Understanding how to apply the Income Approach not only sharpens your pricing recommendations but also builds credibility with investor clients, appraisers, and lenders. This article provides a practical guide to valuing real estate using the Income Approach, specifically geared for experienced real estate professionals.
What Is the Income Approach?
The Income Approach to value estimates what a property is worth based on the income it generates, adjusted for operating expenses and market expectations of return (i.e., capitalization rate or cap rate).
It is most commonly used for:
Multifamily properties (5+ units)
Retail and office buildings
Industrial and mixed-use properties
Single-family rentals (as part of portfolio or investor focus)
Key Components of the Income Approach
1. Net Operating Income (NOI)
The foundation of the Income Approach is NOI, which represents the property’s income after all operating expenses are deducted, but before debt service and taxes.
Formula:NOI = Gross Income – Operating Expenses
Gross Income includes all rent plus additional income (parking, laundry, storage, etc.)
Vacancy & Credit Loss is subtracted (typically 3%–8% depending on market)
Operating Expenses include property taxes, insurance, maintenance, management, utilities (if landlord-paid), etc.
👉 Important: Don’t include mortgage payments in expenses—they are part of the investor’s capital structure, not the property’s performance.
2. Capitalization Rate (Cap Rate)
The cap rate reflects the expected rate of return on a property based on market conditions and asset class. It’s calculated as:
Cap Rate = NOI / Market Value
Or rearranged for valuation:
Market Value = NOI / Cap Rate
Cap rates vary based on:
Property type (e.g., Class A retail vs. small apartment)
Location
Risk profile
Market trends
Example:
A small apartment building with $60,000 in NOI and a market cap rate of 6.0% would be valued at:$60,000 / 0.06 = $1,000,000
Steps to Value a Property Using the Income Approach
Step 1: Gather Financials
Collect or estimate:
Rent roll (actual and market)
Lease terms and renewals
Utility responsibilities
Historical operating expenses
Pro tip: Normalize the data. Remove one-time costs and account for stabilized vacancy.
Step 2: Calculate the NOI
Use actual and pro forma figures. Lenders and investors often look at both:
Actual NOI = trailing 12 months (T12) or recent performance
Pro Forma NOI = expected performance after improvements or lease-up
Step 3: Determine Market Cap Rate
Use:
Comparable sales of similar income-producing properties
Cap rate surveys from brokerage firms (CBRE, Marcus & Millichap, etc.)
Local investor or appraiser feedback
Be market-specific. A Class B multifamily in Miami might have a different cap rate than one in Des Moines.
Step 4: Apply the Formula
Once you have the NOI and cap rate, calculate the estimated value.
Step 5: Cross-Check Against Sales Comparables
While the Income Approach is the primary method for income-producing assets, brokers should cross-check it with the Sales Comparison Approach, especially when investor appetite or market pricing deviates from cap-rate logic.
Special Considerations
Vacancy Rates: Use market vacancy unless actuals are materially different.
Non-Recurring Income: Don’t count one-time fees (e.g., lease-up bonuses) as recurring income.
Owner-Occupancy: For properties with partial owner-use, isolate income-generating portions.
Reinvestment Needs: Properties needing capital improvements may require a price adjustment even if NOI is stable.
When the Income Approach Shines
Use the Income Approach when:
Evaluating investment-grade assets (retail, office, industrial, multifamily)
Assisting investor clients making cash flow decisions
Working with lenders or appraisers during financing or refinance transactions
Assessing rental portfolios or SFRs held as long-term rentals
