Property Valuation Using the Income Approach

There are times when the preferred method of determining the proper price for a certain property is the Income approach. When you wish to lease or rent out units of a property you need to know if the property can pay for itself or if you need to kick in some capital each month. This method is used mainly by commercial property owners There are various methods used to arrive at this valuation but I am using two: Direct Capitalization and Discounted Cash Flow.

In order to use these methods, we need to first calculate the Net Operating Income.

First, we need to estimate the periodic income the property is expected to generate and then we convert that into a value estimate. This step is referred to as income capitalization.

Because this approach is based on the premise that a property’s market value is a function of the income it produces.  The first step is to determine income.

Let say there are two single bed room apartment that rent for $1,500 per month

And there are two, two bed room apartments that rent for $2,250 per month.

Thus, the net income would be $750,000. Take this and multiply it times 12 for each month and the yearly net income is $90,000. Now that you have estimated the net income you need to determine what you must pay out to earn that income. Unless you own it outright you will have a mortgage payment. The government will take its share of the income. There will be up keep cost and sometimes you will lose a tenant and will have to corer the effect of that lost income. When you seek to learn this information verify it. Have the tenants sign forms that say that this is what they pay for rent, ask them to sign saying they will remain for a year after the property exchange. You may be shocked to find out that Bill’s $1,500 rent is really $1,000 because he shovels the snow in the winter and mows the lawn when needed. Sally cleans the common area so her rent is $1,200. People tend to be a little more honest when they are asked to sign an agreement. Look to see if there are things you could do to earn more income. Say there is a laundry room and the washers and dryers are free. That water, electric and gas are not free for you and the equipment and its upkeep isn’t either. You may want to add coin operated machines.

What improvements can you make which justify an increase in rent or an added fee.

Let’s say your total operating expense is $67,300.

Then your net operating income would be: $90,000 – $67,300+ $22,700

Using the direct capitalization method, we simply apply the formula V= NOI/R

V is Value

NOI is the stabilized income of the property for twelve months

 And R is the capitalization rate of comparable property that have recently sold.   

Thus R = NOI/ Sale price or R = NOI/V

(Net operating income / current market value) X 100 = Capitalization Rate.

The sale price is public information but the revenue and expenses are not so you will need to contact the seller to obtain this information.

 Sometime on smaller income producing properties we use the Effective Gross Income Multiplier (EGIM). The formula is

EGIM = Sales Price / EGI

The drawback to this method is it relies heavily on correct data from comparable properties.

Because of this many investors and lenders use the Discounted cash flow method to determine the value of a property.

Discounted Cash Flow method.

The process for determining the DCF is estimating:

1. Future cash flows from the property’s operations
2.  The net cashflow from disposition of the property at the end of the investment period
3. The required rate of return

Five-year Pro Forma NOI

Year	1	2	3	4	5
Potential Gross Income	$187,000	$175,400	$180,962	$186,691	$192,592
-Vacancy & collection loss	$17,000	$17,532	$17,054	17,045	$18,435
=Effective Gross Income	$170,000	$157,868	$163,908	$169,646	$174,157
-Operating Expenses	$64,700	$66,643	$68,642	$70.706	$72,832
-Capital expenditures	$8,000	$8,343	$8,492	$8,751	$9,016
Net operating income	$97,300	$82,882	$86,774	$90,189	$92,984

Note: Images on this blog site are from a free source or taken by the author. No image or group of photos is intended to represent the people the author serves. The author does not care about Race (that is a politically correct term that he does not like because we are all of the same Race, the Human Race. He prefers the term ethnicity), color, religion, sex, gender, marital status, disability, genetic information, national origin, source of income, Veteran or military status, ancestry, citizenship, primary language or immigration status. He is a service provider for all people. We will all rise together when we band together and help one another. Joseph Erwin is a Real Estate Broker, DRE # O2131799, and a CA general contractor # B 696662. He’s a member of the CRMLS and The East Valley Association of Realtors located in the Inland Empire region of Southern California.