The income approach is a type of valuation process or approach that is commonly employed by appraisers during the process of evaluating the value of real estate or other holdings. While the formula used as part of the approach will vary somewhat depending on the type of holding involved, the general idea is to determine what type of income or return can reasonably be expected from the asset within a specified period of time. Investors commonly utilize the income approach when considering the potential of residential or commercial real estate in terms of the level of income that could be generated from renting or leasing the property.
For the most part, the income approach makes use of methods that fall into one of three different categories of classes. One method is known as direct capitalization. This method involves identifying the annual net operating income and dividing it by the capitalization rate that is related to the property. The amount of the annual net operating income includes consideration of maintenance costs, property improvements, depreciation, insurance and any other factor that will reduce the profits associated with owning and using the property in a revenue generation venture. If the resulting figure does not indicate that the property will generate income above and beyond that needed to operate the venture, investors will likely seek opportunities elsewhere.
A second method to the income approach is known as the discounted cash flow method. Here, the idea is to relate the annual cash flow with the discount rate in order to determine the capitalization rate. This is different from the direct capitalization method in that a market-derived rate is not used in the calculation. Depending on whether the goal is to use the property as an investment over the long term, the net operating income may or may not be a major factor in this method.
The gross rent multiplier is a method within the income approach that takes into consideration the revenue generated by rents and leases of the real estate in comparison to the selling price of the property. Depending on the goals of the investor, it may be more helpful to determine the ratio between annual rent and the selling price, or calculate the ratio between the selling price and the monthly rental or lease amount. When the idea is to buy rental homes or apartment buildings as a long-term investment, this method provides a quick snapshot of the base income that can be expected from the property. Often, this method is used in conjunction with one of the other two methods in order to determine if the investment is really worth the time and money of the investor.