In commercial real estate, there are a few generally accepted methods for appraising (or valuing) real property. The three most common are the Cost Approach, the Sales Comparison Method, and the Income Approach. The Income Approach includes two methods, the simpler of the two is the Direct Capitalization method, which this post will cover. The second Income Approach method is the Discounted Cash Flow (DCF), which is not covered in this post but is covered in-depth elsewhere here at A.CRE (see our A.CRE Ai1 as an example of a robust DCF).
Each approach has its advantages and when used in tandem, the various valuation methods give you – the real estate professional – the best idea of what the income-producing real estate you’re analyzing is worth. However, it’s not always prudent to take the time to go through each. Thus, the Income Approach is most commonly used, especially in the early stages of analysis, to appraise real property.
This post, the first in our A.CRE 101: Basic Concepts in Commercial Real Estate series, will introduce you to the Income Capitalization Approach and show you how you can use it to quickly estimate the value of income-producing real estate.
Definition: What is the Income Approach?
First a definition to get the post started. Barron’s Dictionary of Real Estate Terms defines the Income Approach as:
“One of three approaches to appraising real estate. (The others are the Cost Approach and Sales Comparison Approach.) Typically considered the most important for Apartments, Office Buildings, Hotels, and Shopping Centers. Two principal methods are Direct Capitalization, which is based on 1 year of income, and Discounted Cash Flow, based on a multiple-year projection period and reversionary value.”
I’d add that the Income Approach is equally as important for Industrial properties as it is for those property types listed above, and that this approach can be used generally with any property that produces consistent, predictable income. Note though, that the Income Capitalization Approach can not be used with for-sale real estate investments such as condos, for-sale single family, land development, etc.
Basics of the Income Capitalization Approach
To understand the Income Capitalization Approach (i.e. Direct Capitalization), we must first understand two other basic real estate concepts: Net Operating Income and Capitalization Rate. Net Operating Income is the net income from a property, in a given period, after deducting operating expenses but before deducting capital expenditures, debt service, and taxes. The formula for Net Operating Income is:
Effective Gross Income – Operating Expenses = Net Operating Income
The Capitalization Rate is a complex real estate financial term that I’ll oversimplify for purposes of this post. Simply put, it is the ratio of net operating income to a property’s value (NOI ÷ Value = Cap Rate) and generally represents an owner’s return on investment in a given year before accounting for capital costs, amortization, depreciation, taxes, etc. So while I’ll leave the definition for Cap Rate at that, keep in mind the Cap Rate is probably the most widely used, but least understood concept in commercial real estate and deserves further exploration beyond this post. If interested, you might check out this, this, this, or this.
Steps to Completing a Valuation via the Income Capitalization Approach
On its face, this method is incredibly simple:
- Calculate a Pro Forma/Stabilized Net Operating Income
- Determine the appropriate Capitalization Rate
- Divide the Net Operating Income by the Cap Rate to arrive at an estimated value
Net Operating Income ÷ Cap Rate = Property Value
In the embedded video below, I walk you through the process in real-time, and offer some insights into what actually goes into steps 1 and 2.
Important Considerations When Using this Method
As you’ll see in the video, there are numerous considerations that go into this method. While the steps are simple, determining the right NOI and the most appropriate cap rate is where your value as a real estate professional is earned. I’ll most of the details to the video, but allow me to offer a few considerations (rules) when performing this analysis.
- Only cap a stabilized, long-term net operating income. One of the biggest mistakes young real estate professionals make, is to use an unstabilized net operating income in their calculation. The Direct Capitalization method assumes all income and expenses that go into the Net Operating Income are current and perpetual.
- Make sure to use an income figure commensurate with a stabilized occupancy.
- Never include sporadic, one-time, or temporary income or expenses (e.g. lease termination fees, temporary tax incentives, lease-up concessions, etc. ).
- And only include income and expenses directly associate with the property (e.g. generally don’t include interest income, asset management fees, fund-level fees, company-level expenses, etc).
- The resulting value is highly sensitive to minor adjustments to income and expenses. At a 5% cap rate, a $10,000 increase in NOI results in a value that is $200,000 higher. Thus, the income and expense assumptions you use to drive the net operating income are very important. The valuation that your analysis spits out is only as good as the assumptions that went into the analysis; hence the reason CRE professionals are paid the big bucks!
- The more data you have, the better your assumptions will be and the more accurate your resulting valuation will be.
- Get as much property operating and occupancy history that you can.
- Know the tenants, their position in the submarket and financial health, and how their in-place rents compare to market.
- Purveyors of market data (e.g. CoStar, REIS, CBRE Econometrics, RCA, etc) are worth their weight in gold.
- Understand each income and expense item, and ask yourself – is this item likely to persist at or above its current level into perpetuity? If not, make an adjustment to that item accordingly.
- Support your income and expense assumptions with comparable rents and expenses at similar properties in the market.
- Use a realistic, market-proven cap rate. Just as value is highly sensitive to changes in NOI, small adjustments up or down to your assumed cap rate can have an equally great impact. The cap rate you use should be supported by recent sales and/or justified by solid data.
- Develop a strong set of comparable sales to support your cap rate assumption.
- Trust but verify – just because a data source or an acquaintance told you a given deal traded at a certain cap rate does not necessarily make it true. Ask around and do your best to confirm what your data sources are telling you.
- Compare the assumed cap rate to the prevailing risk-free rate (USTs in the United States) and market discount rates. Know the spread between each and ask yourself, is this appropriate and/or likely to persist?
Watch our Video on How to Use the Income Capitalization Approach in Real Estate
Download the Excel File Used in the Tutorial
- Excel file used in tutorial for How to Use the Income Approach to Value Income-Producing Property
- Build a Pro Forma to arrive at Net Operating Income
- Select a Cap Rate to use, together with net Net Operating Income, to derive a potential value