Income Approach (Valuation) – Definition

Cite this article as:"Income Approach (Valuation) – Definition," in The Business Professor, updated July 30, 2019, last accessed June 2, 2020, https://thebusinessprofessor.com/lesson/income-approach-definition/.

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Income Approach Definition

There are many valuation methods and appraisal approaches that evaluators use when determining the fair market value of a property. The income approach is a valuation method used by appraisers to estimate the fair value of a property. The income approach is also called the income capitalization approach. To get the value of a property using the income approach, the capitalization rate of the property is divided by the net operating income (NOI) of the property.

Here are the major points to note about the income approach;

  • In real estate, the income approach is a valuation method for determining the value of a commercial property.
  • Income-generating properties are the category of properties that can be evaluated using the income approach.
  • To calculate the value of a property using this approach, the net operating income of a property would be divided by its capitalization rate.
  • Costs of maintenance and repair and how well a property is efficiently used are important factors to consider when using this approach.

A Little More on What is the Income Approach

There are three popular valuation methods for evaluating the value of properties in real estate, they are; comparable sales approach, income approach, and cost approach. The income approach is regarded as the most complex of the three methods, it is used for real estate properties that generate income only. When using the income approach, the net operating income that the property generates through rent as well as the capitalization rate are of importance.

Investors use the income approach to evaluate the future value of a property when sold under normal market conditions and how profitable the property is at the moment.

Special Considerations

The income approach is specifically used to evaluate properties in commercial real estate, that is, properties that are income-generating are most suitable under the income approach. Investors that evaluate the value of a property using the income approach need to pay attention to the condition of the property as at the time it is being rented. Excessive maintain and repair costs can reduce the income a property generates. If the rent collected on the property is less than the expenses incurred, the property is not profitable. How well a property is being operated also determines the net operating income of the company.

Example of the Income Approach

Using the income approach, investors are able to estimate the future value of a property and the cash flow that the property would generate.  Also, investment decisions are informed when investors have an idea of how much a property would worth when compared to other properties. For example, an investor that wants to invest in a property can value the property by dividing its net operating income by the capitalization rate, this would help to know the worth of the property and make decision whether to invest in it or otherwise.

References for “Income Approach

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