What Is the Income Approach?
The income approach, sometimes referred to as the income capitalization approach, is a type of real estate appraisal method that allows investors to estimate the value of a property based on the income the property generates. It’s used by taking the net operating income (NOI) of the rent collected and dividing it by the capitalization rate.
How the Income Approach Works
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. The income approach for real estate valuations is akin to the discounted cash flow (DCF) for finance. The income approach discounts the future value of rents by the capitalization rate.
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.
Of the three methods for appraising real estate, the income approach is considered the most involved and difficult.
Special Considerations
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 yard work 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.
With the income approach, the cap rate and estimated value have an inverse relationship—lowering the cap rate increases the estimated value
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—suggesting a low occupancy rate. 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.
Key Takeaways
- The income approach is a real estate valuation method that uses the income the property generates to estimate fair value.
- It's calculated by dividing the net operating income by the capitalization rate.
- A buyer should pay special attention to the condition of the property, operating efficiency, and vacancy when using the income approach.
Example of the Income Approach
With the income approach, an investor uses market sales of comparables 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 a net operating income (NOI) of $700,000 and a chosen capitalization rate of 8% is worth $8.75 million.
FAQs
After calculating the capitalization rate, the investor can divide the rental property's NOI by that rate. For example, a property with a net operating income (NOI) of $700,000 and a chosen capitalization rate of 8% is worth $8.75 million.
How do you explain income approach? ›
Summarizing the income approach:
The income approach includes any method of converting an income stream into an indicator of market value. The income approach is also called the capitalization approach because capitalization is the process of converting an expected income into an indicator of market value.
What is an example ng income approach? ›
The income approach is most often used to assess the value of a commercial or investment property. An example of someone who would use the income approach is a rental real estate investor to calculate the income generated by the property and consider the cost of the property in comparison to the rental income.
How to calculate income method? ›
- The Income Method calculates national income by deducting payments given to the main manufacturing factors in the form of rent, wages, interest, and profit for productive services rendered throughout an accounting year. ...
- Domestic Income or Net Domestic Product is the resultant amount.
You would use three formulas throughout the income statement: Step 1: Gross profit = net sales – cost of goods sold. Step 2: Operating income = gross profit – operating expenses. Step 3: Net income = operating income + non-operating income.
What is basic income approach? ›
Universal basic income (UBI) is a social welfare proposal in which all citizens of a given population regularly receive a minimum income in the form of an unconditional transfer payment, i.e., without a means test or need to work.
What is an example of a net income approach? ›
For example, a company can access debt cheaper than equity financing. Thus, it uses only debt to finance its business and does not issue equity. With the net income approach, the company has lowered its cost of capital to the lowest point with 100% debt financing, which maximizes the value of the company.
Why is income approach better? ›
The income approach is generally the most appropriate approach to business valuation for an operating company with positive cash flows. The income approach is a way of determining the value of a business by converting anticipated economic performance into a present value.
What is the formula for the income approach to fair value? ›
IRV – notation for the basic capitalization formula used in the income approach where: Income divided by Rate equals Value. V = I ÷R • Know this income approach formula!
How do you find the value of a property using the income approach? ›
The formula for valuing property using an overall rate is to divide the market net operating income (NIBR) by the capitalization rate to arrive at an indicated total property value.
Gross income includes wages, dividends, capital gains, business and retirement income as well as all other forms income. Examples of income include tips, rents, interest, stock dividends, etc.
What are the income approach models? ›
The income approach is a general way of determining the value of a business by converting anticipated economic benefits into a present single amount. Simply put, the value of a business is directly related to the present value of all future cash flows that the business is reasonably expected to produce.
What is the income approach to calculate real GDP? ›
Income Approach to GDP
Instead of summing the amount spent on goods and services within an economy, it sums the total income generated within an economy as a result of the production of goods and services. It is calculated by summing the total national income, sales tax, depreciation, and net foreign factor income.
Which of the following would be included in the income approach formula? ›
The income approach includes employees' salaries and wages, corporate profits, interest paid to businesses, business owners' incomes, rental income, net payments to factors of production in the rest of the world, and depreciation. Each of the items in the problem is counted as income in the national accounts.
What is an example of a capitalized earnings approach? ›
For example, a small business bringing in $500,000 annually and paying its owner a fair market value (FMV) of $200,000 annually uses $300,000 in income for valuation purposes. When all variables are known, calculating the capitalization rate is achieved with a simple formula, operating income / purchase price.
