Real Estate Valuation – How to Use the Income Approach to Value

The ability to quickly arrive at a real estate valuation for commercial or residential income properties is an essential advantage for any real estate investor, broker or analyst. After all, there are times when we might not have access to our computers and real estate investment software, or might just want to remind ourselves that we can still do the math on a napkin over lunch.

Whatever the case, anyone engaged in real estate investing who has worked with residential income or commercial properties has at one time or another required a ballpark estimate of real estate valuation made on the fly.

In this article, I’m going to show you how you can do that using the income approach to value method. It does require some data insight, but otherwise provides a quick and straightforward way to arrive at estimated investment property values.

For this illustration, we’ll assume that you just came across a rental property listed for sale and want to see whether you think that the asking price is inline with your property value estimate.

Income Approach to Value

This approach requires a net operating income and capitalization rate, so to make the calculation you will have to make a couple of determinations beforehand.

• The property’s net operating income
• The capitalization rate you want to apply

Net Operating Income
First, determine the property’s net operating income (or NOI). You might find this posted on the property’s listing page or other materials such as a marketing package; if not, contact the listing agent directly and ask for it. Or, if you’re acquainted with the property and know its net operating income, fair enough.

In any case, you must start with a somewhat realistic net operating income.

Capitalization Rate
Secondly, determine the capitalization rate (or cap rate) you prefer to use in the computation. In this case, you must decide whether to define the cap rate by the investor’s investment value or a market value using market derived data. Here’s the distinction.

• Investment value to an investor is the present worth of future benefits that will provide a specified target rate of return at the level of risk that is acceptable to the investor – the real estate investor will define the capitalization rate you use.
• Market value involves typical or average cap rates based upon the recent sales of similar-type properties in the area – the local market will define the cap rate you use.

In other words, if you know that your investor will not purchase any investment property with less than a 8.0% yield, than use that figure in the calculation. On the other hand, if he or she is willing to consider properties inline with the average cap rate for market value (say it’s 7.0%), than use that figure for your real estate valuation computation.

Formulation

Net Operating Income divided by Cap Rate = Real Estate Value

Example

Let’s say an apartment building just came on the market listed for $600,000 and you want to do a rough income to value estimate to see whether you should forgo lunch and call your investor.

You learn that the net operating income is $31,140, and from your experience with the investor you know that nothing less than a 6.23% return is desired. How do you solve for real estate valuation? You apply your investor’s desired rate of return to the cap rate in the computation.

Net Operating Income divided by Cap Rate = Real Estate Value
$31,140 divided by 6.23% = $500,000

Result

Your real estate valuation approach indicates that the rental property’s listing price of $600,000 is $100,000 more than your investor has indicated he or she may be willing to pay.

Perhaps you call for the marketing package anyway, or recalculate the numbers on your computer. The point is – at least from your primary real estate valuation calculations – that you do not need to interrupt your lunch with an urgent call to your customer.