Determining the property value using the income approach

When real estate professionals want to determine the value of investment properties, such as apartment buildings, rented apartments, or commercial properties, they often use the income approach. The market value of a property is measured by the income a buyer can expect to generate from renting it out in the future. This method allows investors to assess whether a purchase is worthwhile.

In addition to the asset-based valuation method and the market-based valuation method, the income-based valuation method is one of the three methods of real estate valuation. Sections 17-20 of this regulation are based on a rather complex formula for calculating the income value, which includes the following factors:

• The land value: The value of the undeveloped plot of land.
• The capitalization rate: Essentially corresponds to the market-standard rent level in relation to the purchase price of comparable properties.
• Rental income & operating costs: The so-called annual net income is calculated from the annual rental income minus operating costs.
• Remaining useful life: The condition of the property is the primary factor in this calculation. It also indicates how many more years the current returns (rental income) can likely be achieved without major renovations.
• Deductions/additions: These take into account value-influencing features of the property, for example, structural defects or existing obstacles to renting.

The calculation proceeds as follows: first, the land value, i.e., the value of the property, is considered separately from the value of the buildings. This is justified by the fact that a building loses value over time due to wear and tear, while the land itself does not.

The key factors for the formula, besides the annual net income, are the capitalization rate and the remaining useful life. A capitalization factor (also called a "multiplier" or "present value factor") is derived from the latter. It's immediately obvious that a long remaining useful life, generally resulting from a property in good condition, leads to a higher multiplier and thus a higher property value. Initially, the way the capitalization rate is incorporated into the formula seems rather illogical. A higher capitalization rate—that is, a higher return relative to the purchase price—leads to a lower multiplier. For a property generating above-average returns, this results in a lower market value, because the risk that such a high percentage return cannot be sustained over a longer period, leading to rental losses or other setbacks, is considered particularly high.

A deeper understanding of this method, however, will likely remain the domain of financial professionals. It should be noted that when determining a property's value using the income approach, not only the amount of income and the expected duration of that income are taken into account, but also the risk associated with acquiring the property.

Would you like to know the value of your property or whether the income approach is suitable for your property? Contact us! We would be happy to advise you.

You can find more information here:

https://de.wikipedia.org/wiki/Ertragswertverfahren

https://ivd.net/2015/03/sinn-und-unsinn-von-immobilienbewertungen/

https://de.wikipedia.org/wiki/Immobilie

Legal notice: This article does not constitute tax or legal advice for any specific case. Please consult a lawyer and/or tax advisor to clarify the facts of your individual situation.

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