How to Use the Income Approach in Real Estate Investment
The income approach is one of the few generally accepted types of property valuations that commercial real estate appraisers use. Compared to the other two – the cost approach and sales comparison approach – the income approach is the most important determinant in the early stage of real estate analysis since the valuation prioritizes the income a property generates.
This method allows a real estate investor to determine the current cash flow of a property and if it aligns with their investment goals and strategy. In this article, we delve deep into what the income approach is and how to use it in real estate investment.
Main Types of Property Evaluations
Property valuations, or the estimated fair market value, are used by assessors and appraisers to value real estate assets. If you’re thinking about diversifying your real estate investment portfolio, it’s important to understand the basic concepts of real estate valuation.
There are three main techniques to value real estate property. These are:
- The cost approach
- The sales comparison approach
- The income approach
The Cost Approach
The cost approach to value mainly applies to commercial properties, including special-use properties and new construction properties. The cost approach values by adding the cost to acquire land and the cost of improvements and subtracting any accrued depreciation or adjustments.
Depreciation is the loss in value of an asset from any cause and can take the form of functional obsolescence, economic obsolescence, or physical deterioration. The underlying principle of the cost approach is that a potential real estate investor won’t, or shouldn’t, pay more for a property than it would cost to build an equivalent.
The Sales Comparison Approach
The sales comparison approach focuses on examining comparable transactions with the market you’re considering. As an investor, it’s worth looking at how other sales of properties of a similar size, year of construction, tax classification, and quality within the same market are being valued to inform your decision to invest.
With this valuation method, investors take into account various aspects of the “comparables”, including sales price per square foot and cap rate, to arrive at a reasonable valuation.
The Income Approach
The income approach to value helps investors accurately determine the value of any income-producing property. Among the three, this method is considered the most applicable due to the amount of data available.
By determining how much income a property would generate, an investor can project the future earnings from the property. Income-producing property refers to any property that generates an income stream. These include:
- Nursing homes
- Agricultural land
- Service stations
What Is Income Approach?
The income approach to valuation is a methodology appraisers use to estimate a property’s market value based on the current income of the property, that is, net operating income (NOI).
Also termed income capitalization or capitalization approach, the income approach factors in the costs incurred by an investor on an asset through maintenance works and repairs.
The income approach formula goes like this:
Net Operating Income / Capitalization Rate = Value
The capitalization rate is the percentage of the investor’s current return on investment (ROI) and is calculated as:
Capitalization rate = Net Operating Income / Current Asset Value
To find the net income:
Net Operating Income = Gross Income – Operating Expenses
With the income approach valuation technique, investors use the capitalization rate to determine the actual income of the investor after expenses or costs.
Keep in mind that the accuracy of the value depends on the validity of the assumptions used to estimate its key variables.
There are two types of income approach:
- Direct capitalization is used to estimate a property’s value based on a single year’s income forecast. The method assumes that costs and income will remain constant from year to year. That makes it more suitable for properties that generate consistent income from year to year.
- Yield capitalization. Like a cash-discounted cash flow analysis, this method uses a series of future incomes. It factors in the year-to-year fluctuations in costs, including development, maintenance, vacancy rates, and rent. The result is projected returns at the time of purchase, making it more suitable for volatile investments with higher possibilities of fluctuations.
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How to Use Income Approach in Investment
So, how does the income approach work?
As earlier mentioned, the income approach is typically used for income-generating properties. With this method, the investor utilizes the estimation of the income the investment property will generate over the entire time the investor owns it, along with other factors to determine whether they may profit from the property.
Some of these factors include:
- The property’s condition. If the property needs large repairs or excessive maintenance, you risk a substantial cut in future profits.
- Vacancy rates. How many unrented units are currently sitting unoccupied?
- Non-paying tenants facing economic difficulties.
- The operating efficiency of the property will also determine your net operating income.
Here is a four-step guide to using the income approach:
- Estimate the gross income for the property of interest.
- Calculate your income stream: Estimate projections in vacancy and collection losses and operating expenses and deduct the amount from potential gross income. Add any miscellaneous revenue you might generate from the property, such as income from parking and vending machines or forfeited rent. This will give you the income to be capitalized.
- Choose the most appropriate capitalization method.
- Select a capitalization multiplier or rate and apply it to the income to be capitalized (net income) to generate a value indicator.
- The income approach valuation method in real estate investment is largely based on projections. For this reason, if you’re too optimistic about the numbers, you risk losing money. It’s advisable to use a realistic, market-proven cap rate that is supported by recent sales or justified by data. Therefore, consider working with a property manager and researching the market rents in the location.
- Carefully examine the property condition when estimating expenses as this will impact your net income.
- Also, pay attention to operating efficiency and vacancy rates to determine the estimated profits from the property.
- Know the tenants, their financial health, and the occupancy history of the property.
- The more data you have, the better your assumptions and the more accurate your valuation will be. However, be sure to verify every data source to confirm the numbers. Don’t simply trust an acquaintance’s word of mouth.
If you don’t feel confident using the approach yourself, consider working with a certified property appraiser. These professionals understand the assumptions behind the income approach to value, the steps involved in finding multipliers and rates, and the different capitalization methods.