What is the income approach?
Well, first we need to start with what an appraiser is. An appraiser is a person qualified by education, training, and experience to estimate the value of real and personal property. An appraiser is usually hired by a lender to give their unbiased opinion to the lender on the value of a property. The income approach is one of the formulas the appraiser can use to come to a valuation of a property.
When would an appraiser use the income approach to arrive at a valuation of property?
The income approach is used whenever an appraiser is appraising an income producing property. The valuation or appraisal of real property is determined by the amount of net income the property will produce over its remaining economic life. With this method, the market value is equal to the present worth of future net income.
How does an appraisal arrive at a value using the income approach?
Four main steps are used in calculating a valuation using the income approach:
- Estimate the potential annual gross income, that is, the income that would accrue if all units were rented at their market value.
- Determine the effective gross income by deducting an allowance for vacancy and collection loss.
- Determine the annual net operating income by deducting the annual expenses of operation.
- Apply the appropriate capitalization rate to the annual net income.
How is the capitalization rate determined in the income approach?
This is the most challenging step in the income approach process. The capitalization rate must be selected to reflect the recapture of the original investment over the economic life of the improvements accurately, and thus to give the investor an acceptable rate of return on his or her initial investment and provide for the return of borrowed capital.
What are the benefits to the income approach?
The main advantage of using this approach is that it best approximates the expectations of the typical investor in an income-producing property who is looking for a money return on the investment.
Are there any other options an appraiser has when estimating the value of a property other than the income approach?
Yes, two other approaches may be used to evaluate the value of a property, and they are as follows:
- Replacement Cost or Summation Approach
- Sales Comparison Approach
Here is a sample real estate test question based upon the income approach:
An appraiser would most likely use the income approach when estimating the value of which of the following:
A. Single family home
B. Office building
C. Vacant residential lot
Explanation: Appraisers will most likely use the income approach to estimate the value of an office building.
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