Is real estate valuation just a comparison between two similar properties? In fact, real estate valuation is not limited to one type, but there are a number of real estate valuation methods that aim to determine the market value of a property accurately. When conducting a real estate valuation, the valuer may use one or more methods depending on the purpose of the valuation, the type of property, and the available data. 

Among these methods is the income method, which is based on the expected financial return from the property and is used to appraise commercial and investment properties such as hotels, shopping malls, and leased buildings. 

In this article, we will learn more about the income method, its steps, and how to apply it when conducting a real estate valuation . 

What is the income method in real estate valuation?

The income method is one of the approved real estate valuation methods. It is defined as the method of discounting future cash flows to a single present value, to determine the value of an asset based on the income it generates or the costs it saves.

In other words, this method is based on estimating the expected income from the asset, whether it is rent or return on investment, and then calculating its present value according to the appropriate rate of return. This method is often used to appraise investment properties that generate regular income, such as commercial offices, stores, or rented residential units. 

Like other valuation methods, the income method is based on the economic principles of price equilibrium, the principle of expected benefits, and the principle of substitution and replacement, which can be summarized as follows: 

• The principle of expected benefits: This is the most commonly used principle in the income method, whereby the value of a property is estimated based on the expected future benefits of owning or investing in it.

• The principle of price equilibrium: This assumes that prices in the real estate market tend toward equilibrium according to supply and demand.

• The principle of substitution or replacement: This means that an investor will not pay more than they would pay for an alternative asset that provides the same return and benefits.

As mentioned, the income method is based primarily on the expectation of economic benefits and returns, such as net income, then assessing their stability and risks, and converting them to present value using appropriate capitalization or discount rates.

It is used when the value of the asset or property is determined by income or when the available data is insufficient compared to similar properties. It can be done by:

• Income capitalization method:  Used for properties with stable and fixed income.

• Discounted cash flow method: Used in the case of properties whose income changes over time.
• Residual value method: Used to estimate the value of land or properties intended for development by subtracting construction and financing costs from the expected sales value.
• Earnings method: Used to value commercial properties whose value depends on the earnings from the activity, such as hotels and malls.

The following are the steps for applying the income method in detail:

Step 1: Collect and analyze income data 

The valuer begins by collecting all data related to the property being appraised, such as actual rents, operating expenses, contracts, occupancy rates, and past operating income.

 They then analyze this data to determine the expected net operating income (NOI) of the property, ensuring that the figures reflect the current market situation. Any non-recurring items or items not related to the property’s actual future income are excluded to arrive at the actual and sustainable net income generated by the property on an annual basis.

Step 2: Select the model and determine the capitalization rate or discount rate:

 After determining the net income, the valuer moves on to choosing the most appropriate method within the income method. In the case of fixed income, the Cap Rate Method is used, where the net income is divided by the appropriate capitalization rate that reflects the required return for the risk. In the case of variable income, the discounted cash flow (DCF) method is used, where the expected annual cash flows for a specific period (e.g., 5 or 10 years) are calculated and then discounted to their present value using an appropriate discount rate that reflects market conditions and the level of risk.

Step 3: Calculating the terminal value of the property- 

In the final stage, a certified real estate valuer calculates the terminal value at the end of the forecast period, whether based on an expected sale price or the capitalization of the last annual income. This value is then added to the net present value of cash flows (in the case of DCF) or used directly as the result of income capitalization (in the case of fixed income).

The final result represents the current market value of the property on the valuation date, after taking into account all risks and expected returns for the investor.

In conclusion, the income method is one of the most important tools that real estate valuers rely on when valuing properties, especially those that generate a continuous return, such as commercial and investment properties. It not only considers the location or cost of the property, but also focuses on its ability to generate future income and its sustainability in light of real estate market conditions. 

To determine the market value of your property and ensure more accurate investment decisions, you should hire a certified real estate valuer. Contact Aain for a real estate valuation now and get a reliable valuation of your property.