Loading the player...

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.

  1. Investment Property

    An investment property is a real estate property purchased with ...
  2. Net Operating Income - NOI

    Net operating income (NOI) is a company's income after operating ...
  3. Sales Comparison Approach - SCA

    A real estate appraisal method that compares a piece of property ...
  4. Form 4797

    A tax form distributed by the Internal Revenue Service (IRS) ...
  5. Earning Assets

    Earning assets are an income-producing investment owned by a ...
  6. Personal Property

    Personal property is a type of property which can include any ...
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. Anyone involved in a real transaction can benefit from basic understanding ...
  2. Investing

    4 ways to value a real estate property

    Several approaches to evaluate real estate for investment purposes.
  3. Investing

    How to value a real estate investment property

    Make sure you know what your real estate investment is worth before you sign the ownership papers.
  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. Taxes

    Sell Your Rental Property for a Profit

    Being a landlord can be taxing, especially when you want to sell. Find out how to reduce your burden.
  6. Retirement

    Could Being a Landlord Pay for Your Retirement?

    If you have the money to buy them and the energy to run them – or the funds to pay a good manager – rental properties can help pay for your retirement.
  7. Retirement

    Generate Income For Retirement with Real Estate

    Learn whether rental income is compatible with your lifestyle, how to identify suitable properties, common pitfalls to avoid and how to secure financing.
  8. Investing

    Including Rental Real Estate in Your Portfolio

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

    Is Property Management Worth it? Ask Yourself These 8 Questions

    If you own rental properties, ask yourself these questions when deciding who should manage them.
  1. What is the importance of the capitalization rate in real estate investing?

    Find out why an investment property's capitalization rate is important to real estate investors and how it can be used to ... Read Answer >>
Hot Definitions
  1. Entrepreneur

    An Entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture. ...
  2. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  3. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  4. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  5. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  6. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
Trading Center