The Income Approach is one of three approaches to evaluating of property. The income approach refers to an appraisal technique called the gross rent multiplier (GRM). GRM is a technique which is used to estimate market value of property.
For calculating the value of GRM we need to know the monthly rents and sales prices of similar houses or apartment buildings.
Simply, GRM= Sales price/Monthly rent
We need to know that the GRM method has no direct adjustment for sales or financing concessions, different features, location, property condition, or property operating expenses, this technique yields a first pass appraisal. However, many investors use it as because of its simplicity. GRM method is best when you can find a similar property in the same neighborhood.For multi-unit income properties, the gross rent multiplier is usually based on annual rent collections rather than monthly rents.The GRMs shown in these examples do not necessarily correspond to the GRMs that apply in your city. You must seek out relevant local data before you calculate gross rent multipliers. In short for the application of this method it is necessary to know your local market.
Income Capitalization
Direct capitalization is used to value multi-unit income properties This method uses the following value formula:
V =NOI/R
V represents the value to be estimated. NOI represents the net operating income of the property. R represents the overall rate of return on capital that buyers of similar income properties typically require.
Net Operating Income
Net Operating Income is potential gross annual rental income from a property less vacancy and collection losses, operating expenses, replacement reserves, property taxes, and property and liability insurance. To calculate Net Operating Income we must have a net income statement. Simply itemize and total all operating expenses, subtract this amount from the effective gross income. The resulting figure equals net operating income (NOI).
When you calculate NOI, make sure you include all expenses for the coming year. Never accept a seller's income statement as accurate. Sellers notoriously omit and underestimate expenses. Ask to see the seller's tax return IRS Schedule E for the subject property.The truth will probably sit somewhere between the owner-prepared income statement for sales purposes and a tax return. Even if the seller is perfectly truthful in reporting last year's income and expenses, estimate how each of those figures might move up or down in the coming years. You're buying the future, not the past.
Estimating Capitalization Rates
After you calculate NOI, following what you need to determine is, what capitalization rate (R) to use. When you buy a rental property, you're actually paying now for the right to receive rents over the next years.The question becomes how much these future rents are worth in today's dollars. Example, let's assume that the capitalization rate is 6% and we calculate NOI who say $ 56,100. Then the market value would be $56,100 (NOI) / 0.06 (R) = $ 935,000 (V).
You must be asking fro where I get this 0.06 capitalization rate. You estimate it from the capitalization rates that other investors have applied to buy similar properties. But in real life you may not be able to discover enough similar properties with a narrow range of cap rates. More likely, you'll find that some properties have sold with cap rates of 4.0 to 5.0 percent (or lower) and others have sold with cap rates of 7 or 8 percent (or higher). Why such large differences?
Investors are not just buying a quantity of future rental income. They also pay for quality. In addition, they pay for expected appreciation. Therefore the lower the quality of the income stream, and the lower the expected rate of appreciation, the higher the capitalization rate (or the higher the quality of the property's income and appreciation potential in the eyes of the market-the lower its cap rate).
Marko Lesko is the senior business advisor specialized in marketing, finance and investment. He has his personal blog Genius Solutions where you can find some of his works.
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