The income approach to valuing rental property is a simple calculation that helps property owners determine how valuable property might be now or may become in the future. The approach deals specifically with a figure known as the capitalization rate.
The capitalization rate is calculated by multiplying expected monthly rental income by 12 months and then dividing by the original purchase investment. For example, if someone purchased a duplex for $200,000 and they rented each unit of the duplex for $1,000 per month, the capitalization rate would be 12 percent. We arrive at that figure by multiplying the rent times two (for the two units) and then again by 12 for the total number of months. That figure is $24,000; when divided by the original investment of $200,000, the rate is 12 percent.
Note that the income approach assumes units will be rented at full rent for all months of the year, which is not always the case. It also assumes a straight purchase price, which doesn't include interest rates for any mortgage assumed on a property.
The income approach is only one way to value a rental property. Other common approaches include the capital asset pricing model, the cost approach and the bottom line. How you choose to value rental properties will likely depend on your circumstances, your experience as a property owner and the state of the property. Properties that are ready to rent might be valued on a different model than those that require a lot of work, for example.
Valuation is only one part of the property investment puzzle. Many financial and legal considerations go into each decision made as a property owner or landlord, which is why seeking experienced legal assistance with purchasing decisions and contracts is a good idea.
Source: Investopedia, "4 Ways To Value A Real Estate Rental Property," Stephan Abraham, accessed Oct. 09, 2015