Income Approach

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What is the 'Income Approach'

The income approach is a real estate appraisal method that allows investors to estimate the value of a property by taking the net operating income of the rent collected and dividing it by the capitalization rate. The income approach is typically used for income-producing properties and is one of three popular approaches to appraising real estate. The others are the cost approach and the comparison approach.

BREAKING DOWN 'Income Approach'

When using the income approach for purchasing a rental property, an investor considers the amount of income generated and other factors to determine how much the property may sell for under current market conditions. In addition to determining whether the investor may profit from the rental property, a lender will want to know its potential risk of repayment if it extends a mortgage to the investor.

Determining Capitalization Rate

When determining the property’s net operating income (NOI), an investor uses market sales of comparable properties for choosing a capitalization rate. For example, when valuing a four-unit apartment building in a specific county, the investor looks at the recent selling prices of similar properties in the same county.

After determining a capitalization rate, the investor adjusts the rate based on the property’s characteristics. For example, the property may have higher-quality tenants than other nearby properties, which would slightly reduce the capitalization rate. On the other hand, the property may be less appealing than others in the area, which would slightly increase the rate. The capitalization rate should be set within 50 basis points of the market average. For example, an average market capitalization rate of 8% most likely values the property between 7.5% and 8.5%.

After calculating the capitalization rate, the investor can divide the rental property’s NOI by that rate. For example, a property with an NOI of $700,000 and a chosen capitalization rate of 8% is worth $8.75 million.

Other Property Considerations With the Income Approach

When using the income approach for purchasing a rental property, an investor must also consider the condition of the property. Potential large repairs that may be needed can substantially cut into future profits.

In addition, an investor should consider how efficiently the property is operating. For example, the landlord may be giving tenants rent reductions in exchange for completing yardwork or other responsibilities. Perhaps specific tenants are facing economic difficulties that should turn around in the next few months, and the landlord does not want to evict them. If rent being collected is not greater than current expenses, the investor will most likely not purchase the property.

An investor must also ascertain how many units on average are empty at any given time. Not receiving full rent from every unit will affect the investor’s income from the property. This is especially important if a property is in great need of repairs and many units are vacant. If the units are not filled on a regular basis, rent collection will be lower than it could be, and purchasing the property may not be in the investor’s best interest.