discounting
discounting is the inverse of compounding
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Discount Rate 7%
1 2 3 4 5 Total
NOI 6,200 6,500 6,800 7,200 7,500 34,200
PV Factor 0.9346 0.8734 0.8163 0.7629 0.7130 0.8147
Present Value 5,794 5,677 5,551 5,493 5,347 27,863
DCF of the NOI
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Reversion
return of your capital resale
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ReversionNet Operating Income 7,500
Capitalization Rate 8.14%
Indicated Value 92,138
PV Factor 0.8147
Present Value of the Reversion
75,064
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DCFFace Value
Present Value
Net Operating Income 34,200 27,863
Reversion 92,138 75,064
Summary 126,338 102,927
Rounded To: 103,000
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Income Approach
Direct Capitalization 80,000
Discounted Cash Flow 103,000