The basis for establishing the value of a residential home is the selling price of an equivalent property. This same valuation method however is not applicable with income earning properties. For example, try to establish the value of a 24-unit building. Chances are there is no record of a similar property sold in the recent past.
To base the income property appraisal on replacement costs would not be realistic. You will have a problem if there is no real estate property in the vicinity with no proper zoning that is on sale. This form of appraisal however will be a good indicator of whether to buy or build.
The Cap Rate as the Basis of Property Valuation
Rental properties are purchased for their income potential. In this income approach, the value of the property is based on the actual or potential income. The expected return on investment over a period of time in a specific location is the capitalization rate, or the "cap rate" in that area. This is the method used in calculating the appraised value of the rental property. See the following example for a clearer picture.
Compute the gross annual income of the property. You then subtract all expenses, but not loan payments. For example, if a building's gross income is $82,000 per year, and the expenses $30,000, you have a net (before debt-service) of $52,000. Then divide this figure with the capitalization rate.
If the cap rate in the area is estimated at say 0.10, then your expected return on your property value would be ten percent. What you do then is divide your $52,000 net income with .10 which would give a market value of $520,000 for your property. Supposing further that the property investors in the area presuppose an 8% ROI. Your property then will be valued at $650,000.
A Straightforward Property Valuation?
Dividing the net income before debt service with the "cap rate": that is a straightforward process. The next question would be if you are given the true figures. For example, were all the operating expenses deducted? Was the income not overstated? Suppose he stopped repairs for a year, and also showed you the "projected" rents. In that case, the income figure could be $15,000 too high. Going on with your computation and using a .08 cap rate, the actual value of the building would be $187,000 less than the stated value.
To be on the conservative side, property buyers exclude vending and laundry machines from the rental income. If these provided $6,000 of the income, that income would add $75,000 to the appraised value (.08 cap rate). So a realistic valuation would be to consider only actual rental income and to consider the replacement costs of the machines which is assumed to be less than $75,000.
Of course, you should be careful with any real estate appraisal method. Considering that there is no perfect procedure for every situation, be sure to get the right figures in order to get the right answers. If used wisely, though, appraisal by capitalization rates is one of the most accurate methods of real estate valuation.
To base the income property appraisal on replacement costs would not be realistic. You will have a problem if there is no real estate property in the vicinity with no proper zoning that is on sale. This form of appraisal however will be a good indicator of whether to buy or build.
The Cap Rate as the Basis of Property Valuation
Rental properties are purchased for their income potential. In this income approach, the value of the property is based on the actual or potential income. The expected return on investment over a period of time in a specific location is the capitalization rate, or the "cap rate" in that area. This is the method used in calculating the appraised value of the rental property. See the following example for a clearer picture.
Compute the gross annual income of the property. You then subtract all expenses, but not loan payments. For example, if a building's gross income is $82,000 per year, and the expenses $30,000, you have a net (before debt-service) of $52,000. Then divide this figure with the capitalization rate.
If the cap rate in the area is estimated at say 0.10, then your expected return on your property value would be ten percent. What you do then is divide your $52,000 net income with .10 which would give a market value of $520,000 for your property. Supposing further that the property investors in the area presuppose an 8% ROI. Your property then will be valued at $650,000.
A Straightforward Property Valuation?
Dividing the net income before debt service with the "cap rate": that is a straightforward process. The next question would be if you are given the true figures. For example, were all the operating expenses deducted? Was the income not overstated? Suppose he stopped repairs for a year, and also showed you the "projected" rents. In that case, the income figure could be $15,000 too high. Going on with your computation and using a .08 cap rate, the actual value of the building would be $187,000 less than the stated value.
To be on the conservative side, property buyers exclude vending and laundry machines from the rental income. If these provided $6,000 of the income, that income would add $75,000 to the appraised value (.08 cap rate). So a realistic valuation would be to consider only actual rental income and to consider the replacement costs of the machines which is assumed to be less than $75,000.
Of course, you should be careful with any real estate appraisal method. Considering that there is no perfect procedure for every situation, be sure to get the right figures in order to get the right answers. If used wisely, though, appraisal by capitalization rates is one of the most accurate methods of real estate valuation.
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