The ground rent capitalization method is most applicable when appraising which of the following

In general, the most common reason an appraisal is done is to determine market value for a potential sale or purchase. However, there are more specific situations (e.g., an exchange, partial taking, estate taxes, gifting, environmental constraints) that may also require an appraisal.

The appraisal techniques used for these specific situations are the same; the sales comparison approach, the cost approach and the income capitalization approach. Depending on the specific circumstances it may be that one or more of the techniques is more appropriate than the other(s). This determination is made by the appraiser and should be explained in the analysis of valuation in the final report.

Appraising Market Value of Timber Only

For merchantable and non-merchantable timber the sales comparison approach and income capitalization approaches are generally the most applicable. For non-merchantable timber the cost approach can also be used.

Appraising for a Timber Sale

When a valuation is being done for a timber sale you are generally appraising market value. In this case the income capitalization approach is most applicable. If you are having an appraisal done to submit a bid the sales comparison approach is probably the best indication of value because it accounts for competition in the market.

Appraising for Timber Damages

When a valuation is being done for a timber trespass, fire, or other casualty the income capitalization approach is the most applicable. This method can be used to arrive at a before and after valuation. The sales comparison approach can also be used.

Appraising for an Exchange (Section 1031 Transaction)

Timber Only Exchange — For a timber exchange the income capitalization approach is the preferred method. It accounts for any physical differences between tracts such as species mix, grade, logging costs, access, etc. However, there are certain circumstances when the sales comparison method must be used; either when public timber is involved, part of a legal dispute, or when it is part of an estate.

Entire Property — If all parties agree that each property must be valued at market value, then all three approaches can be used. If use value is the only concern then the cost and income capitalization approaches give the best indications of relative value differences.

Appraising for Section 631 Capital Gains Treatment

When a valuation is being done for purposes of Section 631 of the Internal Revenue Code market value is the primary goal. This applies only to merchantable timber.

Section 631(a) — When appraising for Section 631(a) the market value of the timber must be determined as of the first day of the tax year in which the timber was cut, irrespective of when the timber was actually harvested during the tax year. Either the sales comparison or income capitalization method can be used. The sales comparison method is more likely to capture the full effect of market changes over the entire tax year.

Section 631(b) — An appraisal is not needed when a Section 631(b) election is made. Market value is determined by a contractual agreement in which the seller is paid a stated amount per unit harvested.

Appraising for Gifting Purposes

The Internal Revenue Service rules require that all three appraisal methods be used if appropriate. The report must be done to USPAP standards in a stand alone or summary format. And if the gift is to a charitable organization, Form 8283 must accompany the appraisal report with the appropriate sections completed by the appraiser.

Appraising for an Estate Tax Return

The market valuation of forestland for an estate tax return is no different from appraising for a sale or liquidation. Section 2032A (Valuation of certain farm, etc., real property) of the Internal Revenue Code permits certain real property to be valued for Federal estate tax purposes on the basis of its "current use" rather than at "highest and best use." This is commonly termed "special use valuation."

Real property may qualify for special use valuation if it is located in the United States and is devoted to either (1) use as a farm for farming purposes or (2) use in a closely held trade or business other than farming. In either case there must be a trade or business use.

The term "farm" includes orchards and woodlands. The term "farming purposes" includes the planting, cultivating, caring for, or cutting of trees, or the preparation (other than milling) of trees for market.

In making the election, two valuations must be determined for the affected property: special use value and market value. With respect to woodlands, either bare land or standing timber or both may be specially valued. Timberland special use valuation procedures must follow the general special use valuation rules applicable to farms, as set out in the IRS regulations. No valuation procedures specifically applicable to woodlands are provided. Two methods of farm valuation are described: the "farm method" and the "multiple factors method."

Farm Method

The farm method is determined by dividing the average annual gross cash rental for comparable land used for the same purpose and located in the locality, minus the average annual property tax for such land, by the average annual effective interest rate for all new Federal Land Bank loans. For purposes of the preceding sentence, each average annual computation shall be made on the basis of the 5 most recent calendar years ending before the date of the decedent's death.

Multiple Factors Method

If no comparable rented timberland can be documented, the executor may elect to value the property using the multiple factors method.

The regulations list the following five factors. (the method explained under each of the factors is the procedure that can be used to determine value)

Factor 1. The capitalization of income which the property can be expected to yield for farming or closely held business purposes over a reasonable period of time under prudent management using traditional cropping patterns for the area, taking into account soil capacity, terrain configuration, and similar factors.

Determine the present value of annual as a sustainable harvest with the first harvest 11 years out, one year after the moratorium is over. A site specific capitalization rate is used which is a combination of 10 year stumpage appreciation and average growth.

The discounted cash flow model from the income capitalization approach is used to arrive at net present value of 1 acre of bare forest land for each productivity class represented, then a weighted average is calculated. The discount rate used is a combination of average inflation, growth and stumpage appreciation.

Factor 3. Assessed land values in a State which provides a differential or use value assessment law for farmland or closely held business.

Some states have forest land assessed at values set by statute to match the productivity classes of timberland.

Factor 4. Comparable sales of other farm or closely held business land in the same geographical area far enough removed from a metropolitan or resort area so that nonagricultural use is not a significant factor in the sales price.

It is important that "bare forest land" values are used if available, and that these comparables are zoned for forest use only.

Factor 5. Any other factor which fairly values the farm or closely held business value of the property.

Appraise the immediate harvest value of all merchantable timber and discount for the holding period of 10 years. Immature timber stands should be valued using the income capitalization approach.

The final step in the Five Factors Method (Section 2032A appraisal) is to average the factors into a final indication of value.

Average the results of factors 2, 3, and 4 then expand by total acres to arrive at total value of land.

Average the merchantable timber value from factors 1 and 5.

Add (1) and (2) above and add results to the immature timber value from factor 5 to arrive at final special use value of the property.

The IRS has ruled that each factor relevant to the valuation must be applied, although, depending on the circumstances, certain factors can be weighed more heavily than others. (Revenue Ruling 89-30) Technical Advice Memorandum 9328004 discusses the applicability of the multiple factors method to woodlands and how it is to be used to specially value forest property.

One critical detail investment managers must determine early on in the deal review process is the property’s value. The income approach to appraisal allows investors to calculate a property’s market value based on the income it’s currently generating. With an informed understanding of the cash flow a property can generate, investors can determine if a deal aligns with their goals and criteria. Read on to learn more about the income approach to appraisal.

What is the Income Approach to Real Estate Appraisal?

The income approach to appraisal  is one way to value a property while analyzing a deal. Because it’s based on the income a property generates, investors seeking to determine immediate cash flow can gain a deeper understanding of the value it can deliver within their portfolio immediately.

Income Approach Formula

To calculate a property’s value using the income approach, investors follow the formula below:

Net Operating income/Capitalization Rate= Value

Depending on a number of factors, investors may choose to follow the income approach or other valuation methods like: 

While the income approach can be revelatory when considering commercial buildings occupied by tenants, it’s not applicable to owner-occupied buildings. Instead, the income approach is most relevant for buildings owned by landlords with the goal of generating profits.

The income approach to appraisal encompasses both the direct capitalization method and the yield capitalization method. While both methods follow the idea that income determines value, the direct capitalization method considers the current cash flow value, while the yield capitalization method factors in year-over-year rent growth and cost fluctuations. 

The Direct Capitalization Method for Income Approach Appraisal

The direct capitalization method determines a property’s value based on income in a 1 year timespan. It assumes that both costs and income will remain the same from year to year. Because of this assumption, it’s most suitable for properties that generate consistent income from year to year. As you continue to compare properties using the direct capitalization method, be sure to remain consistent with assumptions factored into the NOI calculation.

The direct capitalization method formula is straightforward. First, calculate the net operating income based on a pro forma model. Then, find the cap rate for the appropriate market and asset class. Finally, divide the net operating income by the cap rate.

The result of this calculation is the property’s value based on the direct capitalization method.

The Yield Capitalization Method

The yield capitalization method of the income approach to appraisal factors in different considerations and goals. Instead of calculating the property’s value based on one year of income, the yield capitalization method acknowledges that many investors purchase real estate with the goal of long-term gains in a volatile, ever-changing market. For this reason, it factors in year-to-year fluctuations in costs, like maintenance and development, as well as vacancy rates and rent. Ultimately, investors strive to determine the projected value at the time of sale by including these considerations. As a result, the yield capitalization method is the preferred income approach for properties with a higher potential for volatile fluctuations.

To calculate the net operating income, create or reference a pro forma cash flow statement for the period in which you’re holding the property. Be sure to factor in assumptions about vacancies, operating costs, the predicted holding period, and other variables that could influence the net operating income. Then, use the net operating income figure for the final year of the pro forma, or the holding period.

Then, find the terminal cap rate based on market comparables, projected for the end of the holding period. Finally, divide the NOI in the final year of the holding period by the cap rate to find the property’s value based on the yield capitalization method.

Income Approach to Appraisal Example

Let’s take a look at one example of the income approach, using the direct capitalization method. For the sake of this income capitalization example, assume the property generates stable cash flow with the following values:

• Revenue: $300,000
• Operating costs: $75,000
• Market cap rate: 5.5%

To find the net operating income, first subtract the operating costs from the revenue:

$300,000-$75,000=$225,000

Based on this information, the net operating income is $225,000.

Then, convert the market standard cap rate for similar properties of 5.5% to a decimal: 0.055.

Finally, divide the net operating income by the cap rate: 

$225,000/0.055= $4,090,909

Based on this direct capitalization example, the property’s value is $4.09 million.

Factors to Remember When Using the Income Approach

Should you rely on the income approach, the cost approach or the sales comparison method? Each method to valuing real estate comes with its own set of assumptions and potential oversights. Different investment strategies call for unique approaches, so the ideal approach varies depending on investors’ preferences, goals and other property-specific factors.

These are some of the most important considerations to keep in mind:

• As mentioned above, the income approach is not suitable for owner-occupied buildings used for business purposes, given that it predicts value based on revenue
• Calculating the net operating income can be challenging given the uncertainty behind operating expenses
• The property may have specific defects, vacancies or other conditions that should be represented in the calculation 
• Identifying the appropriate cap rate to use can be challenging, given the number of variables included in both the market and particular property. However, leveraging a deal management platform with readily available analytics streamlines this process

The Tools Required to Review More Deals at Scale

As you source, value and make informed investment decisions about new deals in your pipeline, taking the time to manually calculate, track and maintain access to data can take a toll on your firm’s time.

That’s why firms like Blackstone, Oxford Properties and others have employed deal management software to approach new opportunities in a data-driven manner.

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