4.4.4.1. Applications.While federal courts recognize the income capitalization may be a valid and reliable approach to value in certain cases, they uniformly hold that it should be used only “when there are no comparable sales and market value must be estimated.”594 Accordingly, the fact that a property produces (or could potentially produce) income will not, on its own, justify use of the income capitalization approach. Rather, its relevance to what a willing buyer would pay to a willing seller must be demonstrated.595 

The income capitalization approach may refer to either direct capitalization or yield capitalization techniques: 

• Direct capitalization techniques are used to derive an indication of the market value of a stabilized income-producing property by applying an overall capitalization rate to a property’s single-year net income.596 

• Yield capitalization techniques are used to derive an indication of the market value of an income-producing property with varying forecasted income or expenses, typically using discounted cash-flow (DCF) analysis. Forecasts of net income, expenses, cash flow and other factors over a holding or projection period are required.597 

Due to the relatively recent development of these techniques in the appraisal of real estate, some specific iterations have faced little or no scrutiny in federal courts.598 But existing case law makes clear that regardless of the technique used, there must be sufficient market data to ensure a reliable indication of value for the specific property being appraised.599 

Use of the income capitalization approach is improper when the future use or demand for that use is speculative.600 As stated in an opinion affirmed by the Second Circuit:

The mere physical adaptability to a given use is insufficient to invoke the capitalization method, and the landowner must show that “an income producing market existed at the date of the taking or will exist in the reasonably near future.”601 

Of course, the highest and best use of a property may increase the value of vacant land because a buyer may pay more for property that is capable of being developed into a profitable operation.602 But “if there is no currently operating business, it would be ‘improper to value the property as if it were actually being used for the more valuable purpose.’”603 

Direct capitalization techniques cannot be used to value property that is not generating income as of the date of value: 

[D]irect capitalization of net income is an appropriate method of valuation only when the landowner can establish actual income, application of the capitalization approach is thus necessarily limited to those situations where eminent domain proceedings impinge an established, on-going business’ opportunity for continued as opposed to prospective profit. There can be no capitalization of income unless the fact of income is itself first established. Any other rule would permit a valuation, speculative ab initio, to be seriously compounded.604 

Yield capitalization techniques may be appropriate to value property with a highest and best use of development into a profitable operation that is not yet generating income on the date of value.605 But such property “may not be valued on the basis of conjectural future demand for [the proposed use]. There must be some objective support for the future demand, including volume and duration.”606 Accordingly, the Sixth Circuit rejected a valuation based on costs fixed on the date of value because it did not reflect the fact that the property interest being valued—the right to remove sand—“extended over a period of years: the value of the deposit might be affected by prospects of future increase or decrease in the cost of similar sand.”607 

Well-documented market support is critical because “[t]his method is highly susceptible to overvaluation, because of the tendency to overestimate the [annual income] and the tendency to employ a capitalization rate that is too low to reflect the hazards of the industry.”608 Market support for yield capitalization techniques should include investigation and analysis of potentially relevant sales. Even if there are insufficient sales to support a reliable sales comparison approach, 

“that does not put out of hand the bearing which the scattered sales may have on what an ordinary purchaser would have paid for the claimant’s property.”609 This holds true for all types of properties, including mineral properties: “There may be cases where quite distant properties can be shown to be comparable in an economic or market sense, due allowance being made for variables” such as (for a mineral property) “quantity, quality, mining costs and access to market . …”610 And sales prices may support a “bonus value” due to a property’s potential for development611—or “demonstrate[ ] that there [i]s no such enhanced value in the market.”612