The investment or income approach to property valuation looks at the income producing potential of a property and determines a value based on this. It is ideally suited to situations where the property in question is to be used as an income producing investment. By assessing the “present value of future benefits of future ownership” the income approach can determine the suitability of an investment. This method is not very common in application for residential investments due to the market approach being a more consistent and proven method. The income approach is used on a number of commercial property valuations but is often overlooked in residential. For this method to work, a suitable capitalisation or cap rate must be determined, which is then used to determine the total value of the property based on the proposed income stream. To determine the income stream, a fair rental amount must be calculated. This is then summed to come to a total amount for the year and depending on what the cap rate is, a final value is reached.
For example a 3 bedroom home may attract $350 pw in rent. Over a year this calculates to $18,200. Assuming the valuer used a cap rate of 5%, the total value of the property would be $364,000 ($18,200/5%). This may seem to be a reasonable assessment of the buildings value and not far off the mark for a house in that particular area. The issue lies in determining an appropriate cap rate. How was that 5% determined? Depending on the location (town, suburb, street) a different cap rate would need to apply. Using the market approach in that same area, we can work backwards to determine the cap rate. We take two properties, one in a new suburb that is classed as highly desirable, the other in a older suburb that is classed as less desirable. Their respective values are $350,000 and $240,000 (this example from my actual portfolio). The $350,000 home has a fair market rental figure of $360 per week or $18,720 per year. This equates to a cap rate of 5.35% ($18,720/$350,000). The less desirable house has rental income of $285 per week or $14,820 per year. This equates to a cap rate of 6.18% ($14,820/$240,000).
In the commercial property market, it is easier to determine the cap rate of a property, as the market values of similar properties are found using the market approach, the rent or lease returns are easier to calculate and from there a cap rate is found. By assessing the cap rate of a number of similar properties an appropriate rate can be found and based on the existing lease and expense details a fair value can be determined.