What is the Income Approach?
The Income Approach Explained
Net Operating Income / Cap Rate = Value
In this formula, there are three necessary steps:
- Calculate the net operating income (NOI)
- Determine the capitalization rate
- Apply the formula (above) to arrive at a market value
A building with a net operating income of $350,000 and a cap rate of 8% would then have a value of $4,375,000.
350,000 / 0.08 = 4,375,000
How to Calculate NOI for the Income Approach
To calculate a property’s net operating income (NOI), you first need to know potential gross potential rent (GPR) when the building is 100% occupied. This can be derived by estimating market rents for similar properties if the building is new or by reviewing contract rent for leased units. If there are other sources of income, such as parking spaces or storage units, they should also be added in during this step.
Then all variable and fixed expenses are added together and subtracted from the property’s effective gross income. Reserves should also be subtracted to arrive at the net operating income.
How to Calculate the Cap Rate for the Income Approach
The cap rate (capitalization rate) is the rate of return the investor expects to get on his investment, expressed as a percentage.
To determine this number, you’ll need the building’s appraised value or a list of comparable sales to arrive at a representative value for the property.
You would then divide the NOI by the appraised or estimated value to arrive at the cap rate. In the example above, imagine comps suggest a value of $600,000. The cap rate for the property would be:
$39,500 / $600,000 = 6.5%
Estimating Value with the Income Approach
Using the examples above, a building with $39,500 in NOI and a cap rate of 6.5%, you would calculate the estimated value using the income approach like this:
$39,500 (NOI) / 0.065 (Cap Rate) = $607,692 (Value)
The relationship between these three variables can be used to estimate any of the other values where at least two of the three are known.
For example, you can estimate NOI by multiplying the Value by the Cap Rate. If you have a building with a value of $500,000 and a cap rate of 8.5%, NOI should be around $42,500.
$500,000 (Value) x 0.085 (Cap Rate) = $42,500 (NOI)
Understanding these values and how they relate to one another is helpful for real estate investors in evaluating potential investment properties.
The income approach doesn’t take the building’s condition and future expenses into account, which is one of its major drawbacks. There’s also no way to factor in operational efficiency.
For example, if a property’s HVAC is nearing the end of its practical life expectancy, replacement costs must be factored into the property’s estimated value.
Operational issues may be more difficult to detect and estimate the financial impact. A property manager may offer discounted rents to certain tenants in exchange for services such as lawn care or snow removal, or the property may command rents below market value due to deferred maintenance issues.
It’s important to do due diligence beyond the value estimates so you can tell whether a property is a profitable opportunity or a potential money pit. The deferred maintenance issue could be a situation where a relatively small investment could reap much higher rents in keeping with the local market—or it could be one requiring expensive, ongoing or structural repairs.
By digging deeply into the property’s financials, investors can better determine whether the numbers are “real” or if underlying issues are skewing the results. Basic valuation calculations like the income approach aren’t enough to know whether the asking price represents a good deal or a gross overpayment. They are, however, a good starting point for further research and validation.