Income Capitalization appraisal also known as income approach assumes that the income derived from a property will control the value of that property. The income approach is used to estimate market value of commercial income producing properties like office buildings, apartment buildings, shopping centers, storage units, etc. It can also be used to estimate value of non-commercial properties income producing properties for which sales comparison approach cannot be used for reasons such as absence of recent comps in the area. With less than 5 units, duplexes and quads are considered residential and an investor will examine both 1. the income of the property as well as 2. comparable sales in the area. Here we will review step by step all formulas needed to calculate the Net Operating Income, Capitalization Rate, Cash Flow and the Return on Investment aka Cash on Cash return.
1. Projected Gross Income (PGI)
First, determine the projected gross income using rents from comparable properties as well as income from other sources like concessions, laundry, vending machines, etc. This is the maximum income a property can collect if there are no vacancies and is estimated for 12 months.
2. Effective Gross Income (Income)
Second, calculate the gross income accounting for 5-10% vacancies depending on market conditions of the area and rent related collection losses. These are subtracted from the Projected Gross Income:
PGI – VACANCIES – COLLECTION LOSS = Income
3. Operating Expenses (Expenses)
Third, determine your Fixed and Variable Expenses.
The Fixed Expenses include:
- Real Estate Taxes, and
The Variable Expenses include:
- Property Management Fees
- Maintenance and Repairs
- Reserves for replacement costs i.e. roof
4. Net Operating Income (NOI)
Now you can derive your NOI. The Net operating Income is your Income minus Expenses and needs to be higher than your debt service.
INCOME – EXPENSES = NOI
5A. Capitalization Rate or Cap Rate
The capitalization rate is your return if you paid cash for the investment without looking at debt service.
On average a Cap Rate higher than 8% is good. Higher capitalization rates of 10% and up doesn’t always mean a great deal as these are typically achieved on properties in lower income neighborhoods where sales prices are more economic but riskier with higher vacancies and collection losses. Lower capitalization rates under 6% are typically found in higher priced neighborhoods with stable income flow but lower profit margins. Once you have your NET OPERATING INCOME or NOI you can arrive at the Cap Rate or if you have the Cap rate and the Sales Price you can calculate the NOI.
Consider a scenario where the owner is getting a NET OPERATING INCOME of $136,500 for a property he bought for $1,450,000. What is the CAP RATE for this commercial property? The CAP RATE = $136,500/$1,450,000 = 0.0941 times 100 to get percent and rounded is 9.4% CAP RATE. The formula is:
CAP RATE = NOI / SALE PRICE
Consider another scenario where you are the buyer looking at a commercial property where the seller is claiming NOI of $56,432 at a CAP RATE of 8%. If the CAP RATE is comparable and reasonable to the local market area, what should be the asking price? The SALES PRICE = NOI/CAP RATE or $56,432 / 8% = $705,400.
SALE PRICE = NOI / CAP RATE
If the CAP RATE is given and the SALES PRICE is presented you can typically estimate the NOI or NET OPERATING INCOME from the same formula:
NOI = SALE PRICE x CAP RATE
5B. Cash Flow
The CASH FLOW is your monthly passive net or take home income after all expenses and debt is paid. It’s all about the cash flow for most investors. The formula is:
NOI – MORTGAGE = Cash Flow
6. Cash on Cash or ROI
This is the annual return on your own cash and your borrowed funds as you are making money with the help of other people’s money by taking out a “good” debt. A return on investment of 10% or higher is excellent but lower percentages initially will get better with the appreciation of home values and raise of rents. Cash on Cash or Return on Investment or Equity Dividend Rate are the common terms used to describe this formula which is:
ROI = CASH FLOW / DOWN PAYMENT
Below is a great video that summarizes how to assess real estate properties, how to perform the income capitalization calculations and how to apply them in practice.