• The Income Approach

 

 

The income approach is based on the present worth of the future rights to income. It assumes that the income derived from a property, to a large extent, will control the value of the property. The income approach is used primarily for valuation of income-producing properties--apartment buildings, shopping centers, and the like. In estimating value via the income approach, an appraiser must go through the following five steps:

  1. Estimate annual potential gross income, including both rental income and income from other sources, such as concessions and vending machines.
  2. Based on market experience, deduct an appropriate allowance for vacancy and collection losses to arrive at effective gross income.
  3. Based an appropriate operating standards, deduct the annual operating expenses of the real estate from the effective gross income to arrive at the annual net operating income. Management costs are always included as operating expenses, even if the current owner also manages the property. Mortgage payments, however, (including principal and interest), are debt service and not considered operating expenses.
  4. Estimate a price a typical investor would pay for the income produced by this particular type and class of property. This is done by estimating the rate of return ( or yield ) that an investor will demand for the investment of capital in this type of building. This rate of return is callled the capitalization (or "cap") rate and it is determined by comparing the relationship of net operating income with the sales prices of similar properties that have sold in the current market. For example, a comparable property that is producing an annual net income of $30,000 is sold for $300,000. The capitalization rate is $30,000 ÷ 300,000, or 10 pecent. If other comparable properties sold at the prices that yielded the same rate, the appraiser should apply a 10 percent capitalization rate to the subject property.
  5. Finally, the capitalization rate is applied to the property's annual net income, resulting in the appraiser's estimate of the property value.