Chapter 13 Income Approach Estimating NOI

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Chapter 13Income ApproachEstimating NOI
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Income ApproachGeneral Comments

• Who Cares?
• Appraisers
• Asset Managers Acquisitions
• Lenders (Underwriting Appraisal Review)
• Focus is typically on NOI or Cash Flow
• Debt/Equity and Tax terms are often unique to an
  investor

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Income Approach

• Value PV of Expected Future Income
• Two General Approaches
• Ratio Models
• Value Income / Rate
• One year stabilized Income
• Direct Capitalization is most common
• Discounted Cash Flow
• Project future income, year by year
• Discount to present value

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Net Operating Income

• Potential Gross Income
• - Vacancy and collection loss
• Other Income
• Effective Gross Income
• - Operating Expenses
• Net Operating Income

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Potential Gross Income

• Rental income at full occupancy (i.e. if all
  units continually rented)
• Sources of data
• Subject property (the most comparable comp)
• Comparable properties
• adjust for size, location, amenities
• Published data (broad comparisons)
• Institute of Real Estate Management
• BOMA
• Dollars Cents of Shopping Centers (ULI)

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Where does PGI come from?

• Unit of comparison
• Office, retail, industrial - rentable square feet
• Apts - usually per unit, sometimes sqft
• Warehouse - rentable sqft and sometimes cubic
  feet
• Hospital - of beds
• Theater/stadium - of seats
• Hotel - of rooms

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Where does PGI come from?

• Comparable Data
• Subject Property
• Brokers, appraisers
• Published Surveys (Michelson)
• Web Sources (cirex.com, loopnet)
• Guidelines
• Stay within the market area
• Actual lease deals are preferable to Asking Rent

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Contract/Quoted Rent vs. Effective Rent

• Contract/Quoted Rent - rent listed on the lease
• Effective Rent - Annualized rent after adjusting
  for concessions TIs
• Tenant Improvements, free rent
• No standard approach consistency is key
• Early 1990s, effective rents were much lower
  than quoted rents

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Vacancy Collection Losses

• Realize that you will not get all the PGI
• Estimating vacancy
• Current/historical vacancy at subject
• Structural vacancy
• Current market vacancy rate
• Long run stabilized or normal vacancy
• Mixed use building
• use separate vacancy rates for each use

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Vacancy Collection Losses

• Vacancy should be considered even if single
  tenant or owner occupant
• Credit Loss dependant upon tenant credit

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Other Income

• Income other than rent
• Parking
• Laundry/Vending Machines
• Antenna or cell tower income?
• Interest Income?
• After hour HVAC
• Usually small in comparison to rents

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Other Income

• Key Issues
• Apply vacancy rate to Other Income?
• Should it be business value?
• Is it income derived from real estate, common for
  property type
• Does it transfer with the property?
• Is it consistent with the purpose of the
  appraisal does the appraisal client recognize
  the income?
• If it is NOT real estate income, but included in
  appraisal, it must be clearly disclosed in the
  report

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Operating Expenses - Fixed

• Predictable, not related to occupancy
• Insurance
• Property Taxes
• Consider impact of sale/value conclusion
• If so, under assessed or regulated assessments
  are likely to change significantly upon a sale
  (Proposition 13, etc.) (Example of the
  difference between market value and investment
  value)
• Understand assessed/market ratio year assessed
  vs. year taxes are paid
• Admin General - acctg, tenant svcs

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Operating Expenses - Variable

• Vary with occupancy other events
• Utilities -- subject history is the best source
• Know how it is metered. Common area only?
• Payroll -- typically grouped by functional area
  (Admin General, Housekeeping, Repair
  Maintenance)
• Marketing
• Common Area Maintenance - typical for
  multi-tenant properties, includes snow removal,
  landscaping, janitorial

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Operating Expenses - Variable

• Management Fees
• Should consider even if owner-occupied or
  owner-managed
• Common to see rates of 3 - 6 of EGI, but varies
  widely by market
• Franchise Fee - typical for hotels

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Operating Expenses - Repair Maintenance

• Repair Maintenance
• Book says appraisers use 5 of EGI, but we can do
  better than that.
• Avoid double counting know what is included,
  particularly for salaries/wages
• Is it RM or a Capital Expense? Is it
  capitalized or expensed per GAAP
• Older properties tend to have higher costs

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Operating Expenses - Replacement Reserve

• Reserve for replacement of short-lived capital
  items
• Roof, HVAC, Parking Lot
• Tenant Improvements?(Usually separate item for
  investment prop.)
• Typically use average annual cost orSinking Fund
  Factor (not common)
• In DCF, use projected capital budget amounts
• Sometimes considered below NOI in DCF,In direct
  cap, how does the market do it?

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NOT Operating Expenses

• Depreciation - exclude from oper. exp.
• Interest Expenses - exlcude from oper. exp.
• These investment financing issues are dealt
  with separately (they vary by investor)
• Watch out for confusion betweenNet Income in
  accounting Net OPERATING Income in Real Estate

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Historical/Owner Statements vs. Reality

• Audited vs. Un-audited statements
• Tax issues can skew statements (expensing items
  vs. capitalizing items)
• Unusual expenses, not part of ordinary business
  practice
• Rent Vacancy
• Management Fee
• Deferred Maintenance

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Market NOI orActual NOI

• Fee Simple - assumes market rents, market
  expenses
• Short-term leases
• Stabilized NOI
• Leased Fee - Assumes contract rents, rolling to
  market rent

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Operating Expense Ratio

• OER Operating Exp/Effective Gross Inc
• useful because it is simple and often effective
• individual estimates of expense can be difficult
  to make

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Leases

• Lease rents
• flat rents
• indexed rents (to CPI or other measure)
• graduated rents (bumps or step-up)
• percentage rents (overage rents)
• Division of expenses
• Triple Net Lease
• pay property taxes, insurance, operating expenses
• Escape Clauses

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Leases

• Renewal and Purchase Options(is renewal rent gt
  forecasted market rent)
• Price and terms equally important
• tenant has right to renew lease at certain times
• tenant may purchase building at certain time
• Both are considered favorable to lessee (tenant)
  Therefore rents may be higher than if these
  clauses did not exist

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Leases

• Tenant Improvements
• Rents may typically be quoted vanilla boxor
  vanilla box plus X per square foot
• Varies by raw vs. second generation spaceand
  by new vs. renewal lease
• Adjust for any lease comps where the landlord
  provides better than vanilla box or typical
  tenant improvements
• Adjust for quality of space at subject property

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Lease Turnovers

• Over the years, some leases will expire
• Assume new leases are at the market rent at the
  time of renewal
• Make a schedule of lease turnovers and future
  projected market rent to estimate EGI

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Forecasting Multi-year NOI

• 1. Extrapolate past trends into the future
• (link variable expenses to occupancy)
• 2. Survey of market expectations
• (Korpacz, CB Commercial survey)
• 3. Use fundamental market analysis to forecast
  supply and demand
• 4. Assume no changes
• 5. Project to a stabilized condition

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Real vs. Nominal Growth

• Real gt net of inflation
• Nominal gt total dollar amounts regardless of
  changes in purchase price
• RULE Be consistent If you project income and
  expense growth in nominal terms, use a nominal
  discount rate.
• Long term, stabilized operation would tend to
  assume income and expenses grow at the same rate,
  about the overall inflation rate

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Using Regression to estimate PGI

• See pages 262-263
• Using variables such as size, age, location, and
  vacancy rate, you can estimate the rents for the
  subject property

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End Chapter 13

• For discussion, work problems 1-11 in text.