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Chapter 4

Applications of the

Approaches to Value

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Chapter Objectives

• Upon completion of this chapter, the participant will be able to:– Choose the most appropriate income methodology to

apply in an assignment– Apply gross rent and income multipliers derived from

market data as part of the appraiser’s income analysis– Estimate and apply rates of capitalization using market

derived data and band of investment techniques– Recognize how the sales comparison approach and cost

approach are applied in assignments of a two- to four-unit or multi-family property

– Identify the most applicable indicators of value leading to the appraiser’s reconciliation and final value opinion

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Key Terms

• Band of Investment

• Direct Capitalization

• EGIM (Effective Gross Income Multiplier)

• Equity Capitalization Rate

• External Obsolescence

• Functional Obsolescence

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Key Terms

• Mortgage Capitalization Rate

• Mortgage Constant

• Physical Deterioration

• PGIM (Potential Gross Income Multiplier)

• Replacement Cost

• Reproduction Cost

• Unit of Comparison

continued

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Income Approach

• Reliable indicator of value when highest and best use of property is determined to be for use as an income property– Given there is sufficient and reliable data

available

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Using a GRM

• A GRM can be derived from transactions of properties rented at the time of sale, or shortly thereafter

• GRM considers gross rent on a monthly basis

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Deriving a GRM

• The appraiser uses a formula known as VIM:

V (Sale Price) ÷ I (Gross Monthly Rent) = M (Multiplier)

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GRM Example

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Applying a GRM

• To develop an opinion, the appraiser multiplies the monthly market rent of the subject by the multiplier:

M (Multiplier) x I (Monthly Market Rent) = V (Value)

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Using a GIM

• Appropriate when subject property produces ongoing income in addition to rent from living units

• Income used could be PGI or EGI

• GIM derived from similar properties with similar rent and (other) income flows

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Using a GIM

• Is the source of additional income based upon occupancy level of living units?

• This assists the appraiser in choosing to apply the GIM, defining the factor as a:– Potential gross income multiplier (PGIM)– Effective gross income multiplier (EGIM)

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PGIM

• Derived from, and applied to, the total gross income generated by the property without vacancy or collection losses being considered

• This is probably the most common application of a GIM

• Appropriate when the source of the additional income is not influenced by the occupancy of the living units

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EGIM

• Derived using EGI—the amount after estimated vacancy and/or collection loss has been deducted from PGI

• Warranted when living unit occupancy is related to the potential for income from other sources

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Deriving a GIM

• Using VIM:

Value ÷ (Annual) Income = Multiplier

• In reality, data with exact similarities is rarely available and appraiser must seek to simply analyze data that has a similar benefit to the investor

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Applying a GIM

• GIM is applied to the total market income of subject

• Appraiser must be careful to apply the GIM consistently with how the multiplier was derived

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Applying the PGIM

• The subject: A 3-unit property generating $21,600 annually in market rent

– A storage building on the property produced $1,200 annually in other income

– Indicated PGIM = 15.67

$22,800 ($21,600 + $1,200) x 15.67 = $357,276

• The appraiser would probably round the indication to $357,000

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Applying the EGIM

• The subject is a 4-unit apartment building:

– Generates $2,800 monthly market rent

– $100 per month from the coin-operated laundry

– Market-extracted vacancy rate = 4.8%

– Indicated EGIM = 12.93

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Applying the EGIM

• To develop an indication of value for the subject, PGI for the subject must first be calculated:

$33,600 ($2,800 Rent x 12 Months)

+ 1,200 ($100 Laundry Income x 12 Months)

$34,800 PGI

continued

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Applying the EGIM

• Now, the vacancy factor must be calculated and subtracted from PGI to result in EGI:

$34,800 x 4.8% (0.048) = $1,670.40 Vacancy

$34,800 - $1,670.40 = $33,129.60 EGI

continued

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Applying the EGIM

• Finally, the subject’s EGI is multiplied by the EGIM to indicate a value conclusion:

$33,129.60 x 12.93 = $428,365.72

• The appraiser would probably round the developed value indication to $428,000

continued

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Direct Capitalization Using an Overall Rate

• Direct Capitalization: An income method that converts a property’s single-year NOI into a value indication by applying an overall capitalization rate using a formula commonly known as IRV:

NOI ÷ Overall Capitalization Rate = Value

• Interprets typical investor reactions and motivations of a particular process

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Deriving an Overall Capitalization Rate

• The two most common techniques for deriving an overall capitalization rate involve:

– Utilizing comparable sales of similar income properties or market data

– The analysis of mortgage and equity components, known as band of investment (a technique for determining an overall capitalization rate by weighting and combining the various components of an investment)

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Using Market Data

• NOI calculations of comparable must be consistent with how the NOI of subject was estimated

• Lease terms of comparable must be similar to those of the subject

• Rents/income generated by comparables should represent those typical for the market

• Element of comparison of comparable data should be consistent with those found in an arm’s length transaction

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Overall Capitalization Rate Example

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Using the Band of Investment Technique

M x RM + (1-M) x RE = RO

• M = LTV ratio

• RM = Mortgage capitalization rate

• 1-M = Equity investment

• RE = Equity capitalization rate

• RO = Overall capitalization rate

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Applying an Overall Capitalization Rate

• Here, the appraiser divides the NOI by the overall capitalization rate

• Formula commonly known as IRV• Example: A subject property has an NOI of

$12,700. The overall capitalization rate indicated in this assignment is 10.25%:

$12,700 ÷ 10.25% = $123,902 (rounded to the nearest dollar)

(Net Operating) Income

÷ =(Overall Capitalization) Rate

Value

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Reconciling the Income Approach

• The appraiser considers: – Quantity and quality of data used– The indications produced by the analysis

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Sales Comparison Approach

• Will usually be developed in support of, or supported by, the income approach

• This approach provides evidence of actions taken within the marketplace

• There must be a presence of market data from which conclusions can be drawn that lead to credible results

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Comparable Analysis

• Comparable data chosen must have the same highest and best use as the subject

• Ideally, truly comparable data will be very similar and can be wholly compared to the subject property

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Units of Comparison

• A component with which a property can be divided for the purpose of comparison

• Common units of comparison for a small residential income property might include the comparable’s sale price per:

– Square foot

– Living unit (or apartment)

– Bedroom

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Units of Comparison Example

• Interpolate somewhere between the per-unit sale price of the two- and four-unit properties (such as the median of this range, $77,000) to determine a sale price of a 3-unit property:

3 units x $77,000 = $231,000

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Reconciling the Sales Comparison Approach

• Relevance is most related to the quantity and quality of data that is available to the appraiser for analysis

• With sufficient and relevant data, the indications produced can be a reliable and valuable tool for developing a value opinion for a small residential income property

• Useful for supporting the:– Presence of investor action and reaction in

the marketplace for such properties– Highest and best use

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Cost Approach

• Not typically developed if:

– Comparable data for income and sales comparison approaches is plentiful and the indications produced by both are not contradictory

– Subject is an older or historic structure

• Can be useful in some assignments

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Rationale for Employing the Cost Approach

• Applicable when:– Sales/income data is scarce and sales

comparison/income approach is not a particularly good indicator

– Improvements are new or relatively new• Requires thoughtful analysis of any physical

deterioration or functional/external obsolescence

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Rationale for Employing the Cost Approach

• Which cost is appropriate?– Reproduction Cost– Replacement Cost

• Primary indicator of value when the appraisal’s intended use is for insurance purposes

continued

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Difficulties of Employing the Cost Approach

• Reproduction cost for older structures can be difficult to estimate

• More complex and challenging when factoring in depreciation (functional or external)

• Can produce misleading indications and poor results when conclusions do not reflect typical market reaction

• Economic characteristics of the market and locational elements of the property must be correctly determined

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Chapter 4 Quiz

1. A small residential income property has two units that generate $950 rent per month each. If the property recently sold for $130,000, what is the indicated GRM?

a. 57.37

b. 68.42

c. 75.87

d. 81.36

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Chapter 4 Quiz

2. If a three-unit property generates a total monthly income of $1,975, and sold recently in an arms-length transaction for $185,000, what is the EGIM if vacancy loss was estimated at 4.35%?

a. 6.74

b. 7.92

c. 8.16

d. 9.47

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Chapter 4 Quiz

3. When the cost approach is developed in a market value assignment of a small residential income property and the appraiser overlooks an oversupply situation in the market, which would likely result?

a. credible results

b. functional obsolescence

c. misleading value indication

d. replacement cost

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Chapter 4 Quiz

4. What is the overall capitalization rate indicated for a property that generated NOI of $42,628 and sold recently for $535,000?

a. 7.97%

b. 8.32%

c. 9.17%

d. 10.21%

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Chapter 4 Quiz

5. A $250,000 mortgage has been provided to an investor at 7% interest for 20 years. If monthly debt service is $1,938.25, what is the mortgage constant?

a. 0.0762

b. 0.0805

c. 0.0837

d. 0.0930

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Chapter 4 Quiz

6. Using the band of investment technique, what is the overall capitalization rate indicated for 70% LTV financing with a loan amount of $300,000 and an annual debt service of $31,360, if the equity dividend rate is 9%?

a. 8.26%

b. 9.71%

c. 10.02%

d. 11.98%

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Chapter 4 Quiz

7. The primary difference between an EGIM and a PGIM is attributed to

a. net income ratio.

b. operating expense.

c. replacement reserve.

d. vacancy.

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Chapter 4 Quiz

8. Which element is considered in a GIM but is NOT considered in a GRM?

a. debt service

b. income from sources other than rent

c. net operating expenses

d. series of annual income flows

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Chapter 4 Quiz

9. A four-unit property generates $500 per month, per unit. Using the mean of the following GRM data, what is the value of the property?

a. $175,360

b. $181,750

c. $190,670

d. $196,220

Comparable #1 Comparable #2 Comparable #3

GRM 95.67 100.32 98.34

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Chapter 4 Quiz

10. In which stage of the appraisal process does the appraiser initially determine the approaches to value that will be developed in a particular assignment?

a. highest and best use analysis

b. market analysis

c. reconciliation

d. scope of work