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Income Approach: Definition – Explanation – Example

What Is the Income Approach for Real Estate Valuation?

Income ApproachThe income approach is a real estate valuation method where investors estimate the worth of a property based on the revenue it generates. This method is also known as the income capitalization technique.  It is a real estate valuation process that allows investors to estimate the worth of a property based on the revenue generated by the property. It is calculated by dividing the net operating income (NOI) of the rent collected by the capitalization rate. The income approach is used by real estate investors to evaluate a property based on its net operating income.  This is the money a property generates less running expenses.

The income approach is arguably the simplest and most direct way of valuation. An investor simply considers the money generated by the property, regardless of sales comparisons or building depreciation. The property’s income is the most essential indicator of its value.

The income approach is based on the principle that the value of an investment property reflects the quality and quantity of the income it is expected to generate over its life. Estimating the value of an income-producing property is done by a method called capitalization. In simple terms, capitalization is the division of a present income by an appropriate rate of return to estimate the value of an income stream. The income approach is a means of converting future benefits to present value. Essential to the approach is the idea that income to be received in the future is less valuable than income received today. (Source: in.gov)

How the Income Approach Works

Using the income approach for purchasing a rental property, an investor evaluates the amount of income expected.  Next, other factors are considered.  For example, how much the property may sell for under current market conditions. Lenders are keen to determine whether the investor may profit from the rental property.  Moreover, a lender will want to know the potential risk of payback when issuing a mortgage to the investor.

The income approach is one of three prevalent approaches to assessing real estate and is primarily utilized for income-producing properties. The cost approach and the comparative approach are the others. The income strategy is analogous to the discounted cash flow (DCF) approach in finance. The income approach discounts the future value of rents by the capitalization rate.

Cost Approach

The cost strategy may appeal to someone who wants to build a new structure or renovate an old one.  Of course, it requires land that allows for building or renovating a home. The land is first appraised using local comparable land values when evaluating property with this approach. Then, calculate the overall cost of on-site development, construction, or remodeling. Finally, subtract the cost of cumulative depreciation from the land value. The cost approach is a dependable method for valuing unique properties. The total cost of constructing a new building typically establishes the top limit of value.   This presumes that the building is the greatest and best use for the property. When a good building replacement or reproduction cost estimate is combined with suitable accrued depreciation estimates, the cost technique offers a trustworthy indicator of market value.

Income Approach

Income-producing properties are valued using all three methods. However, income property is typically acquired and sold based on its potential to generate and sustain an income stream.  Therefore, the income strategy is typically given more weight. The income approach is arguably the simplest and most complete way of valuation. Investors consider the money generated by the property, regardless of sales comparisons or building depreciation. With this method, the property’s income is the most essential indicator of its value. However, the income technique is mostly based on estimates.  Therefore, it can cause you to lose money if your projections are incorrect or overly optimistic.

Sales Comparison

The sales comparison approach determines a property’s value by looking at what adjacent, comparable properties “comps” have been evaluated or sold for. This approach implies that similar properties exist in the near vicinity of the desired property. This method is a dependable way to determine the true market value of a property. This is because the actual behavior of buyers and sellers in the marketplace determines value. This strategy implies that buyers will compare sales and asking prices in order to make the best possible purchase. The sales comparison approach, like the cost approach, is based on the substitution concept. This idea assumes that a sensible buyer will not spend more than the acquisition price of a comparable and similarly attractive property.

Income Approach – Other Considerations 

The income approach estimates the revenue that an investment property will earn during the course of the investor’s ownership.  Therefore, it must take into account factors other than rent. The specific criteria that an investor considers while using the income strategy may vary.  For example,

  • Overall condition –  When employing the income technique to buy a rental property, an investor must additionally examine the property’s condition. Large repairs that may be required can significantly reduce future revenues.
  • Operation expenses – Furthermore, an investor should assess how effectively the property operates. For example, the landlord may provide rent reductions in exchange for renters performing yard maintenance or other obligations.
  • Delinquencies – Perhaps certain renters are experiencing financial troubles that will be resolved in the coming months.  In that case, the landlord does not want to evict them. If the collected rent is less than the existing expenses, the investor will most likely not purchase the property.
  • Vacancies – An investor must also determine how many apartments are vacant on average at any given moment. The investor’s income from the property will be impacted if not all units receive full rent. This is especially true if a property is in need of renovations and numerous units are vacant. If the units are not regularly occupied, rent collection will be lower than it could be.  As a result, purchasing the property may not be in the best interests of the investor.

Example Using the Income Approach

Using the income approach, an investor chooses a capitalization rate based on market sales of comparable units. For instance, consider an investor appraising a four-unit apartment complex in a certain area. In turn, he must consider the recent selling prices of similar properties in the same general location. After establishing a reasonable capitalization rate, the investor can divide the rental property’s net operating income (NOI) by that rate. Using this method, a property with a net operating income of $500,000 and a capitalization rate of 7% is worth approximately  $7.14 million ($500,000 / .07).

With the income approach, the cap rate and estimated value have an inverse relationship.  In other words, lowering the cap rate increases the estimated value.  If a cap rate of 5% was used, the estimated value in the above example would increase to $10 million ($500,00 / .05).

Final Words

Income-producing real estate is often purchased as an investment.  Consequently, income is the most important component of property value in the eyes of an investor. When an investor buys income-producing property, he or she is essentially exchanging present cash for the anticipation of earning future dollars.  This is realized from both an income stream and future appreciation. The income approach to value is a set of methods, techniques, and mathematical procedures used by appraisers to determine the worth of an income-producing property. If the property is not being purchased for the revenue it will generate, the income approach to value is usually not the best tool to use in valuing it.

The income technique is specifically utilized to analyze commercial real estate investments.  Specifically, properties that generate income. However, investors who use the income technique to determine the value of a property must consider the condition of the property at the time it is rented. Excessive maintenance and repair costs might lower the income generated by a property. The property is not profitable if the rent received is less than the expenses incurred. The net operating income of any commercial real estate is also determined by how successfully a property is operated.

Up Next: What is Arrow’s Impossibility Theorem?

Arrow's Impossibility TheoremArrow’s Impossibility Theorem asserts that a clear order of preferences is impossible to determine while adhering to mandatory fair voting procedures. In other words, the Theorem states that converting individuals’ preferences from a fair ranked-voting election system cannot yield clear community-wide ranked preferences. The theorem is sometimes known as “The General Possibility Theorem” or “Arrow’s Paradox.” The research was initially based on economics but has strong social choice applications. Arrow’s impossibility theorem is a social-choice conundrum that highlights the shortcomings of ranked voting systems. Arrow’s impossibility theorem is also known as the universal impossibility theorem, after economist Kenneth J. Arrow.

According to the impossibility theory, it is impossible for a ranked-voting system to attain a community-wide order of preferences.  Specifically,  by collecting ranking preferences while meeting a set of constraints when there are more than two possibilities. However, those same prerequisites are the requirements for a reasonably fair voting procedure.

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