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When it comes to determining the value of real estate, there's no perfect method. But from an investor point of view, the income a property produces is a great starting point for determining how much a property is worth. The income capitalization approach is a method of real estate valuation that uses a property's annual income to determine its fair market value.
In this article, we'll take a closer look at how the income capitalization approach works, how to use it, and some drawbacks to the approach investors should know about, as well as some alternative (or complementary) valuation approaches real estate investors may want to consider.
What is the income capitalization approach?
The income capitalization approach to property valuation, also commonly referred to as the income approach, is a method by which real estate investors attempt to determine the fair market value of real estate based on the amount of net operating income (NOI) the property generates. While most commonly used when evaluating commercial investment properties, it can theoretically be applied to any type of income property.
Specifically, the income capitalization approach uses two variables to determine a property's market value. First is the net operating income, or NOI, which refers to a property's income after all its operating expenses are paid. Second is the cap rate, or capitalization rate, a percentage that expresses a property's estimated NOI as a percentage of its market value.
How to estimate NOI
Experienced real estate investors likely know how to calculate NOI. But if you're new to commercial real estate investing, NOI is equal to a property's gross income (typically its rental revenue) minus the property's operating expenses. In other words, an investment property that generates $50,000 in annual rental income and has $15,000 in operating expenses would have net income of $35,000.
Operating expenses include items like maintenance costs, insurance expenses, and services such as landscaping and cleaning, as well as any repairs you pay for. Property tax is also considered an operating expense. It does not include any debt service (such as your mortgage payments) as an expected cash flow calculation would, and it also doesn't include any capital expenses you incur.
How to determine cap rate
There's no perfect way to determine what the correct cap rate to use for a specific income-producing property is. You could use a market survey that analyzes average cap rates for specific property types -- CBRE (NYSE: CBRE) releases a very good Cap Rate Survey twice a year. Or you could ask an experienced commercial real estate broker for guidance on average cap rates in your particular market.
Calculating valuation using the income capitalization approach
Once you've calculated a property's NOI and determined its cap rate, you can estimate its value by dividing the two numbers.
Here's a simplified example: Let's say you're in the market for an office property and find one generating rental revenue of $100,000 per year. You estimate the property's operating expenses will be about $25,000 per year, so you can reasonably expect the subject property to produce net operating income of $75,000 in your first year of ownership.
Based on a recent cap rate survey, you determine the market average cap rate for this type of property in your local market is 6.5%. By dividing the $75,000 in estimated NOI by this cap rate (remember to convert the percentage to a decimal, or 0.065), the property's fair market value by the income capitalization approach would be just over $1.15 million. This can help you determine how much to offer for a property on the market or decide how much to ask for a property you plan on selling.
Shortcomings of the income capitalization approach
There's no perfect way to determine the value of real estate. If I were to ask five experienced real estate investors to calculate the value of an office building, they'd probably use five different valuation methods -- and come up with five different numbers.
Even within the same valuation method, there can be significant variances. So when using the income capitalization approach, here are shortcomings you should be aware of:
- Even if a property is currently leased to tenants, it's difficult to calculate NOI with accuracy. Several operating expenses can be particularly hard to predict, such as maintenance costs and marketing expenses, just to name a couple.
- Determining what cap rate to use isn't an exact science. You can use market-average cap rates from an industry report, but that doesn't take into account some particular variables of a specific property. Alternatively, you could ask an experienced commercial real estate broker for their opinion, or you can do your own market analysis based on comparable sales to determine the property's cap rate.
- Property-specific factors can dramatically affect the property's market value. For example, if a building immediately needs a new roof, it would be worth less than a comparable property with a roof in excellent shape. Different lot sizes can also play a big role. Two apartment buildings might produce the exact same NOI, but if one is on twice as much land, it plays a role in valuation. After calculating a property's value with the income approach, it can be a good idea to make adjustments for any factors like these.
Other methods of determining property values
As I alluded to in the last section, there are many different ways an investor can determine the value of a commercial property. Aside from the income capitalization approach -- which is certainly one of the most popular and effective -- there are two other popular methods:
- Sales comparison approach: This method involves examining sales of similar properties, also known as comparable properties or sales comps, in the same geographic region to determine fair market value of a property. This can be a better way to find a location-specific property value, especially if you're in a particularly active real estate market where conditions are changing rapidly.
- Cost approach: The cost approach to real estate valuation is essentially a sum-of-the-parts analysis of the property. In a nutshell, it involves determining how much it would cost to build a similar property from the ground up and then make adjustments for its current condition.
Is the income capitalization approach the best way to go?
As with any valuation model, the best way for real estate investors to use the income capitalization model is in combination with several other valuation methods. As mentioned, all valuation methods have shortcomings, so incorporating a few of them into your investment activities can give you a better idea of how much a particular property is truly worth.
A final thought: The income capitalization approach is only as effective as your assumptions when calculating it, so I strongly suggest you err on the side of caution when estimating a property's NOI as well as in the cap rate you use. (Note: A higher cap rate produces a lower valuation.) In short, it's better to be conservative than overvalue a potential investment.
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