Valuation, income approach (direct capitalization) is a real estate appraisal method that values a property by taking net operating income and dividing it by a predetermined capitalization rate. The income valuation method is not suitable for valuing owner-occupied residential properties, as it relies on income produced as a function of the property’s overall value. The income capitalization formula is as follows:
Market Value = Net Operating Income (NOI) / Capitalization Rate
After calculating a property’s net operating income, a capitalization rate is determined by using market sales of comparable properties in the area. For example, say an investor finds that Class A apartments in the submarket are trading at a 5.8% cap rate. After determining the appropriate rate, one can divide NOI by the cap rate to determine a value. If the NOI of the Class A apartment was $2.8 million, the property would be valued at approximately $48.275 million ($2.8 million divided by 5.8%).