The income capitalization approach is one of the three real estate valuation methods, the other two approaches being the cost approach and the sales comparison approach.
You will need to know a little bit about the income approach for your real estate exam, so let’s dig in.
In this article, we will discuss the following:
- Using the income capitalization approach for determining a property’s market value.
- Pros and cons of using income capitalization approach.
- Other alternative methods.
Income Capitalization Approach
The income capitalization approach uses the income a property generates to determine its market value.
It’s also commonly referred to as the income approach. The more income generated by the property, the higher its value.
The income approach is usually used in commercial real estate. For example, office buildings, apartment buildings, and shopping centers.
This method isn’t recommended for for-sale real estate investments such as condos, apartments, single-family homes, land development, etc.
The income capitalization approach formula is referred to as the IRV formula:
Net Operating Income (I) / Capitalization Rate (R) = Property Market Value (V)
Before we get the actual value, we have to do these three steps:
- Estimate net operating income
- Determine capitalization rate
- Apply IRV formula
Estimating Net Operating Income
Real estate investors determine an income-producing property’s fair market value based on the net operating income (NOI) of the property.
The net income is the amount that the property generated after all operating expenses are paid.
To have a close estimate, we need to get the NOI from the monthly cash flow of a real estate property.
The appraiser must have access to income and expense statements of the property for a more accurate calculation.
The formula would look like this:
Rental Revenue – Rental Property Operating Expenses (mortgage, insurance, repairs, property management, etc.) = Monthly Cash Flow
You can break down the formula for net operating income (NOI) in four steps:
Estimate Potential Gross Income
Potential gross income is the income expected from a property that has 100 percent occupancy. This is also assuming that all occupancies are at market rent, lease rent, or both.
- Market Rent: usual rent charged for a particular space in the marketplace
- Lease Rent: scheduled or contract rent
Potential gross income must include all sources of income even those coming from laundry machines and rented parking spaces (if there are any.)
Subtract Vacancy And Collection Loss
Based on the market and local area of the property, an appraiser estimates the nonpayment of rent and periodic vacancies. This determines the normal loss of income.
After you subtract the loss of income from the potential gross income, you now have an effective gross income.
Estimate Operating Expenses
There are three types of building expenses:
- Fixed: expenses that don’t get affected by a building’s occupancy (e.g. property taxes, insurance, etc.)
- Variable: expenses affected by a building’s occupancy (e.g. snow removal, utilities, management fees, etc.)
- Reserves: often called reserves for replacements, these are funds reserved for items that have to be replaced periodically, not necessarily on an annual basis (e.g. cooking stove, built-in appliances, etc.)
These expenses DO NOT include debt services like mortgage payments and building depreciation.
Subtract All Expenses
Now that you have an estimate of your operating expenses, you subtract these from your previously calculated effective gross income.
The final amount is now your net operating income (NOI).
For the second step, we’re going to find the capitalization rate.
The capitalization rate, also known as the cap rate, is basically the return on investment. There are different ways appraisers calculate cap rate. Usually, it’s found in market surveys.
For example, CBRE (NYSE: CBRE), analyzes average cap rates for specific property types. CBRE releases a Cap Rate Survey twice a year.
You could also ask a real estate broker for guidance. They can provide you information on average cap rates in your particular market.
The capitalization rate is a rate of return on a real estate investment property. This estimates the expected returns based on the property’s market price.
Cap rate excludes investment property financing methods such as mortgage, hard money loan, etc.
There is no definite way to get the exact cap rate. But if you have access to compare the sales of similar properties, you could get an estimate with this formula:
Net Operating Income (I) / Sales Price (V) = Cap Rate (R)
This cap rate formula can be applied using the NOI and the sale price that you acquired from comparing similar property values.
The result is supposed to be less than one as the cap rate is a percentage.
Applying IRV Formula
Now that we have a value for our net income (NOI) and cap rate, you can now use these to solve using the income approach formula.
Net Operating Income (I) / Capitalization Rate (R) = Property Market Value (V)
Cons of Income Capitalization Approach
There is no definite way to determine the value of real estate as some values needed are based on market prices that aren’t stagnant.
Experienced real estate investors use different valuation methods that will come up with different numbers.
Even when you consistently use the income capitalization method, you won’t end up with a definite value. The number heavily relies on market data analysis.
Here are some cons of the income capitalization method that you should be aware of:
- It’s difficult to calculate a definite value net operating income even if the property is leased to a tenant. You can’t accurately predict your rental income if your tenant doesn’t diligently pay on time. Expect lapses in your cash flow that will affect your NOI.
- Second, maintenance costs are unpredictable. You cannot properly take into account events such as earthquakes, fires, etc. that can increase it.
- Capitalization rates are only estimated values. These are based on market-average numbers and don’t take into account the variables of the subject property. These particular variables can affect property value.
- Property-specific factors also greatly affect property valuation. For example, if a building is immediately in need of repairs, it costs less than other buildings similar to the subject property. Different lot sizes also affect property valuation.
Remember the income capitalization approach can only give you an estimated value. You have to make proper adjustments for any of the factors mentioned above.
Other Options Used
There are different valuation methods you can use to get an estimate.
Sales Comparison Approach
One of the ways to determine the valuation of an investment property is the sales comparison approach.
This valuation method involves looking at the sales number of real estate comparables (comps) to the subject property. These comps must have a similar lot size, located in a similar area, have the same number of bathrooms and bedrooms, etc.
This method will give you the most accurate result in real estate appraisals as the numbers will rely heavily on market data analysis of similar investment properties.
Another one to consider is the cost approach method.
Property valuation is based on the cost of the land and the construction of the property.
For this approach, the value of a property is equal to the cost of building a similar building minus the depreciation.
This is used in select-use properties such as schools and churches. Mostly for income-producing properties and rarely for residential real estate. The cost approach method can also be used on commercial real estate (especially if, for example, it’s a new office building).
The income capitalization approach might seem complicated but it’s a method that experienced investors usually rely on.
You can only end up with an estimated value. There will always be variables that will heavily affect the price of your property.
A lot of the numbers heavily rely on data analysis of similar properties. The real estate industry moves fast and it’s best to approach an expert to get an accurate appraisal.