Calculating valuation using the income capitalization approach
Once you've calculated a property's NOI and determined its cap rate, you can estimate its value by dividing the two numbers.
Here's a simplified example: Let's say you're in the market for an office property and find one generating rental revenue of $100,000 per year. You estimate the property's operating expenses will be about $25,000 per year, so you can reasonably expect the subject property to produce net operating income of $75,000 in your first year of ownership.
Based on a recent cap rate survey, you determine the market average cap rate for this type of property in your local market is 6.5%. By dividing the $75,000 in estimated NOI by this cap rate (remember to convert the percentage to a decimal, or 0.065), the property's fair market value by the income capitalization approach would be just over $1.15 million. This can help you determine how much to offer for a property on the market or decide how much to ask for a property you plan on selling.
Shortcomings of the income capitalization approach
There's no perfect way to determine the value of real estate. If I were to ask five experienced real estate investors to calculate the value of an office building, they'd probably use five different valuation methods -- and come up with five different numbers.
Even within the same valuation method, there can be significant variances. So when using the income capitalization approach, here are shortcomings you should be aware of:
- Even if a property is currently leased to tenants, it's difficult to calculate NOI with accuracy. Several operating expenses can be particularly hard to predict, such as maintenance costs and marketing expenses, just to name a couple.
- Determining what cap rate to use isn't an exact science. You can use market-average cap rates from an industry report, but that doesn't take into account some particular variables of a specific property. Alternatively, you could ask an experienced commercial real estate broker for their opinion, or you can do your own market analysis based on comparable sales to determine the property's cap rate.
- Property-specific factors can dramatically affect the property's market value. For example, if a building immediately needs a new roof, it would be worth less than a comparable property with a roof in excellent shape. Different lot sizes can also play a big role. Two apartment buildings might produce the exact same NOI, but if one is on twice as much land, it plays a role in valuation. After calculating a property's value with the income approach, it can be a good idea to make adjustments for any factors like these.
Other methods of determining property values
As I alluded to in the last section, there are many different ways an investor can determine the value of a commercial property. Aside from the income capitalization approach -- which is certainly one of the most popular and effective -- there are two other popular methods:
- Sales comparison approach: This method involves examining sales of similar properties, also known as comparable properties or sales comps, in the same geographic region to determine fair market value of a property. This can be a better way to find a location-specific property value, especially if you're in a particularly active real estate market where conditions are changing rapidly.
- Cost approach: The cost approach to real estate valuation is essentially a sum-of-the-parts analysis of the property. In a nutshell, it involves determining how much it would cost to build a similar property from the ground up and then make adjustments for its current condition.
Is the income capitalization approach the best way to go?
As with any valuation model, the best way for real estate investors to use the income capitalization model is in combination with several other valuation methods. As mentioned, all valuation methods have shortcomings, so incorporating a few of them into your investment activities can give you a better idea of how much a particular property is truly worth.
A final thought: The income capitalization approach is only as effective as your assumptions when calculating it, so I strongly suggest you err on the side of caution when estimating a property's NOI as well as in the cap rate you use. (Note: A higher cap rate produces a lower valuation.) In short, it's better to be conservative than overvalue a potential investment.