The income approach is one of three methods used by real estate appraisers to determine the value of a property. The income approach is more sophisticated than the other two techniques, and as a result, many real estate novices find it puzzling. We’ll go over the income approach to property valuation step by step in this article and what you will need to know as an agent and come exam day.
What are the 3 Approaches to Value?
There are three different main approaches that appraisers use while they make an appraisal. They are:
- Market Data Approach, which is also commonly called the sales comparison approach
- Cost Approach, also referred to as summation
- Income Approach, which is also known as capitalization
Each method has its own set of benefits. When applied together, the various valuation methods provide the best estimate of the value of the income-producing real estate under evaluation. However, it is not always advisable to go through each one. As a result, the income approach is most typically employed to appraise real estate, especially in the early assessment phases.
What is the Income Approach?
The income approach is a process used by appraisers to determine the market value of a property based on its income. The approach is based on the finance concept of discounted cash flow analysis. Under the income method, the property’s current worth is the present value of the future cash flows that the owner can expect to receive.
This method is most prevalent for commercial properties with tenants because it relies on rental income. It’s calculated by dividing the rent collected net operating income (NOI) by the capitalization rate.
What is the Income Approach Formula?
The formula for the income approach is:
Net Operating Income / Capitalization Rate = Market Value
How to Use the Income Approach
To comprehend the income capitalization strategy, we must first understand two other fundamental real estate concepts: net operating income and capitalization rate.
Net Operating Income
After deducting operating expenses but before deducting capital expenditures, debt service, and taxes, net operating income is the net income in a particular period. The formula for calculating net operating income is as follows:
Effective Gross Income – Operating Expenses = Net Operating Income
The appraiser will require access to income and expense accounts for the subject building and similar structures in the neighborhood to estimate net operating income. Having that information on hand allows the appraiser to assess the building’s income and expenses accurately. Remember that all income and expenses are always annual values with the income capitalization approach.
The actual procedure of estimating net operating income can be broken down into four steps:
- Estimating the potential gross income. The money generated by the building when it is rented at 100% occupancy, at market rent, lease rent, or a combination of the two, is known as potential gross income. The rent generally charged for that type of space in the marketplace is known as market rent. The term lease rent can also refer to scheduled or contract rent. Income from all sources, such as the laundry machines in an apartment building or separately rented parking spaces, is included in potential gross income.
- Subtract the amount of vacancy and collection loss from the possible gross income. This figure, is commonly given as a percentage, is the appraiser’s estimate based on the market for similar structures in the area. It represents the average loss of income caused by nonpayment of rent and periodic vacancies. At this point, additional income, such as from an antenna rental on the building’s roof, is added in to arrive at effective gross income.
- Estimate all building costs and deduct them from the effective gross profit. There are three types of construction costs: fixed, variable, and reserves. Property taxes and insurance are examples of fixed expenses that do not alter with the occupancy of the building. Variable expenses include almost all additional costs, which may fluctuate depending on the building’s occupancy. Snow removal, utilities, management fees, and other costs are among them.
- Subtract the estimated expenses from the effective gross income. Then, you will have the net operating income!
What is a Capitalization Rate?
With your net operating income, all that’s left to do is find your capitalization rate.
A capitalization rate is comparable to a rate of return in that it represents the proportion of income that the investors expect to get from the building. Appraisers learn to compute capitalization rates in various techniques, luckily on the real estate exam, the capitalization rate is usually given, or there’s a problem with enough information for you to find the cap rate with using basic algebra.
If you would like to find the capitalization rate in real life you need recent comparable sales, such as buildings similar to the subject property being evaluated. On the exam however, you’ll see a question with the properties value and net operating income and you’ll have to find the capitalization rate. Luckily this is way easier then it sounds, so lets do some examples.
Income Approach Examples
If you have an income approach question on the exam, you’ll see a question asking for the capitalization rate or the properties value. First lets do the capitalization rate problem.
In order to find the capitalization rate you just have to use basic algebra. Here’s a simple example:
A property sold for $1,000,000 and had an NOI (Net Operating Income) of $100,000. Find the capitalization rate.
Remember our formula from earlier. Net Operating Income / Capitalization Rate = Market Value
Knowing this, all we need to do is take our numbers and put them into the formula. We have the Net Operating Income – that’s $100,000 and we have the Market Value – that’s $1,000,000. To find the cap rate we just have to divide. So $100,000/$1,000,000 this gives us .1 or 10%.
10% is our capitalization rate. Its that easy!
Another income approach example you may see on the exam is finding the properties value. These problems are a bit more complicated then the last one.
Here’s an example:
A property with a 15% cap rate, an effective gross income of $100,000 and operating expenses of $25,000. Find the Market Value using the Income Approach.
For this one we need to find Net Operating Income before we can find the Market Value. Let’s take a look at our two formulas.
Net Operating Income / Capitalization Rate = Market Value
Effective Gross Income – Operating Expenses = Net Operating Income
First we have to take the Effective Gross Income and subtract it by the Operating Expenses. So let’s do that.
$100,000 – $25,000 = $75,000
Great! Now we have our Net Operating Income. From there we can plug in our numbers from the first formula. Luckily they already gave us our cap rate, so with our Net Operating Income all we have to do is divide.
$75,000 / .15 (or 15%) = $500,000
$500,000 is our Market Value and our answer!
What to Know as a Real Estate Agent
As a real estate agent, it is essential to know all three approaches to value when appraising real estate. For the income approach, keep in mind what type of property you are working with. Remember, the income approach can be used in commercial real estate buildings such as offices, shopping complexes and can even be used for rental properties.
What to Know for the Real Estate Exam
When it comes time for exam day, remember that the income approach is a process used by appraisers to determine the market value of a property based on its income. You must understand the two formulas we went over today and how to use them. Remember:
Net Operating Income / Capitalization Rate = Market Value
Effective Gross Income – Operating Expenses = Net Operating Income
Know this, you will be sure to ace the exam!
Still confused? For a quick simple recap, watch our Income Approach video featured in our Daily Real Estate Vocab Series:
This is an awesome explanation! Thank you!