Investors use three main approaches to valuing commercial property: the cost approach, which calculates the replacement cost of a building plus land value; the sales comparison approach, which compares the property to similar recent sales; and the income approach, which we’ll concentrate on.
The income approach, also called the income capitalization approach, capitalizes net operating income by applying a cap rate to determine a property’s market value. It is the most appropriate method for valuing properties that generate consistent income, mainly from rentals.
The income approach has one non-negotiable requirement for the property to be valued: income. So, this valuation method is not appropriate for owner-occupied buildings or any that doesn’t generate a consistent revenue stream.
Calculating market value using the income approach involves two variables: the cap rate (or capitalization rate) and net operating income. How do we determine these? What are the pros and cons of the income approach, and when do we use it? Let’s take a deep dive.
When Should You Apply the Income Approach?
The properties that you can most effectively use the income approach to value are those whose income is stable and constant so that the Net Operating Income (NOI) calculation and your valuation are likely to be accurate:
- Multi-family residential rental properties such as apartment blocks
- Retail shopping malls
- Hotels
- Office blocks
- Industrial warehouse complexes
Why Use The Income Approach?
It’s based on the idea that a property’s value is related to its ability to generate income. So, if you’re an investor whose primary goal is achieving a future income stream, the income approach is the best way to establish fair market value.
However, if you intend to purchase a property, improve or renovate it, and then resell it for a profit, then the physical value is the most important element in establishing the right price, and the potential income is irrelevant. The sales comparison or cost approach would be the best option in this case.
It is not only investors who use the income method of calculating value. Assessors employed by the state to establish property tax on a building and valuers in lending institutions use it when valuing commercial and industrial properties, often combined with a second method to ensure accuracy.
How The Income Approach is Used
There are three basic steps in using the income approach:
Step 1: Establish NOI
NOI is an assessment of the profitability of an income-generating investment.
Establish the property’s gross income. This can be calculated from the current year’s actual or potential income, which includes rentals plus ancillary income such as parking fees, administration charges, and storage fees—any income additional to that specified in the lease.
Deduct all operating expenses, which include all costs necessary to keep the property functioning and generating income.
Common expenses include:
- Property taxes
- Insurance
- Management fees
- Repairs and maintenance
- Provision for vacancies and credit losses
Excluded are:
- Capital expenditures
- Income tax
- Mortgage loan repayments, depreciation, and interest, as these depend on variables like owner’s equity and should have no bearing on the calculated value
Step 2: Determine What Cap Rate to Use
The cap rate in real estate is defined as the rate of return expected to be generated from an investment property. It is calculated by dividing the NOI by the market value of the property. But when the market value is the unknown in our equation, the cap rate has to be determined, and this is done by market research using information from:
- Commercial brokers in your area who have been active recently will often share information on cap rates.
- Public sales records provided by local authorities that provide selling prices. Rental income information can be obtained from sellers, buyers, or managing agents.
- Listing websites that provide rental income information to attract interested investors, and many will even give the cap rate on income-generating properties.
- Real estate data platforms such as Reonomy and Costar that offer a national subscription service providing detailed financial data on investment properties.
When you’re compiling all this information, it’s essential that you are comparing apples with apples and that your comparables are as close as possible to the subject property in terms of:
- Property type or asset class
- Location
- Condition and quality of the property
- Tenant quality in terms of default rate
- Length of current leases
- Anticipated rent escalation
- External economic factors
These factors have a bearing on how dependable the revenue stream is and will affect the cap rate. A high cap rate may reflect a high return but a high risk while a low cap rate indicates a more secure investment with a lower but more stable income.
The table below, extracted from information on the JP Morgan website, indicates how cap rates vary from city to city and between different asset classes. Figures quoted are from Q3 of 2023.
| Multi-family | Industrial | Office | Retail | |
| Los Angeles | 4.60% | 4.70% | 6.70% | 5.30% |
| San Francisco | 4.20% | 5.40% | 5.90% | 4.60% |
| New York | 4.90% | 5.70% | 6.40% | 5.90% |
| Chicago | 6.50% | 7.70% | 8.90% | 7.40% |
| Seattle | 4.60% | 5.40% | 6.70% | 5.80% |
| Washington | 5.30% | 6.80% | 8.40% | 6.10% |
| National | 5.70% | 7.00% | 8.20% | 6.80% |
Step 3: Apply the NOI and Cap Rate to Establish Value
The equation to calculate the value of a property using NOI and cap rate as the two variables is:
VALUE = NOI ÷ CAP RATE
This is a simple calculation although establishing the value of the two variables is, as we’ve seen, pretty complex. Let’s look at a quick example of how it works in practice:
Assume we’re valuing an apartment block in New York:
- It has a potential gross income from rentals of $400,000.
- Deduct a 5% vacancy provision equal to $220,000, reducing gross income to $ 380,000.
- Subtract operating expenses (as detailed above) of $ 120,000 to give an NOI of $ 260,000.
- The cap rate in New York for this property type is 4.9%
Now, let’s insert these values into our equation:
VALUE = 260 000 ÷ .049 = 5,306,722
This, then, results in a present market value of $5.3 million.
If the investor, after investigating the market more thoroughly, decided he required a 6% return, the estimated value would be reduced:
VALUE = 260 000 ÷ .06 = 4,333,333.33
Thus, he would likely offer $1 million less for the property than the suggested market price.
Conclusion
The income approach to valuation is the best way of comparing the values of similar properties for investors whose primary goal is a reliable income stream. The disadvantage of this method is that it relies on accurate assumptions regarding income and expenditure, and minor variations can have a marked impact on the final valuation figure. For this reason, it is also best to use a second method.