A few months ago, we covered the basics on valuing properties. Since then, we have managed to expand our knowledge on the issue and will be introducing an alternative method of valuation. On a broader level, there are 2 general approaches to value real estate property – Market Approach and Income Approach. The Market Approach is what we have covered previously and we will focus on the Income Approach this time.
As the name implies, this method values a property based on the rental income it can earn during its life. There are 2 methods under the Income Approach.
Property – Direct Capitalization
By applying a multiple to the annual rental income, we will be able to capitalise it and estimate a fair value for the property. Of course, there are fancy, technical names for the multipliers which you will see later, but the concept is a simple one. We can employ this concept to both rental income and operating income.
Gross Rental Income here refers to the annual rent of the property. The Gross Income Multiplier (GIM) is essentially your rental yield masquerading as a seemingly new term – it really is just the inverse of your rental yield. To value a property, you need to know the average rental yield/GIM of similar properties in the vicinity. Divide/multiply the average rental yield/GIM by the annual rent of the property you want to value will give you an estimate of its fair value. This is a straightforward method that is understood and applied by most people.
From your rental yield/GIM, we now add a layer of complexity to arrive at the cap rate. The process of finding sales price from cap rate is identical to that of rental yield and GIM. The only difference is that while rental yield/GIM relates to annual rent, the cap rate relates to the net operating income of the property. Net operating income is your annual rent less operating expenses. Operating expenses include property tax, repairs and maintenance, and administrative expenses but not interest expense. As you might realise, such expenses are not really relevant for single unit properties. As such, I believe that the cap rate is more suitable for valuing buildings as a whole.
Property – Yield Capitalization
This second method involves finding the present value of forecasted cash flows (after-tax) from a property during its life, using the property WACC as the discount rate. You can estimate the property WACC based on the WACC of REITs, adjusting for the leverage of the particular property you wish to value. This is very similar to your DCF method, which is why I would actually rank this method unfavourably as compared to direct capitalization. That being said, one advantage yield capitalization offers would be that is allows you to account for an expected change in rental income from a certain year onwards. This can happen when major asset enhancement initiatives are planned for the future.