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.
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 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 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 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:
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:
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:
Here is a four-step guide to using the income approach:
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.