Property appraisal plays a crucial role in real estate and investment decisions, serving as a cornerstone for understanding a property’s value in the market. The three recognized approaches to developing an opinion of value are the cost approach, the sales comparison approach, and the income approach (or income capitalization approach).
The income approach is a valuation method that estimates the fair market value of a property based on its ability to generate income. It is a foundational method for appraising income-producing properties such as rental homes, multifamily properties, and commercial buildings.
Using this method, real estate appraisers can offer valuable insights that can influence investment strategies and property management decisions. Though it may be especially beneficial for commercial appraisers, the income approach is useful for both residential and non-residential appraisers to have in their toolkits.
In this post, we’re providing a basic overview of the income approach to value, including the main steps involved, important terms, and key benefits and challenges. Additionally, we’re sharing helpful insights from real-world appraisers who answered our survey question, “What’s your best tip for using the income approach?”
Key Steps in the Income Approach
When using the income approach to appraisal, real estate appraisers calculate the net operating income (NOI) and then divide that number by a capitalization rate, or cap rate, to arrive at an indication of value.
The formula used in the income approach is:
NOI ÷ Cap Rate = Property Value
Here’s an overview of the basic steps involved:
Step 1: Estimate potential gross income (PGI) based on what the property should rent for at market level with full occupancy, plus any other income streams (e.g., vending machines, parking fees).
Step 2: Determine effective gross income (EGI) by accounting for vacancies and collection losses.
Step 3: Estimate net operating income (NOI) by subtracting operating expenses (including fixed, variable, and replacement expenses) from the EGI.
Step 4: Determine the appropriate capitalization rate (cap rate) using market-derived data from comparable property sales or investor expectations.”
Step 5: Divide the NOI by the cap rate to get an estimation of property value.
Important Terms and Concepts
Let’s dive deeper into some of the key terms and math concepts involved in the income approach.
Net Operating Income (NOI)
Net Operating Income (NOI) is the total income the property generates minus its operating expenses. These can include any maintenance and upkeep, insurance, property taxes, management fees, and utilities. Accurately calculating the NOI is crucial when using the income approach. Projections for both income and expenses must be realistic and grounded in market data.
Capitalization Rate (Cap Rate)
The capitalization rate, or cap rate, is the estimated rate of return on investment. The cap rate reflects the relationship between a property’s NOI and market value. A higher cap rate typically indicates a higher risk and a lower property value, while a lower cap rate suggests a lower risk and a higher value. Understanding how to determine the appropriate cap rate for different properties is essential for appraisers who employ the income approach.
Present Value of Future Income
The present value of future income refers to the idea that a dollar received today is worth more than a dollar received in the future. This concept underlines the importance of discounting future income streams to assess their current value as of the effective date of the appraisal.
Benefits and Challenges of the Income Approach
Key Benefits
The income approach offers several advantages, particularly for investors seeking income-producing assets. For one, it is highly objective, relying on a property’s financial performance rather than subjective factors. Additionally, it can be applied to a wide range of property types, reinforcing its relevance in diverse real estate markets.
The income approach is particularly effective for appraising properties with consistent income streams, such as apartment complexes and office buildings. It works especially well in markets with robust data on rental and cap rates.
Challenges and Best Practices
The income approach is generally considered to be the most complex and challenging to calculate among the three approaches to value. Some common challenges and limitations of this method include:
- Its dependence on accurate income and expense data, which can pose issues in markets where reliable information is scarce.
- The complexity of estimating cap rates, which can be tricky in certain market environments.
- The complexity of accurately projecting future income and selecting an appropriate cap rate can be challenging, particularly for appraisers new to income-based valuations.
- Its limited usefulness for appraising non-income-producing properties, such as primary residences.
Appraisers must also consider the condition of the property, as significant repairs or deferred maintenance can impact the net operating income and, ultimately, the property’s value.
To effectively use this method, real estate appraisers need to have a solid understanding of financial principles relevant to income-producing properties. They should be careful to gather accurate data on income and expenses, as well as rental and cap rates. In areas where reliable data is hard to come by, appraisers should proceed with caution.
Pro Tips for Using the Income Approach
Because the income approach can be quite challenging, we sought out pro tips from experienced appraisers. As part of our monthly survey series, we asked our community of real estate appraisers, “What’s your best tip for using the income approach?” Here’s what they said:
“Do your due diligence.”
“Make sure that you have a way to verify what you are being told. Does it seem reasonable in the market? If not, question it.”
“Thoroughly verify and cross-check income and expense data from multiple sources, such as historical property records, market surveys, and comparable properties, to build a defensible and realistic net operating income (NOI).”
“Get rental rate and expense information from multiple sources—rental management companies, Craigslist, Facebook Marketplace—in addition to the owner.”
“Always find out who is paying and responsible for the upkeep and repairs.”
“Get the leases in writing [via] email.”
“Using true rentals.”
“Being thorough, to check outside the ‘normal’ parameters for Comps and their characteristics.”
“To assure that you are reporting accurate subject property market rents. You don’t need subject property operating income statement as much as you need accurate property operating income statements from the comparable properties you select. MLS data is almost always projected, and information from agents is rarely verifiable. This is the challenge, and it’s a significant one at best.”
“Explaining the income approach to uninformed clients is best or easiest described as IRV. Income over rate equals value. Net annual income divided by a supported cap rate equates to the income approach to value.”
“Use the IRV formula.”
“I find it helpful to do a GRM analysis of your market areas annually to have those numbers handy and ready to go. When I run across SFR last with rental data in the MLS, I save the PDF of the listing and make note of the data given, then run a GRM study when I have sufficient information using all current listings and recently sold properties I have saved. This saves time when a SFR income property assignment comes across my desk and also helps with rental reconciliations in general as well as builds a robust rental comp database.”
“The income approach, aside from providing an indication of what kind of capitalization income a property can generate, also helps in the contrasting of the sales comparable approach value to see how close or how far apart the two methodologies are.”
“In a rural community, the income approach is often secondary to sales comparison because of lower population density and the lack of public rental data.”
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Comparing the Income Approach to Other Valuation Methods
When comparing the three valuation methods, the income approach emphasizes financial performance, while the sales comparison approach focuses on comparing nearby properties with similar characteristics. Meanwhile, the cost approach focuses on the cost of constructing a new or replacement property and is best suited for new developments or unique properties where comparable sales data is scarce.
Property appraisers may utilize multiple methods to arrive at an accurate valuation. They can often use one approach to value to support the valuation conclusions derived from another.
Conclusion
The income approach is a powerful tool for appraising income-producing properties, providing essential insights for appraisers, investors, lenders, and property owners. A thorough understanding of the income approach empowers appraisers to produce credible valuations that support informed decision-making for investors, lenders, and property owners alike.
Delve deeper into the income approach and other valuation methods with expert-authored appraisal courses from McKissock Learning.
