The Income Approach
As someone who is considering purchasing residential real estate as an investment, you want to be able to utilize the best and most practical methodology there is available in order to determine the value of a specific piece of property. With this in mind, it is a good idea to take a look at the three approaches to value that exist. From a traditional point of view, there are three groups of methodologies that you can choose from.
Let us first take a look at what we believe is the approach that will benefit you the most as a residential real estate buyer which is the income approach. The income approach can be likened to the same methods that are used for determining the price of bonds, analyzing securities, and valuing finances. It is also known as the income capitalization approach. This is the optimal choice for determining the value of both investment and commercial properties.
You might be wondering: why is the income approach considered the most relevant technique for valuing income-producing properties? That is a great question and the answer is because it was designed in such a manner that it can be considered a direct reflection of how participants in the market typically behave as well convey what their expectations are.
Having said that, given a commercial property that produces income, the income approach essentially becomes an indication of the value of the property based on its stream of income. Several factors are used to come up with the specific number such as capitalization rates coupled with a Net Operating Income or perhaps revenue multipliers. In a typical scenario, stabilization of the NOI is applied so that recent events do not weigh too heavily on the valuation. For instance, if there is an un-leased building and the stabilized NOI is to be applied, the assumption would be that the lease would be at a normal rate and that occupancy levels would be standard as well. In this case, the Net Operating Income would be computed by taking the gross potential income and subtracting the collection loss and vacancy. The result would be the Effective Gross Income. Operational costs would be subtracted from this number as well (not including debt service, depreciation rates, and income taxes).
However, there is an alternate way to compute the Net Operating Income. You can do this by using the discounted cash flow analysis or DCF model. The DCF is usually applied when there are more heftier and higher-value properties involved (i.e. office buildings and shopping complexes). Here, yields that are supported by the market or discount rates are applied in view of projected future cash flows. Projected future cash flows can include annual income figures or lump versions from when the property is eventually sold.
Other methods of approaching the value of commercial or residential properties include the cost approach and the sales comparison approach. In the cost approach, buyers do not pay beyond a specific amount if it would cost less or the same to build a similar property. On the other hand, the sales comparison approach examines the characteristics of a property with similar properties in recent transactions.