There are three basic techniques for appraising a property used by commercial real estate appraisers to evaluate real estate. The income approach is one of them and the other two are the Sales comparison approach and the Cost approach. The income approach is said to be the most complicated out of all three.
Also referred to as the income capitalization approach, Income Approach to Value is an assessment where the present market value of a property is determined by the income it generates. It is typically purchased as an investment and therefore generating a return on the investment is the most important element of a property’s value. It is a person investing money to generate more money through the property in the future.
The Income Approach to Value works similarly as discounted cash flow analysis works in finance. It is calculated by dividing the net operating income by the rent collected by the capitalization rate. As this approach is more commonly used for properties to be treated as an investment various factors must be considered before investing in an income-generating property. Some of the key factors to be considered are:
There are two ways to calculate the capitalization rate: the direct capitalization method and the yield capitalization method.
In the direct capitalization method, the value of the property is estimated based on the income of a single year.
The yield capitalization method is a more complex yet more accurate way of calculation. The value of the property in this method is estimated on multiple years’ incomes. Usually, the years considered are an estimated period for which the buyer shall hold the property.
The key reason for purchasing the property should be the income it will produce. If it is not a dominating factor for the purchase, then this method is not the appropriate evaluation method.
The large repairs if any that might be required should also be considered as they can cut down the future profits from the property.
The efficiency in operating the property and its generation of rent must never be ignored. The buyer should ensure that the current expenses on the property should not be greater than the rent that it generates.
If the property is divided into multiple units, how many units remain empty at any given point in time becomes the concern. The reason behind the low occupancy and how the occupancy can be increased.
