Income Approach

Income Approach

What is the Income Approach?

Definition

The income approach is one of the methods by which an investor can value a property. This method, which is also known as the income capitalization approach, involves dividing the net operating income that a property generates by the capitalization rate.

What does income approach mean?

When you are buying a property, it is extremely important that you purchase it at the correct price. If you overpay, you could be stuck with real estate that you could find hard to resell. You are also likely to make a suboptimal return on your investment. The income approach is one of the three methods for valuing a property. The other two are the cost approach and the market approach. This is how a property is valued if you use the income approach:
  1. Determine the net annual income that the property generates. To do this, you would have to take the vacancy factor into account. If a part of the property is vacant, the rental income would be lower. Additionally, the annual operating expenses would have to be reduced from the rental to arrive at the net income.
  2. Calculate the property’s capitalization rate. The cap rate is essentially the net operating income divided by the value of the property. When you are calculating the cap rate, you may have to make some adjustments for the specific property that you are valuing.For example, if the property is not well-maintained, the capitalization rate may need to be raised. On the other hand, if the property is superior to others in the area, the cap rate could be lowered.
  3. Divide the net operating income by the capitalization rate to arrive at the value of the property.

Example of income approach

Trevor White is a real estate broker who is in the process of valuing an apartment block. The gross income that the property generates is $500,000 per year. Expenses, including vacancy and collection loss add up to $100,000. Consequently, the net operating income works out to $400,000. The capitalization rate for the apartment building is 8.75%. Based on this data, Trevor calculates the value of the property: Value = Net operating income divided by the capitalization rate Value = $400,000 divided by 8.75% Value = $4,571,429

Summary

The income approach is one of the three methods used to value a property. It takes the income-earning capacity as well as the values of similar properties in the area into account.