Income approach is a method of real estate valuation popular with real estate investors that prioritizes the income a property generates. Investors use the cost and sales comparison approaches, as well, as each method has its benefits and drawbacks.
Understanding the income approach can help novice real estate investors figure out if a property is the right investment choice for their needs.
Definition and Examples of Income Approach
Real estate investors use the income approach to value a property based on its net operating income, which, in a general sense, is the income a property brings in minus operating expenses.
- Alternate name: Income capitalization
For example, if you’re a real estate investor and you’re looking into a $500,000 residential property, you’ll need a methodology to determine if the home is worth the price not just in the current conditions, but for the duration of the time you want to own the home. What will the property’s monthly income look like after you subtract your mortgage payment (if applicable), property taxes, and any money you save each month for repairs? What’s the capitalization rate you want and how does that factor into the property’s net income? These are questions you’ll need to ask before you buy the home.
How Income Approach Works
The income approach uses the estimation of the income an investment property will generate over the time the investor owns the property, taking into account more than just the rent the property generates. Exactly which factors an investor assesses while applying the income approach may vary, but here’s a general framework for a comprehensive income approach:
- Estimate the gross income you think the property can generate
- Subtract your projections for periods when the property isn’t rented and for income you may lose if tenants don’t pay their rent.
- Add in any extra revenue you might generate through things like parking.
- Calculate your operating expenses, reserves for things like repairs, debt payments, and depreciation.
- Deduct the expenses you calculated from your effective gross income (the result of steps one through three)
- Select a capitalization rate and apply it to the property’s net income via the most fitting capitalization procedure.
Because the income approach is largely based on projections, the income method can cause you to lose money if your projections are too optimistic.
“You can be too optimistic about the numbers,” Jennifer Beadles, a licensed real estate agent and founder of Seattle-based Agents Invest, told The Balance in an email. “You can mitigate that risk by working with a property manager and knowing market rents in the area.”
Beadles went on to note that, of the three types of valuation approaches, the income approach is the best for newcomers to real estate investing.
“Income approach is the best approach for first-time investors because you’ll be considering everything,” she says. “Where a lot of new investors go wrong is they buy a property and then factor in expenses. They lose money.”
Income Approach vs. Cost Approach vs. Sales Comparison Approach
Let’s say that a novice investor is looking to purchase a property. Depending on their reasons for investing, the income approach might be the best way to determine whether or not a property is worth their money:
Arguably the least complicated and most comprehensive method of valuation is the income approach. You look at the income the property provides, regardless of sales comparisons or accrued depreciation of the structure. The income generated by the property is the most important measure of its worth.
The cost approach may appeal to you if you want to build a new structure or renovate a dilapidated one on land that you can acquire for a price that provides you with the budget to construct or refurbish a property.
To evaluate a property using the cost approach, the land is first evaluated using local comparable land values. Then, you calculate the total cost of on-site development and construction or remodel. You can then deduct the cost of accrued depreciation and add back the land value.
The cost approach is a reliable way to value unique properties.
The sales comparison approach evaluates the value of a property based on what nearby, comparable properties (“comps”) have been appraised or sold for. This method assumes that there are similar properties in the immediate area in which the desired property is located. This method is a reliable way to gauge the property’s real market value.
- The income approach is one of three valuation methods used by real estate investors to determine the value of a property.
- The income approach values the property by the net income it generates over the life of the investment or timespan that the investment is owned.
- By using the income approach, real estate investors have more control over property value.
- Investors are paying for the income stream, not the value of the property as determined by comparable sales in the immediate area.