Income Approach

The income approach is the appraisal method that values a property by the income it produces. Its direct capitalization form divides net operating income by a market cap rate. It is the method that gives real-estate NOI its standard definition, including a replacement reserve as an operating expense.

An appraiser using the income approach rebuilds the income statement from scratch: market rent, a vacancy allowance, then every expense the property carries. On the default house, that produces $28,500 of effective gross income, $10,230 of expenses and $18,270 of NOI. Capitalized at 6.5%, the property is worth $281,077. The Wikipedia article covers the reserve convention and the yield capitalization variant that projects NOI over several years.

The method is only as good as the NOI behind it. A pro forma that leaves out management and reserves lifts NOI by about $3,700 on this house and value by $57,000 at the same cap rate. Appraisers add those lines back, which is why an appraised value often lands below a seller's asking price on a small rental.

Further reading: Income Approach on Wikipedia.