How to Value an Investment Property
The basic premise of the income approach to real estate is that the value of a property is related to the present worth of the future income stream that it is capable of producing over its economic life when developed to its highest and best use. Income is typically generated from two basic sources, the cash flow received over the period of ownership (investment horizon) and the future sale price (reversionary value). The conversion of the income into an estimate of value is known as the capitalization process [or capitalization rate] and there are various capitalization techniques available.
The basic 8 steps of the income approach are:
Estimate the annual stabilized or potential gross income at 'full occupancy'. From this is deducted an allowance for vacancy and bad debts to arrive at the Effective Gross Income. The Effective Gross Income also includes any ancillary sources of income such as parking, signage, or storage.
Estimate the total annual operating expenses. This includes all of the normal expenditures required to generate and protect the income stream.
Calculate the Net Operating Income by deducting the annual operating expenses from the Effective Gross Inc
Deduct an appropriate structural allowance to arrive at an Adjusted Net Operating Income.
Select an appropriate method of capitalization and the appropriate capitalization rate.
Using the appropriate mathematical method, convert the estimate of Net Operating Income into an indication of the capital value.
Make any appropriate deductions for tenant inducements, lease commissions, rent abatements, capital expenditures, and lost rental and recovery revenue associated with leasing any existing vacant units or any units which are assumed to commence after the date of valuation.
If necessary, make any appropriate adjustments where the current contract rent(s) are significantly below or above the current market rent(s).
The two primary income calculation methods are:
Overall Capitalization Rate (OCR): The Overall Capitalization Rate method measures the relationship of value to the stabilized or potential Net Operating Income at full occupancy. The OCR method is also referred to as the Direct Capitalization Method.
Discounted Cash Flow (DCF): The Discounted Cash Flow method measures the relationship of value to the income reasonably expected over the entire investment horizon. As a consequence, the price paid reflects both the current and anticipated income as determined by the leases in place and the rents that might be anticipated for vacant space or on renewal or review of existing leases.
Both the DCF and OCR approaches convert the earnings of a property into an estimate of value. Investors typically will use both approaches, applying different weight to each method based on the particular characteristics of the investment.
Furthermore, minor adjustments to the cash flow model can have a considerable effect on the final value estimate. Hence the adoption of both approaches is common in appraisal practice.
*My clients - you do not have to worry about memorizing all of the above as I always crunch the numbers for you. We all know there is not a chance in H-E-Double Hockey sitcks I will allow you to make a poor purchase choice! :)
Lake Okanagan Realty