The income method is seldom used in appraisal. Most probably not used in banking institutions. But how are we sure that we are using the right method in valuing real estate properties? Properties that generate income such as apartment buildings, leasable buildings or even public owned enterprise properties subject for litigation should be appraised using the income approach. Lets dive deeper into this method.
This approach converts the income generated or projected income expected to be generated by a property into an estimate of value using one of two ways: direct capitalization or discounted cash flows. Both approaches use two important components: (1) current or estimated cash flows and (2) a capitalization rate or discount rate.
Estimated cash flows should be realistic enough and comparable to the current and historical financial data of the property. Additional considerations such as the economy or market trends can also impact estimates. Future plans to expand or add additional assets to the property should also be considered if this will increase your cash flow generated from the property.
The capitalization rate or discount rate should be determined and derived from market data. The capitalization rate is used to determine a sales price at a given point in time where factors of the market approach can be used. The sales price could be a current sales price determined by capitalizing the current year’s net operating income. Sales price could also be a future sales price determined by capitalizing the estimated net operating income of a future period. The discount rate is the total rate of return a buyer would require to purchase an investment and is used to discount the estimated future cash flows to a present value because a peso received in the future is worth less than a peso today due to time value of money. The discount rate makes the present value of the property’s future cash flows equal.
An appraisal is extremely beneficial in providing information for valuing property. Thus, Valuers should strive to level up their professional practice and use different methods to arrive at a justifiable and fair market value. That is, a market value that is fair to all concern.