How do you Calculate the income approach for real estate?

Answer 1

Under the income approach you are basing the value of the property on the income it produces. I'll discuss how to calculate the income in a moment. But first, once you have the income, you will either capitalize it (by dividing the annual income by a Cap Rate), or conduct a Discounted Cash Flow analysis by projecting out the income for a number of years.

Cap RatesUsing a Cap Rate is the most common convention in real estate. It is a percentage that indicates the relationship between the property's value and it's income. For example, a property that yields $100,000 of net income per year would be valued at $2,000,000 if the Cap Rate is 5% {(100,000 / 5)x100 = 2,000,000}. Cap Rates vary by real estate type, location, and quality of the building. As a rule, the lower the Cap Rate, the more expensive the property. At the peak of the market some property was transacting in the low-4%'s and even in the 3%'s. That is very aggressive. A high Cap Rate would be in the 10%'s. It's generally easy to find approximations of Cap Rates for a given area and product, however, it's a constantly moving target and only provides a rough estimate of the value at best. Calculating Net Income

Gross Rent (= rentable area X rent rate)

- Vacancy / Credit Losses / Other reductions to revenue (~10%)

= Net Rent

+ Other income (parking, storage, late fees, utility reimbursements, etc...)

= Total Revenue

- Expenses (utilities, payroll, insurance, RE taxes, security, reserves, etc...)

= Net Income

(Note: do not deduct financing payments. Deducting financing payments gives you Cash Flow, which is different from Net Income. Cash Flow is what is left to the owner of the property after the debtor is paid, but it is subject to extraneous financing decisions and conditions and therefore cannot accurately reflect the value of the property)