The formula is: Value = Net Operating Income (NOI) / Capitalization Rate. The appraiser calculates potential gross income, subtracts vacancy and collection losses for effective gross income, then subtracts operating expenses for NOI. Operating expenses include property taxes, insurance, maintenance, and management fees but NOT mortgage payments, income taxes, or depreciation. A lower cap rate indicates higher value.
An apartment building generates $200,000 in potential gross income. After deducting 5% for vacancy ($10,000) and $90,000 in operating expenses, the NOI is $100,000. Using a cap rate of 8%, the value is $100,000 / 0.08 = $1,250,000.
The income approach formula (Value = NOI / Cap Rate) is essential. Remember that mortgage payments and income taxes are NOT operating expenses. Know the inverse relationship between cap rate and value—as the cap rate decreases, value increases.
Related Terms
Related Concepts
Depreciation is an accounting method of allocating the cost of an asset over its useful life, allowing investors to deduct a portion of the asset's cost each year.
Highest and best use is an appraisal concept that identifies the most profitable, legally permitted, physically possible, and financially feasible use of a property. It is the foundation of all property valuation.
The comparable sales approach estimates a property's value by comparing it to similar properties that have recently sold in the same market area. It is the most widely used and reliable approach for appraising residential properties.
The cost approach estimates a property's value by calculating the current cost to rebuild the improvements, subtracting accumulated depreciation, and adding the land value. It is most reliable for new construction and special-purpose properties.
Reconciliation is the final step in the appraisal process where the appraiser analyzes the value indications from all applicable approaches and arrives at a single final opinion of value. It is not a simple average of the three values.
Frequently Asked Questions
Study This in Your State
Income Approach may have state-specific rules. Choose your state to study Valuation with localized content: