How can you simplify income approach for commercial real estate?

1 Step 1: Estimate the potential gross income

The potential gross income (PGI) is the total amount of income that a property can generate if it is fully occupied and rented at market rates. To estimate the PGI, you need to research the rental rates and occupancy rates of similar properties in the same market area. You can use online databases, broker reports, or local publications to find comparable data. Alternatively, you can hire a professional appraiser to do the research for you. Once you have the average rental rate and occupancy rate, you can multiply them by the total rentable area of your property to get the PGI.

2 Step 2: Deduct the vacancy and credit losses

The vacancy and credit losses (VCL) are the amount of income that is lost due to vacancies, tenant turnover, non-payment, or concessions. To calculate the VCL, you need to estimate the vacancy rate and the credit loss rate of your property. The vacancy rate is the percentage of rentable space that is unoccupied or not leased. The credit loss rate is the percentage of rent that is not collected or forgiven. You can use historical data, market trends, or industry standards to estimate these rates. Once you have the rates, you can multiply them by the PGI and add them together to get the VCL. Then, you can subtract the VCL from the PGI to get the effective gross income (EGI).

3 Step 3: Subtract the operating expenses

The operating expenses (OE) are the costs of maintaining and operating the property, such as utilities, maintenance, repairs, management fees, insurance, taxes, and reserves. To calculate the OE, you need to identify and quantify all the expenses that are relevant to your property. You can use your own records, seller's statements, or industry benchmarks to estimate these expenses. Once you have the total amount of OE, you can subtract it from the EGI to get the net operating income (NOI).

4 Step 4: Apply the capitalization rate

The capitalization rate (cap rate) is the ratio of NOI to property value. It reflects the return on investment that a buyer would expect from a property. To apply the cap rate, you need to find out the market cap rate for similar properties in the same area. You can use online sources, appraisal reports, or broker opinions to find comparable cap rates. Alternatively, you can use the band of investment method, which combines the mortgage constant and the equity dividend rate to derive the cap rate. Once you have the cap rate, you can divide the NOI by the cap rate to get the property value.

By following these four steps, you can simplify the income approach for commercial real estate and get a reliable estimate of your property's value. However, keep in mind that the income approach is not the only method for valuing commercial real estate, and you may need to consider other factors, such as market conditions, physical characteristics, and highest and best use, to get a more accurate appraisal.

5 Here’s what else to consider

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