When you are shopping to buy a commercial investment property, you first look at the purchase price, then the quality of the property. Lastly, like most investors you examine the net income of the property - this is what really determines if it is worth the purchase price. The Income Approach to Valuation does the same thing. It is without question the most important method that commercial appraisers use to determine the value of a commercial property. After all, this is a business. Does it really matter that the listing realtor tells you the apartment complex you are interested in costs $1.5 Million dollars to build, and like properties are selling for a lot more than that if it only nets annually a ridiculously small amount – lets say $35,000? You are going to devalue the property if it is not earning what it should – right? Again, the Income Approach does the same thing. It takes the net operating income (Gross Income less all operating expenses) as a base for property value. It is in the Income approach that a market cap rate (capitalization rate) is determined. Realtors sell commercial investment properties based on cap rate and lenders rely on it to give them a comfort level on the value of a property. Lenders value the income approach in the appraisal the most. This is because it tells them that in your market the property is not over priced - of course they love that it also tells them that the net income can afford the loan payments.
A residential appraisal has two approaches – the sales comparable approach and the cost approach. The sales comparison approach looks at what similar properties sold for preferably in the last year and compares them to the subject property using pluses and minuses for square footage and amenities. The cost approach simply looks at what it would cost today to buy the land and build the subject property. A commercial appraisal has three methods of determining value. The Income Approach, the Sales Comparison Approach and sometimes the Cost Approach. In most cases the appraiser uses an average of the Sales Comparison Approach and the Income Approach to determine the final value of a commercial investment property.
To determine the Income Approach the appraiser compares the net operating income and capitalization rate of three to six properties in your market with the subject property. First, they review income and expenses for the subject property for the current year to date and for the previous two years. Then they gather the income and expenses from similar type and size properties in your sub market that have sold along with the capitalization rate of each properties. Finally, they average the capitalization rates of all the comparable properties and the subject property to come up with a market cap rate. This market cap rate is then applied to the subject property to determine its value based on the income approach.
For Example: The subject property has a net income of $166,000. Based on the market cap rate of 8.00, the value of the subject property based on the Income Approach will be $2,075,000.
Net Operating Income: $166,000 divided by CAP Rate: .08 = $2,075,000