Broadly, there are three methodologies used to value a commercial real estate asset: the cost approach, the sales comparison approach, and the income approach. Each has its own strengths and weaknesses.
The purpose of this article is to describe the income approach in detail so that you, a potential investor, can quickly use it to estimate the potential value of a commercial property. Let’s start by defining exactly what it is.
What is the Income Approach to Real Estate Valuation?
The income approach is a valuation method used by commercial real estate appraisers to value an investment property based on the amount of cash flow that it produces. It can be used for any commercial property with rent-paying tenants, but it is most common for apartments, office buildings, industrial properties, hotels, and shopping centers.
The most commonly used method of valuing a property using the income approach is the direct capitalization method.
What is the Direct Capitalization Method?
To calculate value using the direct capitalization method, there are two required input variables—net operating income and the capitalization rate.
Net Operating Income (NOI) is calculated as a property’s Effective Gross Income (EGI), which includes rental income and ancillary payments, minus Operating Expenses. For example, if a property had EGI of $1,000,000 and operating expenses of $500,000, the resulting Net Operating Income is $500,000.
A property’s capitalization rate is the rate of return that could be expected on an all-cash purchase of the asset. The formula used to calculate it is Net Operating Income divided by value. However, in the income approach, the property’s value is unknown. As a proxy, investors may need to view the market cap rate for the recent sales of comparable properties, and make an estimate based on an average. For example, if there are three recent sales of similar properties with a 6%, 6.5% and 6.75% cap rate, the average of these three values is 6.41% and it could be defended as a logical choice.
With these two input variables known, the property’s value can be calculated in three steps.
Steps to Calculating Value Using the Direct Capitalization Method
With an understanding of the required inputs, the three steps to calculating value are:
- Create a pro forma projection of income and expenses for the investment’s proposed holding period, and use the pro forma to identify the property’s stabilized Net Operating Income.
- Identify the appropriate real estate capitalization rate.
- Calculate the value using the following equation: Net Operating Income / Capitalization Rate.
Using the example above, $500,000 in Net Operating Income divided by a capitalization rate of 6.41% implies a sales price of $7.79M. While the calculation itself is relatively simple, the logic and best practices that go into it are far more complex.
Best Practices for Using the Direct Capitalization Method
The creation of a pro forma—and the net operating income it projects—is part art and part science. There are several best practices that should be considered by real estate investors in this process:
- Income estimates should be based on actual leases and historical performance.
- Income growth and lease renewal rate assumptions should be conservative, in line with market trends, and supported by data. For example, it would be unrealistic to assume that income will grow at 10% per year unless there is actual data supporting this.
- Pro forma expenses should be based on historical performance combined with knowledge of existing vendor contracts, property tax rates, and utility bills.
- Expense growth assumptions should be in line with historical inflation trends and they should make sense relative to the income growth assumptions. For example, it would be unrealistic to assume 10% income growth and no expense growth.
- The chosen cap rate should be fully supported by comparable sales data, and it should make sense in the market. These rates should be easily verifiable using data services such as CoStar or the like.
- The chosen cap rate should make sense relative to the risk-free rate (prevailing rate on the 10-year treasury). Investors should be appropriately compensated for the amount of risk associated with the property relative to the 10-year treasury.
- Vacancy assumptions should be in line with historical performance and current market trends. For example, if the market averages 10% vacancy, it may be unrealistic to believe that the property could achieve 3% vacancy.
- Finally, the cap rate should only be applied to a stabilized net operating income. It should not include typical one-time charges like lease termination fees or tax incentives.
There is no “right” value that results from using the income capitalization approach. Instead, there is either a value that can be defended using market data, or there is a value that cannot be defended at all. Ultimately, the property valuation estimate will be proven right or wrong by the market, which will judge a property as being appropriately priced or not.
It is however important to note that nearly every purchase and sale transaction will require a third-party appraisal, which will conclude its own independent market value. The appraiser will likely use all three approaches to value, and his or her conclusion will also serve to validate (or not) the investor’s own valuation estimate.
Interested In Learning More?
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If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.