Question

Which of the following statements properly describes how to apply the income capitalization approach to appraisal?

1.Apply a rate of return to the price paid for an income property.
2.Divide the income a property generates by a rate of return.
3.Estimate the amount of income a property must generate to return the capital amount invested in it.
4.Estimate the rate of return a property owner receives from income generated by the property.

Answer 1

The income capitalization approach is applied by dividing the expected annual net income of a property by the capitalization rate to determine its value. It accounts for potential capital gains and nonfinancial returns from real estate investments.

Step-by-step explanation:

The correct statement that describes how to apply the income capitalization approach to appraisal is: 'Divide the income a property generates by a rate of return'. This approach is used to determine a property's value based on the income it is expected to generate in the future. To apply this method, an appraiser estimates the annual net income the property is likely to produce and then divides this amount by the capitalization rate (cap rate) - an expected rate of return. The formula is thus Value = Net Operating Income / Capitalization Rate. For example, if a property generates $100,000 in net operating income annually and the cap rate is 8%, the value of the property would be calculated as $100,000/0.08, which equals $1,250,000.

Housing and other tangible assets not only provide the potential for capital gains but can also offer nonfinancial returns, such as the opportunity to inhabit the property. This aspect can come into play when determining a property's expected net income and resultant valuation. Investors seek a rate of return that reflects the opportunity cost of capital and accommodates for any associated risks. If an investment appears risky, an investor might require a higher rate of return as a risk premium.