So many things in life are a gamble. You do the best you can with the tools you have at the time. When you know better, you do better. When you do better, you keep doing it so you don't lose it. You let it go when it is no longer of any value to you. Right now, I'm not sure why I'm still in the appraisal game.
I needed to challenge myself and chose to include a course on the Income Approach to Value as part of my 28 hours needed for Continuing Education for my State Certified General Real Estate Appraiser license which comes due every even year by June 30th. I just got an 87% on the exam which is good for me after not being active for a few years! I think that's the highest score I've ever gotten on any income approach course.
This time I am doing all courses online through McKissock. I like that it is less expensive to do it online and that you don't move forward until you understand the concepts presented which is definitely getting your money's worth. Physically attending classes costs more - the courses cost more and gas mileage which for me is quite a chunk of money unless I want to stay overnight in a motel which is another expense. I had taken many of these courses over the years and the best place near me has been with Lowman & Company out of Sedalia, Missouri.
There are a couple advantages to taking courses in person vs online as you only attend for the number of hours you get credit for and you have contacts with peers which is beneficial for busy and actively working appraisers. You may or may not retain all the concepts because the class moves forward whether you keep up or not. The online courses generally take longer because of the stop and start aspect and you just take more time because it is at your speed (for me anyway). Being retired since 12/2011, I'm in no hurry and have been giving it a couple hours 1-2 days a week which is pleasant and I feel confident knowing the material and it is kind of fun the way McKissock presents.
I have taken many courses specifically on the income approach; my first taught by a man named Irv Johnson back in 1984 when I first started working as a Commercial Appraiser for the State of Missouri. IRV is the basic income approach formula:
Income
Rate x Value
Income = Rate x Value or
Rate = Income / Value or
Value = Income / Rate
And so it begins…you have to know two of the components of the formula to find the third. That is the basic game plan. It gets much more complicated and every appraisal has many different ways to find each component and to test it's accuracy. Experience over many years brings confidence. It took me about five years to gain that confidence and I used it in my practice for 30 years and have applied it thousands of times. It is never the same as each component constantly changes and like a slot machine, you have to have the right information compatible with all components at the same time. When it does come together, it can be challenged almost immediately and usually was in my kind of work monitoring the county Assessors' Offices. Creating a path to value with defensible documentation and reasoning is important. Rarely is an appraisal 100% document-able. As with all three approaches to values, intuition is necessary, and that comes with experience. In today's world, intuition is not as acceptable as it was and probably rightly so as it was abused and there was much fraud in the industry. It brought down Savings & Loan Banks in the 1980's and hurt our economy. The 1990's brought appraisal certification with national Uniform Standards of Professional Appraisal Practice (USPAP) evolving; although the lending institutions grew the fraud by making bad loans which eventually increased to bring down the economy even more by 2008. I have addressed these issues in earlier blog articles under Real Estate Issues.
A quick review here may help with understanding the process of real estate appraisal. Start with the Types of Value - business value, disposition value, fair value, going-concern value, goodwill value, insurance value, investment value, liquidation value, market value, use value, and value as is. As a commercial appraiser, I have to understand and identify all types of value but market value is what I do in my line of work. The market is where I get all the components needed for the three different approaches to value. All three approaches are addressed in each appraisal and reconciled to a final value.
The three Approaches to Value are: Cost Approach, Market Approach, and Income Approach. The Cost Approach is most defensible for newer constructed properties as cost manuals are very accurate in measuring the building cost value. It is also good for odd or unique properties. Marshall & Swift is the most widely accepted cost system in the world. It is up to the appraiser to measure and report physical aspects correctly. The variable aspect is depreciation which has more guess-work (intuition); the older the building, the more it is affected by outside forces such as functional and economic issues. Also, land value has to be validated separately for it's highest and best use.
The Market Approach is most defensible in an active market especially where sales of comparable properties occur frequently enough to measure time factors. Also, it is not common to find exact
comparable properties so the adjustment figures weigh very heavy on credibility. Then you need to find at least three or more comparables to do statistical analysis. This method is what the government-back loan agencies require most frequently such as VA, Fannie Mae and Freddie Mac. There is very little room for guess-work (intuition) because this area is where the world of bad loans took a dive. Adjusting comparable sales became an art in itself and massaging figures to make the mortgage loan value the most beneficial in the bank's favor is why USPAP has become such an important compliance tool accepted by everyone in the appraisal field for all types of value.
The Income Approach is most defensible when the income characteristics of a property attract investors. Homeowners are attracted to houses because of the amenity benefits inherent in ownership; it is driven by emotion. The typical investor anticipates future benefits that are financial in nature. Property uses such as retail, office, and warehouse can be rent producers. 2-4 unit properties are typically bought for investment purposes. The use of a gross rent multiplier would be appropriate. More than 4-unit complexes would employ a capitalization of net income by a capitalization rate or a discounted cash flow analysis. General Appraiser Certification is required beyond 4 units. Leases must be analyzed as well as different kinds of rents - contract, scheduled, market (same concept as Market Value).
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| HP12c Financial Calculator |
There are up to 12 formulas to develop an overall rate used in direct capitalization. There are several techniques such as band-of-investment which uses a mortgage constant. There are residual techniques where different rate components are known from building, land, equity, and/or mortgage. The world's first horizontal financial calculator was first introduced in 1981 known as the HP12c. This instrument is the most useful tool for the commercial appraiser! Most courses on the income approach require at least basic skills with the HP12c. Most of the courses are exercises in solving financial problems to develop a final value. To solve a problem, you need to know any 3 items - then solve for the 4th unknown item. Some problems you need 4 items to solve for the 5th. The information can be added into the 5 keys in any order. Those basic 5 components are: present value (PV), future value (FV), payment (PMT), interest rate (i), and term (n).
Here's where that IRV formula comes in. The Income must be net operating income. The process to get net operating income is:
PGI (potential gross income)
plus Other Income
less V&C (vacancy & collection loss)
equals EGI (effective gross income)
minus TOE (total operating expenses)
equals NOI (net operating income)
All of these components must be known and well documented from a year's worth of income and better yet, 3 years. Use of income tax reports is most useful but you have to know what items to exclude, like mortgage payment for one. Figuring out how to obtain the clean numbers in this formula is a large part of any income approach course.
The Rate process is much more complicated. There are whole courses on how to develop capitalization rates but basically you are looking at Yield Capitalization vs Direct Capitalization. Yield capitalization is a profit, or yield, oriented and simulates investor assumptions about the present worth of expected future benefits, assuming specific profit or yield requirements. With yield capitalization, the overall value is estimated by adding together the present worth of the income and the present worth of the reversion of capital. Return of the investment and return on the cash flow. Direct Capitalization is a snapshot of a point in time. Assumes that the income and expenses won't change over time and that you will hold the property until it wastes away to nothing and never recapture the capital invested.
Finally, the Value is usually the unknown item you are looking for. Get the income and divide by the rate and you have the value. Simple. But sometimes you have the value from a sales price of the subject property and/or you have verified it with the Market Approach. You may use this information to find one of the other components. You take that sale price (value) and multiply it times a rate you have processed confidently and you can then estimated the income that a property could produce. Also, you can take a sales price (value) and divide it by income (NOI) and to get a rate you may use in other similar use appraisals. Pretty simple stuff once you line up all similar fruits in the slot machine!
