What is the Income Approach?
Definition: The income approach is a popular concept in both finance and economics. In finance, the income approach is a tool that helps appraisers to determine the value of an income-generating asset. On the other hand, economists use the income approach to determine the gross domestic product (GDP) of a country’s economy.
From the finance perspective, the income approach is one among three techniques that investors use to determine the value of real estate property. Like any other investment, real estate investors aim to maximize their profits. However, the profits might be hard to come by if you make the wrong decision. For example, if you overpay for the real estate asset, you might end up in major losses in future.
To that end, professionals use the income approach to appraise the real estate asset. The appraisal process includes determining the potential income that the asset will generate against the current market value of the asset. During the appraisal, the professional will rely on two techniques, which are the discounted cash flow method and the capitalization of cash flow technique. To utilize the techniques well, professionals focus on the future income of the asset. Not only can the income approach help to appraise the value of a real estate property but it can also help to determine the value of a company.
Income Approach Formula
Income Approach GDP Calculation
Simply, the GDP of a country represents the market value of the final products and services that the economy produced for a given period. The income approach helps to compute this market value by first determining the total national income (TNI). Particularly, the TNI represents the sum total of income that businesses and citizens of the country earned over the period in question.
Total income for a country is simply the sum of all wages and salaries (W), the rent (R) earned by businesses and individuals, the interest (i) on investments, and the profits (P) from business activities. Therefore, the TNI can be represented as TNI = W + R + i + P.
However, TNI alone does not provide the full picture of a country’s GDP. That is why there is need to adjust for depreciation (D), net foreign factor income (F), and sales tax (T). From the foregoing, the formula for calculating the GDP of a country is GDP = TNI + D + F + T.
Income Approach to Business/Real Estate Appraisal
From the perspective of finance, the income approach is a complex approach to valuation of an asset. As earlier noted, professionals use two techniques during the valuation process. On the one hand, the discounted cash flow technique focuses on three things i.e. the cash flow during the first year, the required rate of return, and the growth rate of the asset. Important to note is that this technique assumes the value of the business or real estate grows perpetually.
When dealing with valuation of real estate, the income approach shows the present value of the future income of an asset. For example, an investor that wants to buy an apartment block today will use the discounted cash flow technique to estimate the future income of the property. This technique depends on rental income to compute the present value of future cash flow. As such, it is the most popular among professionals.
However, professionals have to recognize certain things that might significantly affect the accuracy of the technique. Some of the special considerations include the average occupancy rate of the property, operating efficiency of the property and its general condition.
Income Approach Example
Using the Income Approach in Property Valuation
There are various methods that the income approach uses to estimate the future value of property.One of them is direct capitalization method. Here, appraisers use rental income earned in a single year to forecast future cash flow. Usually, the most common income measure used is the net operating income (NOI). Notably, the NOI is the remaining income after deducting all vacancy and credit losses, and operating expenses.
The direct capitalization method relies of a constant stream of up to date sales data. This data is essential when computing the market multiplier. To get the future value of the property, all you need to do is to multiply the market multiplier by the forecasted income of the property i.e.
Net Income Multiplier (NIM) = sales price / NOI
Where NIM is the market multiplier. Hence, future value = NIM x forecasted income.