INCOME

APPROACH

What is the 'Income Approach'

The income approach is areal estateappraisal

method that allows investors to estimate the
value of a property by taking the
net operating incomeof the rent collected and
dividing it by thecapitalization rate. The
income approach is typically used for
income-producing propertiesand is one of
three popular approaches to
appraising real estate. The others are the
cost approachand the comparison approach.

BREAKING DOWN 'Income Approach'

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.

Determining Capitalization Rate

When

determining the propertys net

operating income (NOI), an investor
uses market sales of comparable
properties 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 determining a capitalization rate, the

investor adjusts the rate based on the propertys
characteristics. For example, the property may
have higher-quality tenants than other nearby
properties, which would slightly reduce the
capitalization rate. On the other hand, the
property may be less appealing than others in the
area, which would slightly increase the rate. The
capitalization rate should be set within 50 basis
points of the market average. For example, an
average market capitalization rate of 8% most
likely values the property between 7.5% and 8.5%.

After calculating the capitalization rate,

the investor can divide the rental
propertys NOI by that rate. For
example, a property with an NOI of
$700,000 and a chosen capitalization
rate of 8% is worth $8.75 million.

OTHER PROPERTY CONSIDERATIONS WITH THE INCOME

APPROACH

When using the income approach for purchasing

a rental property, an investor must also consider
the condition of the property. Potential large
repairs that may be needed can substantially cut
into future profits.

In addition, an investor should consider how

efficiently the property is operating. For

example, the landlord may be giving tenants
rent reductions in exchange for completing
yardwork or other responsibilities. Perhaps
specific tenants are facing economic difficulties
that should turn around in the next few
months, and the landlord does not want to
evict them. If rent being collected is not
greater than current expenses, the investor
will most likely not purchase the property.

 An investor must also ascertain how many

units on average are empty at any given

time. Not receiving full rent from every
unit will affect the investors income from
the property. This is especially important if
a property is in great need of repairs and
many units are vacant. If the units are not
filled on a regular basis, rent collection will
be lower than it could be, and purchasing
the property may not be in the investors
best interest.