The income capitalization approach is a valuation method that measures the value of real estate property based on the net income it generates. It values real estate using more than just rental income numbers and allows you to capture important information such as rental yield and cap rate. Income capitalization can be applied for both retail and commercial properties, but it is beneficial for evaluating commercial properties.
Steps of Income Capitalization
There are four steps to the income capitalization process.
1. Determine the Property’s Net Operating Income (NOI)
Income capitalization is a term that refers to the process of determining a property’s value by taking its net operating income (NOI) and dividing it by an appropriate capitalization rate. The most common way to find a property’s NOI is to subtract all expenses from its revenue, but this can be done in other ways. For instance, if you’re interested in buying an apartment building, you might take an average rent for each unit, multiply that number by the number of units, and subtract all expenses.
2. Calculate the Cap Rate
The cap rate calculation considers current market conditions and comparable properties.
The cap rate formula in the income capitalization approach is:
Capitalization Rate = Net Operating Income / Market Value; where NOI is just the annual cash flow to an investor, or cash flow before debt service, depreciation and amortization (DDA), and taxes.
3. Determine the Market Value for the Property
This method determines the market value for the property by predicting the annual net operating income. The appraiser must know or estimate the following several things including the following:
- Net operating income. This is an estimate of a property’s income after accounting for necessary expenses to maintain a property and rent it out. These expenses include utilities, taxes, insurance, and maintenance costs.
- Market vacancy rates. This is an estimate of how many rental properties in the area are vacant and unable to generate rental income for their owners.
- Market cap rate. A cap rate estimates what investors would expect to earn on their investment if they purchased a similar property in the same market at a similar time as this one.
4. Adjust the Market Value for Any Necessary Factors
Property values are always subject to various factors that can affect the market value, such as potential gross rent, vacancy rates in the area, etc. For this reason, it is necessary to adjust the market value for any necessary factors in the income capitalization approach.
The appraiser will try to estimate a future income stream expected from the property and then adjust this figure for any necessary factors. The appraiser then uses this adjusted amount with cap rate to help determine the property’s value.
Advantages of Using the Income Capitalization Approach
- It gives you a clear idea of what the property could be worth based on its income potential.
- It can be used for any property type, whether residential or commercial.
- It considers all expenses associated with operating the property and provides accurate numbers that reflect these costs into your valuation formulas.
- If you’re buying an investment or rental property, this method can help you determine how much money will be left over after paying for taxes, insurance, and maintenance costs.
- The formula used by this method is simple enough even for those who aren’t experienced investors or realtors to understand how it works and apply it properly when evaluating properties on their behalf or considering an offer from another party interested in buying them.”
Disadvantages of Using the Income Capitalization Approach
- Valuing a property is not an exact science, and different methods will give you varying results. Even though there’s one way to go about it, the process can be tricky because of fluctuations in market prices that are constantly changing from day to day or even hour by hour. In addition, they depend on current events happening globally and any local issues affecting your area’s housing market, such as weather-related natural disasters.
- When you invest in real estate, it can be difficult to predict the value of your NOI. Your tenant might not pay on time or at all, which will affect how much money comes in. Be expecting some lapses in cash flow, which could lead to an unexpected road for the calculations regarding net operating income.
- The variables of the property make it unique and worth so much more than another similar one. The estimated capitalization rates don’t account for these differences, resulting in an estimate that may not be accurate enough when predicting whether or how much your home will sell for. It would be best to always get professional advice from someone who knows the market well before making any big decisions about selling off all the stuff you’ve collected over time.
Alternatives to Market Capitalization
Below are the major options for the income capitalization approach:
- The sales comparison approach is used to determine the value of single-family homes and residential apartments by comparing them with similar properties that have been sold in the area recently.
- The replacement cost approach determines the present-day cost of replacing a building or structure. It also considers construction costs, labor costs, and material costs.
Which Approach Do We Use?
At ExcelAppriase, we use the income capitalization approach to help us value properties in our business. It’s a simple process that allows us to help you assess your current property and determine what a fair price for it would be.
First, we’ll look at recent sales of similar properties in the area and determine a price per square foot that can help us establish an estimated selling price for your property. We’ll then adjust that estimate to account for any differences in the cost approach of your property and the others we looked at. This can include location, age, number of bedrooms or bathrooms, or other factors.
Finally, we’ll look at current rental rates on properties like yours in the area and estimate how much income your property could generate monthly if you decided to rent it out instead of selling it outright. This would provide you with an idea of how much money you could make from the property if you chose not to sell it right now.
Contact ExcelAppraise Today
We hope this has given you a good overview of our basic valuation process and why we think it’s right for you. If you’re interested in a free quote of our cost approach, call us at 1-801-882-2292.