This video concludes our analysis of the three appraisal approaches. For more on the other two appraisal approaches, see the market comparison and cost approach videos.

Rental income as the yardstick of value

Under the income approach, an appraiser uses a property’s rental income to set its value.

Property appraised using the income approach includes:

  • apartments;
  • offices;
  • industrial buildings;
  • commercial units; and
  • other income-producing property.

There are two methods of calculating the property’s value under the income approach:

  • the gross rent multiplier (GRM) method; and
  • the capitalization method.

The GRM method uses the market rent, as determined by a survey of similar properties, of the subject property which is then multiplied by a factor, the GRM, to arrive at a value for the subject property. The GRM factor is determined by comparing the subject property to similar properties that have recently been sold.

Alternatively, the capitalization method determines the property’s value based on the property’s future income and operating expenses. Now, the GRM method can use either monthly or annual income. The capitalization method needs to be calculated using annual income and costs.

The first step to establish value using the capitalization approach is to determine the property’s effective gross income. A property’s effective gross income is its gross income minus vacancies and collection losses.

Next, deduct operating expenses from the effective gross income to determine the property’s net operating income (NOI).

Operating expenses include such items as:

  • property taxes;
  • insurance;
  • security;
  • management fees;
  • utilities; and
  • maintenance.

Some operating expenses are variable, such as utilities and repairs. Others are fixed, such as property taxes and insurance. Operating expenses also include reserves set aside for large expenses, such as the replacement of the roof.

Recall that we’ve arrived at the property’s net operating income by deducting the operating expenses from the effective gross income.

The third step is to mathematically divide the property’s NOI by the appropriate capitalization rate (cap rate).

The cap rate is comprised of a prudent investor’s expected annual rate of return on monies invested in this type of property, adjusted for inflation and risk premiums, and a rate of recovery of their invested funds allocated to the improvements. This is also called depreciation.

Thus, the fair market value of the property is determined by dividing the NOI by the cap rate.

For example, if a property’s NOI is $100,000 annually, and a cap rate of 10% is used, the property’s value under the income approach would be $1,000,000.

Since we are dividing by a percentage, the resulting fair market valuation will always be greater than the NOI. Further, the rate of interest paid on mortgages and the amount or terms of mortgage debt on a property have no bearing on a property’s market value. For the purposes of valuing a property under the income approach, the property is viewed as being clear of any monetary encumbrances.