CFA Level I Exam · Real Estate and Infrastructure

Real Estate Valuation Approaches for CFA Level I

Updated 7 October 2026 · Fact-checked

Real estate is valued three ways: the income approach (value from expected net operating income, using direct capitalization or discounted cash flow), the sales comparison approach (adjusted prices of similar sold properties) and the cost approach (land plus replacement cost less depreciation). Direct capitalization is Value = NOI ÷ cap rate.

Understand Real Estate Valuation Approaches

Property is not traded on a screen, so its price must be estimated. Appraisers use three approaches and often compare the results. Each answers a different question.

The income approach asks what the property earns. It fits income-producing assets such as offices, retail and apartments. There are two methods. Direct capitalization divides one year of net operating income (NOI) by a capitalization rate (cap rate). Discounted cash flow (DCF) forecasts NOI over a holding period, adds a terminal value from the expected sale, and discounts everything at a required return.

NOI is rental income plus other income, less vacancy and collection losses, less operating expenses. Operating expenses exclude depreciation, interest and income taxes. The cap rate is roughly the required return minus the long-run growth rate of NOI. A lower cap rate means a higher value.

The sales comparison approach uses recent sale prices of similar properties and adjusts them for differences such as size, location, age, condition and sale date. Units of comparison, such as price per square metre, are common. It works best in active markets with many comparable sales.

The cost approach estimates what it would cost to build the property today, subtracts depreciation (physical, functional and external obsolescence), then adds land value. It suits new or special-purpose buildings where income and comparable sales are scarce. It often misses market demand, so it can differ from market value.

Key formulas to remember

Net operating income: NOI = Potential gross income − vacancy and collection loss + other income − operating expenses; Exclude depreciation, interest and income taxes.
Direct capitalization value: Value = NOI₁ ÷ Cap rate; Use next year's (forward) NOI unless the question states otherwise.
Cap rate: Cap rate = NOI ÷ Value; Approximately equals discount rate minus NOI growth rate (for a constant-growth perpetuity).
Terminal value (DCF): Terminal value = NOI in year after sale ÷ terminal cap rate; Discount it back with the other cash flows. Deduct selling costs if given.
DCF value: Value = Σ CFt ÷ (1 + r)^t + Terminal value ÷ (1 + r)^N; Use the required return r, not the cap rate, as the discount rate.
Cost approach: Value = Replacement cost new − depreciation and obsolescence + land value; Depreciation here covers physical, functional and external obsolescence.

How to solve Real Estate Valuation Approaches questions

Use this order for any real estate valuation question.

1Identify the approach asked for: income (direct capitalization or DCF), sales comparison or cost.
2For income questions, build NOI first: gross income, less vacancy, plus other income, less operating expenses only.
3Remove non-operating items such as depreciation, interest and taxes. They are not in NOI.
4For direct capitalization, divide the correct year's NOI by the cap rate. For DCF, discount each NOI and the terminal value at the required return.
5For sales comparison, adjust the comparable's price, not the subject. Add value when the comparable is inferior and subtract when it is superior.
6For cost, add replacement cost less depreciation, then add land.
7Check the answer: a higher cap rate or discount rate must give a lower value.

Quickest way: Cap-rate shortcut and elimination

When to use it: Use for direct capitalization questions and for choosing between the three options when time is short.

Compute NOI once, ignoring depreciation and interest.
Divide by the cap rate and compare with the three options, which are listed smallest to largest.
If a result is wildly different, you likely included an expense you should not have or used the wrong year's NOI.
For conceptual items, remember: income approach suits income properties, sales comparison suits active markets, cost suits new or unique buildings.
Eliminate any option where a higher cap rate raises value.

Common mistakes in Real Estate Valuation Approaches

Deducting depreciation or interest when computing NOI
Candidates treat NOI like accounting profit.
Fix: NOI uses only operating expenses. Leave out depreciation, financing costs and income taxes.
Using the wrong year's NOI
The question lists current and forecast figures and candidates grab the first.
Fix: Use the forward (next year) NOI for Value = NOI₁ ÷ cap rate unless told otherwise.
Confusing the cap rate with the discount rate
Both are percentages applied to income.
Fix: The cap rate is about discount rate minus growth. Use the discount rate in DCF and the cap rate to capitalize.
Adjusting the subject property in sales comparison
The direction of adjustment feels natural from the subject's view.
Fix: Adjust each comparable toward the subject: add if the comparable is inferior, subtract if superior.
Forgetting land in the cost approach
Depreciation applies only to the building, so land is overlooked.
Fix: Always add land value after subtracting depreciation from replacement cost.
Applying the terminal cap rate to the sale-year NOI
The sale happens at the end of that year.
Fix: Divide the NOI of the year after the sale by the terminal cap rate, unless the question states a different NOI.

Worked examples

Example 1

An office building has potential gross income of $1,000,000, a vacancy and collection loss of 5% of potential gross income, and other income of $20,000. Operating expenses are $300,000. Depreciation is $150,000. Forward NOI is expected to equal this year's NOI, and the market cap rate is 8%. What is the value using direct capitalization? A. $7,375,000 B. $8,375,000 C. $9,375,000

Show the solution

Vacancy loss = 5% × $1,000,000 = $50,000.
Effective income = 1,000,000 − 50,000 + 20,000 = $970,000.
NOI = 970,000 − 300,000 = $670,000. Depreciation is excluded.
Value = 670,000 ÷ 0.08 = $8,375,000.

Answer: Value = $8,375,000 (option B).

Example 2

A subject property is a 2,000 m² warehouse. A comparable sold for $3,000,000 and is 2,000 m² but is in a better location, worth $150,000 more than the subject's location, and has a newer roof, worth $50,000 more than the subject's roof. What is the indicated value of the subject? A. $2,800,000 B. $3,000,000 C. $3,200,000

Show the solution

The comparable is superior in two ways, so adjust its price downward.
Total adjustment = −150,000 − 50,000 = −$200,000.
Adjusted value = 3,000,000 − 200,000 = $2,800,000.

Answer: A. $2,800,000

Exam tips

Questions are three-option MCQs, so quickly compute NOI and test it against the options; the wrong options often come from including depreciation or using the wrong NOI year.
Know the direction rule: a higher cap rate means a lower value.
For approach-choice items, match the approach to the property: income for leased assets, comparison for active markets, cost for new or special-use buildings.
Remember that the cost approach can differ from market value because it ignores demand and income.
In DCF items, discount the terminal value with the same required return as the cash flows.

Practice questions from Real Estate and Infrastructure

Real Estate Valuation Approaches in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Real Estate Valuation Approaches: frequently asked questions

What is the difference between the income approach and the sales comparison approach?

The income approach values a property from the income it is expected to generate, either by capitalizing NOI or by discounting cash flows. The sales comparison approach values it from adjusted prices of similar properties that recently sold. Income suits leased properties, while comparison needs an active market with comparable sales.

How do I calculate NOI and the cap rate?

NOI is effective gross income (after vacancy, plus other income) less operating expenses. Exclude depreciation, interest and taxes. The cap rate is NOI divided by property value.

Direct capitalization vs discounted cash flow: which is better?

Direct capitalization is simple and uses a single year of NOI, so it suits stable income. DCF allows changing cash flows over a holding period and a terminal value, so it handles uneven income better but needs more forecasts.

When is the cost approach used?

It is used for new construction, special-purpose properties and when few comparables or income data exist. You estimate replacement cost, subtract depreciation and obsolescence, and add land.