Income Approach to Value (Income Capitalization Approach)

Definition

The income approach to value, also known as income capitalization approach is used to determine the value of an income generating property by deriving a value indication by conversion of expected benefits like cash flows and reversion into value of property.

This approach is applicable for those properties that generate income like the rental properties which includes non owner occupied building, houses and duplex, apartment building, etc. The income from rent that an owner expects from a property is also a part of the value of that property. This approach is not suitable for purely residential properties that do not generate any income. The value of any income producing property like office building, cell tower rental and storage facility can be determined by the income capitalization approach.

Overview

The income capitalization approach is the approach which is applied to determine the value of an investment or commercial property. This approach to value is best suited for income generating properties that has adequate market data, because it is meant to reflect the behaviors and expectation of participant of typical market.

The income capitalization approach capitalizes the stream of income into an indicator of value of a commercial property that produces income. Capitalization rate or revenue multipliers are applied to NOI that is net operating income in order to do this. An NOI is usually stabilized in order to be less dependent on very recent events. For example, if it is technically seen, then a building that is not leased does not have NOI. A stabilized NOI presupposes that building has been leased to standard occupancy level and at a normal rate.

The net operating income refers to gross potential income (GPI) from which vacancy and collection loss is deducted and then from it operating expenses is deducted. In operating expenses, income tax, depreciation charges made by accountants and debt service is excluded.

NOI = GPI – vacancy and collection loss – operating expenses

Also, NOI for multiple years can be determined by discounted cash flow analysis model. For determining the value of more expensive and larger income generating properties, the DCF model is used.