Browse Proptionary encyclopedia

Build your real estate vocabulary to be able to communicate and invest more effectively and professionally.

Income Capitalization Approach

DEFINITION

Lorem ipsum dolor sit amet, consectetur adipiscing elit. Ut elit tellus, luctus nec ullamcorper mattis, pulvinar dapibus leo.

EXPLANATION

When dealing with multi-unit rental properties, many appraisers will use the income capitalization method, also known as the income capitalization approach. This method assesses the value of real estate based on the income being generated through monthly rent collection. Potential gross income is the property’s combined income from all of the property’s sources (rent collected, washing machine income, and others). The site value is the land value minus improvements.

A property’s market rent is the property’s estimated rent potential. That is, if the property is available, how much would the property collect, or generate, in terms of rental payments? While market rent is the estimated rental potential, the contract rent is the scheduled rent which is under contract between the landlord and tenant.

Find the Value of a Property Using the Capitalization Rate

The income approach is used for rental and investment properties that generate monthly rental income. It is one of the main methods when used to estimate the value of income property.

The income approach uses the income of the property and the property’s expenses to estimate the property’s value. This is one of the method’s lenders use to determine the value of a property when extending a loan. Without knowing how much income a property generates it would be difficult for the lender to know the risk. Knowing the net income minus the expenses helps the lender determine the maximum loan amount they would be willing to extend on a mortgage for an existing borrower or a potential buyer.

Things to Understand When Determining a Property’s Cap Rate

First, the appraiser must calculate the net income by using the following formula (Gross Income-Expenses)

Second, the appraiser will calculate the cap rate by using the net income. This is expressed through the following formula (Net Income divided by property value=Cap Rate)

The effective gross income is the rental income minus considerations, such as not being paid on time, vacancy rates and other factors which may alter the actual rent collected by the landlord.

The net operating income is the income minus all expenses. Expenses may include cost of repair, maintenance, water and power, property taxes, and other costs which may arise from owning the building.

The capitalization rate, more commonly known as the cap rate, is the standard method used to determine the rate of return of a given property.

Condition and Location of the Property

Although the value of income producing property is primarily determined based on how much money the subject property generates, it is not exclusively based off that.

In addition to knowing the profit margin of every property a lender is going to extend a mortgage on, the lender needs to compare the subject property to nearby properties. Knowing the value of neighboring properties, helps appraisers better estimate the value of the subject property. Property values are ultimately determined by comparing them to recently sold properties. Characteristics that are compared include location, size, characteristics, and other specifics of the property and comparing them with the subject property.

Repairs/Additions

In many instances there are no properties to compare to the subject property, either because of differences in the property characteristics, condition, or location. In instances when the property differs in condition, the appraiser or lender must consider how much it costs to create a similar property to the most similar comparable. To do this, the appraiser must calculate the cost of repairs and/or additions to make the property similar to a comparable property.

Example

A real estate investor named Eduardo wishes to purchase any property that can deliver him a minimum of a 7% cap rate on his investment. Eduardo finds what he believes to be a suitable property to purchase to meet his 7% target cap rate. The property he is considering is listed at $393,000 and collects $2,200 a month in net rental income. Based on the following information, does the following property meet his 7% cap rate goal and how can we find out?

No, the cap rate falls a little short of his goal of 7%; however, it is very close. How did we calculate this? We began by using the $2,200 a month in rental income and multiplied it by 12 (for 1 year) which equals $26,400 in rental income and divided it by the listing price. When we calculate the figure we determine that the cap rate is 6.7% which is actually very close to his goal. The calculations can be expressed in the following image below.

Monthly Rent Collected: $2,200

Yearly Rent Collected: $26,400

Cap Rate= $26,400/$393,000 = 6.7%

The inverse of the proceeding cap rate formula can also be expressed as:

Cap Rate X Value=Net Income

Net Income/Capitalization Rate=Value

Interest paid on a loan is not considered an expense when calculating the cap rate. All other expenses, such as property taxes, repairs, maintenance, property management company or manager, water and power, and any other miscellaneous costs are considered when calculating the cap rate.

Sign Up

Start expanding your real estate knowledge

Already have an account?
By signing up to create an account I accept Proptionary’s

Join Us

Get ahead by signing up for the latest real estate, investment and financial articles.