Chapter 1 · Appraiser
The income approach
From rent roll to value
Follow one property through the chapter: an 8-unit apartment building where each unit rents for $1,500 a month.
The income approach values a property by the income it can produce. It is the main approach for income-producing property and the one the exam asks most of its arithmetic about: four steps from gross rent to net operating income, then one division to a value.
1.1 · Potential to effective gross income
Full occupancy, then real life
Potential gross income (PGI) is every unit rented all year at market rent. Subtract vacancy and collection loss, add other income such as laundry or parking, and the result is effective gross income (EGI).
EGI = PGI − vacancy & collection loss + other income
Why: No building is full and paid up every month; EGI is what the owner can actually expect to collect.
PGI: 8 units × $1,500 × 12 = $144,000. Vacancy and collection loss at 5%: $7,200.
Laundry brings in $3,600 a year. EGI = $144,000 − $7,200 + $3,600 = $140,400.
Watch out: Apply the vacancy rate to rent only, then add other income: applying 5% to the laundry income as well would give $140,220. Follow the question if it says other income is subject to the same loss.
1.2 · Net operating income
What the property earns before the mortgage
Net operating income (NOI) is EGI less operating expenses: property taxes, insurance, utilities paid by the owner, management, maintenance and reserves for replacement.
NOI = EGI − operating expenses
Why: Value comes from the property, not from how the buyer pays for it, so financing costs stay out.
Operating expenses are $52,400 a year. NOI = $140,400 − $52,400 = $88,000.
Watch out: Mortgage payments (debt service), income taxes and depreciation are not operating expenses. Subtracting debt service gives cash flow, not NOI.
1.3 · Where the cap rate comes from
Divide each sale's income by its price
An overall capitalization rate is extracted from comparable sales: each sale's NOI divided by its price. The appraiser reconciles the comps into one rate for the subject.
R = I ÷ V (for each comparable sale)
Why: The rate states what buyers in this market are paying for a dollar of net income.
Comp A: $75,000 ÷ $1,150,000 = 6.52%.
Comp B: $92,000 ÷ $1,400,000 = 6.57%.
Comp C: $60,000 ÷ $940,000 = 6.38%.
The three cluster around 6.5%, which the appraiser selects for the subject.
Watch out: Use NOI, not gross income, in the numerator. Gross income over price is a gross income multiplier turned upside down, not a cap rate.
1.4 · Direct capitalization
Income divided by rate is value
Value is NOI divided by the cap rate. The same three numbers rearrange to find any one from the other two.
V = I ÷ R · I = V × R · R = I ÷ V
Why: A buyer paying V for an income I is earning I ÷ V on the purchase; set that equal to the market rate.
$88,000 ÷ 0.065 = $1,353,846.
The figure shows the same NOI at five rates. At 5% the building is worth $1,760,000; at 8%, $1,100,000.
Watch out: A higher cap rate means a lower value. Convert the percentage to a decimal before dividing: 6.5% is 0.065.
Practice · Set 1
Each question sets the figure to its own numbers
A 12-unit building rents each unit for $1,200 a month. Vacancy and collection loss is 6%, and the building earns $2,400 a year from laundry. What is the effective gross income?
Practice · Set 2
Each question sets the figure to its own numbers
Potential gross rent is $240,000. Vacancy and collection loss is 8% of rent, and parking adds $6,000 a year. What is the effective gross income?
- Total
- Added
- Subtracted