Recent Pennsylvania Appellate Court decisions have focused on the Income Approach to valuation for Warehouses, Shopping Centers, Office Complexes, Multifamily Housing, and other Properties that collect income based upon a written Lease.
The Income Approach to value involves an analysis of the present worth of the property’s expected future income. The Income Approach relies on an estimate of the amount that a decision-maker would be justified in paying to acquire the right to receive an income stream of a specified amount. In conducting the Income Approach, a net operating income is obtained by estimating a stabilized income stream based upon past performance and deducting expenses. A capitalization rate is then developed and applied to net operating income to conclude a final value.
Calculation of Net Operating Income
A property’s potential future income can be forecasted using various inputs, including rental rates, absorption rates, and vacancy rates. Rental rates are a major input for the Income Approach; oftentimes, the rent used in this analysis is the actual rental income that can be expected based upon the agreement of the specific leases in effect. If a building is vacant and not otherwise subject to an existing lease, to use the Income Approach, appraisers develop a survey of market-derived rental rates to estimate rent for an accurate approximation of value for the income approach to value. To establish a reasonable market rate of rent, the appraiser should look to the local marketplace for similar properties and the rent collected for such properties.
To identify a property’s net operating income once gross rent is calculated, various factors must be taken into account, including expected vacancy rates, expenses, costs, and rent concessions. Vacancy rates have a significant impact on whether and what rent concessions landlords and property owners provide; therefore, to calculate an accurate estimate of expected income, experts deduct a percentage for the expected level of vacancy of the property at issue. Discounts in rent that a landlord or property owner may give in order to lure tenants are referred to as “concessions” and also significantly impact net operating income. For example, concessions could include non-escalating rent, below-market-rate rent, free rent, tenant improvement not collected as part of the rent. Rent concessions impact the rents that are actually collected, and therefore net operating income.
Once the net income is calculated, a capitalization rate is applied thereto in order to set a value using the Income Approach. A capitalization rate reflects the relationship between the annual net operating income of a property and that property’s total value; it is a multiplier used to value property based on expected income flow. A low capitalization rate results in higher market value. In practical terms, capitalization rates indicate the annual rate of return that is necessary to attract capital to an investment.
A capitalization rate is influenced by the degree of risk, market perceptions of future appreciation, the return on alternate investment opportunities, and historical rates of return for comparable properties. See id. To calculate a capitalization rate on a property for which a sale price is known, net operating income is divided by the sale price. To calculate a capitalization rate when a sale price is not known, appraisers can rely on a variety of sources: rates derived from National Surveys, comparable sales, alternate investment rates, and mortgage/equity components.