What Is It?
The "Income Approach" 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. Using this technique, a buyer can estimate whether a certain property would be a profitable investment.
The process works with the discounted cash flow (DCF) model to determine the present value of an investment. One underlying assumption of this approach is that, because of opportunity cost of capital, money is of more value to its holder today than in the future.
Although complex, this method is essential to any property valuation, especially for buy-to-let investments. It is frequently employed by financial and investment professionals when valuing assets.
First, the prospective income and re-sale value have to be estimated. This appraisal is based on the principle of highest and best use and on comparable data.
Example: I want to buy a three-bedroom flat and let it out. Historical data show that I can expect a 50% increase in market value within 10 years. Market analysis tells me that the average rent of comparable properties in a similar location is £4,000 per annum.
- 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 means the loss of income from other interest-generating investment opportunities (eg. a 4% interest rate in a savings account).
- 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 interest rate fluctations, and records of comparable investments (eg. 4%).
The way to calculate present value (PV) is to divide the future value of a house by (discount rate + 1).
Example: A 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% (4% costs of equity + 4% risk rate). The calculation looks like this:
Sale PV = £180,000 / (1 + 0.08)¹º = £83,375
A property also generates income, however. This has to be incorporated into the calculation. A buy-to-let property produces a constant cash flow in the form of rent, whereas if I buy a house to live in myself I increase my income by saving on 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:
PV = £2,400 / (1 + 0.08).
PV = £2,222
It results that the present value of my new 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 at least 10 years. In that case the calculation goes as follows:
PV = (£2,400 / 1.08) + (£2,400 / 1.08²) + (£2,400 / 1.08³) + ... + (£2,400 / 1.08¹º) = £2,222 + £2,058 + £1,905 + £1,764 + £1,633 + £1,512 + £1,400 + £1,296 + £1,200 + £1,112 = £16,102
It results that the present-day value of the three-bedroom flat is:
PV = £83,375 + £16,102 = £ 99,477
I would therefore be ill-advised to buy the flat at the current price of £120,000.
The valuation that this method generates is highly sensitive to the following variable assumptions:
Rental Net Income: £2,400
Re-Sale Value: £180,000
Discount Rate: 8%
Advantages of the Income Approach
- 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.
Disadvantages of the Income Approach
- 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.