An appraiser has three approaches and they are not alternatives to be picked between. Each answers a different question and a proper valuation reconciles all three.
What are the three valuation approaches?
- The income approach. What would a buyer pay for this income stream? Direct capitalisation for a stabilised asset, a discounted cash flow for one with a leasing story.
- The sales comparison approach. What have similar buildings actually traded for, adjusted for the differences? The cap rate comes out of this approach rather than out of a spreadsheet, and cap rates are observations extracted from closed transactions rather than opinions.
- The cost approach. What would it cost to buy the land and build this again, less depreciation? Dominant for special-purpose property and for new construction, weakest for an older building in a market where nobody is building.
Net operating income is the input everything else runs on, and it is built the same way every time. Potential gross income, less vacancy and collection loss, plus other income, gives effective gross income. Deduct operating expenses and a replacement reserve and you have net operating income. It excludes debt service, income tax, depreciation and capital expenditure above the reserve, because it describes the building rather than the buyer.
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How do direct capitalisation and the multiplier work?
Direct capitalisation is one division: Value = NOI / cap rate. The whole difficulty sits in the cap rate, which must be extracted from comparable sales rather than assumed, as cap = NOI_comp / price_comp for each comparable and then adjusted for the differences that remain. A cap rate carries a growth assumption inside it, because cap rate = discount rate - long-run growth, which is why a low cap rate is a growth forecast rather than a bargain.
The gross income multiplier is the crude cousin: Value = effective gross income x multiplier, where the multiplier comes from comparable sales as price / EGI. It is fast and it ignores operating expenses entirely, which means it is only valid when the subject and the comparables run similar expense ratios.
The relationship is exact and worth memorising: multiplier x cap rate = 1 minus the operating expense ratio. Verify it on any comparable and the arithmetic tells you immediately whether the multiplier is transferable. On the comparables in Worked Example 2 the multiplier indication comes in 4.2% below the direct-capitalisation value, and the entire gap is explained by comparables running a 40.73% expense ratio against the subject's 38.08%.