Income approach and reconciliation
The income approach values a property by the income it is expected to produce. It rests on the principle of anticipation: a buyer pays today for the benefits expected tomorrow. It is the main approach for apartment buildings, offices, and other investment property.
From gross income to NOI
| Line | What it means |
|---|---|
| Potential gross income (PGI) | Market rent if 100% occupied for a year, plus other income such as parking or laundry |
| − Vacancy and collection loss | Expected empty units and unpaid rent, based on the market |
| = Effective gross income (EGI) | What the owner can realistically collect |
| − Operating expenses | Fixed (property taxes, insurance), variable (utilities, management, maintenance), and reserves for replacement |
| = Net operating income (NOI) | The income the property itself produces |
Not operating expenses: mortgage principal and interest (debt service) and income-tax depreciation. NOI is the same no matter how the buyer finances the purchase.
Capitalization: the value triangle
Direct capitalization converts one year's NOI into value with an overall capitalization rate, usually drawn from what similar income properties sold for.
I ÷ R = V (income ÷ rate = value)
I = R × V R = I ÷ V
Cover the letter you want and the other two show the math. A building earning $110,000 NOI at an 8% rate is worth $110,000 ÷ 0.08 = $1,375,000.
Rate and value move in opposite directions. At a 10% rate, the same $110,000 is worth $1,100,000. A higher rate means the market sees more risk, so it pays less for each dollar of income.
Gross rent and gross income multipliers
When expense data is thin, as with single-family rentals and small apartment buildings, appraisers use a multiplier from comparable sales instead.
Multiplier = sale price ÷ gross income
Value = subject's gross income × multiplier
- Gross rent multiplier (GRM): uses monthly rent. Typical for single-family homes and small residential rentals.
- Gross income multiplier (GIM): uses annual gross income.
Example: a rental house sold for $270,000 while renting for $1,800 a month, so the GRM is 150. A similar house renting for $2,000 a month is worth about $2,000 × 150 = $300,000.
The multipliers ignore expenses, so they work only when the comps have similar expenses and vacancy.
Reconciliation
Each approach gives its own indication of value. Reconciliation is the step where the appraiser weighs them and arrives at one final opinion. It is not a simple average. The appraiser gives the most weight to the approach that is most reliable and applicable for this property and explains why. The final value falls within the range the approaches indicated.
| Property | Usually weighted most |
|---|---|
| Owner-occupied home | Sales comparison |
| New or special-purpose building | Cost |
| Apartment or office building | Income |
Fannie Mae requires the income approach for two- to four-unit properties but never as the sole indicator of value, and it does not accept an appraisal resting on the cost approach alone.