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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.
Cash on Cash Return
Cash on Cash Return is a percentage that measures the return on cash invested
in an income producing property. It is calculated by dividing before-tax cash
flow by the amount of cash invested (down payment amount) and is expressed
as a percentage. Let's assume we have a property for $1million with
a $200,000 downpayment. If before-tax cash flow for an investment property
is equal to $30,000 and our cash invested in the property is $200,000,
cash on cash return is equal to 15%.
Before-Tax Cash Flow $30,000
Cash on Cash Return = ------------------------------ ---- x100 or: ------------------ X 100 = 15%
Cash Invested $200,000
The following shows how before-tax cash flow is derived.
Gross Income $119,900
Less Vacancy Amount $5,500
Gross Operating Income 114,400
Less Operating Expenses $34,000
Net Operating Income 80,400
Less Annual Debt Service 50,400
Before-Tax Cash Flow 30,000
The Cash on Cash Return is is used to evaluate the profitability of income
producing properties. It is an important analysis tool when comparing multiple
income properties. The property with the largest cash on cash return
generates the greatest return on each dollar invested. It does however have
some limitations. It doesn't take into account an investor's individual income
tax situation and it doesn't consider the wealth building potential of a property
via appreciation. A property in one area of a city may have a better Cash on
Cash Return then a property in another location, but it may not appreciate as
fast because of it's location. One location may be more desirable than the
other.
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Alexander D. Gonta, Realtor Sales Associate
Phone: Cell: 201-988-3282
AlexGonta@gmail.com |
Exit On The Hudson Realty
808 Broadway
Bayonne, NJ 07002
Office: 201-437-0411
Fax: 201-437-9978 |
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