INCOME APPROACH PROCESS

INCOME APPROACH PROCESS

The main steps to Direct capitalization using an Overall Rate:

Determine the net annual income;

Select the appropriate cap rate by market comparisons; and

Capitalize the income (divide the net annual income by the cap rate).

Determining Net Annual Income

The procedures for determining net annual income are:

Estimate potential gross income the property is capable of producing.

Deduct from potential gross income an annual allowance for vacancy factor and rent collection loss. The
remainder is called the “effective” gross income.

Deduct from effective gross income the estimated probable future annual expenses of operation (fixed
expenses, variable expenses, reserves for replacements for building components or short-lived items) to
obtain the net income of the investment property.

Income and expenses. The potential gross income used is the expected future income. In many cases, the
immediate past or current income may be an indicator of future income. However, reliance solely upon past or
current income is incorrect. The income to use is the one which a typical investor in the subject property would
anticipate.

Income estimates. The gross income estimate for an income property is the potential or anticipated gross
income from all sources (market rents, parking space fees, etc.). Contract rent is the actual, or contracted, rent
received from the property. Market rent is the rent the property should bring in the open market. Rents and
vacancy factors and collection losses are based on market rent data.

Rental data is obtained from the subject property’s rent schedule and the appraiser’s review of rents from
similar properties in the area. The appropriate rent per unit of comparison (rent per square foot, rent per front
foot, rent per apartment unit, etc,) of the comparables are compared with the subject property. Income and
expenses are analyzed on an annual basis.

Expenses must be realistic. The operating expenses (all expenditures necessary to produce income) are to be
deducted from the effective gross income to find the net operating income expected from the property. The
appraiser must use caution in extracting expense information from owner’s operating statement as some items
included on the operating statement, such as principal and interest payments on mortgages and depreciation
allowance for income tax purposes, must be disregarded by the appraiser as not being allowable expense items.

Expenses are generally classified as being one of the following:

Fixed expenses. These are incurred annually and have little correlation to the level of occupancy. They are
to be paid whether the property is fully occupied or not. These items include real property taxes, insurance,
licenses and permits.

Variable expenses. These expenses are incurred continually in order to maintain and give service to the
property. They are variable depending upon the extent of occupancy and include items such as utilities,
management fees, security, costs of administration, maintenance and repairs for structures, grounds and
parking area maintenance, contracted services (e.g., rubbish removal) and payroll.

Reserves for replacements. This is an annual allowance for replacing worn out equipment and short-lived
building components, such as stoves, carpets, draperies, and roof covering.

Selecting the Overall Rate

The appraiser selects an appropriate Overall Rate after market analysis of similar property sales. This rate
provides for return of invested capital plus a return on the investment.

The rate is dependent upon the return which investors will actually demand before they will be attracted by such
an investment. The greater the risk of losing the investment, the higher will be the accompanying rate as

determined in the market for such properties. By analyzing market prices, the rate can be approximated at any
given time.

A variation of only 1 percent may make a substantial difference in the capitalized value of the income.

For example, based on an annual net income of $30,000, and an Overall Rate of 6 percent, the capitalized
property valuation would be $500,000 (income ÷ rate). Capitalizing this same income with an Overall Rate of
7 percent would result in a value of only $428,500 (rounded).

Capitalizing Net Annual Operating Income

The final step after having determined the net annual income and the capitalization rate is to capitalize the
income. This may be merely the mathematical calculation of dividing the income by the rate if the income is
considered to be in perpetuity, as in Overall Rate analysis.

For example, the valuation of property which has an assumed perpetual annual net income of $30,000 and a
capitalization rate of 5 percent is $600,000. The lower the rate, the greater the valuation, and the greater the
assumed security of the investment.