The Income Method of Real Estate Appraisal and Valuation
Understanding the Numbers
This Method Is Used for Income Properties
If a property's use is to be 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 used in conjunction with certain factors to calculate its value on the current market if sold.
It's not just the investors in the property who are interested in the net income generated by operations.
They will almost always be seeking financing and lenders will carefully examine the income and expense details 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
When using capitalization rate to value an income property, the net operating income of the property is used, and there is 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. There are two ways to do this calculation, as there is Gross Potential Income (GPI) and Gross Operating Income (GOI).
As can be seen from the calculations of each, the value estimate is much better using Gross Operating Income, as losses for occupancy and non-payment are considered.
Then Condition and Future Expenses Must be Considered
More subjective, but very important, is taking the property condition into account.
As neither of the income valuation methods consider property condition and future probable large repair expenses, those must be considered in arriving at a final estimate of value.
When purchasing an existing property, it could have been operating very efficiently, or there could be operational problems that are depressing the net income. When investors are evaluating an apartment project as an example, the rents may not be the rents, and the expenses may be higher or lower than they should be.
Let's say that a landlord has been giving rent concessions to some tenants in exchange for services, or just because they have had problems and the landlord doesn't want to evict them. Or, repairs and maintenance expenses have been lower than the norm for similar properties. The landlord may have been tiring of management duties or just not that concerned with the problems that come down the road from poor maintenance.
Investors who examine every facet of the operation could see an opportunity 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 may see that the property's expenses aren't as they should be and the property is falling into disrepair, so they may pass on the purchase.
Sharp investors and definitely lenders will carefully pull apart the project's financials to be certain that the real numbers are what they're working with. It is surprising how many smaller commercial properties are mismanaged. Either rents are too low, expenses too high, or a combination of both. Investors who stop at the basic valuation calculations without digging into the rents and expenses often pass on the very best deals or overpay for properties.
Know the Income Method, as It's Used a Lot
If you plan on working with investor clients, spend significant time if necessary in order to learn the income method of valuation. You don't want your investor buyer or seller clients to use terminology that you don't recognize or ask for calculations you can't perform.
Working with investors can be quite rewarding, as this niche real estate market is quite active.
You will also build great repeat business as well as referrals from satisfied investor clients.
**Update: I'm updating this article after the real estate market crash and during what appears to be the beginning of a recovery. Appraisers became extremely conservative after the market problems and have been blamed for slowing the recovery by undervaluing properties and using foreclosures for comparables. However, they seem to be getting back on an even keel now.