The income approach is often given primary emphasis when appraising a commercial real estate used to generate income. Estimates of value via the income approach are highly sensitive to changes in revenue, expense and capitalization rates.
Correctly performing a cost approach analysis appears to be and is technically difficult. It appears easy to correctly prepare an income approach analysis for commercial real estate. However, correctly preparing the analysis requires three criteria: 1. an understanding on the type of value, 2. accurate data, 3. accurate application of the income approach.
Commercial income properties can be valued based on the leased fee estate. The fee simple estate is appropriate for properties with leases consistent with market rent and terms. Valuation of the leased fee estate is more appropriate for properties with above market or below market rents. Valuing properties with below market rental rates based strictly upon its actual rental rates would understate its value. Valuing it using market rental rates would overstate its market value.
Accurate data is the basis of a reliable income approach conclusion. This includes information on rental rates, occupancy rates, new construction, absorption, operating expenses and capitalization rates. Rental rates are usually obtained from rental comparables, subject property leases and aggregate market data. The same is true for occupancy rates. New construction can be obtained from personal observation while doing fieldwork, research and aggregate market data.
Operating expenses are evaluated on a line-item by line-item basis. The first step is usually to summarize the subject property's operating expenses for a two to four year period. This is termed "spreading the data". It tends to highlight anomalies in data. Comparable expenses and industry data (IREM and DOMA) can also be useful.
Capitalization rates are estimated based on data from recent comparable sales and discussions with market participants.
The direct capitalization method and the discounted cash flow analysis are frequently utilized to determine estimates of value for the income approach. Other techniques include gross rental multiplier (GRM) and effective gross income multiplier (EGIM).
The formula for the direct capitalization method is as follows:
Market Value = NOI / Cap Rate
NOI is net operating income. Cap rate is capitalization rate.
The formula for GRM is:
Market Value = Gross Possible Rent x GRM
GRM is gross rent multiplier. It is abstracted from market data and discussions with market participants.
The formula for EGRIM is: Market Value = effective gross income x EGIM
Effective gross income is abstracted from market data and discussions with market participants.
The discounted cash flow analysis evaluates net appreciating income and net sales proceeds and discounts these to a current indication of value.
The income approach is often given primary emphasis in appraising income properties. An appraiser "should look through the eyes" of market participants when selecting an income approach methodology. The appraiser should emulate the process of market participants rather than an alternate approach.