The Income Approach to Property Valuation

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

The income approach to property valuation is a useful tool for investors to evaluate income producing real estate. We will discuss the three major formulas that comprise the approach.

Income Approach Definition

Bill wants to buy a rental property. Since this won't be the house where he lives, his main concern is making a profit. An investor's point of view on value is often different than a retail buyer. Bill might be willing to overpay for his own house, but a rental should be treated as a business decision. An income approach for appraisal is an ideal method in this case.

The income approach to property valuation is suitable for income producing real estate. It weighs the potential income of the property to the purchase price. Within the approach, there are three common techniques. These include direct capitalization, discounted cash flow, and gross income multiplier methods.

Direct Capitalization

Direct capitalization is calculated by dividing the net operating income by the desired capitalization rate (cap rate). The capitalization rate formula is:

capitalization rate = net operating income / sale price

Net operating income for a rental house is:

rents - mortgage interest - depreciation - reserve funds for future expenses

If the net operating income a property is $4,000 per year and it will sell for $150,000, the cap rate is 2.66%. If the same property brought in $6,500 per year, the cap rate would be 4.33%.

To find the direct capitalization value, let's take that $6,500 net operating income and divide it by a goal cap rate of 6%. The direct capitalization method tells us that the investor should not pay more than $108,333.33. With the current level of income, that is how much the house has to be bought for to meet the 6% cap rate goal.

Discounted Cash Flow

The discounted cash flow method is mathematically the same as the net present value formula in other types of investing. It is the sum of the present values of rents over a period of time. Present and future values can be quickly and easily calculated using spreadsheet software or financial calculators. The investor would be interested in purchasing an income producing property if the present value of the expected future rents over a desired time period is greater than the purchase price.

Let's say in a given property the present value of all the future net income in a desired 5 year investment period is $75,000. Under those conditions, an investor would not want to pay anything more than $75,000. That would mean the property could break even in 5 years. Every dollar below that amount increases the profit margin and drops the break even time line..

Gross Income Multiplier

The gross income multiplier method is a ratio of the selling price over the gross monthly rent:

selling price / gross monthly income = gross income multiplier

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