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:
- The cost approach, which determines value based on the costs of operating and upkeep
- The sales comparison approach, which relies on values from similar transactions in the same market and asset class
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:
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:
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.
Download our e-book to learn more about why leading investment management firms are leveraging deal management software to grow their portfolios.