Valuation Methodologies: The Income Approach

The Texas Tax Code requires, in Section 23.0101, that the chief appraiser consider each of the three standard methodologies in determining the market value of property. These methodologies include: market sales, cost, and income approach.

Previously, we discussed the sales approach and the cost approach in determining market value. In this article, we will look at the income approach.

Under the income approach, the value of property is estimated based on the income (typically, rent) that the property can be expected to generate. There are several different methods of applying an income approach to valuation, including Gross Rent Multiplier, Net Income Multiplier, Discounted Cash Flow, and Income Capitalization.

Though the Tax Code does not require the use of the Discounted Cash Flow or Income Capitalization method, it does appear to require that the chief appraiser consider one of those methods in determining value. Section 23.012 provides that, in applying the income method of appraisal, the chief appraiser must use comparable rental data to estimate the earnings potential of the property, and must use comparable operating expense data to estimate the operating expenses of the property, must use comparable data to estimate a capitalization rate or discount rate.

In a recent court opinion a court of appeals implied that the Tax Code requires that both the appraisal district and the property owner must use information from comparable properties when determining appraised value based on the income approach.

The Discounted Cash Flow method essentially consists of creating a spreadsheet to determine the future income of the property (including any increases in rents or other income in future years) and the future expenses of the property (including any increases in future years) over a number of years, with a residual value at the end of the term. A discount factor is then applied to determine the current value of that anticipated stream of income. Essentially, the Discounted Cash Flow is based on an assumption that a buyer will pay a certain amount today to receive that stream of income in the future. The discount rate reflects the lost investment opportunity of the purchase price if invested elsewhere plus a risk factor, as well as possibly considering any future changes in investment rates.

The Income Capitalization method essentially does the same thing as the Discounted Cash Flow, but by a different method. Under Income Capitalization, the net income of the property for the coming year is estimated based on market rents, market expenses, market conditions (such as vacancy rates), etc. This estimated net income is then divided by a capitalization rate, which reflects the lost investment opportunity for the purchase price if invested elsewhere plus a risk factor. Essentially, the Income Capitalization method looks at a one-year period while the Discounted Cash Flow looks several years into the future.

In using both the Discounted Cash Flow method and the Income Capitalization method, it is important that market factors be considered and not just the rents and expenses associated with the particular property. The subject property may have long-term leases in place that pay considerably more or less than prevailing market rates. If the property is valued based on those leases, then the appraisal becomes a leased fee appraisal and not a fee simple, or market value, appraisal.

This, of course, creates some conflict because a purchaser is going to be willing to pay more for a building with contract rents above market and pay less for a building with contract rents below market. However, it is the property that is being valued for tax purposes and not the rental contracts.

Under the Cost Approach, this conflict in lease rates versus market rates might be covered by an obsolescence factor. However, obsolescence factors theoretically are not considered under the Income Approach, at least not as a separate component of valuation.

Nevertheless, lease rates might play a factor in determining the discount rate or the capitalization rate to be applied, since these methodologies must take into consideration what an investor would expect in return for his purchase price. In other words, the lease rates might play a role in determining the risk factor in building the discount or capitalization rate. With below-market rents in place, there is a greater risk to the investor. With above-market rents in place, there is potentially less risk.

The impact that lease rates have on the investor's risk will depend on market rates, market conditions and expectations, the amount of variance between market and lease rates, the future conditions and terms of the existing leases, and the dependability of the tenants in place.

Gross Rent Multiplier involves taking the rent associated with a property, ignoring all expenses, and multiplying by a market factor. This market factor usually must be determined by analyzing sales of comparable properties and the income associated with those sold properties.

Net Income Multiplier is based on the same theory, but instead of gross rent of the property, the net income (income minus expenses) is used. The market factor will, of course, be different, but still is based on market factors normally determined through comparable sales.

When considering office buildings, apartment complexes, or other income-generating properties, both appraisal districts and property owners often consider the income approach as the most accurate estimate of value. As the properties are income-generating, a purchaser would be expected to buy the property based on its income potential.

However, if an investor purchases a property on an income approach basis, then the approach might also be useful in disputing the property's purchase price. For example, if the purchase price was based strictly on leases in place, then the purchase price was based on a leased fee instead of a fee simple basis. Or, if the income approach turned out to be erroneous (for example, buying a fully leased building at above-market rents only to have the tenant declare bankruptcy six months after closing), the property owner might show that he overpaid based on erroneous conclusions that a subsequent purchaser would not make.

For properties that are not income-generating (vacant land, single-family residences), the income approach is almost never used, though it could be.

The income approach is also seldom used for personal property, and then it would probably have to be some sort of specialized property asset where the value is associated with the income potential of the property.

If you have any questions about the contents of this article, please contact the GPD Property Tax Section at propertytax@gpd.com.