Investing Assets & Markets Real Estate Investing Valuing Real Estate With the Income Method By Jim Kimmons Jim Kimmons Jim Kimmons is a real estate broker and author of multiple books on the topic. He has written hundreds of articles about how real estate works and how to use it as an investment and small business. learn about our editorial policies Updated on September 19, 2022 Fact checked by Taylor Tompkins In This Article View All In This Article Using Capitalization Rate (Cap Rate) to Estimate Value Using Gross Rent Multiplier for Value Estimate Condition and Future Expenses Must be Considered Know the Income Method Frequently Asked Questions (FAQs) Photo: Caiaimage / Martin Barraud / Getty Images When a property's intended use is to generate income from rents or leases, the income method of appraisal or valuation is most commonly used. The net income generated by the property is measured in conjunction with certain other factors to calculate its value in the current market if it were to be sold. It's not just investors in the property who are interested in the net income generated by operations. They will almost always be seeking financing and potential lenders will carefully examine the income and expense details as well. They'll want to be as certain as possible that their investment is protected. Lenders want to see normal occupancy rents that exceed expenses enough to make mortgage payments with a profit left over for owners. Key Takeaways If you or your client is looking to buy an investment property, a good way of valuing prospects is using the income method. The income method looks at a property's net operating income in conjunction with other factors to calculate the return on investment. Using the income method could help you find investment properties that are good deals. Using Capitalization Rate (Cap Rate) to Estimate Value The net operating income of the property is used when the capitalization rate is employed to value an income property. Note There's an inverse relationship between the asking price and cap rate. In other words, the higher the cap rate, the lower the asking price. Using Gross Rent Multiplier for Value Estimate The gross rent multiplier or GRM uses the gross rentals of a property rather than the net operating income used with cap rate. This calculation can be done in one of two ways using either gross potential income (GPI) or gross operating income (GOI). The value estimate is much better using gross operating income because losses for occupancy and non-payment are considered. Condition and Future Expenses Must be Considered It's more subjective but very important to take the property condition into account as well. Neither of the income valuation methods considers property condition and potential large repair expenses in the future so these must be considered in arriving at a final estimate of value. Note An existing property might have been operating very efficiently or there could be operational problems that are depressing the net income. The rents might not be at market value and the expenses might be higher or lower than they should be. Let's say a landlord has been giving rent concessions to some tenants in exchange for services, or maybe repairs and maintenance expenses have been lower than the norm for similar properties. The landlord might have been tired of dealing with management duties or maybe he just wasn't that concerned about the problems that come down the road from poor maintenance. Investors who examine every facet of the operation would see an opportunity here because the rent numbers aren't real. They see that getting tenants into those units at full current rents would make a significant difference in net profitability, so they want to buy them. They might see that the property's expenses aren't as they should be and the property is falling into disrepair, leading them to pass on the purchase. Note Investors who stop at the basic valuation calculations without digging into rents and expenses often pass on the very best deals or overpay for properties. Sharp investors and lenders will carefully pull apart the project's financials to make certain that they're working with the real numbers. It's surprising how many smaller commercial properties are mismanaged. Rents are too low, expenses are too high, or it's a combination of both. Know the Income Method It's a good idea to spend significant time learning the income method of the valuation if you plan on working with investor clients. You don't want your investor buyer or seller clients to use terminology that you don't recognize or understand or ask for calculations that you can't perform. Working with investors can be quite rewarding because this niche real estate market is quite active. You'll also build great repeat business as well as referrals from satisfied investor clients. Frequently Asked Questions (FAQs) How do I calculate an income approach appraisal? To appraise an investment property's potential income, start by estimating the gross income that you could make on the property and subtracting estimated expenses. Be sure to consider periods of time that the property may not be rented or any other income streams that could come from the property. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Nisivoccia. "Can Capitalization Rate Issues Affect My Property Valuation?" Pickens County Assessor. "The Appraisal Process."