Part 2: Income Approach to Real Estate Valuation

Income Approach to Valuation:

Picking up where we left off in our last conversation there are three common approaches to valuation, Cost, Income and Sale Comparison Approach.  We started off with the Cost Approach in our last discussion and now we are moving on to the Income Approach.  The income approach to value, also known as income capitalization approach is used to determine the value of an income generating property by deriving a value indication by conversion of expected benefits like cash flows and reversion into value of property.  This approach is applicable for those properties that generate income like commercial office buildings, industrial warehouses, residential/commercial rental properties, apartments, etc.

What factors are taken into consideration?

The Income Approach in order to represent the actual property will need current and historical income and expense statements (suggested 3 years for a good base look) and insight into the property activity that will flag income or expenses that maybe temporary and not something that is not consistent for the property.  A few examples are new roof expense vacancy, tenant improvements etc.  These are a few factors that will change the view of the income and expense statements and adjustments will be made to account for things like this.

The income capitalization approach capitalizes the stream of income into an indicator of value of a property that produces income. Capitalization rate or revenue multipliers are applied to Net Operating Income (“NOI”) in order to do this. An NOI is usually stabilized in order to be less dependent on very recent events. For example, if it is technically seen, then a building that is not leased does not have NOI. A stabilized NOI presupposes that building has been leased to standard occupancy level and at a normal rate.

The net operating income refers to gross potential income (GPI) from which vacancy and collection loss is deducted and then from it operating expenses is deducted. In operating expenses, income tax, depreciation charges and debt service is excluded.  It is also a good check to run an income analysis based on market data only and compare it to the properties actual to get a good sense of correctness.

NOI = GPI – vacancy and collection loss – operating expenses

In the next post we will discuss the sales comparison approach to valuation.

In the meantime, if you have real estate valuation issues or questions about real estate valuation services, please contact Holly Swisher, CMI, Columbus, Ohio CPA firm Clarus Partners at hswisher@claruspartners.com or 614-256-3445.

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