Theory of economics

Income Approach

The income approach is one of three major groups of methodologies, called valuation approaches, used by appraisers. It is particularly common in commercial real estate appraisal and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or business valuation.

While there are quite a few acceptable methods under the rubric of the income approach, most of these methods fall into three categories: direct capitalization, discounted cash flow, and gross income multiplier. This is simply the quotient of dividing the annual net operating income (NOI) by the appropriate capitalization rate (CAP rate). For income-producing real estate, the NOI is the net income of the real estate (but not the business interest) plus any interest expense and non-cash items (e.g. -- depreciation) minus a reserve for replacement.

The CAP rate may be determined in one of several ways, including market extraction, band-of-investments, or a built-up method. When appraising complex property, or property which has a risk-adjustment due to unusual factors (e.g. contamination), a risk-adjusted cap rate is appropriate. An implicit assumption in direct capitalization is that the cash flow is a perpetuity and the cap rate is a constant. If either cash flows or risk levels are expected to change, then direct capitalization fails and a discounted cash flow method must be used.In UK practice, Net Income is capitalize by use of market-derived yields. If the property is rack-rented then the All Risks Yield will be used.

However, if the passing rent differs from the Estimated Rental Value (ERV), then either the Term & Reversion, Layer or Equivalent Yield methods will be employed. In essence, these entail discounting the different income streams - that of the current or passing rent and that of the reversion to the full rental value - at different adjusted yields.However, capitalization rate inherently includes the investment-specific risk premium. Each investor may have a different view of risk and, therefore, arrive at a different capitalization rate for a given investment.

The relationship becomes clear when the capitalization rate is derived from the discount rate using the build-up cost of capital model. The two are identical whenever the earnings growth rate equals 0.The Discounted cash flow model is analogous to net present value estimation in finance. However, appraisers often mistakenly use a market-derived cap rate and NOI as substitutes for the discount rate and/or the annual cash flow. The Cap rate equals the discount rate plus-or-minus a factor for anticipated growth.

The NOI may be used if market value is the goal, but if investment value is the goal, then some other measure of cash flow is appropriate.The GRM is simply the ratio of the monthly (or annual) rent divided into the selling price. If several similar properties have sold in the market recently, then the GRM can be computed for those and applied to the anticipated monthly rent for the subject property. GRM is useful for rental houses, duplexes, and simple commercial properties when used as a supplement to other more well developed methods.

The income approach equates the total output of a nation to the total factor income received by residents or citizens of the nation. Main types of factor income are:

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  Employee compensation (cost of fringe benefits, including unemployment, health, and retirement benefits);
  
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  Interest received net of interest paid;
  
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  Rental income (mainly for the use of real estate) net of expenses of landlords;
  
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  Royalties paid for the use of intellectual property and extractable natural resources.
  

All remaining value added generated by firms is called the residual or profit or business cash flow.

Formula: GDI (gross domestic income, which should equate to gross domestic product) = Compensation of employees + Net interest + Rental & royalty income + Business cash flow. The income approach adds up the factor incomes to the factors of production in the society. It can be expressed as:

GDP = National Income (NY) + Indirect Business Taxes (IBT) + Capital Consumption Allowance and Depreciation (CCA) + Net Factor Payments to the rest of the world (NFP). GDP = compensation of employees + gross operating surplus + gross mixed income + taxes less subsidies on production and imports. Alternatively, this can be expressed as:

GDP = COE + GOS + GMI + T_{P & M} – S_{P & M⁶}

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  Compensation of employees (COE) measures the total remuneration to employees for work done.
  
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  Gross operating surplus (GOS) is the surplus due to owners of incorporated businesses.
  
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  Gross mixed income (GMI) is the same measure as GOS, but for unincorporated businesses.This often involves small businesses.
  
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  T_{P & M} is taxes on production and imports.
  
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  S_P&M is subsidies on production and imports.
  

The sum of COE, GOS, and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices. The difference between basic prices and final prices (those used in the expenditure calculation) is the total taxes and subsidies that the government has levied or paid on that production. So, adding taxes less subsidies on production and imports converts GDP at factor cost (as noted, a net domestic product) to GDP.

By definition, the income approach to calculating GDP should be equivalent to the expenditure approach (Y = C + I+ G + (X – M)). In practice, however, measurement errors will make the two figures slightly off when reported by national statistical agencies.

While both the expenditures approach and the income approach are used to calculate GDP, there are key differences between the two:

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  The expenditure method assumes GDP to be equal to the total amount of money spent on goods and services within a nation’s borders.
  
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  The income method calculates GDP in terms of the amount of money earned within those borders. This includes wages, rent, interest, and profits.
  

Within the income method, it is assumed that all economic expenditures should equal the income generated by the production of goods and services. It further expects that there are four major factors of production in an economy, with revenues going to one of these four factors.

The primary difference between the two approaches, then, and the easiest way to understand their distinction, is their starting points:

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  The expenditure approach starts with money spent on goods and services; the income approach begins with income earned from the production of goods and services.
  
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  Yet the expenditure approach remains the more common and practical method for calculating nominal GDP (and ultimately real GDP), while the income approach is generally considered to be more accurate. Economists often use both methods to produce one final estimate of GDP.
  

The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and noincorporated firms, and taxes less any subsidies.