What Is the Income Approach to Real Estate Valuation?
The income approach to real estate valuation is a method of appraising or assigning a value to a piece of real estate based on its ability to generate income. It is one of three approaches to appraisal. These three approaches are:
- Comparable Sales Approach. Compare the property to recent similar property sales and assume it has comparable market value.
- Replacement Cost Approach. How much would it cost to build the structure from scratch? Particularly useful for unique or historical properties.
- Income Approach. Extrapolate a value based on its ability to produce income.
If you’ve ever bought or sold commercial property, you’re familiar with “sales comps.” You, or your broker look at the recent “sold” prices of nearby, similar property types—the more recent, the better. In theory, your property is worth about the same. If it’s older or is a little distressed, maybe it’s worth a little less; if it’s newer or upgraded, maybe a little more.
This approach to valuation is used for commercial property to an extent, but there are problems. Say you are looking at a 25-unit class B apartment building. You look around, but no other 25-unit Class B apartment complexes have sold in this neighborhood in the last 5 years. However, a 100-unit class B complex did sell nearby last month, for $5 million. “Cost-per-unit” is not a bad sales comp metric.
Your building is similar in quality and a quarter of the size, so based on that comparable sale of the bigger property, $1.25 million isn’t a bad value estimate ($5 MM ÷ 4).
However, when commercial property changes hands or faces an appraisal, sales comps tend to take a back seat to the income approach to real estate valuation.
An apartment complex, an office building, a retail store … all of these properties generate rental and fee income by leasing the space to tenants. With income and expenses, the property is a business. Businesses have a market value based on their potential to produce income.
There are two ways to apply the income approach:
Direct Capitalization Method
The direct capitalization method is a snapshot of a property’s current value based on the previous calendar year of income, also called a “trailing 12 months” or T-12.
Direct capitalization requires simple algebra, using an income metric and a multiplier. biproxi’s variety of data products can help make this calculation even easier.
The examples in later sections apply the direct capitalization method. Extra steps will be required to do yield capitalization.
Yield Capitalization Method
The yield capitalization method applies the “time value of money” to your valuation. It extrapolates the investment over a set life cycle—say, five years—and tries to predict how income and expenses will increase or decrease, as well as projecting the possible sale value.
Based on that five-year projection of income, it sets today’s value (also called the “net present value” or NPV”) based on a desired “internal rate of return” (IRR). Many sophisticated investors with a diverse portfolio of holdings want to know the IRR to compare a real estate investment to other possible investments and may have a target IRR in mind.
How the Income Approach Works
Whether performing direct capitalization or yield capitalization, you have two options when applying the income approach:
- Gross Rent Multiplier. Also called the “gross income multiplier” or shortened to “GRM.” This method uses the gross income earned on the trailing 12 months, without subtracting any expenses.
The equation for direct capitalization by GRM is as follows:
Gross Income x GRM = Value
GRM is usually an integer between 4 and 10. The higher the GRM, the higher the value.
- Capitalization Rate. Also called the “net income multiplier” or shortened to “Cap Rate.” This method uses the “net operating income” (NOI) from the T-12. NOI is the gross income, minus the operating expenses. Note that NOI does not include any mortgage or debt repayment—just operating expenses like property taxes, insurance, repairs, etc.
The equation for direct capitalization by cap rate is as follows:
NOI ÷ Cap Rate = Value
Cap rate is usually a percentage between 4% and 12%. The higher the cap rate, the lower the value.
How do you determine the GRM or cap rate? The market may set a GRM or cap rate for the class of property you are looking at; ask a broker or see what figures recent sales have produced.
Alternately, your buying strategy could target a cap rate of 8% or a GRM of 5. Plug those figures into your equations to determine your maximum offer on a property.
These methods create an apples-to-apples comparison of different properties. After all, one property may be a gas station, the other a duplex, but income earned is income earned, right?
Be careful about making too direct of a comparison. For example:
- GRM is very dependent on the property class. For example, a self-storage facility and an apartment complex might make the same income, but the self-storage facility has lower expenses, so applying the same GRM won’t give you accurate values because the net incomes are different.
- Even when comparing apples to apples, consider the property condition. A “class B” office complex in desperate need of a new roof probably needs to be capitalized with the “class C” GRM or cap rate, because some major expenses are looming, increasing the initial cash investment.
- Make sure your income and expense assumptions are valid. Include a realistic vacancy rate and possible worst-case expense scenarios in your projections, as well as possible income increases.
Income Approach to Valuation Example
Say you are considering purchasing a 20-unit apartment building. You request the trailing 12 financial reports from the owner.
Here’s what the income statement and rent roll tells you:
- 100% occupancy.
- $600 rent per unit per month.
- $132,000 in gross income collected last year.
- $60,000 in expenses incurred last year, including property taxes, insurance, repairs, utilities, management, etc.
- $4,000 monthly mortgage payment, for a total annual debt service of $50,000.
How do we start to evaluate this property with the income approach?
First of all, we ignore the mortgage payment. It isn’t relevant to the income approach to valuation.
$600 per month over 20 units for 12 months would result in a gross potential income of $144,000. However, 0% vacancy for years on end is probably unrealistic. The actual gross income is about 91% of the potential rent. That looks realistic.
You consult several brokers and discover that properties of this class, in this location, tend to sell for a GRM of 7 and a cap rate of 6%.
That gives us two possible equations to try:
$132,000 (gross income) x 7 (GRM) = $924,000 value.
($132,000 – $60,000) (NOI, income minus expenses) ÷ 0.06 (cap rate) = $1,200,000 value.
As you can see, these two methods gave us different values. In the case of the cap rate method, we can look at how we arrived at the NOI. The expenses are about 45% of the gross income.
Experienced real estate investors know that apartments tend to have expenses closer to 50%-57% of the gross income. This landlord might have scrimped on expenses or had a lucky year of low expenses. You might want to adjust your expense expectations up, which will decrease your NOI and bring your cap rate equation value closer to your GRM value.
Let’s say the owner has the property listed on the market for $1,400,000. Your equations have now told you that this seller may need to bring his/her expectations down to earth. Unless the property has something exceptional to recommend it, your capitalization equations have revealed an overpriced property.
Now let’s turn the tables. Say you want to buy property at a GRM of 5 or a cap rate of 8%. You can come up with an offer price by plugging in these figures.
$132,000 (gross income) x 5 (GRM) = $660,000 offer.
($132,000 – $60,000) (NOI, income minus expenses) ÷ 0.08 (cap rate) = $900,000 offer.
Are you lowballing? Maybe, from the seller’s perspective … but you are making an offer commensurate with your investment goals.
If you want to perform yield capitalization on this property with a target IRR over five years, estimate income and expenses for each of those five years, as well as a possible sale price five years from now (use direct capitalization based on your year-5 income projections). Plug in an initial cash investment to see what IRR you get. Adjust that initial cash investment until it gives you the IRR you want.
IMPORTANT: That initial cash investment needs to encompass the purchase price and any immediate repairs, so make sure to subtract any year-1 repair budget from your offer. Note also that this method could become even more complicated if you want to buy with a mortgage.