The three approaches
Income: value as a function of what the property earns
For property bought for its return, value is the income it produces divided by the rate a buyer would require. Almost every disagreement inside this approach is a disagreement about that rate.
The mechanics
Net operating income over a capitalisation rate
Direct capitalisation divides a single year of stabilised net operating income by a capitalisation rate drawn from comparable sales. Discounted cash flow projects income over a holding period and discounts it to present value, and is used for property with irregular income or lease up assumptions.
Both are arithmetically simple. The difficulty is entirely in the inputs. A property earning one hundred and twenty thousand in net income is worth one point five million at an eight percent rate and two million at six. Nothing about the property changed; only the rate did.
Where an income approach is in dispute, the capitalisation rate is almost always the pressure point. It should be derived from sales of comparable investment property, and the derivation should be shown rather than asserted.
Contested inputs
What to question in an income analysis
| Input | Common dispute |
|---|---|
| Market rent | Whether below market leases in place depress the figure, and whether they should |
| Vacancy allowance | Whether the rate reflects this submarket or a national average |
| Expenses | Whether owner costs, management and reserves are realistically stated |
| Capitalisation rate | What sales it was derived from and how comparable those investments are |
| Holding period assumptions | In a discounted analysis, whether growth and exit assumptions are supported |
In a partial taking
Income analysis for the remainder
Where part of an income producing property is taken, the approach is applied twice like any other method. The remainder is analysed with the income it will produce after the taking: fewer parking spaces, a changed entrance, a smaller yard or reduced lettable area all show up as lower rent, higher vacancy or both.
This is often where the clearest evidence of severance damage appears, because the effect on income is measurable in a way that the effect on a residential property\u2019s amenity is not. A tenant who renegotiates rent after an access change has produced direct evidence.
Questions about the income approach
My tenant pays below market rent. Does the appraisal use the lease or the market
Generally market rent, since fair market value assumes a sale between willing parties and a buyer would price the property on its market earning capacity. The leasehold interest may be valued separately where a lease has value of its own.
Does the income approach apply to my owner occupied business premises
It can. The property is valued, not the business. An owner occupied building is valued on what it would rent for, not on what the business earns inside it.
Is lost business income compensable
Usually not as part of the valuation. The income approach prices the real estate\u2019s earning capacity, not the enterprise. A few states compensate business damages separately by statute.
Get a valuation question answered
If an offer has arrived and the number does not match what you believe the property is worth, the appraisal behind it is the place to look. Start with the pages below.