The Income Capitalization Approach for Appraisals

Instructor: Ian Lord

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

Every real estate investor needs to know the potential investment returns of a property before buying. The income capitalization approach to appraisals helps investors figure out a maximum purchase price for a particular rental property.

Income Capitalization Approach Definition

Sarah decides she wants a rental real estate investment that provides her with a monthly income. She wants something to diversify her current investments in stocks and bonds. Because she feels she is taking on more risk by putting her money in one single property, she wants to be compensated well for that risk. She would like to earn an amount equal to 8% of the purchase price each year. So how much should she pay for a given house to ensure that return?

The income capitalization approach to appraisal assigns a property value based on the estimated returns of a property. The appraisal determines the market value of a property. For Sarah, this number is the maximum allowable purchase price if she wants to achieve her desired rate of return. The appraisal method could be calculated by a professional appraiser, but it's more likely that Sarah and her agent will go over these numbers to sort through properties on their own.

Income Capitalization Approach Formula

The income capitalization approach formula is Market Value = Net Operating Income / Capitalization Rate. Let's help Sarah get a better idea of what these terms mean.

Net Operating Income

Sarah finds a house in a great area. Similar houses in the neighborhood rent for \$1,200 a month. If she can keep the place rented year round, she can expect an annual gross revenue of \$14,400. But there are always expenses. Even if she doesn't get a mortgage and pays all cash for the house, there are expenses. Property taxes, insurance, and repairs all cut into that income. Items like taxes and insurance are relatively fixed, but repairs generally have to be estimated. These essential, unavoidable expenses are operating expenses. Sarah can calculate the net operating income (NOI) by subtracting the operating expenses from revenue.

Other types of property have additional sources of revenue and expenses. Consider an apartment building. There may be income from vending machines or parking fees. The landlord may pay some of the utility bills or maintain common areas, like pools or gyms.

The NOI formula is NOI = Revenue - Operating Expenses

Capitalization Rate

Capitalization (or cap) rate refers to the return of an investment in comparison to its value, or capital. A high cap rate means the property generates more income in proportion to the amount of capital. A low rate means less income in proportion to property value. Remember when we said Sarah wants an 8% return? The easy way to imagine this is for every \$100 of property value Sarah should receive \$8 of net income.

She can use the 8% figure as her cap rate in the income capitalization approach formula. Let's pretend she has a specific price in mind. If she knows the value and knows the estimated operating expenses she can solve for the cap rate. Notice anything familiar about the cap rate equation? The formula Cap Rate = NOI / Value gives us the reverse of our appraisal formula!

Investor Application

Time for Sarah to crunch numbers! She gathers information about the property taxes from the sales listing and gets an estimate from her insurance company for the property she is considering. The taxes are \$3,000, and the insurance is \$600 each year. She lives in a similar house and knows that it costs about \$1,000 a year to maintain the home. Being cautious, she decides to add another \$500 to account for tenants being harder on the property.

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