How do you estimate the value of future income?

1 The income approach

The income approach is a method that values a property based on its current and potential income. The income approach assumes that the value of a property is equal to the present value of its future income streams. To use the income approach, you need to estimate the net operating income (NOI) of the property, which is the income after deducting all operating expenses, such as taxes, insurance, maintenance, and vacancy. Then, you need to apply a capitalization rate (cap rate) to the NOI, which is the rate of return that you expect to earn from the property. The cap rate can be derived from comparable properties in the market or from your own investment criteria. The formula for the income approach is:

Value = NOI / Cap Rate

For example, if a property has an NOI of $50,000 and a cap rate of 8%, the value of the property is:

Value = $50,000 / 0.08 = $625,000

2 The discounted cash flow analysis

The discounted cash flow analysis is a method that values a property based on its projected cash flows over a specific time horizon, usually 5 to 10 years. The discounted cash flow analysis considers both the income and the expenses of the property, as well as the terminal value, which is the estimated value of the property at the end of the time horizon. To use the discounted cash flow analysis , you need to forecast the cash flows of the property, which include the NOI, the capital expenditures, the debt service, and the sale proceeds. Then, you need to discount the cash flows to their present value, using a discount rate that reflects your required rate of return. The discount rate can be calculated from the weighted average cost of capital (WACC) or from your own investment criteria. The formula for the discounted cash flow analysis is:

Value = Sum of (Cash Flow / (1 + Discount Rate)^n) for n = 1 to N

Where N is the number of years in the time horizon.

For example, if a property has the following cash flows and a discount rate of 10%, the value of the property is:

Year | Cash Flow

1 | $40,000

2 | $42,000

3 | $44,000

4 | $46,000

5 | $650,000 (includes sale proceeds)

Value = ($40,000 / 1.1) + ($42,000 / 1.1^2) + ($44,000 / 1.1^3) + ($46,000 / 1.1^4) + ($650,000 / 1.1^5) = $548,317

3 The advantages and disadvantages of each method

Both the income approach and the discounted cash flow analysis have their advantages and disadvantages when estimating the value of future income. The income approach is simpler and easier to use, as it only requires the NOI and the cap rate of the property. However, the income approach does not account for the changes in income and expenses over time, the risk and uncertainty of the cash flows, or the exit strategy of the investment. The discounted cash flow analysis is more comprehensive and realistic, as it incorporates the growth, variability, and timing of the cash flows, as well as the terminal value of the property. However, the discounted cash flow analysis is more complex and data-intensive, as it requires the forecasting of the cash flows, the estimation of the discount rate, and the calculation of the present value.

5 How to improve your estimation skills

Estimating the value of future income is not an exact science, but a skill that can be improved with practice and experience. To enhance your estimation skills, it is important to research the market and the property, gathering as much information as possible about market conditions, property characteristics, income and expense history, and comparable sales and rentals. Additionally, you should utilize multiple sources and methods to cross-check and validate your results, and account for different scenarios and assumptions. Furthermore, you should not assume that your estimates are fixed and final; updating and revising them as new information or goals become available is essential.