Income Approach and Investment Valuation
This domain tests income capitalization and investment valuation: converting expected benefits into value and matching the yield or discount rate to the risk. You must distinguish market value from a client's investment value.
Core rules
- Start with net operating income (NOI): market rent, less vacancy and collection loss, less operating expenses, less non-recoverable costs. Exclude financing and income tax.
- Direct capitalization: value = NOI / cap rate. The cap rate must come from comparable sales with similar risk, lease profile, and growth.
- Discounted cash flow: forecast NOI, add terminal value, discount at a market-derived rate. Keep nominal with nominal and real with real.
- Lease events drive risk: expiry, reviews, breaks, incentives, and capex. A short lease may raise the cap rate.
- Investment value reflects a specific investor's assumptions; market value reflects the market.
Worked example
A warehouse has market rent of 110,000, vacancy at 5%, and operating expenses of 25,000. NOI = (110,000 x 0.95) - 25,000 = 79,500. Comparable sales indicate an 8% cap rate. Indicated market value = 79,500 / 0.08 = 993,750. If the passing rent were below market, capitalizing it directly would understate value; the market rent and lease profile must be modelled.
Traps
- Capitalizing gross rent or ignoring vacancy and expenses.
- Using the client's borrowing rate as a cap rate.
- Taking a cap rate from a different asset class.
- Mixing real cash flows with nominal discount rates.
- Double-counting growth in both cash flow and terminal value.