How to Use the Income Approach for Real Estate Valuation?
Introduction to Real Estate Valuation
For many of us, the most substantial investment we’ll ever make and the largest source of real estate wealth we’re likely to ever own is our home and the property on which it sits. That’s not the case for everyone, however. You may own or be considering the purchase of property other than that on which you live. Even if you don’t own the property on which you live, you may wish to invest in property as a source of income rather than a site on which to build your personal residence.
The most common reason to do such a thing would be in hopes of making a reasonable profit through its use – supply and demand, the (relatively) free market, and good ol’ American capitalism. One of the most fundamental questions you’ll need to answer before taking such a big step is exactly what the property is worth and what it’s likely to make. As it turns out, those questions are trickier than they may at first seem.
The “Income Approach” To Real Estate Valuation
We’re going to talk about ways to determine the value of real estate you own as an investment, particularly the Income Valuation Approach. My goal is to break things down into accessible terms for easy understanding – not to train anyone to get their Master’s Degree in Economics or even to make sure you pass the exam for your real estate license. Don’t get me wrong – you’re welcome here no matter what your goal, and I’ll try to be both accurate and thorough. My priority, however, is general understanding for “normal people.”
Well, at least relatively “normal.” You can still be a LITTLE strange. That’s might actually be better.
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“Price” vs. “Value”
Before we get into the specifics of the “Income Approach,” let’s start by clarifying that “price” (or “cost”) and “value” are related, but not always the same. Your property taxes are based on the estimated VALUE of your home, for example, not the PRICE you paid for it a decade ago. On the other hand, if you’re looking to order those rare, independently produced Hanson CD’s from before “MMMBop” hit it big, what you’re hoping for is a decent PRICE.
How They Defer
Or let’s say you stop in at a local used car dealer, where you fall in love with a sporty little number in your favorite shade of blue. The salesperson flirts and smiles and makes you feel like you’re the most discerning, well-informed customer she’s seen in decades, and before you know it you’ve signed the paperwork and driven away in your 1982 Zippy Omega.
You feel like you got a great deal at $4,000, but when you get home and look online, the average bluebook value is $2,200. Accounting for mileage and some minor damage, the actual VALUE of your “new” car is about $2,000. That’s considerably less than the PRICE you paid of $4,000.
Conversely, maybe you’d just made your twice-a-year trip to Costco or Sam’s right before the Covid-19 scare hit and loaded up, among other things, on toilet paper and hand sanitizer. The average PRICE of a 12-pack of Charmin was about $12 (hey, you buy in bulk), and that hasn’t changed. A month or two later, however, you’re on social media reading about people offering $3 per roll – triple what you paid. Even if you don’t take advantage of this insane act of desperation (and thank you for not preying on your acquaintances that way), the VALUE of your toilet paper has nevertheless tripled in a very short time.
These are extreme examples, but hopefully, they’ll make it easier to remember as we lay the groundwork for the “income approach.” Often, “price” and “value” are almost interchangeable. Other times, however, it’s important to note the difference.
VALUE often shapes PRICE, and if enough people are willing to pay the same PRICE, the law of supply and demand says that can change the VALUE – but they’re still not technically the same things.
The Four Elements of Real Estate Value
There are THREE primary methods used to compute real estate value, but all of them (including the income approach) rely in varying degrees on the FOUR universal elements of value in making these sorts of determinations:
1) Demand
Do people who COULD buy it or rent it WANT to buy it or rent it? If the people who might otherwise want to use the property can’t afford it, or the people who could afford it don’t want it, then you don’t have demand – you just have supply.
2) Scarcity
Are there too many other similar options potential renters or buyers could choose instead? This is related to Demand, in that VALUE is largely a function of “supply and demand.” If there’s too much supply, the demand is too easily satisfied with plenty left over. No scarcity, no meaningful value.
3) Utility
Is the property USEFUL? This is another distinct type of Demand. If it’s a rental home, is it in good shape and big enough for an average-sized family? If it’s an office building or other property, is it structurally sound? Does it have reliable and affordable heat, air, water, and plumbing? Is it located somewhere accessible to those who might wish to access or utilize it?
4) Transferability
How easily can ownership and occupation be transferred from one entity to another? Are there physical, legal, or logistical barriers to occupying or using the property once rented or purchased? This is a cousin of Supply. If you have something but can’t use it the way you’d like, is it still worth the same amount to you?
The Three Primary Methods for Determining Real Estate Value
1. The first method is the “Sales Comparison Approach.” - If you’ve ever bought or sold a home, this is probably the method your real estate agent used to help you figure out what to offer on the home you wanted or how to set your initial asking price in order to sell yours. The Sales Comparison Approach estimates value by comparing the property to similar properties in the area.
2. The second method is the “Cost Approach,” - sometimes called the “Replacement Cost Approach.” This method for determining property value is a bit more involved. It considers the cost of the actual land on which the property is located PLUS the cost of replacing the structure in question. This total is reduced by computing depreciation in much the same way businesses do for expensive equipment when figuring their taxes each year.
For the homes, buildings, or other structures, replacement cost is generally used as a starting point. Using comparable materials, what would it cost to essentially duplicate the property in question today? If there are similar structures nearby, a cost-per-square-foot value can be determined in much the same way as for the land itself.
3. The third method - as you’ve probably guessed by now, is the “Income Approach.”
The “Income Approach”
The income approach tackles the question of value from a different angle than either the Sales Comparison or Replacement Cost Approach. Rather than focusing on the foundational expenses like the land or construction of buildings, it tackles two simple factors (albeit in a rather detailed way):
1. What Does It Cost to Keep This Property Going?
If the property in question is an apartment complex or a small shopping center, for example, what sorts of maintenance is involved over the course of the year? What materials are consumed and which items regularly replaced? Are there utilities or personnel for which the owner is responsible? Anything that you, as owner, are responsible for and can be assigned a dollar value goes in this column.
2. How Much Income Does It or Can It Realistically Create for You Over the Course of That Same Year?
Usually, this is in the form of leasing payments, although it would apply just as well if you had a direct interest in any of the sales or services being offered on the premises.
The concept of the income approach is perhaps the most straightforward of the three, but in practice it requires extreme attention to detail. Much like the first time you get serious about making a household budget and attempt to account for all of your spendings over the course of a month or two, it can be challenging to document direct and indirect expenses and income at first.
An even more daunting reality is that past performance doesn’t guarantee future behavior. In almost any town, you’ve no doubt watched restaurants, shopping centers, or even apartment complexes rise up, dominate the market for a year or a decade, then either close or find themselves reduced to sad, sketchy echoes of what they once were. That half-empty strip of retail space with the weird-looking nail salon and the dollar store isn’t just visually depressing – it’s not generating the same sort of income for its owners as its trendy, fully utilized counterpart across town with the Indian restaurant, upscale boutiques, and earth-friendly gift shop.
In other words, this valuation approach is in some ways the most practical of the three. What do you care what a property might cost to replace or what similar locations are going for if you have reason to believe you can make a serious return on your investment right here, right now? (OK, maybe you care a little -but you see my point.)
“Income Approach” Terminology Guide
As in any field, there are some abbreviations, acronyms, and fancy-sounding terminology you’re likely to come across if you spend any time with the issue. Here are a few you might encounter and some stripped-down explanations for each. Remember, unless you’re a realtor or county assessor, you don’t have to master these approaches. The idea is to help you get more comfortable with them so you can make better decisions about your own personal or small business finances.
Because some terms are essential to understanding others, we’re not going to arrange them alphabetically. Instead, we’ll start with the most basic and work our way towards “confused” before wrapping up with “completely befuddled.”
Hopefully I’m kidding about that last part. Let’s find out:
Comparables
We saw this term above when discussing the “Cost Approach” to real estate valuation. Comparables are similar properties or services in the same or a similar area, whose own values, costs, incomes, etc., are used to help estimate the value, income, or cost of the property in question.
Net Operating Income(NOI)
This is your income from a property after subtracting the various expenses required to take care of it (but before paying taxes on it). The use of NOI and its elements can become quite complex when financial experts get to talking fancy finance stuff (what I think of as “financy” talk) with one another, but we’re going to stick with its most basic definition here. For our purposes, this is one of the most basic elements of the “Income Approach” to property valuation.
Capitalization Rate
This is a method used to help decide whether or not a particular real estate investment is a good idea. There’s no objectively “good” or “bad” rate involved; as with so many things, it’s always relative and always tangled with other considerations. Capital Rates are typically used to compare multiple investment options. If you’re looking to buy real estate as an investment, a higher “cap rate” (as it’s often called) is a positive factor in your decision. Let’s elaborate on this one a bit…
The “Capitalization Rate”
Is determined by dividing a property's net operating income (see above) by its current market value. If you’re weighing a specific purchase, you can divide the NOI by the asking price instead, since what you’re looking for is not a strictly theoretical, maybe-someday value, but a useful estimate of its relative worth to you using the information you have right now. Let’s say, for example, you’re looking at two rental properties – Option A is a row of townhouses and Option B is a commercial property several miles away.
Option A has an NOI of around $65,000 – that’s rental paid by those living there minus the predictable costs of maintaining the property. The asking price is $500,000. That would mean a capitalization rate of 13%. If all went according to plan each year you’d make back 13% of your investment. At some point during year eight, you’d start making your profits from this investment. Option B has an NOI of around $110,000 – almost double! The asking price is $925,000. That makes for a capitalization rate of just under 11.9%. It would be halfway through year nine before you’d begin making a profit.
These numbers assume that the cost of maintenance, your annual income, and other factors stay exactly the same over time – which of course never happens. Still, the capitalization rate offers a chance to compare potential profits from diverse properties and factor this into your overall considerations.
Holding Period
The precise length of time you own a property. This is mostly important for figuring out taxes and computing relative profits base don the time any given owner held title to the profit-generating property.
Terminal Capitalization Rate
This is a calculation used to estimate the resale value of a property at the end of your holding period. It relies on comparables as well as other factors and primarily matters when estimating the value of your investment and making decisions about the most profitable path(s) forward.
Conclusion
Any investment carries risk. The central goal of all this fancy terminology is to better clarify and predict this risk in order to inform our decisions. The more informed we are about any given property and the processes involved, the better our ability to make the right decisions for us.
One of our aspirations at Goalry is to reduce the guesswork involved in any real estate sale or purchase. That’s why we’ve expanded our content mall to welcome Accury – why estimate when you can accūRATE? We’ll be continuing to de-mystify real estate processes and terminology, and you can utilize our real estate valuation calculator online anytime to help compute your property values, calculate Net Operating Income, or whatever else you choose.
As always, if you’d like more information or need a little help navigating along the way, don’t hesitate to let us know.