Income approach

The Income Approach is one of three major groups of methodologies, called valuation approaches, used by appraisers. It is particularly common in commercial real estate appraisal and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or business valuation. The Income Approach is one of three major groups of methodologies, called valuation approaches, used by appraisers. It is particularly common in commercial real estate appraisal and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or business valuation. While there are quite a few acceptable methods under the rubric of the income approach, most of these methods fall into three categories: direct capitalization, discounted cash flow, and gross income multiplier. This is simply the quotient of dividing the annual net operating income (NOI) by the appropriate capitalization rate (CAP rate). For income-producing real estate, the NOI is the net income of the real estate (but not the business interest) plus any interest expense and non-cash items (e.g. -- depreciation) minus a reserve for replacement. The CAP rate may be determined in one of several ways, including market extraction, band-of-investments, or a built-up method. When appraising complex property, or property which has a risk-adjustment due to unusual factors (e.g. -- contamination), a risk-adjusted cap rate is appropriate. An implicit assumption in direct capitalization is that the cash flow is a perpetuity and the cap rate is a constant. If either cash flows or risk levels are expected to change, then direct capitalization fails and a discounted cash flow method must be used. In UK practice, Net Income is capitalised by use of market-derived yields. If the property is rack-rented then the All Risks Yield will be used. However, if the passing rent differs from the Estimated Rental Value (ERV), then either the Term & Reversion, Layer or Equivalent Yield methods will be employed. In essence, these entail discounting the different income streams - that of the current or passing rent and that of the reversion to the full rental value - at different adjusted yields. However, capitalization rate inherently includes the investment-specific risk premium. Each investor may have a different view of risk and, therefore, arrive at a different capitalization rate for a given investment. The relationship becomes clear when the capitalization rate is derived from the discount rate using the build-up cost of capital model. The two are identical whenever the earnings growth rate equals 0. The Discounted cash flow model is analogous to net present value estimation in finance. However, appraisers often mistakenly use a market-derived cap rate and NOI as substitutes for the discount rate and/or the annual cash flow. The Cap rate equals the discount rate plus-or-minus a factor for anticipated growth. The NOI may be used if market value is the goal, but if investment value is the goal, then some other measure of cash flow is appropriate.