 Show How do you defend yourself from this? Or wait—let’s rephrase that—how do you include sufficient data in your workfile to make an informed decision as to whether the income approach to value is necessary for credible results? When to include the income approach to valueWhat if a client or an underwriting guideline says that the purchaser of the mortgage does not care if the appraisal report includes an income approach (or one of the other approaches)? Does that mean that you, the professional appraiser, do not have to bother collecting the data and considering the inclusion of this approach? Hint: USPAP says that you should “be aware of, understand, and correctly employ those recognized methods and techniques that are necessary to produce a credible appraisal” and “not commit a substantial error of omission or commission that significantly affects an appraisal.” This does not mean that every appraisal must include all three approaches to value to be credible. It simply means that you must consider what it takes to provide a credible appraisal. If the data collection process is completed, the highest and best use analysis is completed, and the appraiser has a clear understanding of scope of work necessary to produce credible results, the assignment may not need to include all of the approaches in order to produce credible results. If you reach that conclusion and can support and defend it, then the USPAP requirements have been met. What about limited scope assignments?The considerations above apply to all appraisal assignments, but most critically to limited scope assignments. When considering a limited scope assignment, you face additional necessity to be sure that the credibility of the analysis and the resulting report is clearly evident. Just because a client says “we don’t need all of that extra stuff” does not relieve you from professional responsibility as well as obligations under USPAP, laws and regulations of the state wherein the property is located, and applicable laws and regulations governing the loan for which the appraisal was requested.
Research tips for income approach dataUse the following tips to ensure your workfile contains sufficient information regarding the income approach to valuation. This actually works:
Omitting something that significantly affects an appraisal is something you want to avoid. You own this appraisal, which means that you are solely and strictly responsible for its credibility. Facing an inquiry or deposition can make even the most competent and well prepared appraiser nervous. Wouldn’t it make you feel better to have this income approach to value information in your workfile? Learn about the nuances of limited scope assignments in our brand new online course, Evaluations, Desktops, and Other Limited Scope Appraisals. Plus, check out our on-site course, Limited Scope Appraisals and Appraisal Reports: Staying Compliant and Competitive. Visit McKissock.com/Appraisal to find a classroom near you.
The income approach is one of three methods used by real estate appraisers to determine the value of a property. The income approach is more sophisticated than the other two techniques, and as a result, many real estate novices find it puzzling. We’ll go over the income approach to property valuation step by step in this article and what you will need to know as an agent and come exam day. What are the 3 Approaches to Value?There are three different main approaches that appraisers use while they make an appraisal. They are:
Each method has its own set of benefits. When applied together, the various valuation methods provide the best estimate of the value of the income-producing real estate under evaluation. However, it is not always advisable to go through each one. As a result, the income approach is most typically employed to appraise real estate, especially in the early assessment phases. What is the Income Approach?The income approach is a process used by appraisers to determine the market value of a property based on its income. The approach is based on the finance concept of discounted cash flow analysis. Under the income method, the property’s current worth is the present value of the future cash flows that the owner can expect to receive. This method is most prevalent for commercial properties with tenants because it relies on rental income. It’s calculated by dividing the rent collected net operating income (NOI) by the capitalization rate. What is the Income Approach Formula?The formula for the income approach is: Net Operating Income / Capitalization Rate = Market Value How to Use the Income ApproachTo comprehend the income capitalization strategy, we must first understand two other fundamental real estate concepts: net operating income and capitalization rate. Net Operating IncomeAfter deducting operating expenses but before deducting capital expenditures, debt service, and taxes, net operating income is the net income in a particular period. The formula for calculating net operating income is as follows: Effective Gross Income – Operating Expenses = Net Operating Income The appraiser will require access to income and expense accounts for the subject building and similar structures in the neighborhood to estimate net operating income. Having that information on hand allows the appraiser to assess the building’s income and expenses accurately. Remember that all income and expenses are always annual values with the income capitalization approach. The actual procedure of estimating net operating income can be broken down into four steps:
What is a Capitalization Rate?With your net operating income, all that’s left to do is find your capitalization rate. A capitalization rate is comparable to a rate of return in that it represents the proportion of income that the investors expect to get from the building. Appraisers learn to compute capitalization rates in various techniques, luckily on the real estate exam, the capitalization rate is usually given, or there’s a problem with enough information for you to find the cap rate with using basic algebra. If you would like to find the capitalization rate in real life you need recent comparable sales, such as buildings similar to the subject property being evaluated. On the exam however, you’ll see a question with the properties value and net operating income and you’ll have to find the capitalization rate. Luckily this is way easier then it sounds, so lets do some examples. Income Approach ExamplesIf you have an income approach question on the exam, you’ll see a question asking for the capitalization rate or the properties value. First lets do the capitalization rate problem. In order to find the capitalization rate you just have to use basic algebra. Here’s a simple example: A property sold for $1,000,000 and had an NOI (Net Operating Income) of $100,000. Find the capitalization rate. Remember our formula from earlier. Net Operating Income / Capitalization Rate = Market Value Knowing this, all we need to do is take our numbers and put them into the formula. We have the Net Operating Income – that’s $100,000 and we have the Market Value – that’s $1,000,000. To find the cap rate we just have to divide. So $100,000/$1,000,000 this gives us .1 or 10%. 10% is our capitalization rate. Its that easy! Another income approach example you may see on the exam is finding the properties value. These problems are a bit more complicated then the last one. Here’s an example: A property with a 15% cap rate, an effective gross income of $100,000 and operating expenses of $25,000. Find the Market Value using the Income Approach. For this one we need to find Net Operating Income before we can find the Market Value. Let’s take a look at our two formulas. Net Operating Income / Capitalization Rate = Market Value Effective Gross Income – Operating Expenses = Net Operating Income First we have to take the Effective Gross Income and subtract it by the Operating Expenses. So let’s do that. $100,000 – $25,000 = $75,000 Great! Now we have our Net Operating Income. From there we can plug in our numbers from the first formula. Luckily they already gave us our cap rate, so with our Net Operating Income all we have to do is divide. $75,000 / .15 (or 15%) = $500,000 $500,000 is our Market Value and our answer! What to Know as a Real Estate AgentAs a real estate agent, it is essential to know all three approaches to value when appraising real estate. For the income approach, keep in mind what type of property you are working with. Remember, the income approach can be used in commercial real estate buildings such as offices, shopping complexes and can even be used for rental properties. What to Know for the Real Estate ExamWhen it comes time for exam day, remember that the income approach is a process used by appraisers to determine the market value of a property based on its income. You must understand the two formulas we went over today and how to use them. Remember: Net Operating Income / Capitalization Rate = Market Value Effective Gross Income – Operating Expenses = Net Operating Income Know this, you will be sure to ace the exam! Still confused? For a quick simple recap, watch our Income Approach video featured in our Daily Real Estate Vocab Series: |
The income approach to value must be developed in an appraisal when
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