Commercial Real Estate Appraisal Income Approach

The income approach is often given primary emphasis when appraising a commercial real estate used to generate income. Estimates of value via the income approach are highly sensitive to changes in revenue, expense and capitalization rates.

Correctly performing a cost approach analysis appears to be and is technically difficult. It appears easy to correctly prepare an income approach analysis for commercial real estate. However, correctly preparing the analysis requires three criteria: 1. an understanding on the type of value, 2. accurate data, 3. accurate application of the income approach.

Properties that are leased and therefore bound by a specific income stream are valued based on the leased fee estate. Properties that are vacant or owner-occupied are valued based on the fee simple estate.

Accurate data is the basis of a reliable income approach conclusion. This includes information on rental rates, occupancy rates, new construction, absorption, operating expenses and capitalization rates. Rental rates are usually obtained from rental comparables, subject property leases and aggregate market data. The same is true for occupancy rates. New construction can be obtained from personal observation while doing fieldwork, research and aggregate market data.

Operating expenses are evaluated on a line-item by line-item basis. The first step is usually to summarize the subject property's operating expenses for a two to four year period. This is termed "spreading the data". It tends to highlight anomalies in data. Comparable expenses and industry data (IREM and DOMA) can also be useful.

Capitalization rates are estimated based on data from recent comparable sales and discussions with market participants.

The direct capitalization method and the discounted cash flow analysis are frequently utilized to determine estimates of value for the income approach. Other techniques include gross rental multiplier (GRM) and effective gross income multiplier (EGIM).

The formula for the direct capitalization method is as follows:

Market Value = NOI / Cap Rate

NOI is net operating income. Cap rate is capitalization rate.

The formula for GRM is:

Market Value = Gross Possible Rent x GRM

GRM is gross rent multiplier. It is abstracted from market data and discussions with market participants.

The formula for EGRIM is: Market Value = effective gross income x EGIM

Effective gross income is abstracted from market data and discussions with market participants.

The discounted cash flow analysis evaluates net appreciating income and net sales proceeds and discounts these to a current indication of value.

The income approach is often given primary emphasis in appraising income properties. An appraiser "should look through the eyes" of market participants when selecting an income approach methodology. The appraiser should emulate the process of market participants rather than an alternate approach.

he appraisal division of O’Connor & Associates is a national provider of commercial real estate appraisal services including cost segregation studies, due diligence, insurance valuations, business purchase price allocation, feasibility studies, financial modeling, gift tax valuations, highest and best use analyses, casualty loss valuation and HUD map market studies.

Patrick C. O'Connor has been president of O'Connor & Associates since 1983 and is a recipient of the prestigious Mai designation from the Appraisal Institute.