Income approach
The income approach values a property from the income it produces. It is the primary method for anything bought as an investment rather than as a place to live.
The basic form#
Net operating income divided by the capitalisation rate equals value.
A property producing $24,000 of NOI, at an 8 percent cap rate, is worth $300,000.
The arithmetic is trivial. Both inputs are contestable, and that is where the entire difficulty sits.
Getting NOI right#
Net operating income is gross rent, less vacancy and credit loss, less operating expenses — and not less debt service.
The errors are consistent and they all run in the same direction.
Vacancy assumed too low. A property is never fully occupied over time.
No maintenance reserve. Roofs, furnaces and water heaters fail on schedules that do not respect a single year's accounts.
Management valued at zero because the owner does it. The labour has a cost whether or not anyone is paid for it.
Property taxes at the current figure rather than at what they will be after the sale triggers a reassessment.
Each omission inflates NOI, and every dollar of inflated NOI is multiplied by the inverse of the cap rate. At an 8 percent cap, overstating NOI by $2,000 overstates value by $25,000.
Choosing a cap rate#
From actual sales of comparable income property in the same market, which is harder than it sounds because those sales are fewer and less transparent than residential ones.
A cap rate imported from a national average, or from a different market, or from a different property class, produces a number with no relationship to the property being valued.
Where it disagrees with sales comparison#
Frequently, on small residential rentals, and the disagreement is informative.
In markets where modest houses are bought by owner-occupiers, the sales comparison value reflects what a family will pay to live there. The income approach reflects what the rent supports.
Where the first substantially exceeds the second, the property is worth more as a house than as a rental — which is a sell signal for an investor and an explanation for why rental yields in desirable areas are poor.
In distressed property#
The income approach is what makes an occupied rental at a sheriff's sale valuable, and it depends on rent that is actually being collected.
A building with tenants in arrears, or with leases below market, or with vacancy the seller has not disclosed, produces an NOI that does not survive contact with the rent roll. Verifying actual collections rather than scheduled rent is the whole of the due diligence.