How does the income approach to real estate valuation work, and what determines cap rates?

The income approach is the most common method for valuing income-producing commercial real estate. It converts a property's income stream into a value estimate.

Step 1: Calculate Net Operating Income (NOI)

NOI represents the property's income after all operating expenses but before financing costs and taxes.

Operating expenses include: property taxes, insurance, maintenance, property management fees, utilities (if landlord-paid), reserves for replacement.

Operating expenses exclude: mortgage payments (debt service), depreciation, income taxes, capital expenditures.

Step 2: Apply the Cap Rate

Value = NOI / Cap Rate

If the market cap rate for similar office properties is 6.5%:

Value = $662,400 / 0.065 = $10,190,769

What Determines Cap Rates?

The cap rate is essentially the required yield investors demand for holding a property. It's influenced by:

Key Insight: Lower cap rates mean higher valuations. A Class A office building in Manhattan might trade at a 4% cap rate ($662,400 / 0.04 = $16.6M), while the identical NOI in a secondary market might warrant a 7.5% cap rate ($662,400 / 0.075 = $8.8M).

Cap Rate vs. Discount Rate:

• Cap rate applies to a single year's NOI (a simplified, static measure)
• Discount rate is used in DCF analysis to discount projected future cash flows
• Relationship: Cap rate approx = Discount rate - NOI growth rate
• If the discount rate is 9% and NOI growth is 2.5%: Cap rate approx = 6.5%

Exam tip: CFA Level I problems typically give you PGI, vacancy rate, operating expenses, and a cap rate, then ask for property value. Be careful not to subtract debt service from NOI — that's the most common mistake. Also remember: lower cap rate = higher value = lower risk.

Explore more real estate valuation techniques in our CFA Level I alternatives section on AcadiFi.