Which of the following represents the six steps in the income approach to value in the correct order?

• A. Calculate the net operating income; Estimate potential annual gross income; Estimate total annual operating expenses; Calculate the effective gross income; Select the appropriate capitalization rate; Capitalize the net income into value
• B. Estimate potential annual gross income; Calculate the net operating income; Estimate total annual operating expenses; Calculate the effective gross income; Capitalize the net income into value; Select the appropriate capitalization rate
• C. Calculate the effective gross income; Estimate potential annual gross income; Estimate total annual operating expenses; Calculate the net operating income; Capitalize the net income into value; Select the appropriate capitalization rate
• D. Estimate potential annual gross income; Calculate the effective gross income; Estimate total annual operating expenses; Calculate the net operating income; Select the appropriate capitalization rate; Capitalize the net income into value

Answer: (D)

The income approach values a property by forecasting cash flow and then converting that cash flow into value. Start with potential annual gross income from rents and other sources, because that sets the upper bound of what the property could earn. Next, subtract vacancy and credits to obtain the effective gross income, adjusting for the reality that units aren’t always fully rented. Then deduct total operating expenses to arrive at net operating income, which represents the property’s actual available income after necessary costs but before debt service and taxes. With NOI known, select the appropriate capitalization rate that reflects current risk and market conditions, and finally capitalize the NOI by dividing it by the cap rate to estimate the property’s value.