Advantage Software LLC How do Appraisers use the Income Approach?
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     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. 

Income Approach Summary - 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.  The vacancy allowance amount is 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. 

            Gross Rents Possible        100,000
            Other Income            3,000
        Potential Gross Income        103,000
            Less Vacancy Amount            2,000
        Effective Gross Income        101,000
            Less Operating Expenses          31,000
        Net Operating Income          70,000
  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.  
                                                              NOI                70,000     
               Capitalization  Rate  =   ----------------   = ---------------    =   .1045   X  100  =  10.45  Rounded
                                                         Sales Price         670,000       
  We have several other similar income properties that have recently sold in the same area.  There financial data is summarized below.  
  Comparable No.    Sales Price   Net Operating Income  Cap Rate
               1      670,000              70,000     10.45 
               2      730,000              75,000     10.27 
               3      625,000              65,000     10.40 
               4      705,000              77,000     10.92 
               5      780,000              80,000     10.25 
  We calculate a market cap rate by averaging the individual cap rate data.  The market cap rate for the above data equals 10.46 rounded.  The appraiser would estimate the value of a similar income property like this.  He would go through the procedure above to calculate the net operating income for the property in question.  Lets assume that the net operating income is equal to 73,000.  He would use the following formula to calculate the market value.  
                                                                   Net Operating Income              73,000
               Estimated Market Value   =     ------------------------------     =      ----------     =    $697,897
                                                                     Capitalization Rate                  .1046
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  It should be noted that recent sales of similar property types may be unavailable or very infrequent.  For example, it may be difficult to calculate a market cap rate for shopping centers since there may be no recent sales.  The income property investor should have a good understanding of the income approach and how a market cap rate is calculated.  

If you are able to obtain a market cap rate for the type of property you are analyzing, On Target can help you estimate the value of other similar income properties.  The On Target real estate investment analysis software provides comprehensive ratio analysis and includes an extensive reporting and graphics facility to facilitate the decision making process.  You can learn more about On Target at  Software Features  .  The On Target real estate software includes a 30 day money back guarantee and free support.

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