There are three commercially recognized valuation models for real estate: the “comps” approach (comparable market analysis), the “income capitalization” approach (cash flows) and the replacement value approach.
If you’re looking to buy an investment property, you’ll likely want to use the income capitalization approach to determine whether you’d be getting a fair deal. Here’s a breakdown of how it works:
Comps vs. income method
As a refresher, the comparable market analysis approach theorizes that a property that is similar in size, style, age, finishes, location, views and all other characteristics should be worth about the same amount as other comparable properties in its general vicinity around the same date of sale. One property is comparable to another.
The income capitalization approach does the same thing, except instead of using the comparable information about the physical aspects of the property, you primarily use the net operating income (NOI) the property can generate as the comparable feature and determinant of value.
Determining NOI and cap rate
NOI is calculated as the rental income, less all the operating expenses, before taking out the mortgage payment.
Example: Let’s say apartment Building A in La Mesa, CA has NOI of $100,000 and sells for $2,000,000. That’s a capitalization rate of 5 percent — NOI divided by purchase price.
If 20 separate apartment buildings in the general vicinity of La Mesa sold with cap rates of 5 percent in the past 90 days, and another apartment building comes on the market, it probably would also sell for a 5 percent cap rate.
Let’s say a building with NOI of only $35,000 comes on the market. Because the general average cap rate is 5 percent, you’d divide $35,000 (NOI) by .05 (cap rate) to get a value of $700,000. So any apartment building income stream in a similar area can be capitalized by the average cap rate to get an approximate valuation.
This method works best when comparing similar types of buildings, such as apartment buildings to apartment buildings, not apartments to retail or apartments to office.
The income capitalization approach provides an approximation of value and can never supplement determining your cash-on-cash returns on any particular property.
So use the income approach to valuation as you like but always fall back on this question: Are the realistic cash-on-cash returns that I project I will earn on this deal fair enough to make this investment an attractive option?
Leonard Baron is America’s Real Estate Professor® – his unbiased, neutral and inexpensive “Real Estate Ownership, Investment and Due Diligence 101” textbook teaches potential real estate buyers how to make smart and safe purchase decisions. He is a past San Diego State University Lecturer, blogs at Zillow.com, and loves kicking the tires of a good piece of dirt! More at ProfessorBaron.com.