Overview of the Income Approach

The income approach is a common strategy used in order to value real estate. An appraiser can use one of three strategies to come up with the value of a piece of property, and the income approach is one of those methods. Here are the basics of the income approach.

Income Approach

With this valuation strategy, a real estate appraiser is going to look at the value of a property in relation to the income that it can produce instead of how much it would cost to actually build a piece of property. This approach is most commonly used with commercial property. When trying to evaluate commercial property, you have to look at how much money it can produce to try to determine a value. For example, a piece of property that is located on the main strip in a large town is often going to be more valuable than an exact replica of the property that is located off the beaten path.

Variations

There are three different methods that can be used under the umbrella of the income approach. All three methods look at the value of the business depending on how much income it brings in. However, the way that they arrive at the value is different. These methods are known as the discounted cash flow method, the gross rent multiplier method and the direct capitalization method.

Direct Capitalization

One way that you can calculate the value of a business is to use direct capitalization. In order to do this, you will need to use a capitalization rate. The formula for calculating direct capitalization is to take the net operating income for the year and divide it by the capitalization rate. This method of calculating value can result in several different values being calculated. The capitalization rates is something that is unique to each investor and can be difficult to determine.

Discounted Cash Flow

Another method that you can use to determine the value of a business or commercial property is the discounted cash flow method. In order to use this calculation, you will need to estimate the amount of each cash inflow that is scheduled to come in and discount it to find its present value. Once you have done this, you can add the cash flows together and come up with a value.

Gross Rent Multiplier

Another strategy that you can use is called the gross rent multiplier. The gross rent multiplier is the amount of rent that is charged for a property divided by the selling price. This provides you with a ratio that you can work with. In order to determine the value of a property, you can look at recent sales in the area. You will be able to tell how much money was charged for rent at these other properties and then divide that number by the selling price. You can compare the ratios and come up with an average ratio. Then apply the average ratio to the amount of rent that is charged at the building that you are evaluating.

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