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.

    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 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            2,000
        Potential Gross Income        102,000
            Less Vacancy Amount            2,000
        Effective Gross Income        100,000
            Less Operating Expenses          45,000
        Net Operating Income          55,000   

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.

Capitalization Rate = NOI/Sales Price          

We calculate a market cap rate by averaging the individual cap rate data in a particular area .

Estimated Market Value = Net Operating Income/Capitalization Rate

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Determine the Real Estate Financial Statistics for a Property

Before you buy an investment property it is critical that you create your own projection of the property's profitability. Real-Estate-Proforma.com has a quick-proforma with which you can calculate real estate financial statistics such as Internal Rate of Return, Capitalization Rate, Cash-on-Cash, Debt Multiplier, Loan-to -Value Ratio, Debt Coverage Ratio, and Mortgage Payments. You can use this JavaScript proforma to project the profitability of a real estate project. By becoming a member you will receive access to a number of Excel real estate proformas. membership | services

If you are analyzing another person's proforma, or you are examining a prospectus for a real estate deal, it is very important that you read the document carefully and determine how the values of the financial statistics above are being calculated. For instance, values such as the Cap Rate may be determined from overly optimistic projections of the future rental income of a property.

You can "reverse engineer" the financial projections you receive from a prospectus and/or request the Excel (or other type of) spreadsheet a developer used to create their proforma. A very useful Excel or Visual Basic macro used to check Excel formulas is available in the spreadsheet below for download. Download Mortgage Formula Excel Spreadsheet

The due-diligence you do on a potential investment may uncover a number of potential problems with a real estate deal and we suggest you research each real estate investment very carefully. There are a variety of real estate financial consultants who can help with this, but if you are like many Real-Estate-Proforma.com members, you can or are learning to do your own due-diligence.

We hope you become a more successful real estate investor by using this site! membership | services