What Is It?
The "Income Method" is also termed the fundamental, or intrinsic method of property valuation. In this method, the present worth of a property is estimated on the grounds of projected future net income (in rent, for example) and re-sale value.
The method uses the discounted cash flow (DCF) model to determine the present value of an investment. One underlying assumption of this approach is the principle of opportunity cost of capital, i.e. that money is of more value to its holder today than in the future. The principle of anticipation is fundamental to this approach. It states that value can be created today by expected future profits.
Although slightly complicated, this method is an essential element to the valuation of any property; it is almost always employed by financial and investment professionals when valuing assets.
This method relies on making certain key assumptions - both the prospective income generated by the property and resale value have to be estimated. This appraisal is based on the principle of highest and best use and on comparable data.
Example: A three-bedroom flat is bought to let. Historical data and analysts predict that I can expect a 50% increase in market value within 10 years. Market analysis tells me that I can expect to receive £4,000 of rent each year for the next 10 years.
In order to calculate the present value of a property, prospective future income has to be discounted to reflect the cost of equity capital. This is part of the discounted cash flow (DCF). The opportunity cost of capital can be interpreted as the income that would otherwise have been generated had the capital been invested in an asset of similar risk instead.
Example: Instead of a buy-to-let property, I could have invested in high-yield bonds that I believe would have been of similar risk. The high-yield bonds generate an 8% yield, so I will assume my discount rate (cost of equity capital) to be 8%.
The difficult part in calculating the DCF is how to estimate the risk involved. In property dealings, these estimates are usually based upon historical data on house price volatility. This volatility is broadly in line with the general market volatility, and our 8% example as the cost of equity capital can be safely justified.
The next step involves calculating the present value (PV) of the property based on selling it for 50% more in ten years' time. The way to calculate present value (PV) is to divide the future value of a house by the discount rate plus one to the power of the number of years.
Example: The three-bedroom flat costs £120,000. I expect to be able to sell it for £180,000 in 10 years. I set my discount rate at 8%. The calculation looks like this:
Sale PV = £180,000 / (1 + 0.08)¹º = £83,375
In recognition of the fact that the property will also generate income over the next ten years we need to calculate the present value of this income stream and add it to the value calculated above. A buy-to-let property produces a constant income stream in the form of rent, but this concept can also be applied to owner-occupied properties. Simply imagine the owner is paying themselves the market rate in rent.
Example: The three-bedroom flat generating £4,000 per year in rent costs £1,600 in expenses. That means I have an annual income of £2,400. I set my discount rate at 8%. The calculation for the net present value of the first year's income is:
Income PV = £2,400 / (1 + 0.08)¹= £2,222
The present value of my value net income in year 1 is £2,222.
Yet, I do not plan to re-sell my flat after one year; instead, I will keep it for 10 years. In that case the calculation goes as follows:
Income PV = (£2,400 / 1.08¹) + (£2,400 / 1.08²) + (£2,400 / 1.08³) + ... etc ... + (£2,400 / 1.08¹º)
Income PV = £16,102
The results, based on our assumptions, imply that the present-day value of the three-bedroom flat is:
PV = Sale PV + Income PV
PV = £83,375 + £16,102
PV = £ 99,477
I would therefore be ill-advised to buy the flat at the current price of £120,000. It is worth noting that this valuation method generates a result that is highly sensitive to the following variable assumptions:
Rental Net Income: £2,400
Resale Value in 10 years: £180,000
Discount Rate: 8%
These assumptions dictate the intrinsic value placed on a property.
Income Method Advantages
It focuses directly on the value of the property to the individual concerned.
Income analyses are very detailed and derive specific conclusions (in contrast to the more general approach practised in the Comparable Sales Method.
Income Method Disadvantages
- This method is more complex and less intuitive than the Comparable Sales Method. This is one of the reasons why it is often overlooked.
- This method ignores the actual market prices for property by neglecting the comparable sales analysis.
- The ultimate house price recommendation is highly sensitive to the assumptions made.
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