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The 'Income Method' is also termed the fundamental or intrinsic method
of
property valuation. In this method, the present worth of a property
is estimated on the grounds of projected future net income (in rent, for
example) and re-sale value. Using this technique, a buyer can estimate
whether a certain property would be a profitable investment.
The method uses the discounted cash flow (DCF) model to determine the
present value of an investment. One underlying assumption of this
approach is the principle of opportunity cost of capital, i.e. that
money is of more value to its holder today than in the future.
Although complex, this method is essential to any
property valuation, especially for buy-to-let investments. It is
frequently employed by financial and investment professionals when
valuing assets.
Procedure
First, the prospective income and re-sale value have to be estimated.
This valuation is based on the principle of highest and best use and on
comparable data.
Example: Mr. X want to buy a three-bedroom
condominium and let it out.
Historical data show that Mr. X can expect a 50% increase in
market
value within 10 years. Market analysis tells Mr. X that the average rent
of comparable properties in a similar location is RM12,000 per annum.
In order to calculate the present value of a property, prospective
future income has to be discounted to reflect the cost of equity
capital. This is part of the discounted cash flow (DCF). The opportunity
cost of capital can be interpreted as the income that would otherwise
have been generated had the capital been invested in an asset of similar
risk instead (eg. an 8% interest rate in a high-yield ISA account).
The difficult part in calculating the DCF is how to estimate the risk
involved. In property dealings, these estimates are usually based upon
historical data on house price volatility. This volatility is broadly in
line with the general market volatility and our 8% example as the cost
of equity capital can be safely justified.
The way to calculate present value (PV) is to divide the future value of
a house by (discount rate + 1) no. of years.
Example: A three-bedroom
condominium costs RM220,000. Mr. X expect to be
able to sell it for RM330,000 in 10 years. Mr. X set his discount rate
at 8%.
The calculation looks like this:
Sale PV = RM330,000 / (1 + 0.08)¹º = RM152,853.85
A property also generates income, however. This has to be incorporated
into the calculation. A buy-to-let property produces a constant cash
flow in the form of rent, whereas if Mr. X buy a house to live in
himself, Mr. X increase his income by saving on rent.
Example: The three-bedroom
condominium generating RM12,000 per year in
rent costs RM2000 in expenses. Meaning that Mr. X have an annual income
of RM10,000. Mr. X set his discount rate at 8%. The calculation
for the net present value of the first year's income is:
PV = RM10,000 / (1 + 0.08) 1.
PV = RM9259.25
It results that the present value of Mr. X new income in year 1 is
RM9259.25.
The valuation that this method generates is highly sensitive to the
following variable assumptions:
Rental Net Income: RM10,000
Re-Sale Value after 10 years: RM330,000
Discount Rate: 8%
Advantages
- It focuses directly on the value of the property to the individual
concerned.
- Income analyses are very detailed and derive specific conclusions (in
contrast to the more general approach practiced in the
Comparison Method.
Disadvantages
- This method is more complex and less intuitive than the
Comparison Method.
This is one of the reasons why it is often overlooked.
- This method ignores the actual market prices for property by
neglecting the
Comparison Method analysis and fragile market economy.
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