chapter 18 the income or investment approach

Question 1

Consider the following statements:

Vacancy and bad debt allowance is an allowance for reductions in gross potential revenue attributable to vacancies, tenant turnover, and non-payment of rent or other income.
When a property owner uses debt to finance a property, the net operating income represents a return on the equity portion of the property’s value.
Property taxes generally represent the single largest operating expense for an income-producing property.
The gross potential rent of the subject property is only estimated by the actual rents currently being paid on the subject property.
Which of the above statements is/are TRUE?

1. C only
2. A and C only
3. B and D only
4. A, B, and C only

Answer 1

Correct Answer: 2

Statement A is true; vacancy and bad debt allowance are not operating expenses, rather they indicate long term vacancy rates or trends in the area and are deducted from gross potential revenue property. Statement C is true; property taxes generally represent the single largest expense for income‑producing property. Statement B is false; net operating income represents a return on the entire value of the property, before financing is considered; net operating income is not a return on the equity portion of the property’s value. Statement D is false; the gross potential rent of the subject property is estimated by comparing current rental levels of comparable buildings, not the current rental level in the subject building. The rents of the subject property may be significantly more or less than the rents that the building would receive due to the poor management, the state of repair of the building or other factors. The appraiser must estimate the rent the building could receive by considering the rents received by several comparable buildings.

Question 2

An appraiser is using the income approach to determine the market value of income-producing properties. Which of the following items should be included in the calculation of net operating income?

An allowance for vacancy
An allowance for the leasing inducement paid at the onset of the lease
An allowance for the replacement of items such as the appliances in the suites
All taxes, including real property and income tax

1. A, B, C, and D
2. A, C, and D only
3. A and C only
4. A and D only

Answer 2

Correct Answer: 3

Calculation of net operating income (NOI) includes vacancy and debt allowance and, ongoing operating expenses. These include real property taxes, fuel, electricity, maintenance and repairs, replacement reserves, water, wages, management costs, insurance policies and some miscellaneous expenses. A leasing inducement, much like sales commission is not an ongoing operating expense, rather it is a one-time payment and deducted from the estimate of market value. The items omitted when calculating NOI are depreciation, income tax, capital cost allowance and debt service.

Question 3

Consider the following statements regarding the income approach. Which of the statements are TRUE?

The cost of repairs considered a one-time payment and immediately required at the time of appraisal, should be deducted as a lump sum from the property’s final value.
Items specific to an owner or investor are omitted in the calculation of net operating income.
The income approach cannot be applied to an owner-occupied commercial building.
Direct capitalization is the only technique used in the income approach of appraisal.

1. A and D only
2. B and C only
3. C and D only
4. A and B only

Answer 3

Correct Answer: 4

Statement A is true; an immediate repair is not considered an ongoing operating expense and so the amount is deducted from the calculated market value to arrive at the final estimate of value as at the effective date of appraisal. Statement B is true; many items are specific to the owner and should therefore not be used in the calculation of NOI, such items include: depreciation, income tax, and debt service. Statement C is false; the income approach focuses on “market” rental income and so whether or not it is inhabited by its owner makes no difference in principle in applying this method. Statement D is false; both the direct capitalization and discounted cash flow techniques can be used in the income method of appraisal.

Question 4

Which of the following statements is/are FALSE?

The conversion from net operating income to a capital amount is referred to as the capitalization process.
A gross lease is where the tenant pays a base rent, all operating expenses, and structural maintenance and repairs.
Net operating income is a return on the equity portion of the property’s value.
The economic life of a building depends on its economic durability, not its physical durability.

1. A and D only
2. A and B only
3. B and C only
4. C and D only

Answer 4

Correct Answer: 3

Statement B is false; a gross lease is where the landlord pays all the operating costs and structural repairs and maintenance. The tenant is charged a base rent plus a contribution to these expenses, with this gross rent remaining constant during the term of the lease. Statement C is false; the net operating income is not a return on the equity portion of the property’s value, it is a return on the entire value of the property.

Question 5

Which of the following statements is/are TRUE?

Real property taxes, income taxes, and replacement reserves are all examples of typical deductions when calculating the net operating income for apartment buildings.
Potential revenue from laundry machines is not considered to be “other income” because it is difficult to estimate the amount of laundry tenants will do in a year.
A wide gap may exist between the Gross Potential Revenue and Gross Effective Revenue of an apartment building if the property is managed poorly.
Gross potential revenue is estimated using the rents currently earned by the property.

1. C only
2. A and D only
3. A, B, and D only
4. B, C, and D only

Answer 5

Correct Answer: 1

Statement C is true; the difference in the figures is determined by the deduction of operating expenses where some expenses are directly controlled by management. Furthermore, higher revenues by way of higher rentals may be attainable given better management of the premises. Statement A is false; income tax is not deducted in determining net operating income. Statement B is false; the revenue collected by the coin‑operated machines in the apartment building, provides an estimate of machine use by the tenants and is considered “other income”. Statement D is false; market rents are used to estimate gross potential revenue. Therefore, option (1) is correct.

Question 6

Simon is considering investing in either investment A or investment B. Compared to investment A, investment B has lower risk, higher liquidity, and fewer management requirements. Simon selects investment B, expecting a __________.

1. a lower return
2. a higher return
3. a zero return
4. the same return

Answer 6

Correct Answer: 1

When comparing two investments, one should consider the liquidity, risk, and management requirements, as well as the return on equity. Higher liquidity, lower risk, and less management requirements will all lower the return required by investors.

Question 7

A group of investors are presented with the opportunity to invest in a class B office tower. In their review of the financial statements, they note that the depreciation expense for the building is $22,000 and that the capital cost allowance for the same year is $33,000. They are not sure which value to use in the calculation for the net operating income. Which of the following is correct?

1. Use the capital cost allowance since it provides a higher deductible.
2. Use capital cost allowance as it conforms to Canada Revenue Agency’s standards.
3. Use the depreciation expense as it is the actual expense incurred.
4. Neither value is included in the calculation of net operating income.

Answer 7

Correct Answer: 4

Depreciation, capital cost allowance, income tax, and financing costs are specific to the individual owner, and are omitted from NOI calculations.

Question 8

You determine the local apartment building market has a vacancy and collection loss rate of 1% while the national average is 3%. Which of the following is the most probable conclusion that you can draw from this information?

1. Supply in the local market well exceeds demand.
2. The risk of default in the national market is lower than the local market.
3. Demand for apartments in the local market is robust.
4. Tenant turnover rates are similar in both markets.

Answer 8

Correct Answer: 3

The lower vacancy and collection loss rate in the local market reflects stronger demand.

Question 9

THE NEXT THREE (3) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION:

You are appraising a property using the income approach. You have gathered the following information regarding two comparable properties and the subject property. Long term vacancy and bad debt allowance rates for all buildings are expected to be 3%. Vacancy and bad debt allowance applies also to the parking and laundry revenue.

Subject Property

Patricia’s Place

Tommy’s Towers

Gross Potential Rent

$835,000

$860,000

$720,000

Other Income:

Potential Parking Revenue

11,600

10,200

9,400

Potential Laundry Revenue

4,700

5,300

4,100

Operating Expenses

252,000

255,000

243,000

Sale Price

         ?

7,900,000

8,250,000

The net operating income (rounded to the nearest dollar) for the subject property is:

1. $542,139
2. $573,761
3. $597,568
4. $583,600

Answer 9

Correct Answer: 2

Gross Potential Rent

$835,000

+ Potential Parking Revenue

11,600

+ Potential Laundry Revenue

4,700

= Gross Potential Revenue

$851,300

Less Vacancy/BD Allowance (3.0%)

(25,539)

= Effective Gross Income

$825,761

Less Operating Expenses

(252,000)

Net Operating Income

$573,761

Question 10

You are appraising a property using the income approach. You have gathered the following information regarding two comparable properties and the subject property. Long term vacancy and bad debt allowance rates for all buildings are expected to be 3%. Vacancy and bad debt allowance applies also to the parking and laundry revenue.

Subject Property

Patricia’s Place

Tommy’s Towers

Gross Potential Rent

$835,000

$860,000

$720,000

Other Income:

Potential Parking Revenue

11,600

10,200

9,400

Potential Laundry Revenue

4,700

5,300

4,100

Operating Expenses

252,000

255,000

243,000

Sale Price

         ?

7,900,000

8,250,000

Assume that the appropriate market capitalization rate is 7.15% and that the appropriate net operating income of the subject property is $620,000. What is the value of the subject property rounded to the nearest $1,000?

1. $87,000
2. $8,000,000
3. $8,671,000
4. $4,433,000

Answer 10

Correct Answer: 3

Market Value = NOI ÷ Capitalization Rate = $620,000 ÷ 0.0715= $8,671,000.

Question 11

You are appraising a property using the income approach. You have gathered the following information regarding two comparable properties and the subject property. Long term vacancy and bad debt allowance rates for all buildings are expected to be 3%. Vacancy and bad debt allowance applies also to the parking and laundry revenue.

Subject Property

Patricia’s Place

Tommy’s Towers

Gross Potential Rent

$835,000

$860,000

$720,000

Other Income:

Potential Parking Revenue

11,600

10,200

9,400

Potential Laundry Revenue

4,700

5,300

4,100

Operating Expenses

252,000

255,000

243,000

Sale Price

         ?

7,900,000

8,250,000

The yield of Tommy’s Towers and Patricia’s Place are:

1. 6.71% and 8.23% respectively.
2. 8.23% and 6.71% respectively.
3. 5.68% and 7.52% respectively.
4. 7.52% and 5.68% respectively.

Answer 11

Correct Answer: 3

Yield = NOI/Sale Price

Net Operating Income Calculation: Tommy’s Towers A Patricia’s Place B

Gross Potential Rent $720,000 $860,000
+ Potential Parking Revenue 9,400 10,200
+ Potential Laundry Revenue 4,100 5,300

= Gross Potential Revenue 733,500 875,500
Less Vacancy and Bad Debt Allowance (22,005) (26,265)

= Gross Realized Revenue 711,495 849,235
Less Operating Expenses (243,000) (255,000)

Net Operating Income 468,495 594,235

Yield Calculation:

Comparable A: Yield = $468,495 ÷ $8,250,000 = 0.0567873, rounded to 5.68%
Comparable B: Yield = $594,235 ÷ $7,900,000 = 0.0752196, rounded to 7.52%

Question 12

In appraising a residential apartment building, you used a market determined capitalization rate of 5.33% to estimate a market value of $9,350,000. If a more appropriate capitalization rate turned out to be 4.13%, then the market value rounded to the nearest $1,000 would be:

1. $12,067,000
2. $11,220,000
3. $10,568,000
4. Impossible to determine from the information provided.

Answer 12

Correct Answer: 1

If a cap rate of 5.33% results in a market value of $9,350,000, that means the NOI for this property is $498,355 (NOI = market value H cap rate).
Now calculate the market value using this NOI and the more appropriate 4.13% cap rate.
Market Value = $498,355 divided by 0.0413 = $12,066,707, rounded to $12,067,000.

Question 13

You have been asked to appraise the market value of an industrial project. Therefore, you need to determine the project’s net operating income. The building is comprised of 83,000 square feet of rental space on which rent is charged at $10 per square foot per annum. All leases are to be fully net (the tenant pays all operating expenses except management expenses). Management expense is estimated to be 10% of annual gross realized revenue. The vacancy rate is 4% and depreciation expense for the year is $42,700. What is the net operating income of this project?

1. $674,420
2. $747,000
3. $708,570
4. $717,120

Answer 13

Correct Answer: 4

Gross Potential Revenue (83,000 x 10) = $830,000
Less vacancy allowance (4%) (33,200)

= Gross Realized Revenue 796,800
Less management expense (10%) (79,680)

= Net Operating Income $717,120

Note that depreciation is not used when calculating net operating income for appraisal purposes.

Question 14

An appraiser has obtained the following information on the subject property, an apartment building, and four comparables:

COMPARABLES

Subject Property

A

B

C

D

Number of Suites

75

94

60

49

70

Gross Potential Rent

461,800

765,500

454,600

295,400

488,300

Age of Building

16 years

6 years

7 years

13 years

20 years

Vacancy & Bad Debt Allowance

5.00%

4.00%

4.50%

4.50%

5.00%

Real Property Taxes

51,567

70,770

42,354

28,631

46,301

Utilities

31,760

37,640

29,050

21,920

34,470

Maintenance

29,840

38,500

25,700

19,000

28,600

Replacement Reserves

0

22,000

15,000

12,000

18,600

Depreciation

30,000

75,000

65,000

40,000

55,000

Management Fee

51,000

28,500

18,000

19,000

29,000

Miscellaneous Expenses

18,600

28,900

19,500

10,200

19,800

Net Operating Income

?

508,570

284,539

171,356

?

Sale Price

?

8,072,500

4,377,500

3,116,000

4,101,600

The subject property is located in the same general neighbourhood as the comparables and is in an average state of repair. The heating system is in need of immediate repairs which are expected to cost $202,950.

What is the net operating income of Comparable D?

1. $287,114
2. $258,469
3. $282,427
4. $264,580

Answer 14

Correct Answer: 1

Gross potential rent $488,300
Less vacancy and bad debt allowance 24,415
Gross effective rent $463,885
Less operating expenses:
Real property taxes $46,301
Utilities 34,470
Maintenance 28,600
Replacement reserves 18,600
Management fee 29,000
Miscellaneous expenses 19,800 176,771
Net operating income $287,114

Question 15

An appraiser has obtained the following information on the subject property, an apartment building, and four comparables:

COMPARABLES

Subject Property

A

B

C

D

Number of Suites

75

94

60

49

70

Gross Potential Rent

461,800

765,500

454,600

295,400

488,300

Age of Building

16 years

6 years

7 years

13 years

20 years

Vacancy & Bad Debt Allowance

5.00%

4.00%

4.50%

4.50%

5.00%

Real Property Taxes

51,567

70,770

42,354

28,631

46,301

Utilities

31,760

37,640

29,050

21,920

34,470

Maintenance

29,840

38,500

25,700

19,000

28,600

Replacement Reserves

0

22,000

15,000

12,000

18,600

Depreciation

30,000

75,000

65,000

40,000

55,000

Management Fee

51,000

28,500

18,000

19,000

29,000

Miscellaneous Expenses

18,600

28,900

19,500

10,200

19,800

Net Operating Income

?

508,570

284,539

171,356

?

Sale Price

?

8,072,500

4,377,500

3,116,000

4,101,600

The subject property is located in the same general neighbourhood as the comparables and is in an average state of repair. The heating system is in need of immediate repairs which are expected to cost $202,950.

The indicated market yield on the sale of the comparables is within which one of the following ranges?

1. 3.0% to 4.8%
2. 4.5% to 6.1%
3. 5.5% to 7.0%
4. 6.0% to 10.0%

Answer 15

Correct Answer: 3

Yield = NOI ÷ Sale Price

Comparable
A $508,570 ÷ $8,072,500 = 6.3%
B $284,539 ÷ $4,377,500 = 6.5%
C $171,356 ÷ $3,116,000 = 5.5%
D $287,114 ÷ $4,101,600 = 7.0%

The comparables indicate a market yield between 5.5% − 7.0%.

Question 16

An appraiser has obtained the following information on the subject property, an apartment building, and four comparables:

COMPARABLES

Subject Property

A

B

C

D

Number of Suites

75

94

60

49

70

Gross Potential Rent

461,800

765,500

454,600

295,400

488,300

Age of Building

16 years

6 years

7 years

13 years

20 years

Vacancy & Bad Debt Allowance

5.00%

4.00%

4.50%

4.50%

5.00%

Real Property Taxes

51,567

70,770

42,354

28,631

46,301

Utilities

31,760

37,640

29,050

21,920

34,470

Maintenance

29,840

38,500

25,700

19,000

28,600

Replacement Reserves

0

22,000

15,000

12,000

18,600

Depreciation

30,000

75,000

65,000

40,000

55,000

Management Fee

51,000

28,500

18,000

19,000

29,000

Miscellaneous Expenses

18,600

28,900

19,500

10,200

19,800

Net Operating Income

?

508,570

284,539

171,356

?

Sale Price

?

8,072,500

4,377,500

3,116,000

4,101,600

The subject property is located in the same general neighbourhood as the comparables and is in an average state of repair. The heating system is in need of immediate repairs which are expected to cost $202,950.

The operating expenses listed for the subject are as reported by the owner. The appraiser makes two modifications in order to stabilize the net operating income and have it reflect market norms. Determine which one of the following choices illustrates the most appropriate adjustments and the appropriate net operating income for the subject property.

1. Adjustment 1: Depreciation = $50,000
   Adjustment 2: Maintenance = $46,100
   Estimated NOI: NOI=$240,508
2. Adjustment 1: Immediate repairs = $202,950
   Adjustment 2: Management Fee = $55,500
   Estimated NOI: NOI=$266,008
3. Adjustment 1: Management Fee = $25,500
   Adjustment 2: Depreciation = $60,000
   Estimated NOI: NOI=$222,108
4. Adjustment 1: Management Fee = $24,000
   Adjustment 2: Replacement Reserves = $16,900
   Estimated NOI: NOI=$266,043

Answer 16

Correct Answer: 4

Adjustments must be made to the operating expenses of the subject property whenever these expenses are out of line with the amount paid by comparable properties for the same items.
In the problem, the subject property does not make any deduction for replacement reserves while all four of the comparables account for replacement reserves. It appears then, that by not allocating an amount to replacement reserves for the subject the property is out of line compared to other similar properties and an amount should be allocated.
The adjustment is estimated by considering the site condition and age of the subject property, the amount paid by comparables and any other factors the appraiser considers relevant. An adjustment of $16,900 is made to the operating expenses of the subject property to account for replacement reserves.
Similarly, the amount the subject property pays for management ($51,000) seems out of proportion to the management fees of the comparable properties ($28,500, $18,000, $19,000 and $29,000). The management fee for the subject property is adjusted to $24,000.
Note that depreciation is not adjusted because depreciation is not an operating expense. Depreciation is an accounting item and is irrelevant for the purposes of determining net operating income for appraisal purposes. Likewise, immediate repairs are deducted from the final estimate of market value and are not accounted for under operating expenses.

The NOI for the subject property is $266,043 ($461,800 - $23,090 (for vacancy) - $51,567 - $31,760 - $29,840 - $18,600 - $24,000 - $16,900).

Question 17

An appraiser has obtained the following information on the subject property, an apartment building, and four comparables:

COMPARABLES

Subject Property

A

B

C

D

Number of Suites

75

94

60

49

70

Gross Potential Rent

461,800

765,500

454,600

295,400

488,300

Age of Building

16 years

6 years

7 years

13 years

20 years

Vacancy & Bad Debt Allowance

5.00%

4.00%

4.50%

4.50%

5.00%

Real Property Taxes

51,567

70,770

42,354

28,631

46,301

Utilities

31,760

37,640

29,050

21,920

34,470

Maintenance

29,840

38,500

25,700

19,000

28,600

Replacement Reserves

0

22,000

15,000

12,000

18,600

Depreciation

30,000

75,000

65,000

40,000

55,000

Management Fee

51,000

28,500

18,000

19,000

29,000

Miscellaneous Expenses

18,600

28,900

19,500

10,200

19,800

Net Operating Income

?

508,570

284,539

171,356

?

Sale Price

?

8,072,500

4,377,500

3,116,000

4,101,600

The subject property is located in the same general neighbourhood as the comparables and is in an average state of repair. The heating system is in need of immediate repairs which are expected to cost $202,950.

The appraiser, for reasons of their own, estimates a market capitalization rate of 5% and a net operating income for the subject property of $290,000. Given this information, and the status of the heating system, calculate the estimated market value of the subject property (rounded to the nearest $1,000).

1. $6,003,000
2. $5,800,000
3. $5,597,000
4. $5,497,000

Answer 17

Correct Answer: 3

Market Value

= Net Operating Income ÷ Capitalization Rate

= $290,000 ÷ .05

= $5,800,000

Less Immediate Repairs

($202,950)

Market Value

= $5,597,050, rounded to $5,597,000

Question 18

Richard owns an office building in Hamilton. If fully occupied, the building has potential rental income of $425,000 per year; however, the building is currently only 50% occupied. Operating expenses are estimated at $160,000. Three comparable properties yielded capitalization rates of 5.0%, 6.5%, and 6.0% with an average vacancy rate of 13% (the market vacancy rate). The appraiser determined that a 6.0% cap rate was reasonable. What is the market value of Richard’s property (rounded to the nearest $100)?

1. $3,044,600
2. $3,495,800
3. $3,597,700
4. $4,416,700

Answer 18

Correct Answer: 2

Gross Potential Rental Income
$425,000

Less market vacancy rate 13%

(55,250)

= Gross Effective Income

369,750

Less Operating expenses

(160,000)

= Net operating Income

$209,750

Market Value = Net Operating Income/Capitalization Rate

Market Value

= $209,750/0.06

= $3,495,833, rounded to $3,495,800

Question 19

You have been engaged to appraise an owner-operated multi-family building. The subject property’s operating expenses indicate that no property management fee was taken. When comparing the income data of your comparable properties you find that:

Comparable A is also owner-operated, with no property management fee taken; and
Comparable B uses a professional property management company that charges the standard industry rate of 2% of gross potential revenue. The data is summarised below:

Subject Property

Comparable A

Comparable B

Sale Price

    ?

 $1,216,382

 $1,239, 560

Gross Potential Revenue

            $115,560

    $148,840

     $100,500

Vacancy & Bad Debt Allowance

               4%

             4%

              4%

Net Operating Income

    $60,125

     $57,850

     $56,400

Based on this information, what is the market value range of the subject property, rounded to the nearest hundred dollars?

1. $1,328,700 to $1,349,400
2. $1,263,100 to $1,276,500
3. $1,321,400 to $1,351,100
4. $1,381,000 to $1,438,600

Answer 19

Correct Answer: 2

Subject Property

Comparable A

Comparable B

Reported NOI

$60,125

$57,850

$56,400

Adjustment for property management fee (2%)

+$2,010

Adjusted NOI

$60,125

$57,850

$58,410

Recent Sale Price

$1,216,382

$1,239,560

Capitalization Rate

4.76%

4.71%

Lower Bound: $60,125/0.0476 = $1,263,130 rounded to $1,263,100

Upper bound: $60,125/0.0471 = $1,276,539 rounded to $1,276,500

Question 20

Which of the following statements regarding “escalator clauses” in property management is TRUE?

1. An escalator clause allows the landlord to avoid giving notice of rent increases and is found only in residential tenancies.
2. An escalator clause allows the landlord to recover expenses from the tenant should expenses increase, and is generally found in industrial and commercial leases.
3. An escalator clause assigns rental increases based on comparable increases and is found strictly in residential tenancies.
4. An escalator clause allows rent to increase along with inflation and is commonly found in all types of leases.

Answer 20

Correct Answer: 2

Escalator clauses are usually found in industrial and commercial leases. An escalator clause gives the landlord the ability to recover any increases in operating expenses from the tenant.