Value from income
The income approach applies anticipation: an investor buys for the future benefits the property will produce, so its value is the value of its income stream. The core formula is:
V = I ÷ R — value equals net operating income divided by the capitalization rate
Building net operating income
Start with potential gross income, subtract vacancy and collection loss to get effective gross income, then subtract operating expenses to reach net operating income (NOI).
Operating expenses are the ordinary costs of running the real estate: property taxes, insurance premiums on the building, management fees, maintenance.
Three things are never operating expenses: debt service (the mortgage payment), depreciation, and income taxes. The mortgage payment is the trap: it reflects how the owner financed the property, not how the property operates.
A worked capitalization
A building produces $125,000 of gross income with operating expenses running 32%, and the market cap rate is 14%.
Expenses: $125,000 × 32% = $40,000 NOI: $125,000 − $40,000 = $85,000 Value: $85,000 ÷ 0.14 = $607,143
Capitalizing the gross $125,000 gives $892,857, and capitalizing the $40,000 of expenses gives $285,714. Only NOI goes into V = I ÷ R.
Deriving the rate from a comparable
Cap rates come out of the market. Rearranged, R = I ÷ V. If a comparable with $50,000 NOI sold for $625,000:
R = $50,000 ÷ $625,000 = 0.08, or 8%
Apply it to a subject with $60,000 NOI: $60,000 ÷ 0.08 = $750,000. Multiplying NOI by the rate instead of dividing gives $480,000, and adding the $10,000 NOI difference to the comparable's price without capitalizing it gives $525,000.
Gross rent multipliers
For small residential rentals, a gross rent multiplier substitutes for full capitalization. GRM = sale price ÷ monthly gross rent. If a comparable sold for $240,000 with $2,000 monthly rent, GRM = 120. For a subject renting at $2,200:
$2,200 × 120 = $264,000
Keep the periods consistent. Feeding an annual rent into a monthly multiplier is the standard trap.