The Income Method of Real Estate Appraisal and Valuation

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When a property's intended use is to generate income from rents or leases, the income method of appraisal or valuation is most commonly used. The net income generated by the property is measured in conjunction with certain other factors to calculate its value on the current market if it were to be sold.

It's not just investors in the property who are interested in the net income generated by operations. They will almost always be seeking financing and potential lenders will carefully examine the income and expense details as well. They'll want to be as certain as possible that their investment is protected.

Lenders want to see normal occupancy rents that exceed expenses enough to make mortgage payments with a profit left over for owners.

Using Capitalization Rate (Cap Rate) to Estimate Value

The net operating income of the property is used when capitalization rate is employed to value an income property. There's an inverse relationship between the asking price and cap rate. In other words, the higher the cap rate, the lower the asking price.

Using Gross Rent Multiplier for Value Estimate

Gross rent multiplier or GRM uses the gross rentals of a property rather than the net operating income used with cap rate.

This calculation can be done in one of two ways using either gross potential income (GPI) or gross operating income (GOI). The value estimate is much better using gross operating income because losses for occupancy and non-payment are considered.

Condition and Future Expenses Must be Considered

It's more subjective but very important to take the property condition into account as well. Neither of the income valuation methods consider property condition and potential large repair expenses in the future so these must be considered in arriving at a final estimate of value.

An existing property might have been operating very efficiently or there could be operational problems that are depressing the net income. The rents might not be the actual rents and the expenses might be higher or lower than they should be. 

Let's say a landlord has been giving rent concessions to some tenants in exchange for services, or maybe repairs and maintenance expenses have been lower than the norm for similar properties. The landlord might have been tired of dealing with management duties or maybe he just wasn't that concerned about the problems that come down the road from poor maintenance. 

Investors who examine every facet of the operation would see an opportunity here because the rent numbers aren't real. They see that getting tenants into those units at full current rents would make a significant difference in net profitability so they want to buy it. They might see that the property's expenses aren't as they should be and the property is falling into disrepair, leading them to pass on the purchase.  

Sharp investors and lenders will carefully pull apart the project's financials to make certain that they're working with the real numbers. It's surprising how many smaller commercial properties are mismanaged.  Rents are too low, expenses are too high, or it's a combination of both.

Investors who stop at the basic valuation calculations without digging into rents and expenses often pass on the very best deals or overpay for properties.

Know the Income Method

It's a good idea to spend significant time learning the income method of valuation if you plan on working with investor clients. You don't want your investor buyer or seller clients to use terminology that you don't recognize or understand or ask for calculations that you can't perform.

Working with investors can be quite rewarding because this niche real estate market is quite active. You'll also build great repeat business as well as referrals from satisfied investor clients.