Whether you’re an investor, broker, or just looking to rent, buy, or sell a house, real estate is a unique industry that affects just about everyone at one point or another in their lifetime. In almost any case, from residential to commercial, an appraisal is needed in order to accurately determine the value of property. With every appraisal comes a standard seven-step process known as the Normative Evaluation Model. The fifth step of this model requires the appraiser to estimate the value using three methods; Cost Approach, Sales Comparison Approach, and Income Capitalization Approach.
The Income Capitalization Approach is one of three valuation methods used by appraisers and investors to estimate the value of a real property. This particular approach is based on the premise of anticipation, or the expectation of future benefits (cash flows). It values property by the amount of income that it can potentially generate, so it’s most heavily relied on by investors looking for income producing property, such as apartments, office buildings, malls, and any other property that generates a regular income.
To ultimately find the property’s value using the income capitalization approach, you must first find, in this order, 1) the annual gross income, 2) effective gross income, 3) net operating income, and 4) capitalization rate.
The annual gross income is found by doing market studies to determine what the property could potentially earn. The effective gross income is then found by subtracting the vacancy rate and rent loss from the gross income. Next, the net operating income (NOI) is found by subtracting the annual operating expenses from the effective gross income. Then the capitalization rate is found by finding the rate of return, or yield, that other property investors are getting in the local market. You may also find it by dividing the net operating income by the property value.
Ex) Annual Gross Income=100,000 Vacancy Rate =9,000 Rent Loss=1,000
Operating Expenses=5,000 Property Value=400,000
1) Effective Gross Income= 100,000-9,000-1,000
= 90,000
2) Net Operating Income = 90,000-5,000
= 85,000
3) Capitalization Rate =85,000/400,000
=.2125 or 21.25%
Also, the property value could be determined by dividing the net operating income by the cap rate (if the cap rate is already known).
The capitalization rate is the rate of return on the investment, so ultimately, the higher the cap rate, the more money an investor is likely to make on the initial investment.
Sources
· Rattermann, Mark. The Student handbook of Appraisals, 12th Edition. 550 West Van Buren, Chicago, IL 60607
· http://www.propex.com/C_g_inc.htm
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