The income approach to value must be developed in an appraisal when

The income approach to value must be developed in an appraisal when
The three recognized approaches to developing an opinion of value include: cost, sales comparison, and income capitalization. Sadly, the income approach to value gets the least attention from productive residential appraisers. Many have a boilerplate excuse either copied from someone else or written to attempt a one-size-fits-all statement that eliminates the need to seriously consider one of three ways to develop an opinion of value. If you look at their workfiles (assuming they have one), you will not find a list of nearby rentals, or any attempt to find recently sold properties that were rented at the time of sale. A good forensic reviewer can quickly destroy the appraiser’s credibility on this one item alone.

How do you defend yourself from this? Or wait—let’s rephrase that—how do you include sufficient data in your workfile to make an informed decision as to whether the income approach to value is necessary for credible results?

When to include the income approach to value

What if a client or an underwriting guideline says that the purchaser of the mortgage does not care if the appraisal report includes an income approach (or one of the other approaches)? Does that mean that you, the professional appraiser, do not have to bother collecting the data and considering the inclusion of this approach?

Hint: USPAP says that you should “be aware of, understand, and correctly employ those recognized methods and techniques that are necessary to produce a credible appraisal” and “not commit a substantial error of omission or commission that significantly affects an appraisal.”

This does not mean that every appraisal must include all three approaches to value to be credible. It simply means that you must consider what it takes to provide a credible appraisal. If the data collection process is completed, the highest and best use analysis is completed, and the appraiser has a clear understanding of scope of work necessary to produce credible results, the assignment may not need to include all of the approaches in order to produce credible results. If you reach that conclusion and can support and defend it, then the USPAP requirements have been met.

What about limited scope assignments?

The considerations above apply to all appraisal assignments, but most critically to limited scope assignments. When considering a limited scope assignment, you face additional necessity to be sure that the credibility of the analysis and the resulting report is clearly evident. Just because a client says “we don’t need all of that extra stuff” does not relieve you from professional responsibility as well as obligations under USPAP, laws and regulations of the state wherein the property is located, and applicable laws and regulations governing the loan for which the appraisal was requested.

Get your limited scope questions answered. Check out our new online course: Evaluations, Desktops, and Other Limited Scope Appraisals.

Research tips for income approach data

Use the following tips to ensure your workfile contains sufficient information regarding the income approach to valuation. This actually works:

  • When running the MLS service search, pull the list of all listings within the defined market area, including rentals, rental offerings, withdrawn or expired listings, properties off the market or under contract, active listings, etc. Do not limit the date of listing to the last 6 months. Depending on the activity in the market, don’t be afraid to go back two years. Don’t be afraid to get a big fat list. Print that list and drop it in the file, or burn a PDF for your electronic workfile.
  • Sort by relevance. Are there any similar properties that were rented in the past few years? If so, take a minute to look at them and see if they are worthy of further analysis.
  • Does your MLS have a connection to public tax assessment records or does the property’s taxing authority provide an online service? Are there sales in there that did not appear in MLS? Pull those up and look for old listings. Sometimes the property is rented and the tenants make a deal outside of MLS to buy the property from the owner. Call the new owner and ask.
  • Does your MLS have a “showing instructions” section? Is there a code that says “tenant occupied”? Look for that in the list of sales (they don’t need to be specifically similar yet; we are fishing for a market area GRM). If you find a list of these but the amount of the rent is not shown in the listing, try looking for the older rental listing, and/or contact the agent or seller and ask. Or, if the former tenant’s phone number was listed for showing instructions, try calling them. Make a few notes about what you did and what you found.
  • Best news: You find sufficient data to run the GRM approach and can generate a credible opinion of value from that viewpoint. Okay news: You cannot find sufficient data to estimate the market rent or calculate a market derived GRM or both. Failing to find sufficient data is not a failure of the appraisal. It’s just a reportable fact.
  • If you cannot successfully use the income approach to value for this property at this time and provide credible results, at least now your file has sufficient information to support your statement why the approach was not included. Supportable and defensible, credible results. (Remember: The words supportable and defensible are key to the definition of appraisal.)
  • Do not be surprised when you do find sufficient information to develop the GRM income approach, it happens more than most appraisers realize.

Omitting something that significantly affects an appraisal is something you want to avoid. You own this appraisal, which means that you are solely and strictly responsible for its credibility. Facing an inquiry or deposition can make even the most competent and well prepared appraiser nervous. Wouldn’t it make you feel better to have this income approach to value information in your workfile?

Learn about the nuances of limited scope assignments in our brand new online course, Evaluations, Desktops, and Other Limited Scope Appraisals. Plus, check out our on-site course, Limited Scope Appraisals and Appraisal Reports: Staying Compliant and Competitive. Visit to find a classroom near you.

Get your limited scope questions answered. Check out our new online course: Evaluations, Desktops, and Other Limited Scope Appraisals.

The income approach is one of three methods used by real estate appraisers to determine the value of a property. The income approach is more sophisticated than the other two techniques, and as a result, many real estate novices find it puzzling. We’ll go over the income approach to property valuation step by step in this article and what you will need to know as an agent and come exam day.

What are the 3 Approaches to Value?

There are three different main approaches that appraisers use while they make an appraisal. They are:

  1. Market Data Approach, which is also commonly called the sales comparison approach
  2. Cost Approach, also referred to as summation
  3. Income Approach, which is also known as capitalization 

Each method has its own set of benefits. When applied together, the various valuation methods provide the best estimate of the value of the income-producing real estate under evaluation. However, it is not always advisable to go through each one. As a result, the income approach is most typically employed to appraise real estate, especially in the early assessment phases.

What is the Income Approach?

The income approach is a process used by appraisers to determine the market value of a property based on its income. The approach is based on the finance concept of discounted cash flow analysis. Under the income method, the property’s current worth is the present value of the future cash flows that the owner can expect to receive.

This method is most prevalent for commercial properties with tenants because it relies on rental income. It’s calculated by dividing the rent collected net operating income (NOI) by the capitalization rate.

What is the Income Approach Formula?

The formula for the income approach is:

Net Operating Income / Capitalization Rate = Market Value

How to Use the Income Approach

To comprehend the income capitalization strategy, we must first understand two other fundamental real estate concepts: net operating income and capitalization rate.

Net Operating Income

After deducting operating expenses but before deducting capital expenditures, debt service, and taxes, net operating income is the net income in a particular period. The formula for calculating net operating income is as follows:

Effective Gross Income – Operating Expenses = Net Operating Income

The appraiser will require access to income and expense accounts for the subject building and similar structures in the neighborhood to estimate net operating income. Having that information on hand allows the appraiser to assess the building’s income and expenses accurately. Remember that all income and expenses are always annual values with the income capitalization approach.

The actual procedure of estimating net operating income can be broken down into four steps:

  1. Estimating the potential gross income. The money generated by the building when it is rented at 100% occupancy, at market rent, lease rent, or a combination of the two, is known as potential gross income. The rent generally charged for that type of space in the marketplace is known as market rent. The term lease rent can also refer to scheduled or contract rent. Income from all sources, such as the laundry machines in an apartment building or separately rented parking spaces, is included in potential gross income.
  2. Subtract the amount of vacancy and collection loss from the possible gross income. This figure, is commonly given as a percentage, is the appraiser’s estimate based on the market for similar structures in the area. It represents the average loss of income caused by nonpayment of rent and periodic vacancies. At this point, additional income, such as from an antenna rental on the building’s roof, is added in to arrive at effective gross income.
  3. Estimate all building costs and deduct them from the effective gross profit. There are three types of construction costs: fixed, variable, and reserves. Property taxes and insurance are examples of fixed expenses that do not alter with the occupancy of the building. Variable expenses include almost all additional costs, which may fluctuate depending on the building’s occupancy. Snow removal, utilities, management fees, and other costs are among them.
  4. Subtract the estimated expenses from the effective gross income. Then, you will have the net operating income!

What is a Capitalization Rate?

With your net operating income, all that’s left to do is find your capitalization rate.

A capitalization rate is comparable to a rate of return in that it represents the proportion of income that the investors expect to get from the building. Appraisers learn to compute capitalization rates in various techniques, luckily on the real estate exam, the capitalization rate is usually given, or there’s a problem with enough information for you to find the cap rate with using basic algebra.

If you would like to find the capitalization rate in real life you need recent comparable sales, such as buildings similar to the subject property being evaluated. On the exam however, you’ll see a question with the properties value and net operating income and you’ll have to find the capitalization rate. Luckily this is way easier then it sounds, so lets do some examples.

Income Approach Examples

If you have an income approach question on the exam, you’ll see a question asking for the capitalization rate or the properties value. First lets do the capitalization rate problem.

In order to find the capitalization rate you just have to use basic algebra. Here’s a simple example:

A property sold for $1,000,000 and had an NOI (Net Operating Income) of $100,000. Find the capitalization rate.

Remember our formula from earlier. Net Operating Income / Capitalization Rate = Market Value

Knowing this, all we need to do is take our numbers and put them into the formula. We have the Net Operating Income – that’s $100,000 and we have the Market Value – that’s $1,000,000. To find the cap rate we just have to divide. So $100,000/$1,000,000 this gives us .1 or 10%.

10% is our capitalization rate. Its that easy!

Another income approach example you may see on the exam is finding the properties value. These problems are a bit more complicated then the last one.

Here’s an example:

A property with a 15% cap rate, an effective gross income of $100,000 and operating expenses of $25,000. Find the Market Value using the Income Approach.

For this one we need to find Net Operating Income before we can find the Market Value. Let’s take a look at our two formulas.

Net Operating Income / Capitalization Rate = Market Value

Effective Gross Income – Operating Expenses = Net Operating Income

First we have to take the Effective Gross Income and subtract it by the Operating Expenses. So let’s do that.

$100,000 – $25,000 = $75,000

Great! Now we have our Net Operating Income. From there we can plug in our numbers from the first formula. Luckily they already gave us our cap rate, so with our Net Operating Income all we have to do is divide.

$75,000 / .15 (or 15%) = $500,000

$500,000 is our Market Value and our answer!

What to Know as a Real Estate Agent

As a real estate agent, it is essential to know all three approaches to value when appraising real estate. For the income approach, keep in mind what type of property you are working with. Remember, the income approach can be used in commercial real estate buildings such as offices, shopping complexes and can even be used for rental properties.

What to Know for the Real Estate Exam

When it comes time for exam day, remember that the income approach is a process used by appraisers to determine the market value of a property based on its income. You must understand the two formulas we went over today and how to use them. Remember:

Net Operating Income / Capitalization Rate = Market Value

Effective Gross Income – Operating Expenses = Net Operating Income

Know this, you will be sure to ace the exam!

Still confused? For a quick simple recap, watch our Income Approach video featured in our Daily Real Estate Vocab Series: