Getting an accurate real estate appraisal for your investment property is crucial to your business. One of the appraisal methods is the income capitalization approach. What does it mean? How do calculate value with this method? And what other methods of property valuation are there? In this article, we will discuss this property valuation method and break it down in the simplest way possible.
But since the income capitalization approach is one of three main property appraisal methods, let’s talk a little about the other two, so you can understand the difference and the usage of each technique.
Methods of Investment Property Appraisal
In real estate investing, there are three main ways to appraise investment property. The first is through comparative market analysis. The second is the cost approach. The third is the income approach. Each of these methods is used differently and serves different purposes. Let’s take a look:
The Comparative Market Analysis
The comparative market analysis is one way of estimating the property’s value. The way you conduct it is by finding real estate comparables (comps) and comparing the subject property to them. These comps must be similar in type, lot size, square footage, number of bedrooms and bathrooms and they should be located within the same neighborhood. This process will guarantee the most accurate results in real estate appraisals.
To learn more about the comparative market analysis and how Mashvisor’s investment property calculator can help you find real estate comps, click here.
The Cost Approach
The cost approach is another method of property valuation. It is based on the cost of property construction and the cost of the land it stands on. The easiest way to explain this approach is by saying that the price of the investment property should be equal to the cost of building an identical building minus the depreciation which explains why this method is very precise.
This property valuation method is mostly used by real estate appraisers to evaluate select-use properties such as schools and churches. Other types of property which are evaluated using the cost method are commercial real estate– especially if it’s a new building. Insurance companies also use this approach to estimate the value of a property that is the subject of an insurance policy.
Note that we did not mention residential real estate here. Using this property valuation approach for residential properties is rare. In most cases, real estate appraisers and investors use either the comparable approach or the income capitalization approach for residential property valuation.
Now that we are done with two methods, let’s take an in-depth look at the income capitalization method:
What Is the Income Capitalization Approach?
Income capitalization approach, as we have mentioned, is one of the three main methods used by real estate appraisers and real estate investors to estimate the value of an investment property. In essence, it focuses on the income the investment property produces. Therefore, it is a way of turning the property’s income into value. The more income generated by the property, the higher its value.
The Income Capitalization Approach Formula
The income capitalization formula looks like this:
Property Market Value = Net Operating Income (NOI) / Capitalization Rate
As you can see, this appraisal approach consists of two main variables: the capitalization rate and the net operating income (NOI). So, here’s how to calculate each of the components:
How to Calculate NOI
The net operating income is the monthly cash flow an investment property generates multiplied by 12. So, if we were to calculate the monthly cash flow of a rental property, it would look like this:
Rental Income – Rental Property Expenses (mortgage, insurance, property management, etc.) = Monthly Cash Flow
Let’s put this into action to make sure you got the idea:
You own a duplex that is fully occupied and generates $1,500/unit/mo. You have a mortgage payment of $800/mo., an insurance payment of $150/mo., and you manage your rental property on your own, so that means you have no professional property management fees. But you pay $100/mo. for landscaping services to a contractor. What is the cash flow?
Cash Flow = (1500*2) – ($800 + $150 + $100)
= $3000 – $1050 = $1950 positive cash flow on a monthly basis.
So, now, how do you calculate the NOI?
You multiply the cash flow value by 12 because the NOI is the annual cash flow of an investment property. $1950 * 12 = $23,400.
Determining Cap Rate
The capitalization rate is the second component of the income capitalization approach. It is one of the return on investment metrics which estimate the expected returns relative to the property’s market price. It excludes any investment property financing methods you use (mortgage, hard money loan, etc.).
The cap rate formula looks like this:
Cap Rate = NOI / Property Value
To demonstrate how it works, we’ll take the previous example and suppose that you purchased the duplex for $200,000.
Cap Rate = $23,400 / $200,000 = 0.117 (11.7%)
Notice, this example includes a high cap rate property, which means it looks like one that is profitable. Also, notice that we used the NOI in this formula as well. Therefore, it means that the NOI is an important measure for all return on investment and appraisal calculations.
However, not all cap rate calculations are this simple. Sometimes, you’ll find real estate properties that have more variables which might make the calculation more complicated. And when using the income capitalization approach, it’s much easier to have readily calculated cap rates. Therefore, you’ll need to use real estate investment tools and resources. A cap rate calculator is the resource you’re looking for! Mashvisor’s cap rate calculator has your back since it provides a real estate investor with readily calculated cap rates that you can use for the income capitalization approach formula.
The Income Capitalization Approach Calculation
First, let’s take a look at the income capitalization formula:
Income Capitalization = NOI / Cap Rate
Let’s put this to work in a different example:
Let’s say you are looking for investment properties and stumble upon a property with an 8% capitalization rate and it generates $20,000 in NOI each year. What is the property’s estimated value?
IRV = 20,000 / 0.08 = $250,000
Here you can see that the property’s estimated value is $250,000. The reason is apparent; it is the high capitalization rate which means it is a financially promising rental property, and it is generating a good amount of positive cash flow on an annual basis.
It all seems simple and easy to conduct. However, unless you’ve been in the business for a few years, it is hard to do on your own. You will always find new variables which are different from one investment property to another. You may want to see expert help in order to ensure you are calculating property value accurately. Mashvisor has provided all the necessary real estate investing tools in conducting all types of analysis and property valuation techniques. To learn more about how we can help you find profitable investment properties, schedule a demo.