A.CRE

Income Approach

One of three appraisal methods used in commercial real estate to estimate the value of income-producing property. The Income Approach includes two methods. The first method, the Income Capitalization Method, is a process whereby one year’s Net Operating Income is divided by a market Capitalization Rate to arrive at an estimated value. The second method uses the Discounted Cash Flow to calculate the present value of a real estate investment’s forecasted future income and reversion value. The Income Approach is the most common appraisal method used to evaluate income-producing real estate.

Putting “Income Approach” in Context

Crescent Property Partners, a real estate investment firm based in Vancouver, Canada, has recently acquired Pacific Heights Plaza, a grocery-anchored retail center in a growing suburban neighborhood. The property spans 85,000 square feet, with a mix of retail tenants including a large national grocery chain, several small retailers, and a few quick-service restaurants. Pacific Heights Plaza has an annual Net Operating Income (NOI) of CAD 1,750,000.

To determine the value of the property during acquisition, Crescent Property Partners used the Income Approach, employing both the Income Capitalization Method and the Discounted Cash Flow (DCF) Method. Below is a summary of their process:

Step 1: Income Capitalization Method

The Income Capitalization Method estimates value by dividing one year’s NOI by a market-derived capitalization rate. Crescent Property Partners identified a cap rate of 5.5 percent for similar properties in the Vancouver market.

Formula:
Value = NOI ÷ Cap Rate

Calculation:
Value = CAD 1,750,000 ÷ 0.055
Value = CAD 31,818,181

Based on the Income Capitalization Method, the estimated value of Pacific Heights Plaza is approximately CAD 31.8 million.

Step 2: Discounted Cash Flow (DCF) Method

In addition to the Income Capitalization Method, Crescent conducted a Discounted Cash Flow analysis. This method calculates the present value of forecasted future income and the property’s reversion value at the end of a 10-year holding period. Here are their assumptions:

  • Annual NOI Growth Rate: 2.5%
  • Discount Rate: 6.5%
  • Exit Cap Rate: 5.75%
  • Year 10 NOI: CAD 2,160,345 (reflecting 2.5% annual growth)
  • Reversion Value at Year 10:
    • Reversion Value = Year 10 NOI ÷ Exit Cap Rate
    • = CAD 2,160,345 ÷ 0.0575
    • = CAD 37,569,478

They then discounted the annual NOI and reversion value back to the present at the 6.5% discount rate, yielding a total present value of CAD 33 million.

Insights from the Analysis

The two methods yielded slightly different valuations:

  • Income Capitalization Method: CAD 31.8 million
  • DCF Method: CAD 33 million

Crescent Property Partners considered both results and concluded the fair acquisition price was CAD 32.5 million, reflecting the blend of the two approaches and their confidence in the property’s growth potential. The Income Approach proved vital in confirming the property’s value and guiding their investment decision.

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