Capitalizing Income to Arrive at Fair market Value

The most common method used to set the fair market value of an income-producing real property is the Income Approach to Value, using the Overall Capitalization Rate.

A multi-family apartment complex's Gross Scheduled Income next year is estimated to be $425,000. Apartment properties in the local area currently show a 4% annual vacancy rate, which is projected to remain steady.
Operating Expenses are projected to be 35% of the Gross Operating Income.

An appraiser has collected recent sales and operating data from 3 nearby apartments complexes of similar size, age, number and quality of amenities, and quality of construction.

Comparable Properties	Gross Operating Income	% Operating Expenses	Recent Sales Price
A	$465,00	34%	$3,375,000
B	$425,00	36%	$3,025,000
C	$485,000	33%	$3,692,600

What is the most likely price/value range of the property to be appraised using the capitalization approach to value?

The problem specifies two different types of income: the Gross Scheduled Income (GSI) and the Gross Operating Income (GOI). (These terms are defined in the Glossary)

In order to convert the subject property's GSI to GOI, we must deduct an allowance for vacancy and credit losses, stated in the problem as 4% of GSI .

Therefore the GOI will be 96% of GSI, or $408,000. This number now conforms to the GOI of the properties gathered as market comparables.

The next step is to calculate the overall capitalization rates for each comparable property. We can do this by dividing the Net Operating Income by the recent sales price for each property:

Comparable Properties	Gross Operating Income	Net Operating Income	Recent Sales Price	Indicated Overall Capitalization Rate
A	$465,00	$306,900	$3,375,000	9.10%
B	$425,00	$272,000	$3,025,000	9.00%
C	$485,000	$325,950	$3,692,600	8.80%

While it may appear to be reasonable to average these capitalization rates, appraisers never average the values, but rather make subjective adjustments in the value of each property to reflect any significant differences between them and the property to be appraised.

In this case, the appraiser reasoned that an appropriate capitalization rate for the subject property would be 8.9%.

After deducting 35% operating expenses from the GOI, the appraiser estimates next year's NOI to be
$408,000 * (1-35%) = $265,200.

Using the capitalization rate of 8.9%, the indicated market value, based on income, would be:

If you have enjoyed working these problems, you will probably enjoy our text, Introduction to Cashflow Analysis, which contains many more problems and worked-out answers.