Real estate valuation approaches -income approach

The Income Approach (also called the Income Capitalization Approach) estimates the value of a property based on the income it generates or is expected to generate in the future.

It is founded on the principle of anticipation, which states that the value of an investment property equals the present value of the future benefits (income) it will produce.

💡 Key Concept:

This approach is mainly used for income-producing properties, such as rental apartments, office buildings, or commercial real estate.

🧮 Basic Formula:
Property Value
=
Net Operating Income (NOI)
Capitalization Rate (Cap Rate)
Property Value=
Capitalization Rate (Cap Rate)
Net Operating Income (NOI)
​


Where:

NOI (Net Operating Income) = Gross Income – Operating Expenses

Capitalization Rate (Cap Rate) = Rate of return expected by investors

📊 Steps in the Income Approach:

Estimate Potential Gross Income (PGI):
The total income the property could generate if fully occupied.

Deduct Vacancy and Collection Losses:
To obtain the Effective Gross Income (EGI).

Deduct Operating Expenses:
Such as maintenance, insurance, property management, and taxes.
(Exclude financing costs and depreciation.)

Calculate Net Operating Income (NOI):

NOI
=
EGI
−
Operating Expenses
NOI=EGI−Operating Expenses

Select the Capitalization Rate (Cap Rate):
Based on market data, investor expectations, and property risk.

Compute the Property Value:

Value
=
NOI
Cap Rate
Value=
Cap Rate
NOI
​

📈 Alternative Method – Discounted Cash Flow (DCF):

For properties with variable or uneven income, the DCF method can be used:

Value
=
∑
Expected Cash Flow
𝑡
(
1
+
𝑟
)
𝑡
Value=∑
(1+r)
t
Expected Cash Flow
t
​

​


where r = discount rate and t = time period.

✅ Advantages:

Reflects the income-earning potential of investment properties.

Useful for commercial and rental properties.

Helps investors assess returns and profitability.


Relies on accurate income and expense data.

Cap rate estimation can be subjective and market-sensitive.

Less applicable to non-income properties (e.g., schools, churches).

Sensitive to changes in market rents and interest rates.


Rental apartments

Office buildings

Shopping centers

Industrial properties


In exams, start by stating the principle of anticipation, outline the steps, provide the formula, and end with advantages and limitations. Use an example of a rental property for illustration if time allows.