Estimating Real Estate Value Using the Income Approach

Instructor: Ellen Gill

Ellen earned her juris doctor degree in 1984 and is licensed to practice law and teach real estate in Illinois.

Sellers use market value to set their list price. Buyers use it to decide the amount they will offer for a property. Learn how to estimate market value using one of the three long-established approaches to valuation, the income approach.

Choosing an Investment Property

Imagine you have $500,000 to invest and you wish to augment your earnings with rental income, so you look for an apartment building to buy. You find two desirable properties:

  • The first is not for sale, but you believe the owner may sell within your budget.
  • The second is $650,000 but the owner may reduce the price.

To help you choose which property to make an offer on and set the amount of your offer, you want to estimate the market value of each.

Market Value

Market value is not the final sale price or the cost of the land and improvements. It is someone's opinion of the most likely price the buyer will pay the seller in a fair sale where the buyer and seller are unrelated. A fair sale is one made in a competitive market with no unusual circumstances that could affect the price such as a defect in the property or a natural or economic disaster affecting the neighborhood.

Choosing a Valuation Approach

You can hire a real estate professional to estimate market value or you can estimate it using one of the three traditional approaches for calculating market value:

  1. the sales comparison approach,
  2. the cost approach, or
  3. the income approach - based on the property's net operating income and return on investment.

Real estate professionals prefer the income approach for rental income properties like apartment buildings, office buildings or shopping malls because the true value of such properties is in the income generated by them. Let's learn how to estimate market value using this approach.

Using the Income Approach

The formula for estimating market value using the income approach is:

Annual net operating income / capitalization rate = value

Make this calculation in the following five steps:

Step 1. Estimate the Property's Annual Potential Gross Income

To estimate the property's annual potential gross income, start with the monthly rental rate for each unit and add it all together. Then, multiply everything by 12 months to compute the annual rental income.

For example, to estimate the market value of an apartment building with three units renting at $1200 per month, four units renting at $1500 per month and two units renting at $2000 per month, add the monthly rent and multiply by 12 months per year to get an annual figure:

12 * ((3 * $1200) + (4 * $1500) + (2 * $2000)) = $163,200 annual potential gross income

Add any additional income from laundry and vending machines, parking fees to annual potential gross income.

Step 2. Calculate Effective Gross Income

Calculate effective gross income by subtracting expected rental loss, including known or expected vacancies and unpaid rent, from annual potential gross income. For example, if one lease at the rate of $1200 per month ends at the end of September, subtract three months' rent at that rate:

$163,200 - (3 * $1200) = $159,600 effective gross income

Step 3. Calculate Net Operating Income

Calculate net operating income, which is effective gross income minus annual operating expenses. In this step, add up all annual operating expenses including real estate taxes, utilities, insurance, maintenance and repair costs, administrative costs, and professional services costs for items such as decorating, legal, accounting, advertising and management.

Do not include mortgage principal and interest in annual operating expenses. However, you can subtract a reserve for capital expenditures. If total operating expenses for the example property are $126,000 and you add an $8,000 reserve for capital expenditures, net operating income is $25,600:

$159,600 Effective Gross Income -$126,000 Total Operating Expenses - $8,000 Capital Expenditures Reserve

= $25,600 Net Operating Income

Step 4. Estimate the Capitalization Rate

The capitalization rate is the rate of return or yield an investor expects from an investment, in our example, a small apartment building. You can estimate the capitalization rate by asking other investors or real estate investment professionals for their opinion, or you can calculate a capitalization rate for your property using information from comparable properties. To calculate the capitalization rate, divide the net income of a comparable property by its most recent purchase price.

For example, your friend owns an apartment building in the neighborhood with 10 units renting at between $1500 to $2200 per month. If you don't know the precise number of units at any given monthly rate, you can average it out. The average of $1500 and $2200 is $1800.

Multiply that average by the number of units and then by 12 to get an estimated annual gross income of $222,000.

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