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An Income Approach to Real Estate Investing

by gbaf mag
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The income approach is just one of three main categories of approach, known as valuation approaches, applied by financial appraisers. It is especially popular in commercial real estate valuation and in financial valuation. The basic mathematical model is quite similar to that used for other financial models, such as risk-free bond pricing, or stock-price prediction. This approach tends to be better at predicting market price changes.

The main benefit of the income approach is that it is conservative in nature. It assumes that whatever the market value of the underlying property generates, the value of the realized gain should always be lower than the initial cost. Therefore, it treats the appreciation as a replacement income. However, it does not consider the capitalization rate or rental income assumption, which can be significant in certain types of real estate investments. Other valuation methods are more conservative in nature, relying on current market data to estimate the value of the property.

The second major advantage of the income approach is that it tends to minimize over-valuation or under-valuation of any given property. When valuing a home, for example, the appraiser typically not only takes into consideration the local market price, but also the income it could generate over time. By comparing this with the cost of living index, it is likely that the value will be too high. The cost of living index, in turn, is often considered to be a fair measure of fair market value since it is a fairly accurate measure of current prices and trends. Because the investor would rather pay less for a property and receive higher returns over time, this approach prevents over-valuation, thereby minimizing potential losses.

The third major advantage of the income approach relates to tax liability. In the past, it was common for an appraiser to include an assumption of depreciation when calculating a property’s potential rental income (or earnings) and net operating income (or gross profit) based on the cost of living index. Generally, if a property generates a lower return than its purchase price, its depreciation would be included in the equation. The IRS has since changed this practice, however, and now requires an additional ingredient to calculate the tax liability for such properties.

Currently, the IRS has defined a cap rate equal to the historical average of the cost of living throughout the previous year. Appraisers must add the cap rate to the gross sale price in order to determine the resulting net income for the investor. This means that when using the income approach for purchasing a rental property, an investor must add the cap rate to all costs associated with the property in order to determine its rental value. If the property is undervalued, the result will typically undervalue the property.

One of the most common problems that occur when using the income approach for purchasing real estate involves the possibility of purchasing a property for which the appraisal has a high cap rate. When the cost of living index drops, an investor may find that he or she has undervalued the property, and may be required to pay more than the fair market value. By using a method that involves the use of the geographic area in which the property is located as well as the local property taxes, investors have a much higher degree of success when applying the income approach for buying real estate when using the cap rate method.

When an appraiser applies the income approach for purchasing real estate that is not located in a particular area, it is important to determine the appropriate use of geographic location in addition to local property taxes. Many real estate appraisers, when applying the income approach for purchasing such property, fail to take into consideration these local taxes because they rely on the cost of living index. When using this approach for these properties, it is important to determine the appropriate use of the geographic area in which the property generates the appropriate gross rental revenue. For properties that generate a significant portion of their gross rental revenue from sources outside the immediate geographical area in which the property is located, the investor may use a different method, such as the geographic area approach, in order to calculate the appropriate cap rate.

Regardless of which method is used in order to calculate the appropriate cap rate for a property, there are several important factors that must be considered. First, an investor must ensure that the property may generate enough gross rental revenue in order to cover its expenses, including the costs of maintaining its property and paying its maintenance fees. Second, the investor must ensure that he or she can locate tenants in the area in which the property may be built. The availability of qualified potential tenants is dependent upon the number of available units in the building as well as other criteria. Finally, an investor must ensure that he or she can locate financing for the project, as financing is necessary in order to raise the funds necessary for construction. Although there are many factors that must be considered in determining the appropriate tax and insurance requirements and the final costs of constructing the property, the primary purpose of the Income Approach is to ensure that the investor has enough capital to complete the project, while maintaining a comfortable operating margin.

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