Income Approach                                                                
 
    Appraisers use three different methods to estimate the value of real estate.
    They are the income approach, the sales comparison approach and the cost 
    approach.  The sales comparison approach is considered the best method 
    for appraising single family homes.  The cost approach is used to appraise 
    special purpose buildings such as churches, schools and public buildings. 
    The income approach is used to estimate the market value of income 
    producing properties such as office buildings, warehouses, apartment 
    buildings and shopping centers.  When adequate financial data for recent 
    sales of similar income producing properties is unavailable, appraisers may 
    utilize all three approaches.
    
    The following is a brief and simplified summary of the income approach.  
    The income approach is used when reliable financial data is available for 
    recent sales of similar income properties in a given market place.  A 
    property's net operating income and sales price are used to calculate a 
    capitalization rate for the sale of each similar property in a given area or  
    market place.  If sufficient sales of similar income properties are available, 
    a market cap rate can be determined by averaging the cap rate values from
    the individual sales.  Appraisers will sometimes use a market gross rent  
    multiplier or gross income multiplier instead of a cap rate to estimate the 
    value of single-family rentals and 2 units.  
 
    Income Approach Summary - Net operating income is calculated like this.
 
      1)  The appraiser first estimates the annual potential gross income for a 
           property.  This involves estimating how much rent each unit could 
           generate in the current market place.  The rental rates being charged 
           by the current owner may be too low and may not reflect potential 
           market rental rates.  Appraisers study the current market place to 
           estimate potential rental rates.
 
      2)  The appraiser then calculates an effective gross income for the  
            property by reducing the annual potential gross income by a 
            vacancy allowance amount.  The vacancy allowance amount is 
            determined by current market rental conditions for the type of 
            property being analyzed.
 
      3)  Miscellaneous income such as parking fees, laundry and vending 
           receipts are added to the income.
 
      4)  Operating expenses are deducted from the effective gross income  
            to determine the annual net operating income for the property.  
 
        Income     
            Gross Rents Possible        100,000
            Other Income                     3,000
        Potential Gross Income        103,000
            Less Vacancy Amount          2,000
        Effective Gross Income        101,000
            Less Operating Expenses    31,000
        Net Operating Income            70,000 
 
 
    Once the net operating income is determined, a capitalization rate is  
    calculated for the property.  If the above property sold for $670,000 , 
    the cap rate is calculated like this.
 
                                                       NOI               70,000     
     Capitalization  Rate  =   ----------------   = ---------------   = .1045  X  100  = 10.45  Rounded
                                                 Sales Price         670,000       
 
    We have several other similar income properties that have recently  
    sold in the same area.  There financial data is summarized below.
 
  Comparable No.     Sales Price   Net Operating Income  Cap Rate
               1         670,000              70,000     10.45  
               2         730,000              75,000     10.27  
               3         625,000              65,000     10.40  
               4         705,000              77,000     10.92  
               5         780,000              80,000     10.25  
 
 
    We calculate a market cap rate by averaging the individual cap rate data.         
    The market cap rate for the above data equals 10.46 rounded.  The appraiser
    would estimate the value of a similar income property like this.  He would 
    go through the procedure above to calculate the net operating income for 
    the property in question.  Lets assume that the net operating income is equal 
    to 73,000.  He would use the following formula to calculate the market value 
 
                                                           Net Operating Income              73,000
      Estimated Market Value  =     ------------------------------     =      ----------     =   $697,897
                                                             Capitalization Rate                   .1046
 
    It should be noted that recent sales of similar property types may be 
    unavailable or very infrequent.   For example, it may be difficult to calculate 
    a market cap rate for shopping centers since there may be no recent sales.  
    The income property investor should have a good understanding of the  
    income approach and how a market cap rate is calculated.      

 Please be aware that the larger the property, the lower the vacancy rate plays a role in calculating net-   operating income. In other words, in a 4 unit residential property, the loss of one tenancy is equal to 25% of the entire gross operating income, but in a 6 family apartment building, the loss of a single tenant represents 1/6th of the total gross income, or roughly 16%, and as the size of the property grows, to a 22 unit apartment complex, the vacancy factor decreases even further as a percentage of overall gross operating income.