There are two income-based approaches that are primarily used when valuing a property, the direct capitalization method and the discounted cash flow method(DCF). These methods are used to value a property based on the amount of income it is expected to generate in the future.
Both methods are data driven.
The Direct Capitalization Method is most often used when a property is expected to have a relatively stable level of margins and growth in the future – it effectively takes a single benefit stream and assumes that it grows at a steady rate into perpetuity. The Discounted Cash Flow method, on the other hand, is more flexible and allows for variation in margins, growth rates, debt repayments and other items in future years that may not remain static.
I have valued an income generating properties in different parts of Cebu and nearby provinces and applied both the direct capitalization and discounted cash flow method. Based on the comparable properties and research, I used varying future growth rates (estimating the population growth, property value appreciation, risk and income).
In using this approaches to value, I put my shoes in my investor client. The motivation for the acquisition of property is to generate income.
In the discounted cash flow method, the value of a property is equal to the present value of its projected future benefits (including the present value of its terminal value). The terminal value does not assume the actual but rather represents the point in time when the projected cash flows level off or flatten (which is assumed to continue into perpetuity). The amounts for the projected cash flows and the terminal value are discounted to the valuation date using an appropriate discount rate, which encompasses the risks specific to investing in the specific property being valued. Inherent in this method is the incorporation or development of projections of the future operating results of the subject property.
In using the income approach to valuation, it is important to have a grasp on the present value factor; capitalization rate; to arrive at the present value of the property appraised. After the number crunching of the income statement and other financial documents, an appraiser can get the cash flow in a year and can model the succeeding years on the assumption that it will generate the projected income and growth, either steady or vary in several years.
Income approach is a tool in valuation that an appraiser can continue to harness and be proficient in arriving at a credible and defensible appraisal.
I remember a lecturer in a government assessors seminar, in referring to the application of income approach to valuation. He said, “Private appraisers are more advanced in the applications of different methods in the appraisal. They can apply even the income approach.” Thus, we have to prove it, in practice.