THE INCOME CAPITALIZATION APPROACH
Steps in the approach 
/ Gross rent and gross income multiplier approach
The income capitalization approach, or income approach, is used for income properties and sometimes for other properties in a rental market where the appraiser can find rental data. The approach is based on the principle of anticipation: the expected future income stream of a property underlies what an investor will pay for the property. It is also based on the principle of substitution: that an investor will pay no more for a subject property with a certain income stream than the investor would have to pay for another property with a similar income stream.
The strength of the income approach is that it is used by investors themselves to determine how much they should pay for a property. Thus, in the right circumstances, it provides a good basis for estimating market value.
The income capitalization approach is limited in two ways. First, it is difficult to determine an appropriate capitalization rate. This is often a matter of judgment and experience on the part of the appraiser. Secondly, the income approach relies on market information about income and expenses, and it can be difficult to find such information.
Steps in the approach
The income capitalization method consists of estimating annual net operating income from the subject property, then applying a capitalization rate to the income. This produces a principal amount that the investor would pay for the property.
Estimate potential gross income. Potential gross income is the scheduled rent of the subject plus income from miscellaneous sources such as vending machines and telephones. Scheduled rent is the total rent a property will produce if fully leased at the established rental rates.
Scheduled rent
+ Other income
Potential gross income
An appraiser may estimate potential gross rental income using current market rental rates (market rent), the rent specified by leases in effect on the property (contract rent), or a combination of both. Market rent is determined by market studies in a process similar to the sales comparison method. Contract rent is used primarily if the existing leases are not due to expire in the short term and the tenants are unlikely to fail or leave the lease.
Estimate effective gross income. Effective gross income is potential gross income minus an allowance for vacancy and credit losses.
Potential gross income
– Vacancy & credit losses
Effective gross income
Vacancy loss refers to an amount of potential income lost because of unrented space. Credit loss refers to an amount lost because of tenants’ failure to pay rent for any reason. Both are estimated on the basis of the subject property’s history, comparable properties in the market, and assuming typical management quality. The allowance for vacancy and credit loss is usually estimated as a percentage of potential gross income.
Estimate net operating income. Net operating income is effective gross income minus total operating expenses.
Effective gross income
– Total operating expenses
Net operating income
Operating expenses include fixed expenses and variable expenses. Fixed expenses are those that are incurred whether the property is occupied or vacant, for example, real estate taxes and hazard insurance. Variable expenses are those that relate to actual operation of the building, for example, utilities, janitorial service, management, and repairs.
Operating expenses typically include an annual reserve fund for replacement of equipment and other items that wear out periodically, such as carpets and heating systems. Operating expenses do not include debt service, expenditures for capital improvements, or expenses not related to operation of the property.
Select a capitalization rate. The capitalization rate is an estimate of the rate of return an investor will demand on the investment of capital in a property such as the subject. The judgment and market knowledge of the appraiser play an essential role in the selection of an appropriate rate for the subject property. In most cases, the appraiser will research capitalization rates used on similar properties in the market.
Apply the capitalization rate. An appraiser now obtains an indication of value from the income capitalization method by dividing the estimated net operating income for the subject by the selected capitalization rate
Gross rent and gross income multiplier approach
The gross rent multiplier (GRM) and gross income multiplier (GIM) approaches are simplified income-based methods used primarily for properties that produce or might produce income but are not primarily income properties. Examples are single-family homes and duplexes.
The methods consist of applying a multiplier to the estimated gross income or gross rent of the subject. The multiplier is derived from market data on sale prices and gross income or gross rent.
The advantage of the income multiplier is that it offers a relatively quick indication of value using an informal methodology. However, the approach leaves many variables out of consideration such as vacancies, credit losses, and operating expenses. In addition, the appraiser must have market rental data to establish multipliers.
Steps in the gross rent multiplier approach. There are two steps in the gross rent multiplier approach.
First, select a gross rent multiplier by examining the sale prices and monthly rents of comparable properties which have sold recently. The appraiser’s judgment and market knowledge are critical in determining an appropriate gross rent multiplier for the subject. The gross rent multiplier for a property is:
In the illustration, the indicated GRM for the subject is 160, based on the appraiser’s research and judgment. Applying the GRM to a rental rate of $2,000, the indicated value for the subject is $320,000.
Steps in the gross income multiplier approach. The GIM approach is identical to the GRM approach, except that a different denominator is used in the formula. Step one is to select a gross income multiplier by examining the sale prices and gross annual incomes of comparable properties which have sold recently. The gross income multiplier for a property is:
Step two is to estimate the value of the subject by multiplying the selected GIM by the subject’s gross annual income:
GIM x Subject gross annual income = estimated value
In the illustration, the indicated GIM for the subject is 13.5 , based on the appraiser’s research and judgment. Applying the GIM to the property’s gross annual income gives an indicated value for the subject of $324,000.
