Appraising the Worth of a Property by the Income Approach (A Translation)

Thu, Jun 13, 2013

Commercial Real Estate

The Income Approach also goes by many other names including Present Earning Value Method, Income Capitalization Approach, Investment Approach and etc. But whatever name it goes by, it is a valuation method that relies on income to compute the value of an asset, and not cost nor investment amount. In other words, it ignores the amount of capital invested and only makes use of income to determine an asset value.

The Income Approach is commonly used for property that generate monies, income or has income-generating potential; such as industrial buildings, commercial buildings, playgrounds, food center, theaters, etc. (as opposed to schools, military bases, parks, recreational facilities and other non-profit public assets). Furthermore the property has to be in continual operations. Hence future income and risks can be quantified in dollars and cents.

Property net of income; of course, refers to the net housing valuation after deducting the cost and interest – net income generally refers to the rental minus income. Net income that is subject to excess profits usually have the profit coming from three avenues: When profit exceeds what is normally earned in a similar business, it can be because demand outstrips supply leading to a rental hike; possession of exceptional business foresight like converting a forsaken warehouse into a eating place or a dance studio; finally, obtaining licensing to conduct a niche business.

Other factors that affect excess profit is the discount rate (a.k.a. capitalisation rate).

The discount rate can affect the profit level as it reveals the level of impatience of an individual. It varies between 0 and 1.

The mathematical notation for the discount rate is

Beta = 1/(1+r)

where r = interest rate

When Beta > 0 and approaches 1, it means that the individual has a high level of patience and expectation, thus driving the result of an excess profit.

Another factor is the earning period. The right to use a property and the duration of use are determined by the terms of the contract; hence the duration is directly related to the earning period.

Net income is a key determinant in the income approach of housing valuation because Value = Capitalisation Rate (capitalisation rate is the rate of return which is the discount rate or yields).

But first you must obtain the excess profit before you can find the net income (this will, of course, involves lots of calculation and adjustment); after which you can find the interest rate and thus the discount rate. This way the expected value of the property can be computed.

If you are renting out a property, as the owner you can earn a net income of $100,000 from rental. With a rate of return equal to 0.1, you can easily arrive at the value of the property, which is $1 million. This figure comes about because Value = Return / Rate of Return ($100,000 / 0.1 = $1 million). The income approach attempts to predict the value of a property by making use of the expected income to forecast the final value of the property. This valuation amount forms the basis for negotiation in the sale process. A purchase price below this value implies a discount.

In order to arrive at a reasonable valuation figure, you have to collect accurate, reliable and useful data for income. In addition you also need the terms of contract, rental regulations, interest rate, tax rate and cost. Using these information, you can ascertain the net income from rental and discount rate to calculate the value.

The discount rate is not the same as the interest rate or yield. Rather it can be seen as the Return of Investment. In the process to find the property value through the income approach, the discount rate simply becomes the capitalisation rate.

Chai Qiang in his book, Real Estate Appraisal (revised second edition), defined the income approach as: “The income approach uses the expected net income of the property and an appropriate capitalisation rate to discount to the present value of the property.” Chai Qiang added that,”From the point of view of the income approach, the value of real estate is its present value of future net income.”

We can also strengthen our understanding of the income approach by familiarising ourselves with some terminology:

1) Investment yield or rate of return.

This variable is commonly used in valuation or investment analysis to find out the returns. It is expressed in percentage and found by dividing the annual net income derived from capital value. It measures the potential returns. The smaller it is the better the potential of the investment and the lower its risk is; hence the investment price will be higher.

Using our previous example of an owner with a $100,000 net rental income and a rate of return of 0.1, here we change the rate of return to 0.08. Based on the formula, we get Value =100,000/0.08 = 1,250,000. Compared to when the rate of return was 0.1, our value has increased by 250,000.

2) Capitalisation rate.

This variable discounts the net income of the item to be valuated; hence it can be seen as a form of rate of return and discount rate. The latter is used to find the present value of the net income of different years.

But we must recognise that the discount rate is not the interest rate or yield. Interest is the return from investment whereas the discount is the return to management. The discount rate reflects the interest payment after the due date. The yield is the internal rate of deduction.

The discount rate (a.k.a. refinancing rate) is the interest rate after subtracting the yield.

For example, if you are due to receive payment of $100,000 at a future date, but you are in need of money now you can go to a financial institution with this promised future payment and obtain a loan now. The financial institution will conduct checks to determine the interest rate that will compensate them for risk and earn them profit.

The yield is made part of two types of interest rates: First as the payment is not yet due, the financial institution has to lend from its own reserves. This will involve borrowing cost or interest. Secondly, lending entails risks, an interest is attached to compensate for the risk. Hence two components make up the interest. Finally the balance (less than $100,000) after subtracting the interest will be lent to you. This is termed the yield.

3) Years’ Purchase or YP.

This variable is the revenue ratio of the property, it shows the number of years needed to recover the value for a given net rental income.

It directly reflects the value of a property.

Expressing it in mathematical notation, it becomes

V = a x YP

where V is the value

a is the net income

YP is the number of years needed to recover the value for a given net rental income

To illustrate this further, we use an example of a 3-room flat in a non-mature estate

with a net rental income of $25,000 and a YP of 15, the value of the flat will thus be

$25,000 x 15 = $375,000.

However, a similar 3-room flat in a mature estate also with a value of $375,000, but a YP of 10, its net rental income will be 375,000/10 = $37,000, based on a = V/YP.

The next question is how do you obtain the YP. As YP is the revenue ratio of the property, it is similar to the Price / Earning Ratio (PE Ratio) of a stock. If you have a PE Ratio = 20, it means you have to wait 20 years to recoup the price you paid for the stock. A market analyst will say the stock is undervalued.

A stock with a PE Ratio of 1 or less is considered a poor performer and nobody will buy it as reselling it is going to be an uphill task. On the other hand, a PE Ratio between 60 and 150 is a high performing stock with strong potential.

4) Internal Rate of Return or IRR.

This variable measures the real value of the return on an investment. It is a discount rate based on a net present value of zero.

If the Investment Value is $1,000,000 and the Revenue is also $1,000,000, the net income becomes $0, and so the investment yield is 0. For such an investment, the investor loses the replacement cost and time.

Conversely, if the investment has a net income that is negative, it is definitely loss making.

Thus the net income has to be positive before the investment has a value; otherwise you should just abandon it.

When the net income is positive, investors will rely on its magnitude to decide on a commensurate purchase price.

In conclusion, I will say that the income approach is a highly complicated valuation method with plenty of formula. But this article has not discussed the formula aspect as it is a dry academic topic; instead through this article I hope to bring to readers a basic idea of the income approach, so that in future they will be able to engage in intelligent discourse about the subject.

I am a writer for iCompareLoan and PropertyBuyer.com.sg

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