What Is the Income Approach?-Real Estate
What Is the Income Approach?
The income approach, sometimes referred to as the income capitalization approach, is a type of real estate appraisal method that allows investors to estimate the value of a property,
based on the income the property generates. It’s used by taking the net operating income (NOI) of the rent collected and dividing it by the capitalization rate.
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How the Income Approach Works
The income approach is typically used for income-producing properties and is one of three popular approaches to appraising real estate. The others are the cost approach and the comparison approach.
The income approach for real estate valuations is akin to the discounted cash flow (DCF) for finance. The income approach discounts the future value of rents by the capitalization rate.
When using the income approach for purchasing a rental property,
an investor considers the amount of income generated and other factors to determine how much the property may sell for under current market conditions. In addition to determining whether the investor may profit from the rental property, a lender will want to know its potential risk of repayment if it extends a mortgage to the investor.
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Example of the Income Approach
With the income approach, an investor uses market sales of comparables for choosing a capitalization rate. For example, when valuing a four-unit apartment building in a specific county, the investor looks at the recent selling prices of similar properties in the same county.
After calculating the capitalization rate, the investor can divide the rental property’s NOI by that rate. For example, a property with a net operating income (NOI) of $172,800 and a chosen capitalization rate of 8% is worth $2.16 million.