Income Approach for Real Estate Valuation
A let property is a stream of rent, and its value is what that stream is worth today.
The income approach values a property from the income it can produce. A buyer of a let shop is buying a stream of rent, so the price is the present value of that stream. The tools are old and simple: net income, a capitalisation rate, and the years' purchase that turns one into the other.
It is the main method for let commercial property, leasehold interests and income-producing special properties such as hotels, cinemas and petrol pumps. It is weak where income is notional, as with an owner-occupied bungalow, where the market or cost approach is used instead.
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Core Terms
- Gross income
- Rent receivable before any deduction.
- Outgoings
- Costs the owner bears: municipal tax, repairs, insurance, management and collection, and an allowance for vacancy.
- Net income
- Gross income less outgoings. This is what gets capitalised.
- Years' purchase (YP)
- The multiplier that converts annual net income into a capital value. In perpetuity, YP = 1 ÷ rate, so at 8% YP is 12.5.
- Remunerative rate
- The return the investor expects on capital.
- Accumulative rate
- The lower, safe rate at which a sinking fund is assumed to grow to replace a wasting asset such as a lease.
- Reversion
- The value of the property when the current lease ends and the rent moves to market level.
Worked Example 1: Direct Capitalisation of a Mumbai Shop
Illustration only. A freehold shop let at ₹1,00,000 a month, rent at market level, capitalisation rate 8%.
| Line | ₹ lakh a year |
|---|---|
| Gross rent (₹1 lakh × 12) | 12.00 |
| Less municipal tax | 1.20 |
| Less repairs (10% of gross) | 1.20 |
| Less insurance | 0.20 |
| Less management and collection (5% of gross) | 0.60 |
| Net income | 8.80 |
| YP in perpetuity at 8% (1 ÷ 0.08) | 12.5 |
| Capital value (8.80 × 12.5) | 110.00, i.e. ₹1.10 crore |
Worked Example 2: Term and Reversion
Illustration only. A Bengaluru office is let at ₹6 lakh net a year for the next 5 years. Market rent is ₹9 lakh net. Rate 8% throughout.
- 1
Value the term
YP for 5 years at 8% = (1 minus 1 ÷ 1.08^5) ÷ 0.08 = 3.9927. Term value = 6 × 3.9927 = ₹23.96 lakh.
- 2
Value the reversion
YP in perpetuity at 8% = 12.5, deferred 5 years by the present value factor 1 ÷ 1.08^5 = 0.6806. Reversion = 9 × 12.5 × 0.6806 = ₹76.57 lakh.
- 3
Add
₹23.96 lakh + ₹76.57 lakh = ₹100.53 lakh, reported as about ₹1.01 crore.
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Other Income Methods in the Syllabus
- check_circleDual-rate YP for leaseholds: YP = 1 ÷ (remunerative rate + annual sinking fund at the accumulative rate). For 20 years at 8% and 4%, YP is about 8.80, against 9.82 at single rate 8%. The lower multiplier reflects that the lessee's interest runs out.
- check_circleDiscounted cash flow: each year's net income and the exit value are discounted at the target return. Used where income changes year to year, for example a mall in lease-up. IRR and NPV come from the same cash flows.
- check_circleProfit method: for hotels, cinemas, petrol pumps and hill resorts, value comes from the business's trading accounts. Gross receipts less working expenses less a fair return to the operator leaves the rent the property could bear, which is then capitalised.
- check_circleLessor's and lessee's interests: the lessor holds rent for the term plus the reversion; the lessee holds the profit rent (market rent less rent paid) for the unexpired term.
How the Valuation Examination Tests This
Income questions are arithmetic under time pressure, on a non-memory calculator. The usual traps: capitalising gross rent instead of net income, using a single-rate YP where the question gives an accumulative rate, and forgetting to defer the reversion. Practise computing YP and present value factors by hand until each takes under a minute.
FAQs
What is years' purchase in property valuation?expand_more
The number by which annual net income is multiplied to give capital value. In perpetuity it is 100 divided by the rate per cent, so 8% gives 12.5 YP. For a fixed term it is the present value of ₹1 a year for that term.
What is the difference between the income approach and the profit method?expand_more
The income approach capitalises rent. The profit method is used where there is no rental evidence, as with a hotel or cinema, and works out the rent the property could pay from its trading profit.
When is a dual-rate years' purchase used?expand_more
Traditionally for terminable incomes such as leaseholds, where the investor has to recover capital by the end of the term. A single-rate YP is used for freeholds. Many valuers now use single rate for leaseholds as well, so read which rates the question gives.
Is DCF part of the Land and Building syllabus?expand_more
Yes. The income approach module names discounted cash flow, internal rate of return and net present value, along with the capital asset pricing model, as investment decision tools.
Next steps
- Rent and Cap Ratearrow_forward
- Leasehold vs Freeholdarrow_forward
- Market Approacharrow_forward
- Syllabusarrow_forward
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