Is the Income Approach always viable?

[Paul Ness MAI]

There is nothing miraculous about considering adjustments for ownership interest and making them when needed. In fact it is required.

If you don't do a cost approach or sales approach in a leased fee appraisal, fine, then you are not presenting two ownership interests and "never mind" about making adjustments in those approaches.

However, my question was...do you always exclude an income approach in the appraisal of a fee simple interest? This goes wayyyy back to the original statement you made that the income approach "estimates the lease fee interest". IMHO that is just plain wrong, the income approach can be appropriately used in the valuation of a fee simple interest, and it is used by thousands of appraisers across the country in such cases and yes it's taught that way in Appraisal 101. But we can agree to disagree :wink:

 

[Fred]

Paul,
"If you don't do a cost approach or sales approach in a leased fee appraisal"
I never said no sales comparison. Appraising leased fee or subleased interests with cap rates compared to and reconciled from sales 1, 2, 3, etc. is sales comparison.

"However, my question was...do you always exclude an income approach in the appraisal of a fee simple interest? This goes wayyyy back to the original statement you made that the income approach estimates the lease fee interest"
Probably excluded. As I said, I try to compare rented to rented; and owner-occupied to owner-occupied. I think we agree that rent capitalization measures leased interests. If I understand, you go further and say rent capitalization also measures the market value of un-rented property in fee simple ownership.

"If you complete an income approach based on the terms and conditions of an existing lease, then it represents the leased fee interest. If you are completing an income approach based on market rent, vacancy and expenses, then you are appraising the fee simple interest."
And presumably a market cap rate, too. You made similar statements a few times and tell me, rather dogmatically, that it is a fact. You should at least be able to see that I am asking reasoned and reasonable questions and if your conclusion is correct, then you should be able to offer a reasoned and reasonable answer. How do you substantiate what I call the hypothesis (what you call a fact) that market rent etc., capped at a market rate is the market value of fee simple interest? You mentioned that many appraisers buy into this hypothesis. So, a clear, concise explanation for it should be widely known and easily accessible.

If you apply the market-rent-capitalized method to a vacant building (fee simple ownership), is that saying that building has the same market value vacant and that it has fully rented? Would that make sense? What happens when market evidence says that the market value of fee simple interests in the form of prevailing sales prices is NOT equal to the leased fee at market rent capitalized? Then, which is the fact: the actual sales prices or the hypothesis?

"There is nothing miraculous about considering adjustments for ownership interest and making them when needed. In fact it is required."
I only applied the water-wine miracle statement turning replacement cost into the present value of an income stream or income stream plus reversion (leased interests). And as I asked wayyy back, where in Appraisal 101 does it teach that one can find the present value of an income stream by adjusting replacement cost. A lease is a contract. You cannot build a substitute contract.

 

[Paul Ness MAI]

An internet forum is not conducive to in-depth detailed discussion of the underpinnings of the income approach. I suggest you read some good text or take some education pertaining to the subject. This is such basic stuff, and after 18 years in this business, after taking numerous courses including advanced courses in income capitalization, and knowing dozens of commercial appraisers over those years, I have never come across an appraiser who did not understand that the income approach could be applied to estimate the value of the fee simple interest. The process of estimating market rent, operating expenses and, yes, a market-derived cap rate to conclude a fee simple interest in a property that is unencumbered, is not just my “hypothesis”, it is a commonly accepted, taught and appropriate practice.

If you look in the income approach chapter of 11th Edition of The Appraisal of Real Estate, there is a paragraph that summarizes my two main points in this whole thread that (1) the income approach is commonly used to estimate the fee simple interest, and (2) the sales and cost approaches can be used to estimate the leased fee interest, and in fact must be adjusted to reflect the leased fee interest if that is the interest being appraised. Here is a quote from page 454 of the 11th Edition: “This text discusses the income capitalization approach as it is applied to estimate the market value of a fee simple or leased fee interest. The conclusions reached reflect the use and analysis of market data; they should be consistent with value indications reached in the other valuation approaches. The value indications from each of the approaches applied should reflect the same interest in the property.”

 

[Fred]

Paul
I agree that fee simple as market rent capitalized is commonly taught, but I do not agree common equals true. Until someone can show that it is true with some reasoning or sufficient market studies, the word hypothesis is appropriate. You say I am the first that you have encountered who does not "understand" this idea. I am questioning whether anyone "understands" it or if they just "believe" it. There is a big difference. In order to understand it, there would have to be an understandable explanation. No one is putting that forth.

I have several editions of the text you cite, but not 11. A prime example of what you are talking about also appears in the sales comparison chapter, property rights adjustment section. My personal library includes books on income capitalization that span 100 years. Some espouse this idea. Some do not. None of the books that espouse the idea includes an explanation of why it would be true.

Is it possible that whoever first placed this idea in The Appraisal of Real Estate was just wrong? Maybe over the years no one has questioned it, been forced to support or prove it. Everyone memorized it so as not to be marked wrong on a test. Now, it is just part of lore or legend; dogma. Has this never happened before in human history? At times, folks have been visited by inquisitions for proposing such heresy as a heliocentric solar system. Maybe no one can explain why this hypothesis is true because it is not true.

I am not having any problem with the Internet form of written communication. I understand everyone in the thread and I don’t think I am being misunderstood. I am not sure why in-depth detail is necessary. I am able to support my position with simple and straightforward points.

One basic point I raised a few times that no one has addressed:
Assume there is a commercial building under long-term lease at market (etc.) that capitalizes to $1 million. You are arguing that this a fee simple value, even though the building is not in fee simple ownership. Is that oxymoronic? Assume further that the neighboring building is virtually identical except that it is vacant (fee simple title). If your hypothesis is correct, then fee simple value for the vacant building is also $1 million. Does it make sense that equivalent space either fully occupied with long-term market leases or vacant would have the same probable selling price? Of course not, and market data will not bear that out.

Is it that hard to see why someone would question this hypothesis as oxymoronic and contrary to market data? And you also have not answered the question of whether you would reconsider if the hypothesis is shown contrary to market data.

 

[Paul Ness MAI]

Well, if you are the only appraiser who is right on this and everyone else is wrong, then I suggest you write a book and prove us wrong (as Copernicus did on his death bed). You said you are able to support your position “with simple and straightforward points”, so go for it!

You are not misunderstood – I understand you, I just don’t agree with you. There is a difference! You may think you have no problem understanding me through this forum but you have completely missed my point about applying the income approach to appraise the fee simple interest.

Regarding your example of a commercial building under a long-term lease – your statements pertaining to the two properties ownership interests are absolutely correct - HOWEVER, I NEVER said that appraising a property based on its existing lease is the fee simple interest. Of course it would be leased fee. Further, I am NOT arguing that the fee simple interest of an identical nearby vacant building would be the same value. I’m not sure where you got that from. What I AM saying is that by applying the income approach and estimating market rent, vacancy, operating expenses and a market–derived cap rate, an estimate of the fee simple interest can be estimated for that vacant property. This does not represent a contrived lease as you stated before, it simply reflects an estimate of the income the property would likely generate. Now – if the property could not easily be rented, then lease-up time would have to be considered in some manner.

I recently appraised a 560,000 sq. ft. distribution facility that was owner-occupied. In the subject’s market such properties are just as easily found to be leased as they are owner-occupied. Based on the economic theory of substitution, a potential buyer could analyze sales of similar properties. Based on the economic theory of anticipation, a buyer could also look at the potential income they could expect to earn during the time of ownership. If the buyer completes due diligence on income potential, the data would be based on a market-derived rental rate, commensurate expenses and a market derived cap rate. In both approaches, the conclusion would reflect the fee simple interest. Have you ever bought a vacant rental property and completed a pro-forma to determine what potential income the property would generate? It’s the same thing, essentially replicating the market – what buyers do in determining what they would pay for a property. But if it's not leased and your analysis is all market-derived, then it reflects the fee simple interest.

If my subject had been leased, I would have been appraising the leased fee interest. The income approach would have been based on the terms and conditions of the actual lease. AND – in the sales and cost approaches, an adjustment may have been required for the ownership interest. This is a matter of “report consistency”. Without an adjustment these two approaches would reflect the fee simple interest and would not adequately reflect the impact, if any, of the existing lease.

I’m starting to wonder if you are pulling my chain because I am utterly flabbergasted at your position that capitalization based on market-derived potential income does not reflect the fee simple interest. Why doesn’t it? Direct capitalization of market-derived potential income implies capitalization of income at market levels into perpetuity based on typical escalations found in the market, a stabilized vacancy rate, normal turnover, operating expenses commensurate with typical lease terms, and a market-derived capitalization rate reasonable for the property.

I'm surprised nobody else jumped into this discussion. How about someone else taking over or starting a new thread? This is my last hurrah for this thread. I‘ve already hit exasperation mode and it’s time to quit. Sorry to disagree with you Steve, but it’s not the first (and it won’t be the last) time two appraisers disagreed. That’s what makes life interesting. If I were you, I’d chill out and spend the rest of the afternoon on the beach! Do you scuba dive? If you don’t you should in the Virgin Islands! I used to dive in a past life when I lived in Florida.

 

[Fred]

Paul,
I certainly appreciate the efforts and the non-condescending way you have of addressing me. It is always a pleasure to find someone who can disagree without being disagreeable.
Here are two things you posted today.

"I NEVER said that appraising a property based on its existing lease is the fee simple interest. Of course it would be leased fee"

"I’m starting to wonder if you are pulling my chain because I am utterly flabbergasted at your position that capitalization based on market-derived potential income does not reflect the fee simple interest."

In quote 1, appraising leases at market would be leased fee.
In quote 2, appraising leases at market would be fee simple.

Why should anyone have trouble deciphering that?

 

[Paul Ness MAI]

Ok, so I lied about giving up on you Steve. But you now have me confused by your last post. I have wondered all along if the problem lies in your concept of the leased fee interest. I don't understand what you mean by "appraising a lease at market". Now that is an oxymoron! You can only appraise the leased fee interest of a property if there is a real live lease contract(s) and you can only appraise the leased fee interest based on the terms and conditions of the actual lease, not "at market". In quote 1 above, I am only talking about appraising a lease based on contract rent and terms, not "at market".

I thought of the following example on the way home from work today. Take any vacant investment property as an example....You are asked to appraise a proposed 50-unit apartment "assuming completion of construction". No leases in place, so by definition only the fee simple interest can be appraised, right? By your argument, you would not apply the income approach because you said the income approach can only appraise the leased fee interest. By my argument, the income approach could be used and would be based on market rent, vacancy, expenses and a cap rate - hence the valuation of a fee simple interest by the income approach. Someone would be willing to pay that price for that property at that time and they would be purchasing the fee simple interest. A year or two later when there are 45 or 46 leases in place, then an appraisal of the leased fee interest could be completed, based on the contract rents.

 

[Anonymous]

Gee, both of you went right over my head....

ter

 

[Damon Pedersen]

Whats the big deal???

You people need a new hobby...lol

Damon