What valuation method uses the income generated by a property to determine its value?

The capitalization rate approach is a valuation method that focuses on the income generated by a property to determine its value. This method is particularly relevant for investment properties, such as rental units or commercial buildings, where the income stream is a critical factor in assessment.

To utilize this approach, an appraiser typically calculates the property's Net Operating Income (NOI), which is the income generated from the property minus the operating expenses. Once the NOI is determined, the capitalization rate (cap rate), which is a percentage derived from comparable properties in the market, is applied. The cap rate reflects the expected rate of return on investment and considers factors such as risk and property type.

The formula used is:

Property Value = Net Operating Income / Capitalization Rate

This calculation provides a direct assessment of what an investor might be willing to pay for the property based on its income-generating potential, making the capitalization rate approach a vital tool in real estate valuation. By focusing on income rather than physical characteristics or comparable sales, this method emphasizes the earning power of a property, which is key in investment decision-making.