When I interviewed for a credit analyst position more than ten years ago for a previous employer, I met with two people. The first meeting was with the Credit Manager, and the second meeting was with the Chief Credit Officer “CCO” who was known to be a difficult person to interview with. The CCO liked to throw unusual questions during an interview to see how the thought process of the candidate worked. During the second interview, the CCO asked me which type of loan I liked to underwrite the most, thinking that I was going to stumble since the position required someone that knew about all types of commercial loan underwriting. He was a little surprised when I answered without hesitation that underwriting income producing property loans were my favorite loans to underwrite.
I remember most of what I said, and the answer is probably the reason why I got the job. I said “I like underwriting income producing property loans such as apartment building loans because they are so simple. Not only do we have a primary source of repayment that is easily tested against the market in the form of rent-rolls and P&L reports, but we can use that same information to estimate the viability of the liquidation of the underlying collateral as a secondary source of repayment by running a simple income capitalization approach analysis on the numbers” After I gave him the response, he chuckled said “fair enough”, and offered me a job.
I was reminded of that conversation the other day when I was doing a quick calculation using the income capitalization approach for an apartment loan that one of the analysts was underwriting. While commercial credit analysts are not appraisers, it is common procedure to include assumptions of value in loan approvals, subject to corroboration by a formal appraisal performed by an independent professional. Using the income approach to value estimation is a tool that will serve you well if you are ever involved in real estate.
Income Capitalization Approach
The ability to estimate the value of a property using its earning power is basically what investors and the market do. Most times the market is pretty good at estimating the value of properties using this approach, which is why lenders also use it. The Income Capitalization Approach is a set of procedures through which a value indication for an income producing property is derived. The process works by converting anticipated benefits (cash flows) into property value. The approach results in a property value estimate that reflects the decision-making process performed by a typical, well-informed potential buyer.
For the purpose of simplicity most loan underwriting where the analyst includes an estimate of value in the credit approval memorandum, the method used is that of direct capitalization. In direct capitalization, one single year’s income is converted into an estimate of value. Then it is just a matter of going through the steps.
Step #1: Estimate the Potential Gross Income (PGI). This is how much the property could take in if it was rented at full occupancy at market rents.
Step #2: Calculate Effective gross income (EGI). While the idea of 100% occupancy, and tenants that never miss a payment is a dream that both landlords and lenders wish was true, in reality vacancies and collection loss are a reality. Effective gross income (EGI) is the result of subtracting those expected losses from Potential Gross Income.
Step #3: Estimate the total operating expenses and deduct them from EGI to calculate Net Operating Income (NOI).
Step #4: Divide the resulting Net Operating Income by the capitalization rate to come up with the estimate of value. The capitalization rate is market driven and reflects the appetite of investors for that particular type of property investment.