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Reconciliation to Indicated Value by the Income Approach

Instructor: Janice Chretien
In this lesson, you'll learn how to perform reconciliation to indicated value by the income approach to property valuation. The formula for the income approach to property valuation will be explained and demonstrated.

The Income Approach

Judy has been dreaming of building a portfolio of income-producing real property for years. The time has come. Today, Judy found her first rental property of many that she will own.

Judy has hired Joe from Shiny Side Appraisers to assess the value of her investment. Joe explained to Judy that he would be using the income approach to appraise the property.

The income approach is a value approach used for properties that produce income for the owner. Income-producing properties include duplexes, apartment building, and single-family rentals. The income approach will help Judy assess if she will profit from the rental property. Also, her lender will use the income approach to estimate the risk of extending a loan to Judy.

The IRV formula is used to estimate value:

net operating income (I) / capitalization rate (R) = estimated value (V)

The formula can be worked in three simple steps:

  1. Estimate the net operating income
  2. Determine the capitalization rate
  3. Apply the IRV formula

First, the net operating income is estimated by:

potential gross income = income generated when rented at the market rate

- vacancy and collections based on the normal market rate

= effective gross income

- all expenses (fixed, variable, and reserve)

= net operating income

Second, the capitalization rate is determined by:

net operating income / sales price = capitalization rate

Third, apply the IRV formula:

net operating income (I) / capitalization rate (R) = estimated value (V)

An Example of Value by the Income Approach

The property Judy is interested in purchasing is $98,000. The records provided by the current owner indicate that the net operating income is $12,000.

capitalization rate = $12,000 / $98,000 = 12.24%

I / R = V

$12,000 / 0.1224 = $98,039

Let's assume in the same scenario, the net operating income was not available. The appraiser, Joe, can determine the capitalization rate based on sold comparable properties. Joe estimated the capitalization rate at 12%. We can calculate the income using the IRV formula:

I / R = V

I / 12% = $98,000

Multiply both sides by 12%

(0.12) I / 0.12 = $98,000 (0.12)

I = $98,000 x 0.12

I = $11,760

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