How to value a building

Three valuation approaches exist for real estate, and a competent appraiser uses all three to triangulate. The income approach values the building by what it earns. The sales-comparison approach values it by what similar buildings have sold for. The cost approach values it by what it would cost to rebuild today. For stabilised, income-producing commercial property the income approach dominates; for residential the comparable sales approach dominates; for unusual buildings (a hospital, a power plant) the cost approach is sometimes the only credible option.

The income approach — Net Operating Income

The income approach values a building from its operating cash flow, the same way DCF values a company from its free cash flow. The number you start with is Net Operating Income — NOI — and the bridge to it is where careful underwriting lives.

  Gross Potential Income (GPI)            (rent if 100% occupied at market)
  − Vacancy and Credit Loss               (typically 5–15% of GPI)
  + Other Income                          (parking, signage, service charges retained)
  ───────────────────────────────────────
  Effective Gross Income (EGI)
  − Operating Expenses                    (property tax, insurance, utilities,
                                           management fees, repairs, leasing costs)
  ───────────────────────────────────────
  Net Operating Income (NOI)

Variable glossary — every line item explained

• Gross Potential Income (GPI) — the rent the building would collect if every leasable square foot were leased to a paying tenant at the current market rent. A theoretical maximum; almost never achieved in practice. Expressed in currency per period (typically annual). Reading order: floor-by-floor leasable area × current market rent psf, summed.
• Vacancy and Credit Loss — the deduction for space that is empty plus the deduction for tenants who don't pay. Stabilised properties in healthy markets run 5–8%; properties in distressed markets or with concentrated lease expiries can run 15–30%. Expressed as a percentage of GPI. Do not use the long-run market average if your specific building's vacancy is materially different.
• Other Income — any income the property generates that isn't base rent. Parking fees, billboard / signage leases, service charges that the landlord retains rather than passes through, ATM lease income, antenna leases, vending. Modest in absolute terms (5–10% of GPI for most properties) but persistent.
• Effective Gross Income (EGI) — GPI minus vacancy and credit loss plus other income. The realistic top-line cash collection.
• Operating Expenses — everything it costs to keep the building running and generating rent: property tax, building insurance, utilities (for the common areas and any landlord-paid spaces), management fees (typically 3–5% of EGI), routine repairs and maintenance, leasing commissions (amortised), reserves for replacement (HVAC, roof). Critical exclusions: capital expenditure for major upgrades, debt service, depreciation, income tax. Operating expenses are what it costs to run the building this year, not the cost of capital improvements or financing.
• Net Operating Income (NOI) — EGI minus Operating Expenses. The operating profit of the building. The equivalent of EBITDA for a property: pre-financing, pre-tax, pre-capex.

Direct capitalisation — the workhorse formula

  Property Value  =  NOI  ÷  Cap Rate

  where the cap rate is the market-required yield on this property's risk profile,
  observed from recent comparable transactions or estimated from peer pricing.

• Property Value — the present value of the building from the income approach. Expressed in currency.
• NOI — Net Operating Income for the next 12 months (forward NOI) is the convention; trailing NOI is used for buildings with stable rent rolls and clean comparables.
• Cap Rate (Capitalisation Rate) — the yield the market currently demands to own a building of this type, in this location, with this tenant profile, at this lease expiry exposure. Expressed as a decimal or percentage. Cap rates for prime Nairobi office land in 2024 ran 9–11%; for prime Kileleshwa apartments 7–9%; for industrial Mombasa Road 10–13%. Higher cap rate = lower price = market views this property as riskier or less in demand.

Worked example: a Westlands mid-tier office

Subject: 6-storey office, Westlands, Nairobi
  Net leasable area:       4,000 sqm
  Current market rent:     KES 1,300 /sqm/month  →  KES 15,600 /sqm/year

  Gross Potential Income:  4,000 × 15,600   =  62.4m
  Less: vacancy & credit loss 12%             ( 7.5m)
  Plus: parking + signage income                2.1m
  ───────────────────────────────────────
  Effective Gross Income                       57.0m
  Less: operating expenses (38% of EGI)       (21.7m)
  ───────────────────────────────────────
  Net Operating Income                  KES   35.3m

With a market cap rate of 10.5% for mid-tier Westlands office:

  Property Value  =  35.3m  ÷  0.105   ≈  KES 336m

The cap rate as a window into the market

The cap rate is not arbitrary. It is the algebraic expression of three market views combined: how much investors discount future cash flows (the discount rate r), how fast NOI is expected to grow long-term (g), and a small adjustment for any expected change in the cap rate at exit. The Gordon-growth identity, applied to property, says approximately:

  Cap Rate  ≈  Discount Rate  −  Long-term NOI Growth
  c        ≈  r              −  g

When prime Nairobi office cap rates moved from 9% in 2014 to 11% in 2024, the market was saying one of two things had changed: investors required a higher discount rate (e.g. higher interest rates, higher country-risk premium), or they expected slower NOI growth (e.g. the office oversupply story we'll meet in module 11). Usually both. The cap rate is therefore a useful summary statistic for what the market is currently thinking about a sector, and tracking cap-rate movement is how analysts spot regime shifts.

Direct cap vs DCF — when to use which

Direct capitalisation works when NOI is stable and the cap rate is observable from recent comparable trades. For a stabilised, fully-leased building in a deep market, direct cap is the right tool — it's a simple, defensible market-relative valuation. DCF (the building-level equivalent of the corporate DCF in the DCF course) is the right tool when NOI is not stable: a lease-up scenario, a redevelopment, a major tenant rolling, a market in transition. The DCF lets you forecast NOI year by year, capture the lumpy events (a new lease, a major capex year, a stabilised year), and apply a terminal cap rate to the stabilised cash flow at the end of the explicit forecast.