You’re Never Too Small – The Income Approach in Small Jurisdictions

Description

In small jurisdictions the Income Approach to value can be difficult to implement.  Income and expense information can be hard to obtain, cap rates are often difficult to determine, making model building and calibration a real challenge.  So much so, small jurisdictions often write off the approach all together due to lack of information.  This session will explore and discuss different techniques and practices an appraiser can use to build and calibrate an income model.

The goal of the session in to give appraisers some creative, out of the box ideas on how to implement and/or expand their income models in their jurisdictions.  The session will focus on examples and concepts for small jurisdictions where virtually no national or regional data exists, however, the ideas discussed could also be used to test and calibrate models in larger jurisdictions.

This was originally presented at the 2022 IAAO Conference in Boston, MA

Presentation Narrative

Smaller jurisdictions face difficulties when it comes to the income approach.  A lack of market data related to rental, vacancy, and expense rates combined with limited sales to extract market cap rates make the income approach a real under taking. Furthermore, values arrived at using the income approach can be difficult to defend given the lack of support documentation. It’s not uncommon for smaller jurisdictions to completely abandon the income approach given these concerns. 

This report will consider techniques that smaller jurisdictions can use in order to supplement for a lack of market data and be able to perform an income approach that generates defendable, market values.

The Income Approach Reviewed

The Income Approach considers the capitalization of future benefits in order to arrive at an estimation of value. The formula for the Income Approach is as follows:

Potential Gross Income (PGI) refers to the maximum amount of rental income the property could generate.  PGI is an annualize amount that considers a market rental rate at 100% occupancy.

Vacancy and Collection Loss is the amount of unrealized income.  Typically, all properties will experience at least a minimal amount of vacancy or collection loss.

Miscellaneous Income is additional income the property generates that is more incidental in nature.  Money collected from laundry and parking fees are a few examples.  Miscellaneous income is typically not included in valuation models unless it can be determined that these income streams are normal in the market.

Effective Gross Income (EGI) is the amount of income actually received.

Operating Expenses refer to the expenses required in order for the property to reach its income potential.  Expenses are categorized as proper, sometimes referred to as allowable, and improper, or unallowable.  Only proper expenses are subtracted from the EGI.  Proper expenses include management fees, utilities, repairs and maintenance, and insurance, to name a few.  Improper expenses, such as interest expense, depreciation, property taxes, and capital expenditures, are not included in the total operating expenses for the property.

The Net Operating Income (NOI) is calculated by subtracting the operating expenses form the EGI.  The NOI is then divided by a capitalization rate to arrive at an Income Approach to value.

Getting Started

As the saying goes “Rome wasn’t built in a day”, and likely neither will the necessary data base and model to adequately perform the Income Approach in smaller jurisdictions.  It takes time to obtain enough information in order to build an income model to perform the Income Approach.  

The assessor should reflect on their jurisdiction and determine the best model set up and design that tailers to the jurisdiction’s specific make-up.  Some use types, apartment, retail, office, warehouse, hotel, etc., are standard and will be present is virtually all markets, but there could be some properties with income producing potential unique to a particular jurisdiction.  For example, if a jurisdiction is home to a regional lake destination the assessor may find it necessary to create a model that values boat and RV storage facilities.  If a jurisdiction has an abundance of hog producing facilities, they may wish to develop an income model that can aide in their valuation.

Establishing a data bank of market data will be essential to developing income models.  Without it, it will be impossible to manage the information you collect through questionnaires and interviews.  Some thought should be given to these data bases as well.  Ensure that enough information is collected and in a manner that will be easy for the assessor to maintain year over year while having enough characteristically data collected to recognize possible factors that influence market rates.

In time, the assessor may collect enough information that they can better differentiate market data based on the age, location, quality, and overall desirability of structures and make the decision to incorporate investment classes and economic areas in their valuation models. 

The main take away is to be patient when developing income models.  Initial income models may be built using minimal information that may lack defensibility, but the assessor should remain patient in the development of income models.  Eventually, market rates will begin to become clear and the income approach will carry more weight when reconciled with the other two approaches to value.

 Techniques in Establishing Market Rent

Sourcing rental information can be challenging, but not impossible in smaller jurisdictions. Having fewer leased properties and a greater percentage of owner-occupied ones makes the process harder, but collecting rental information that is available can be done none the less.  Sending questionnaires to property owners is the first and easiest step in collecting the required information.  Rental rates can also be collected by conducting interviews with market participants, such as, property managers, tenants, real estate brokers, appraisers, or lenders.  Putting the time in to establish these relationships and create these lines of communication can prove to be an important resource.

As with most other things, the internet can be an important tool in an assessors hunt for reliable market data. Property management sites and listing services such as LoopNet, CREXi, Brevitas are a few sources where even smaller jurisdictions can find listings for rentable properties.  Local Multiple Listing Sites (MLS) and other paid subscriber services are also available. Recently social media sites have joined the game as been places where landlords will turn to list vacant properties. 

Online listings can demonstrate a reasonableness in arriving at a market rental rate.  For example, hotel Average Daily Rates (ADR’s) as reported by owner/operators can be compared to the lowest rate on popular booking sites.  This demonstrates that when actual ADR’s are not known list rates demonstrate market value and can be used as supplemental rates when building models. Consider the table below:

Four operators reported ADR’s between $65 and $79 dollars while web rates for these some hotel properties were found to be between $65 and $91.  By conducting a simple ratio study by comparing the reported ADR with the corresponding web rate a median ratio of 99% demonstrates the web rate is a reasonable assumption that can be used in model building when actual rates are unknown.  The assessor could now review web rates for hotel properties that did not report income information in order to create a better model.

One of the best opportunities to collect income data comes during the appeal process.  This information is often shared with assessors during this process.  Following an appeal decision, it is then the responsibilities of the assessor to file that information in a place where it can be added to their data base of rental information. 

Techniques in Establishing Market Occupancy

Vacancy and collection loss is typically experienced by all properties, no matter the tenant or specific lease terms.  For this reason, every income model should include at least some rate of vacancy or collection loss. Vacancy rates are found by dividing the amount of vacant space by the total amount of rentable space.  Occupancy is often used conjunction with vacancy as the two are just the inverse of each other.  For example, if a property has a vacancy rate of 8%, the occupancy rate is 92%. 

Collection loss is also a consideration of the realized income that needs to be factored into the model and should not be left out.  Collection loss is calculated by dividing the unrealized income by the total billable income.  Though vacancy loss and collection loss can be calculated separately there are often applied to a model in one combined rate.

Occupancy rates can be difficult to decipher without having conversations with property owners, however, market participants may be able to share some of their experiences.  Local chamber of commerce, landlord associations, and business bureaus may have some information available as provided by their members and their own research.  Often times this information is collected and complied in an effort to better plan for growth and future development in the area.  This information is available to aide potential investors considering projects in the area, but it may also serve well in establishing occupancy rates in income models.

When occupancy rates are not provided it can, in some cases, be observed.  By taking count and comparing a population of vacant or occupied spaces with the total number of spaces in the population vacancy rates can be observed and then applied.

Consider the aerial image of a mobile home park below.  It can be observed that there is a total of twenty lots in this park.  Three of the lots are vacant while seventeen are occupied.  This indicates that there is an 85% occupancy rate or a 15% vacancy rate.  Its important to keep in mind that when conducting an observed vacancy review that collection loss it not included.  If the observed occupancy rate is 85% the actual amount of vacancy and collection loss applied to the model should be less than 85% in order to account for the total amount of unrealized income.

Techniques in Establishing Market Expenses

As indicated earlier only proper or allowable expenses should be included in the operating expenses. These are the expenses that are essential in order for the property to generate income for the property consistent with market indications.  Operating expense rates should also reflect market rates for the area.

When operating expenses are unknown or information collected by a jurisdiction is limited, conflicting, or unclear, regional comparisons could be the answer.  Unlike rental or occupancy rates that could vary greatly between jurisdictions due to market size, economics, or overall desirability, expenses remain fairly consistent.  Regional studies and comparisons are a great way to fill-in-the-blank when data is limited or missing.

Consider some of the most common allowable expenses.  Utilities vary little jurisdiction to jurisdiction as many neighboring jurisdictions share the same utility providers so cost are relatively similiar.  Repairs and maintenance remain comparatively consistent jurisdiction to jurisdiction as the effects of wear and tear caused by nature and conducting business won’t be all that different between neighboring jurisdictions.  Other fees such as management, accounting, insurance, and legal services too have little variation between jurisdictions as often times these service providers are offering services in adjoining jurisdictions.

With these considerations it would be reasonable to assume that if expense rates are unknown or unclear, regional comparisons could serve nicely in their place and be used as supplemental information. The unallowable or improper expenses are the ones that will vary the most between jurisdictions.  However, these expense items are accounted for in the creation of the capitalization rates and are not factored in the operating expense line item of income models.

Techniques in Establishing Capitalization Rates

Establishing capitalization rates are one of the most challenging aspects for the income approach regardless of a jurisdiction’s size, small or large.  Cap rates can be very difficult to put your thumb on what a true market cap rate is.  For this reason, when conducting a cap rate study, its more about accumulating as much information as possible in order to defend the conclusions made by the assessor.  For example, if the assessor is able to collect enough information that suggests a retail cap rate ranges between 6.0% and 9.2%, with an average of 7.5%, a median of 7.6%, and concludes that a cap rate of 8.0% will be used in the model; then it may be able to stand up to the test because of the amount of supporting documentation.

The direct capitalization method and the band-of-investment method are the two most common  methods in estimating a market capitalization rate that work best in smaller jurisdictions.  However, they each have their benefits and downsides. 

The direct capitalization method is the best way of extracting market cap rates because it establishes cap rates directly from market transaction using actual market NOI.  The downside is NOI data and comparable sales in small jurisdictions can be difficult to come by.  The band-of-investment method is very easy to calculate mathematically with a minimal amount of information, however, it falls short in accounting for changes in income and expenses.

One method over the other will not yield the most defendable results due the inherent challenges.  However, if both methods are explored in conjunction with establishing a market capitalization rate, the end results can be a good representation of a market rate.  The more support documentation the assessor is able to obtain the less likely the final cap rate conclusions will be questioned.

With the band-of-investment method, collecting market data from market participants will be essential and relatively easy to accomplish.  A survey of local lending institutions can be conducted in order to gather up-to-date data related to lending practices on income producing properties.  Once the necessary information is collected, it is plugged into the formula to calculate the overall capitalization rate.  The calculated rate will not include an effective tax rate (ETR).  This will need to be added to the end result.

The equity component of the band-of-investment method will likely be the most challenging to collect even when market participants are interviewed.  Establishing an equity dividend rate may lend cause to referencing a national or regional publication.  These rates can typical range between 8.0% and 16.0%, but there are a lot of factors that contribute to an investor’s return on their investment.  Even in small jurisdictions these types of publications may be an assessor’s best tool in identifying those market factors.

The direct capitalization method is derived directly from comparable sales, and in small jurisdictions finding enough comparable sales in which NOI at the time of sale is known is not always easy.  Identifying information related to the NOI can be obtained during the sales verification process or through MLS.  When NOI is determined the direct capitalization method is straightforward, divide the NOI by the sale price to arrive at a capitalization rate through this method.

When collecting NOI data, the assessor will want to verify whether property taxes were included as an expense line item.  This will be important in determining the final cap rate used in the model and whether the ETR must be added to or subtracted from the calculated results.

In some cases, comparable market transactions may be available, however, the accompanying NOI data is not.  The assessor could consider performing a proforma direct capitalization method by using the NOI calculated through the model.  This approach works best when the assessor feels confident the model does a reasonable job at predicting market NOI however enough actual NOI data is not available.  The calculation is done in the same manner as the direct capitalization method by dividing the model NOI by the sale price.

If a proforma approach is done the ETR will need to be added to the end conclusions as taxes are not included in the model expense rate.

Model Testing and Calibration

Once an income model has been built with the available data there is still some testing and fine tuning the assessor should consider.  To an extent the model will always be a work in progress.  The model may predict values for certain properties well and others not as much.  It will be the assessor’s responsibility to review the completed model and determine whether slight adjustments can be made in order to predict values with more consistency.   

The quickest and easiest way to test a model is with a simple ratio study.  Comparing income values to recent sales prices will give the assessor a quick, general idea as to how well the model predicts value. Ideally the sales ratio should be between .90 and 1.10. 

The coefficient of dispersion (COD) will measure the overall dispersion of the data and how “tight” the ratios are to each other.   The desired COD should be below 20.0%.

When conducting a ratio study the assessor may want to include an occupancy code or income use code as this may indicate if one model is working better then another.  For example, assume sales R862 and R1164 are retail properties and indicate sales ratios in the low .90’s, while R981 and R1258 are warehouse properties that both indicate sales ratios below the acceptable range.  While the retail model indicates the model is working, the assessor may want to review the elements of the warehouse model in an effort to achieve better results. 

Another approach to calibrate an income model would be to consider a rent extraction from sales.  For this analysis the assessor would work the income approach backwards.  Start out with known sales and multiple them by the market cap rate found during the capitalization rate study.  This will indicate an NOI based on an actual sale price.  The assessor would then back the model expenses and the vacancy and collection loss.  This works the income equation backwards to arrive at a PGI.  The extracted PGI would then be divided by the unit of comparison used in the model to arrive at an extracted rent per unit.  The extracted rent can be compared to the rate used in the model.

When information is limited or unavailable extracting rental rates from sales is a great way to demonstrate, with a degree of reasonableness, that the model is either working or not working at predicting sale prices.  Doing a study like this can allow the assessor to take a hard second look at the rates used for each income use or occupancy assignment. 

Furthermore, this study can allow for rental rates to be reviewed based on investment class.  The assessor can review rental rates used in the model and make sure there is enough variation between the classes that are in line with sales prices.  It is another opportunity for the assessor to perform a quality control check on the investment classes assigned to individual properties.  Which may further trigger a full review of all investment classes within a property use type, neighborhood, or economic group.

Summary

The Income Approach does not have to be a difficult approach for small jurisdictions.  There are strategies and techniques an assessor can use to create predictive, defendable values.  Data and data sources may be difficult to come by at times, but with patience and creativity in obtaining available information a thoughtful model can be created.  The income approach does not have to be an approach only used by larger jurisdictions with a higher percentage of leasable properties; smaller jurisdictions can utilize it as well.