Loading the player...

WHAT IS AN 'Income Approach'

Income approach is a type of 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

BREAKING DOWN 'Income Approach'

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. 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.

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 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 percent 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.

RELATED TERMS
  1. One Percent Rule

    The one percent rule is a rule of thumb used to determine if ...
  2. IRS Publication 527 - Residential ...

    An Internal Revenue Service (IRS) document providing tax information ...
  3. Cost Approach

    The cost approach valuation method recommends the price a buyer ...
  4. Tangible Personal Property

    Tangible personal property is a tax term describing personal ...
  5. Form 4797

    Form 4797 is a tax form distributed by the Internal Revenue Service ...
  6. Commercial Property

    Commercial property is buildings and land that are intended for ...
Related Articles
  1. Investing

    What You Should Know About Real Estate Valuation

    Accurate real estate valuation is important to mortgage lenders, investors, insurers, and buyers and sellers of real property.
  2. Investing

    4 ways to value a real estate property

    Here are several approaches to evaluate real estate properties for investment purposes.
  3. Investing

    Investing in Rental Property: What to Consider

    Investing in rental property has some unique issues which need to be considered.
  4. Investing

    Tips for prospective landlords

    Investing in rental property can generate serious income, but there's more to it than collecting rent. Check out all the pros and cons before you invest in the rental property.
  5. Investing

    Learn to Value Real Estate Investment Property

    Make sure you know what your real estate investment is worth before you sign the ownership papers. Learn what capitalization rate means to your net operating income.
  6. Investing

    Including Rental Real Estate in Your Portfolio

    Why you should consider adding rental properties to your retirement investment portfolio.
  7. Investing

    10 Tips for Buying Your First Rental Property

    Buying a property for rental income is a bit different than buying a home to live in.
  8. Investing

    8 Must-Have Numbers For Evaluating A Real Estate Investment

    These calculations can help you figure out if a particular property will be a valuable investment.
Trading Center