What is Income Approach?
The Income Approach is a valuation method used by real estate appraisers to estimate the fair market value of a property based on the income it can generate.
Under the income approach, the implied valuation is determined by dividing the capitalization rate (or ”cap rate”) by the net operating income (NOI) of a rental property.
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How to Calculate Income Approach in Real Estate Valuation
The income approach, under the specific context of real estate valuation, is a method used by appraisers to determine a property’s market value based on its income.
The income approach, or “capitalization approach”, states that the value of an investment property is a function of the quality and quantity of the income it is expected to generate.
The estimation of an income-producing property is performed via capitalization, where the present income of a property is adjusted by an appropriate rate of return to estimate the true value of an income stream.
Because the capitalization approach is the process of converting an anticipated stream of income into a market value indicator, the term is often used interchangeably with the income approach.
- Net Operating Income (NOI) → The net operating income (NOI) is a real estate metric representing a property’s operating income, minus the operating expenses incurred in a period. The NOI is most frequently calculated on an annual basis, and thus reflects the future revenue (and profit potential) of a property. NOI is unaffected by discretionary financing decisions.
- Capitalization Rate → The capitalization rate (or “cap rate”) is a fundamental real estate metric calculated by dividing the net operating income (NOI) of a property by its asset value. The cap rate concept can be thought of as the implied yield on a property investment in one year.
How Does the Income Approach Appraisal Work
The income approach is among one of the three primary methodologies that appraisers utilize to make an appraisal.
The two other methods, aside from the income approach, are the following:
- Sales Comparison Approach (SCA)
- Cost Approach
The income approach treats the net operating income (NOI) of a property as a perpetuity, i.e. a constant stream of cash flows discounted using an appropriate required rate of return based on the market.
The aforementioned hurdle rate is formally termed the market capitalization rate, or “market cap rate”. The market cap rate is the rate of return used as of the present date to capitalize future income into a market value as of the present date.
Under the income approach, the value of a property is the present value (PV) of its future cash flows that the owner expects to receive, akin to the discounted cash flow analysis (DCF).
Notably, there are three assumptions that underpin the income approach method.
- Long-Term Investors → The market participants purchase properties for their potential to generate future income and provide long-term benefits.
- Rational Market → The investors in the market are rational in that the quality and quantity of the property’s anticipated income stream are closely considered.
- Time Value of Money (TVM) → The time value of money (TVM)—the premise of fundamental intrinsic value—states that “a dollar today is worth more than a dollar received on a future date”.
Income Approach Formula
The income approach formula to determine the market value of a property is as follows.
Where:
- Market Value = Net Operating Income ÷ Capitalization Rate
- Net Operating Income (NOI) = Effective Gross Income – Operating Expenses
Therefore, a property’s appraised market value, under the income approach, is estimated by dividing net operating income (NOI) by the market capitalization rate.
- Net Operating Income (NOI) = Potential Gross Income (PGI) – Vacancy and Credit Losses – Operating Expenses
- Market Cap Rate = Net Operating Income (NOI) ÷ Current Property Market Value
Common operating expenses deducted from net operating income (NOI) include the following:
- Property Insurance
- Property Tax
- Maintenance Costs
- Repair Fees
- Utilities
