The Income Capitalization Approach to Value, or Income Approach, is likely the method most widely employed by commercial real estate appraisers when valuing income-producing properties.
Most buyers who purchase apartments, retail stores or industrial spaces are interested in the ability of the property to earn income through rental revenue; they want the property to provide cash flow. The Income Capitalization Approach is a method by which an appraiser can derive a value estimate based upon a subject commercial property’s income. Essentially, the question asked by a buyer is, “How much will I pay for this property based upon its income-producing potential?”
In this article, we will explain what the Income Capitalization Approach is and how it leads to an opinion of value.
What Is The Income Capitalization Approach to Value?
The name of the approach is a hint at its definition. In the Income Capitalization Approach to Value, a property’s net operating income (NOI) is divided by a capitalization rate, or cap rate, to derive an estimate of market value.
An appraiser valuing an income property will need to understand how the subject compares to other properties in the marketplace in terms of its ability to generate income. As in the Sales Comparison Approach to Value, a comparative analysis is undertaken to determine the likely rental rates for an income property. Once an estimated market rent is established, the appraiser can calculate the subject’s potential gross income (PGI). PGI is the gross income a property can generate if it is leased at a stabilized occupancy rate, at market-level rental rates and with no unusual conditions.
How Does A Review of Similar Properties Lead an Appraiser to an Opinion of Value?
This question is important in the valuation of properties based on their income potential. A review of similar properties helps the appraiser establish ranges for various data that must be imputed into the value equation. When an appraiser:
- Compares the subject’s rental units to similar units, a probable rental rate can be estimated
- Reviews the occupancy of similar properties, a likely vacancy expectation can be developed
- Examines the expenses (such as taxes, insurance, repairs and maintenance) of similar properties, the likely expense burden for the subject can be projected
- Analyzes the cap rates for other recently sold comparable properties, an appropriate cap rate to be applied to the subject’s NOI can be established.
What is NOI and How is NOI Estimated?
NOI, or Net Operating Income, is the product of a few simple calculations. First, the appraiser establishes the PGI or Potential Gross Income of the subject property. He then applies an appropriate vacancy rate (during periods of vacancy, there is no income). After deducting a loss due to the estimated vacancy from the PGI, the appraiser will have an estimate of Effective Gross Income, or EGI, for the subject property. Next, the estimated operating expenses for the subject are deducted from the EGI to derive the NOI. So the NOI is the income the landlord is left with after vacancy and expenses are deducted from the Potential Gross Income.
How is the Capitalization Rate Determined?
A commercial real estate appraiser has a wealth of resources to review in order to establish an appropriate cap rate for a given income property. Three common methods for the development of cap rates include:
- Looking at Published investor surveys
- Detailed mathematical calculations employing expected investment returns for other asset classes
- A comparative analysis of recently sold similar properties
By comparing an investment in the subject property to investments in other assets, or in similar income producing properties in the subject’s market area, a commercial appraiser can gain an understanding of the expectations of typical investors in such properties.
Consideration of market participant expectations and a review of the actions of buyers and sellers in the market will help the appraiser to determine the most appropriate capitalization rate to apply to the subject’s NOI.
How is the Cap Rate Used to Estimate Market Value?
Once an appropriate capitalization rate has been established, the appraiser will divide the subject’s net operating income by the capitalization rate. This results in an estimate of market value for the subject. An appraiser may apply a range of capitalization rates to the subject’s NOI in order to establish a range of likely values and decide whether to estimate a value at the higher or lower end of the indicated range, based on factors observed during the appraisal process.
Important Considerations
It is important to understand that this article is a basic overview of the Income Capitalization Approach. There are many factors that can have an impact on the income potential of a given property. Many of the factors that are considered in the Sales Comparison Approach to Value can also be considered in the Income Approach when determining a likely Potential Gross Income for a property.
Locational characteristics, size, condition and amenities are among a few of the factors that can impact the rental rate, for example. Temporary or trending market conditions can impact the appraiser’s estimate of vacancy for a given property. The condition of a property, location, expectations of renters and other market factors can impact a property’s expenses.
All of these issues and more must be taken into consideration by the commercial real estate appraiser when valuing income-producing properties.
In Summary
The Income Capitalization Approach to Value is a method by which a property’s Net Operating Income is divided by an appropriate Capitalization Rate in order to derive an estimate of value.
The commercial real estate appraiser must be knowledgeable about rental rates, vacancy trends and expectations of market participants regarding returns on such investments. The more data an appraiser reviews, the more credible will be the resultant value conclusion(s).
A buyer will determine if a property is a good buy if the Net Operating Income is adequate to cover the expense of operating the subject while providing an appropriate return on the investment.
If you would like to learn more about the appraisal process, and specifically about our experience in valuing commercial properties utilizing the Income Capitalization Approach and the other approaches to value, please do not hesitate to reach out to us at any time. We will be happy to answer all of your questions and get you started on the path to truly understand the value of your real estate assets.
