Income approach
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The income approach is one of three major groups of methodologies, called valuation ''approaches'', used by appraisers. It is particularly common in commercial
real estate appraisal Real estate appraisal, property valuation or land valuation is the process of developing an opinion of value for real property (usually market value). Real estate transactions often require appraisals because they occur infrequently and every pro ...
and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or
business valuation Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Here various valuation techniques are used by financial market participants to determine the price they are willing t ...
. While there are quite a few acceptable methods under the rubric of the income approach, most of these methods fall into three categories: direct capitalization,
discounted cash flow The discounted cash flow (DCF) analysis is a method in finance of valuing a security, project, company, or asset using the concepts of the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate devel ...
, and gross income multiplier.


Direct Capitalization

This is simply the quotient of dividing the annual
net operating income In accounting and finance, earnings before interest and taxes (EBIT) is a measure of a firm's profit that includes all incomes and expenses (operating and non-operating) except interest expenses and income tax expenses. Operating income and ope ...
(NOI) by the appropriate
capitalization rate Capitalization rate (or "cap rate") is a real estate valuation measure used to compare different real estate investments. Although there are many variations, the cap rate is generally calculated as the ratio between the annual rental income produ ...
(CAP rate). For income-producing real estate, the NOI is the net income of the real estate (but not the business interest) plus any interest expense and non-cash items (e.g. -- depreciation) minus a reserve for replacement. The CAP rate may be determined in one of several ways, including market extraction, band-of-investments, or a built-up method. When appraising complex property, or property which has a risk-adjustment due to unusual factors (e.g. -- contamination), a risk-adjusted cap rate is appropriate. An implicit assumption in direct capitalization is that the cash flow is a perpetuity and the cap rate is a constant. If either cash flows or risk levels are expected to change, then direct capitalization fails and a discounted cash flow method must be used. In UK practice,
Net Income In business and accounting, net income (also total comprehensive income, net earnings, net profit, bottom line, sales profit, or credit sales) is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, a ...
is capitalised by use of market-derived yields. If the property is
rack-rent Rack-rent denotes two different concepts: # an excessive rent. # the full rent of a property, including both land and improvements if it were subject to an immediate open-market rental review. The second definition is equivalent to the economic re ...
ed then the All Risks Yield will be used. However, if the passing rent differs from the Estimated Rental Value (ERV), then either the Term & Reversion, Layer or Equivalent Yield methods will be employed. In essence, these entail discounting the different income streams - that of the current or passing rent and that of the reversion to the full rental value - at different adjusted yields. However, capitalization rate inherently includes the investment-specific
risk premium A risk premium is a measure of excess return that is required by an individual to compensate being subjected to an increased level of risk. It is used widely in finance and economics, the general definition being the expected risky return less t ...
. Each investor may have a different view of risk and, therefore, arrive at a different capitalization rate for a given investment. The relationship becomes clear when the capitalization rate is derived from the discount rate using the build-up cost of capital model. The two are identical whenever the earnings growth rate equals 0.


Discounted Cash Flow

The Discounted cash flow model is analogous to
net present value The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount ...
estimation in finance. However, appraisers often mistakenly use a market-derived cap rate and NOI as substitutes for the discount rate and/or the annual cash flow. The Cap rate equals the discount rate plus-or-minus a factor for anticipated growth. The NOI may be used if market value is the goal, but if investment value is the goal, then some other measure of cash flow is appropriate.


Gross Rent Multiplier

The GRM is simply the ratio of the monthly (or annual) rent divided into the selling price. If several similar properties have sold in the market recently, then the GRM can be computed for those and applied to the anticipated monthly rent for the subject property. GRM is useful for rental houses, duplexes, and simple commercial properties when used as a supplement to other more well developed methods.


Short-cut DCF

The Short-cut DCF method is based on a model developed by Professor
Neil Crosby Neil Crosby is an academic valuer, Professor of Real Estate at the University of Reading.http://www.emeraldinsight.com/journals.htm?articleid=844986&show=abstract ("Neil Crosby is a Professor in the Department of Land Management and Development, ...
of the
University of Reading The University of Reading is a public university in Reading, Berkshire, England. It was founded in 1892 as University College, Reading, a University of Oxford extension college. The institution received the power to grant its own degrees in 192 ...
(and ultimately based on earlier work by Wood and Greaves). The
RICS The Royal Institution of Chartered Surveyors (RICS) is a global professional body for surveyors, founded in London in 1868. It works at a cross-governmental level, and aims to promote and enforce the highest international standards in the val ...
have encouraged use of the method in appropriate circumstances. The Short-cut DCF is an adaptation to property valuation of the DCF method, which is widely used in finance. In the Short-cut DCF, the passing rent, which is constant (in nominal or real terms) for the duration of the rent period, is discounted at an appropriate
rate of return In finance, return is a profit on an investment. It comprises any change in value of the investment, and/or cash flows (or securities, or other investments) which the investor receives from that investment, such as interest payments, coupons, ca ...
(possibly derived by reference to the risk-free rate of return obtained on government bonds, to which is added an allowance for risk and an allowance for the illiquidity of property assets). The reversion is discounted at the market-derived All Risks Yield (ARY), which correctly implies growth in the reversionary income stream. The reversionary income is the current Estimated Rental Value (ERV) inflated by an appropriate annual growth factor (or
CAGR Compound annual growth rate (CAGR) is a business and investing specific term for the geometric progression ratio that provides a constant rate of return over the time period. CAGR is not an accounting term, but it is often used to describe some ele ...
- Compound Annual Growth Rate). The crux of the Crosby-Wood model, and that which sets it apart from the customary DCF, is that the growth factor is derived by means of formula, as a function of the rate of return and the All Risks Yield. For example, if the rate of return is 10% per annum, the ARY is 8% per annum and rent is reviewed annually, then the growth factor will be 2%. (This simple subtraction only works when rent is reviewed annually - in all other situations the growth factor is derived by use of the Crosby formula.) Thus the Short-cut DCF produces a mathematically consistent valuation and country


See also

*
German income approach The German income approach (German: Ertragswertverfahren, abbr. EWV) is the standard approach used in Germany for the valuing of property that produces a stream of future cash flows. Basic principles and regulations The EWV is one of three va ...


Further reading

*Baum, A. and Mackmin, D. (1989) ''The Income Approach to Property Valuation'' (Third Edition), Routledge, London. *Baum, A. and Crosby, N. (1988) ''Property Investment Appraisal'' (Second Edition), Routledge, London. *Havard, T. (2004) ''Investment Property Valuation Today'', Estates Gazette, London. *''The Appraisal of Real Estate'' (12th Edition), The Appraisal Institute, Chicago. * Kilpatrick, John A., (2007) Valuation of Brownfields, Chapter 29 in ''Brownfield Law and Practice'' (
Lexis-Nexis LexisNexis is a part of the RELX corporation that sells data analytics products and various databases that are accessed through online portals, including portals for computer-assisted legal research (CALR), newspaper search, and consumer informa ...
Matthew Bender)


References

{{DEFAULTSORT:Income Approach Real estate valuation Valuation (finance) de:Ertragswertverfahren ja:収益還元法