Income Approach
Appraisers use three different methods to estimate the value of real estate. They are the income approach, the sales comparison approach and the cost approach. The sales comparison approach is considered the best method for appraising single family homes. The cost approach is used to appraise special purpose buildings such as churches, schools and public buildings. The income approach is used to estimate the market value of income producing properties such as office buildings, warehouses, apartment buildings and shopping centers. When adequate financial data for recent sales of similar income producing properties is unavailable, appraisers may utilize all three approaches. The following is a brief and simplified summary of the income approach. The income approach is used when reliable financial data is available for recent sales of similar income properties in a given market place. A property’s net operating income and sales price are used to calculate a capitalization rate for the sale of each similar property in a given area or market place. If sufficient sales of similar income properties are available, a market cap rate can be determined by averaging the cap rate values from the individual sales. Appraisers will sometimes use a market gross rent multiplier or gross income multiplier instead of a cap rate to estimate the value of single-family rentals and 2 units. Income Approach Summary – Net operating income is calculated like this.
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1) The appraiser first estimates the annual potential gross income for a property. This involves estimating how much rent each unit could generate in the current market place. The rental rates being charged by the current owner may be too low and may not reflect potential market rental rates. Appraisers study the current market place to estimate potential rental rates.
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2) The appraiser then calculates an effective gross income for the property by reducing the annual potential gross income by a vacancy allowance amount. The vacancy allowance amount is determined by current market rental conditions for the type of property being analyzed.
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3) Miscellaneous income such as parking fees, laundry and vending receipts are added to the income.
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4) Operating expenses are deducted from the effective gross income to determine the annual net operating income for the property.
Income:
Gross Rents Possible 100,000
Other Income 3,000
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Potential Gross Income 103,000
Less Vacancy Amount 2,000
Effective Gross Income = 101,000
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Less Operating Expenses 31,000
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Net Operating Income = 70,000
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Once the net operating income is determined, a capitalization rate is calculated for the property. If the above property sold for $670,000, the cap rate is calculated like this.
NOI 70,000
Capitalization Rate = NOI ($70,000) / Sale Price ($670,000) = .1045 X 100 = 10.45
CAP Rate = 10.45
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It should be noted that recent sales of similar property types may be unavailable or very infrequent. For example, it may be difficult to calculate a market cap rate for shopping centers since there may be no recent sales. The income property investor should have a good understanding of the income approach and how a market cap rate is calculated.
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Lindbergh Field, CA
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